When an industrial mortgage lender sets out to enforce a mortgage loan following a borrower default, an essential objective is to determine the most expeditious manner in which the loan provider can acquire control and ownership of the underlying collateral. Under the right set of circumstances, a deed in lieu of foreclosure can be a faster and more cost-effective option to the long and drawn-out foreclosure process. This post goes over steps and problems lenders should consider when deciding to continue with a deed in lieu of foreclosure and how to prevent unforeseen risks and obstacles during and following the deed-in-lieu process.
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Consideration
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A crucial element of any contract is ensuring there is sufficient consideration. In a standard transaction, consideration can quickly be developed through the purchase rate, however in a deed-in-lieu situation, verifying appropriate factor to consider is not as simple.

In a deed-in-lieu scenario, the quantity of the underlying financial obligation that is being forgiven by the lender usually is the basis for the consideration, and in order for such factor to consider to be considered "adequate," the debt should a minimum of equal or exceed the fair market worth of the subject residential or commercial property. It is crucial that lenders acquire an independent third-party appraisal to corroborate the worth of the residential or commercial property in relation to the amount of debt being forgiven. In addition, its advised the deed-in-lieu agreement consist of the debtor's reveal acknowledgement of the reasonable market price of the residential or commercial property in relation to the quantity of the debt and a waiver of any possible claims connected to the adequacy of the factor to consider.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English common law that a debtor who protects a loan with a mortgage on real estate holds an unqualified right to redeem that residential or commercial property from the lending institution by repaying the financial obligation up till the point when the right of redemption is lawfully snuffed out through a correct foreclosure. Preserving the borrower's fair right of redemption is the reason, prior to default, mortgage loans can not be structured to ponder the voluntary transfer of the residential or commercial property to the lender.

Deed-in-lieu deals preclude a borrower's equitable right of redemption, nevertheless, steps can be required to structure them to restrict or prevent the danger of a blocking obstacle. Primarily, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure need to occur post-default and can not be pondered by the underlying loan documents. Parties ought to also be cautious of a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which ponder that the debtor keeps rights to the residential or commercial property, either as a residential or commercial property manager, a renter or through repurchase options, as any of these arrangements can produce a threat of the transaction being recharacterized as a fair mortgage.

Steps can be required to mitigate versus recharacterization risks. Some examples: if a customer's residential or commercial property management functions are restricted to ministerial functions instead of substantive decision making, if a lease-back is brief term and the payments are clearly structured as market-rate use and occupancy payments, or if any provision for reacquisition of the residential or commercial property by the customer is set up to be totally independent of the condition for the deed in lieu.

While not determinative, it is advised that deed-in-lieu contracts include the parties' clear and unequivocal acknowledgement that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for only.

Merger of Title

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

The general rule on this concern supplies that, where a mortgagee acquires 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 cost happens in the absence of evidence of a contrary intention. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is necessary the contract clearly shows the celebrations' intent to keep the mortgage lien estate as unique from the cost so the lender keeps the capability to foreclose the underlying mortgage if there are stepping in liens. If the estates merge, then the lending institution's mortgage lien is snuffed out and the lending institution loses the ability to handle stepping in liens by foreclosure, which might leave the loan provider in a potentially worse position than if the lending institution pursued a foreclosure from the start.

In order to clearly reflect the celebrations' intent on this point, the deed-in-lieu contract (and the deed itself) should include express anti-merger language. Moreover, since there can be no mortgage without a financial obligation, it is popular in a deed-in-lieu scenario for the loan provider to provide a covenant not to sue, 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, secures the borrower against direct exposure from the debt and also keeps the lien of the mortgage, therefore enabling the loan provider to keep the ability to foreclose, should it end up being preferable 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 transactions can be a significant sticking point. While the majority of states make the payment of transfer tax a seller responsibility, as a practical matter, the lending institution ends up absorbing the expense since the borrower remains in a default circumstance and usually does not have funds.

