When a commercial mortgage lending institution sets out to enforce a mortgage loan following a debtor default, an essential objective is to recognize the most expeditious manner in which the lending institution can get control and ownership of the underlying security. Under the right set of scenarios, a deed in lieu of foreclosure can be a much faster and more affordable option to the long and protracted foreclosure process. This short article goes over actions and problems lenders ought to think about when deciding to proceed with a deed in lieu of foreclosure and how to prevent unanticipated risks and challenges during and following the deed-in-lieu procedure.
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Consideration

A crucial element of any agreement is ensuring there is adequate consideration. In a basic transaction, factor to consider can quickly be established through the purchase cost, however in a deed-in-lieu circumstance, validating adequate factor to consider is not as straightforward.

In a deed-in-lieu scenario, the quantity of the underlying debt that is being forgiven by the loan provider usually is the basis for the factor to consider, and in order for such factor to consider to be deemed "adequate," the debt must at least equivalent or exceed the fair market value of the subject residential or commercial property. It is crucial that lending institutions acquire an independent third-party appraisal to corroborate the value of the residential or commercial property in relation to the amount of debt being forgiven. In addition, its recommended the deed-in-lieu agreement consist of the debtor's reveal recognition of the fair market price of the residential or commercial property in relation to the of the debt and a waiver of any prospective claims related to the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a principal rooted in ancient English typical law that a customer who secures a loan with a mortgage on real estate holds an unqualified right to redeem that residential or commercial property from the lender by paying back the debt up till the point when the right of redemption is lawfully snuffed out through a proper foreclosure. Preserving the customer's fair 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 loan provider.

Deed-in-lieu deals prevent a debtor's fair right of redemption, however, actions can be taken to structure them to limit or avoid the threat of an obstructing challenge. Firstly, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure should happen post-default and can not be contemplated by the underlying loan files. Parties should likewise be careful of a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which ponder that the customer keeps rights to the residential or commercial property, either as a residential or commercial property supervisor, a renter or through repurchase options, as any of these arrangements can develop a danger of the transaction being recharacterized as a fair mortgage.

Steps can be taken to alleviate against recharacterization dangers. Some examples: if a debtor's residential or commercial property management functions are limited to ministerial functions instead of substantive choice making, if a lease-back is short term and the payments are clearly structured as market-rate usage and occupancy payments, or if any provision for reacquisition of the residential or commercial property by the customer is established to be completely independent of the condition for the deed in lieu.

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

Merger of Title

When a loan provider makes a loan secured by a mortgage on real estate, it holds an interest in the realty by virtue of being the mortgagee under a mortgage (or a recipient under a deed of trust). If the lender then gets the realty from a defaulting mortgagor, it now also holds an interest in the residential or commercial property by virtue of being the charge owner and getting the mortgagor's equity of redemption.

The general rule on this concern supplies that, where a mortgagee obtains the cost 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 lack of proof of a contrary objective. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is important the contract plainly shows the celebrations' intent to maintain the mortgage lien estate as distinct from the charge so the loan provider keeps the ability to foreclose the underlying mortgage if there are stepping in liens. If the estates merge, then the lending institution's mortgage lien is extinguished and the lender loses the ability to deal with stepping in liens by foreclosure, which might leave the lending institution in a possibly even worse position than if the lender pursued a foreclosure from the outset.

In order to clearly reflect the parties' intent on this point, the deed-in-lieu agreement (and the deed itself) should consist of express anti-merger language. Moreover, since there can be no mortgage without a debt, it is traditional in a deed-in-lieu scenario for the lending institution to deliver a covenant not to sue, rather than a straight-forward release of the debt. The covenant not to take legal action against furnishes consideration for the deed in lieu, secures the borrower against direct exposure from the financial obligation and also maintains the lien of the mortgage, thereby permitting the lender to maintain the ability to foreclose, should it end up being desirable to get rid of junior encumbrances after the deed in lieu is complete.

Transfer Tax

Depending upon the jurisdiction, dealing with transfer tax and the payment thereof in deed-in-lieu deals can be a substantial sticking point. While a lot of states make the payment of transfer tax a seller responsibility, as a useful matter, the lender ends up taking in the expense since the debtor is in a default scenario and usually does not have funds.

