When a business mortgage lender sets out to implement a mortgage loan following a debtor default, a key goal is to determine the most expeditious way in which the lender can obtain control and possession of the underlying security. Under the right set of situations, a deed in lieu of foreclosure can be a faster and more affordable option to the long and protracted foreclosure process. This post discusses actions and problems loan providers ought to think about when deciding to continue with a deed in lieu of foreclosure and how to avoid unexpected dangers and challenges throughout and following the deed-in-lieu procedure.
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Consideration
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A crucial aspect of any agreement is making sure there is adequate factor to consider. In a standard transaction, consideration can easily be developed through the purchase rate, but in a deed-in-lieu situation, confirming appropriate factor to consider is not as uncomplicated.

In a deed-in-lieu situation, the quantity of the underlying financial obligation that is being forgiven by the lending institution typically is the basis for the factor to consider, and in order for such consideration to be deemed "appropriate," the financial obligation should at least equivalent or go beyond the reasonable market price of the subject residential or commercial property. It is essential that lending institutions get an independent third-party appraisal to substantiate the worth of the residential or commercial property in relation to the quantity of financial obligation being forgiven. In addition, its advised the deed-in-lieu contract include the customer's reveal acknowledgement of the fair market price of the residential or commercial property in relation to the amount of the financial obligation and a waiver of any potential claims connected to the adequacy of the factor to consider.

Clogging and Recharacterization Issues

Clogging is shorthand for a principal rooted in ancient English typical law that a debtor who secures a loan with a mortgage on property holds an unqualified right to redeem that residential or commercial property from the lending institution by paying back the financial obligation up till the point when the right of redemption is legally snuffed out through a correct foreclosure. Preserving the customer's equitable right of redemption is the reason that, prior to default, mortgage loans can not be structured to ponder the voluntary transfer of the residential or commercial property to the lending institution.

Deed-in-lieu deals preclude a borrower's fair right of redemption, however, actions can be taken to structure them to restrict or avoid the risk of an obstructing obstacle. Most importantly, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure must happen post-default and can not be considered by the underlying loan files. Parties should likewise watch out for a deed-in-lieu plan where, following the transfer, there is a continuation of a debtor/creditor relationship, or which consider that the customer maintains rights to the residential or commercial property, either as a residential or commercial property manager, a tenant or through repurchase alternatives, as any of these arrangements can develop a risk of the transaction being recharacterized as a fair mortgage.

Steps can be taken to mitigate versus recharacterization dangers. Some examples: if a borrower's residential or commercial property management functions are limited to ministerial functions rather than substantive decision making, if a lease-back is short term and the payments are plainly structured as market-rate usage and occupancy payments, or if any provision for reacquisition of the residential or commercial property by the borrower is set up to be entirely independent of the condition for the deed in lieu.

While not determinative, it is suggested that deed-in-lieu agreements consist of the celebrations' clear and unquestionable acknowledgement that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security functions only.

Merger of Title

When a lender makes a loan protected by a mortgage on property, it holds an interest in the property by virtue of being the mortgagee under a mortgage (or a recipient under a deed of trust). If the lender then obtains the property from a defaulting mortgagor, it now likewise holds an interest in the residential or commercial property by virtue of being the fee owner and acquiring the mortgagor's equity of redemption.

The basic guideline on this concern provides that, where a mortgagee obtains the fee or equity of redemption in the mortgaged residential or commercial property, and there is no intermediate estate, merger of the mortgage interest into the charge takes place in the absence of evidence of a contrary intent. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is necessary the arrangement clearly shows the parties' intent to keep the mortgage lien estate as distinct from the fee so the lending institution maintains the capability to foreclose the hidden mortgage if there are stepping in liens. If the estates merge, then the loan provider's mortgage lien is extinguished and the loan provider loses the capability to deal with intervening liens by foreclosure, which could leave the loan provider in a possibly worse position than if the loan provider pursued a foreclosure from the beginning.

In order to clearly reflect the parties' intent on this point, the deed-in-lieu contract (and the deed itself) need to include reveal anti-merger language. Moreover, because there can be no mortgage without a financial obligation, it is popular in a deed-in-lieu situation for the lender to deliver a covenant not to take legal action against, instead of a straight-forward release of the debt. The covenant not to take legal action against furnishes factor to consider for the deed in lieu, safeguards the borrower versus exposure from the financial obligation and likewise maintains the lien of the mortgage, thereby allowing the lending institution to preserve the ability to foreclose, ought to it become desirable to get rid of junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending upon the jurisdiction, dealing with transfer tax and the payment thereof in deed-in-lieu deals can be a considerable sticking point. While the majority of states make the payment of transfer tax a seller obligation, as a practical matter, the lending institution ends up taking in the cost considering that the borrower is in a default situation and usually lacks funds.