How transfer tax is determined on a deed-in-lieu deal depends on the jurisdiction and can be a driving force in identifying if a deed in lieu is a viable option. In California, for example, a conveyance or transfer from the mortgagor to the mortgagee as an outcome 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 straightforward exemptions for deed-in-lieu transactions. In Connecticut, however, while there is an exemption for deed-in-lieu deals it is limited only to a transfer of the borrower's personal house.

For a commercial transaction, the tax will be calculated based upon the complete purchase price, which is expressly specified as including the quantity of liability which is presumed or to which the real estate is subject. Similarly, but even more potentially severe, New York bases the quantity of the transfer tax on "consideration," which is specified as the unsettled balance of the financial obligation, plus the overall quantity of any other enduring liens and any amounts paid by the beneficiary (although if the loan is fully recourse, the consideration is capped at the reasonable market price of the residential or commercial property plus other amounts paid). Keeping in mind the loan provider will, in many jurisdictions, have to pay this tax again when ultimately offering the residential or commercial property, the specific jurisdiction's guidelines on transfer tax can be a determinative element in choosing whether a deed-in-lieu deal is a practical option.

Bankruptcy Issues

A significant issue for lenders when identifying if a deed in lieu is a practical alternative is the concern that if the customer becomes a debtor in an insolvency case after the deed in lieu is complete, the insolvency court can trigger the transfer to be unwound or set aside. Because a deed-in-lieu transaction 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 dealing with preferential transfers. Accordingly, if the transfer was made when the debtor was insolvent (or the transfer rendered the customer insolvent) and within the 90-day period set forth in the Bankruptcy Code, the borrower becomes a debtor in a personal bankruptcy case, then the deed in lieu is at risk of being reserved.

Similarly, under Section 548 of the Bankruptcy Code, a transfer can be reserved 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, became insolvent due to the fact that of the transfer, was participated in a company that maintained an unreasonably low level of capital or intended to incur financial obligations beyond its ability to pay. In order to alleviate versus these risks, a lender needs to thoroughly examine and examine the borrower's financial condition and liabilities and, preferably, require audited financial declarations to confirm the solvency status of the debtor. Moreover, the deed-in-lieu agreement must include representations regarding solvency and a covenant from the borrower not to file for bankruptcy throughout the preference period.

This is yet another reason it is imperative for a lender to acquire an appraisal to validate the value of the residential or commercial property in relation to the debt. An existing appraisal will assist the lending institution refute any accusations that the transfer was made for less than fairly equivalent worth.

Title Insurance

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

Since lots of lending institutions choose to have title vested in a separate affiliate entity, in order to make sure ongoing coverage under the lender's policy, the named lending institution ought to assign the mortgage to the designated affiliate title holder prior to, or concurrently with, the transfer of the cost. In the option, the lending institution can take title and then communicate the residential or commercial property by deed for no consideration to either its moms and dad company or a wholly owned subsidiary (although in some jurisdictions this could trigger transfer tax liability).

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

Due to the truth deed-in-lieu deals are more prone to challenge and dangers as detailed above, any title insurer providing an owner's policy is most likely to undertake a more rigorous review of the transaction throughout the underwriting process than they would in a common third-party purchase and sale deal. The title insurance company will scrutinize the parties and the deed-in-lieu documents in order to identify and alleviate dangers provided by concerns such as merger, clogging, recharacterization and insolvency, thus potentially increasing the time and costs involved in closing the transaction, but eventually supplying the loan provider with a greater level of protection than the lending institution would have absent the title business's participation.

Ultimately, whether a deed-in-lieu transaction is a practical option for a loan provider is driven by the specific truths and situations of not only the loan and the residential or commercial property, however the parties included also. Under the right set of circumstances, and so long as the appropriate due diligence and paperwork is gotten, a deed in lieu can offer the loan provider with a more efficient and more economical means to realize 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 need help with such matters, please reach out to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach lawyer with whom you most regularly work.