How transfer tax is determined on a deed-in-lieu deal is reliant on the jurisdiction and can be a driving force in determining if a deed in lieu is a practical option. In California, for example, a conveyance or transfer from the mortgagor to the mortgagee as a result of a foreclosure or a deed in lieu will be exempt as much as the amount of the debt. Some other states, consisting of Washington and Illinois, have uncomplicated exemptions for deed-in-lieu deals. In Connecticut, however, while there is an exemption for deed-in-lieu transactions it is restricted just to a transfer of the debtor's individual house.

For an industrial deal, the tax will be computed based upon the complete purchase rate, which is specifically defined as consisting of the amount of liability which is presumed 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 defined as the unpaid balance of the debt, plus the total amount of any other enduring liens and any amounts paid by the grantee (although if the loan is completely option, the factor to consider is topped at the fair market price of the residential or commercial property plus other quantities paid). Bearing in mind the lending institution will, in most jurisdictions, need to pay this tax again when ultimately offering the residential or commercial property, the specific jurisdiction's rules on transfer tax can be a determinative element in choosing whether a deed-in-lieu deal is a feasible option.

Bankruptcy Issues

A significant issue for lenders when determining if a deed in lieu is a practical alternative is the issue that if the debtor ends up being a debtor in a bankruptcy case after the deed in lieu is complete, the personal bankruptcy court can cause the transfer to be unwound or set aside. Because a deed-in-lieu deal is a transfer made on, or account of, an antecedent debt, it falls squarely within subsection (b)( 2) of Section 547 of the Bankruptcy Code dealing with preferential transfers. Accordingly, if the transfer was made when the borrower was insolvent (or the transfer rendered the debtor insolvent) and within the 90-day period set forth in the Bankruptcy Code, the borrower ends up being a debtor in an insolvency case, then the deed in lieu is at danger 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 an insolvency filing and the transfer was produced "less than a reasonably equivalent value" and if the transferor was insolvent at the time of the transfer, became insolvent due to the fact that of the transfer, was engaged in a service that kept an unreasonably low level of capital or intended to sustain financial obligations beyond its ability to pay. In order to mitigate against these risks, a lending institution should thoroughly review and evaluate the borrower's financial condition and liabilities and, preferably, require audited financial declarations to validate the solvency status of the debtor. Moreover, the deed-in-lieu agreement should consist of representations as to solvency and a covenant from the customer not to submit for personal bankruptcy during the choice duration.

This is yet another reason that it is crucial for a loan provider to acquire an appraisal to verify the value of the residential or commercial property in relation to the debt. An existing appraisal will assist the loan provider refute any accusations that the transfer was made for less than reasonably comparable worth.

Title Insurance

As part of the preliminary acquisition of a genuine residential or commercial property, many owners and their lenders will acquire policies of title insurance to secure their respective interests. A loan provider thinking about taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can rely on its lending institution's policy when it ends up being the charge owner. Coverage under a lending institution's policy of title insurance coverage can continue after the acquisition of title if title is taken by the same entity that is the called guaranteed under the lender's policy.

Since lots of lenders prefer to have title vested in a separate affiliate entity, in order to guarantee continued coverage under the lender's policy, the named lending institution needs to appoint the mortgage to the desired affiliate title holder prior to, or simultaneously with, the transfer of the cost. In the alternative, the lender can take title and then 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 activate transfer tax liability).

Notwithstanding the continuation in protection, a lending institution's policy does not transform to an owner's policy. Once the lending institution ends up being an owner, the nature and scope of the claims that would be made under a policy are such that the loan provider's policy would not supply the same or an adequate level of protection. Moreover, a lending institution's policy does not get any defense for matters which emerge after the date of the mortgage loan, leaving the lending institution exposed to any concerns or claims stemming from occasions which occur after the initial closing.

Due to the truth deed-in-lieu deals are more susceptible to challenge and dangers as laid out above, any title insurance provider releasing an owner's policy is most likely to carry out a more strenuous review of the transaction during the underwriting procedure than they would in a common third-party purchase and sale deal. The title insurer will inspect the parties and the deed-in-lieu documents in order to identify and mitigate dangers provided by concerns such as merger, clogging, recharacterization and insolvency, thereby potentially increasing the time and costs included in closing the transaction, but eventually offering the lender with a greater level of security than the loan provider would have missing the title business's participation.

Ultimately, whether a deed-in-lieu deal is a practical choice for a lending institution is driven by the particular truths and circumstances of not just the loan and the residential or commercial property, but the celebrations included too. Under the right set of situations, and so long as the proper due diligence and documents is acquired, a deed in lieu can supply the lender with a more efficient and more economical means to recognize on its collateral when a loan enters into default.

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