How transfer tax is calculated on a deed-in-lieu transaction depends on the jurisdiction and can be a driving force in figuring out if a deed in lieu is a viable alternative. In California, for instance, a conveyance or transfer from the mortgagor to the mortgagee as a result of a foreclosure or a deed in lieu will be exempt up to the amount of the debt. Some other states, consisting of Washington and Illinois, have simple exemptions for deed-in-lieu deals. In Connecticut, however, while there is an exemption for deed-in-lieu transactions it is restricted only to a transfer of the customer's personal residence.

For a business deal, the tax will be calculated based on the complete purchase price, which is specifically defined as including the amount of liability which is assumed or to which the real estate is subject. Similarly, but much more potentially severe, New york city bases the amount of the transfer tax on "consideration," which is specified as the overdue balance of the financial obligation, plus the total quantity of any other enduring liens and any quantities paid by the beneficiary (although if the loan is totally recourse, the factor to consider is capped at the reasonable market price of the residential or commercial property plus other amounts paid). Remembering the loan provider will, in most jurisdictions, have to pay this tax once again when ultimately selling the residential or commercial property, the particular jurisdiction's guidelines on transfer tax can be a determinative factor in deciding whether a deed-in-lieu transaction is a practical alternative.

Bankruptcy Issues

A major concern for loan providers when identifying if a deed in lieu is a practical option is the issue that if the borrower ends up being a debtor in a bankruptcy case after the deed in lieu is total, the insolvency court can cause the transfer to be unwound or reserved. Because a deed-in-lieu deal is a transfer made on, or account of, an antecedent financial obligation, it falls squarely within subsection (b)( 2) of Section 547 of the Bankruptcy Code with preferential transfers. Accordingly, if the transfer was made when the borrower was insolvent (or the transfer rendered the borrower insolvent) and within the 90-day duration set forth in the Bankruptcy Code, the borrower ends up being a debtor in a personal bankruptcy case, then the deed in lieu is at threat of being reserved.

Similarly, under Section 548 of the Bankruptcy Code, a transfer can be set aside if it is made within one year prior to a bankruptcy filing and the transfer was produced "less than a reasonably comparable worth" and if the transferor was insolvent at the time of the transfer, ended up being insolvent because of the transfer, was engaged in a company that preserved an unreasonably low level of capital or intended to sustain financial obligations beyond its capability to pay. In order to reduce versus these threats, a loan provider should carefully evaluate and evaluate the customer's monetary condition and liabilities and, ideally, need audited financial declarations to validate the solvency status of the debtor. Moreover, the deed-in-lieu contract ought to include representations as to solvency and a covenant from the borrower not to declare bankruptcy during the preference duration.

This is yet another reason it is vital for a loan provider to acquire an appraisal to verify the value of the residential or commercial property in relation to the financial obligation. An existing appraisal will help the lending institution refute any accusations that the transfer was produced less than fairly comparable value.

Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, many owners and their loan providers will get policies of title insurance to protect their particular interests. A lender thinking about taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can count on its lender's policy when it becomes the cost owner. Coverage under a loan provider's policy of title insurance coverage can continue after the acquisition of title if title is taken by the same entity that is the named insured under the loan provider's policy.

Since numerous lenders choose to have title vested in a different affiliate entity, in order to make sure ongoing coverage under the lender's policy, the called lending institution needs to appoint the mortgage to the intended affiliate title holder prior to, or at the same time with, the transfer of the fee. In the alternative, the lending institution can take title and after that communicate the residential or commercial property by deed for no factor to consider to either its moms and dad company or a wholly owned subsidiary (although in some jurisdictions this might trigger transfer tax liability).

Notwithstanding the extension in protection, a lender's policy does not transform to an owner's policy. Once the lender ends up being an owner, the nature and scope of the claims that would be made under a policy are such that the lending institution's policy would not supply the same or an appropriate level of defense. Moreover, a lending institution's policy does not get any defense for matters which occur after the date of the mortgage loan, leaving the lending institution exposed to any problems or claims originating from events which happen after the initial closing.

Due to the fact deed-in-lieu deals are more susceptible to challenge and risks as detailed above, any title insurance provider issuing an owner's policy is most likely to carry out a more extensive evaluation of the deal during the underwriting procedure than they would in a typical third-party purchase and sale deal. The title insurance company will inspect the celebrations and the deed-in-lieu files in order to determine and mitigate risks presented by concerns such as merger, clogging, recharacterization and insolvency, therefore possibly increasing the time and expenses included in closing the transaction, however ultimately supplying the lender with a higher level of protection than the lending institution would have missing the title business's involvement.

Ultimately, whether a deed-in-lieu deal is a practical alternative for a lending institution is driven by the particular truths and circumstances of not only the loan and the residential or commercial property, however the celebrations involved too. Under the right set of scenarios, and so long as the appropriate due diligence and paperwork is gotten, a deed in lieu can provide the loan provider with a more effective and less costly ways to recognize on its security when a loan enters into default.

Harris Beach Murtha's Commercial Realty Practice Group is experienced with deed in lieu of foreclosures. If you require help with such matters, please reach out to lawyer Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most regularly work.