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When an industrial mortgage lending institution sets out to impose a mortgage loan following a customer default, a crucial objective is to identify the most expeditious way in which the loan provider can get control and possession of the underlying collateral. Under the right set of circumstances, a deed in lieu of foreclosure can be a much faster and more cost-effective alternative to the long and lengthy foreclosure process. This post discusses steps and concerns lenders ought to think about when making the decision to proceed with a deed in lieu of foreclosure and how to avoid unanticipated threats and challenges throughout and following the deed-in-lieu procedure.

Consideration
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A crucial element of any contract is making sure there is sufficient consideration. In a basic deal, factor to consider can easily be established through the purchase rate, however in a deed-in-lieu scenario, confirming appropriate consideration is not as straightforward.

In a deed-in-lieu situation, the amount of the underlying debt that is being forgiven by the lending institution typically is the basis for the consideration, and in order for such factor to consider to be considered "adequate," the debt must a minimum of equal or go beyond the fair market value of the subject residential or commercial property. It is imperative that lending institutions get 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 suggested the deed-in-lieu agreement consist of the customer's reveal recognition of the fair market price of the residential or commercial property in relation to the quantity of the debt and a waiver of any potential 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 borrower who protects a loan with a mortgage on realty holds an unqualified right to redeem that residential or commercial property from the lender by paying back the financial obligation up until the point when the right of redemption is lawfully snuffed out through an appropriate foreclosure. Preserving the debtor's equitable right of redemption is the reason why, prior to default, mortgage loans can not be structured to consider the voluntary transfer of the residential or commercial property to the loan provider.

Deed-in-lieu transactions preclude a debtor's fair right of redemption, nevertheless, steps can be taken to structure them to restrict or avoid the danger of an obstructing difficulty. First and primary, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure should take location post-default and can not be pondered by the underlying loan files. Parties must also watch out for a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which ponder that the debtor retains 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 danger of the deal being recharacterized as a fair mortgage.

Steps can be taken to mitigate against recharacterization threats. Some examples: if a debtor'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 clearly structured as market-rate usage and tenancy payments, or if any arrangement for reacquisition of the residential or commercial property by the borrower is established to be completely independent of the condition for the deed in lieu.

While not determinative, it is recommended that deed-in-lieu contracts consist of the parties' clear and unquestionable recognition 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 loan provider makes a loan protected by a mortgage on property, it holds an interest in the real estate by virtue of being the mortgagee under a mortgage (or a recipient under a deed of trust). If the loan provider then obtains the genuine estate from a defaulting mortgagor, it now likewise 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 guideline on this concern provides that, where a mortgagee gets 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 happens in the absence of proof of a contrary objective. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is important the contract clearly reflects the parties' intent to maintain the mortgage lien estate as unique from the cost so the lending institution keeps the ability to foreclose the underlying mortgage if there are intervening liens. If the estates combine, then the lending institution's mortgage lien is snuffed out and the lender loses the capability to handle stepping in liens by foreclosure, which could leave the loan provider in a potentially 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) must include reveal anti-merger language. Moreover, since there can be no mortgage without a debt, it is customary in a deed-in-lieu situation for the lender to deliver a covenant not to take legal action against, rather than a straight-forward release of the financial obligation. The covenant not to take legal action against furnishes consideration for the deed in lieu, safeguards the borrower against exposure from the financial obligation and likewise keeps the lien of the mortgage, thereby enabling the lending institution to keep the capability to foreclose, must it end up being desirable to eliminate junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending on the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu transactions can be a considerable sticking point. While most states make the payment of transfer tax a seller responsibility, as a useful matter, the lender winds up absorbing the cost since the debtor remains in a default circumstance and usually does not have funds.

How transfer tax is determined on a deed-in-lieu transaction is reliant on the jurisdiction and can be a driving force in figuring out if a deed in lieu is a feasible option. In California, for instance, a conveyance or transfer from the mortgagor to the mortgagee as an outcome of a foreclosure or a deed in lieu will be exempt approximately the quantity of the financial obligation. Some other states, consisting of Washington and Illinois, have straightforward exemptions for deed-in-lieu transactions. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu transactions it is limited just to a transfer of the debtor's personal residence.

For a business transaction, the tax will be calculated based upon the complete purchase cost, which is specifically specified as including the quantity of liability which is assumed or to which the real estate is subject. Similarly, however even more possibly severe, New York bases the quantity of the transfer tax on "factor to consider," which is specified as the unsettled balance of the debt, plus the overall amount of any other surviving liens and any amounts paid by the beneficiary (although if the loan is completely recourse, the factor to consider is topped at the reasonable market worth of the residential or commercial property plus other quantities paid). Remembering the lender will, in a lot of jurisdictions, need 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 factor in deciding whether a deed-in-lieu deal is a feasible choice.

Bankruptcy Issues

A major concern for lenders when figuring out if a deed in lieu is a feasible alternative is the issue that if the customer ends up being a debtor in an insolvency case after the deed in lieu is total, the insolvency court can trigger 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 directly 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 customer insolvent) and within the 90-day period stated in the Bankruptcy Code, the borrower ends up being 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 set aside if it is made within one year prior to an insolvency filing and the transfer was produced "less than a reasonably comparable value" and if the transferor was insolvent at the time of the transfer, became insolvent due to the fact that of the transfer, was taken part in a business that preserved an unreasonably low level of capital or meant to incur financial obligations beyond its ability to pay. In order to reduce versus these dangers, a loan provider ought to carefully examine and evaluate the borrower's financial condition and liabilities and, ideally, need audited financial statements to validate the solvency status of the customer. Moreover, the deed-in-lieu agreement ought to include representations regarding solvency and a covenant from the debtor not to apply for bankruptcy throughout the choice duration.

This is yet another reason it is essential for a loan provider to procure an appraisal to verify the value of the residential or commercial property in relation to the debt. An existing appraisal will assist the lender refute any claims that the transfer was produced less than fairly comparable value.

Title Insurance

As part of the preliminary acquisition of a genuine residential or commercial property, many owners and their lending institutions will acquire policies of title insurance to protect their respective interests. A loan provider considering 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 fee owner. Coverage under a lender's policy of title insurance coverage can continue after the acquisition of title if title is taken by the very same entity that is the named insured under the loan provider's policy.

Since lots of lenders prefer to have title vested in a separate affiliate entity, in order to guarantee continued protection under the loan provider's policy, the called loan provider must designate the mortgage to the designated affiliate title holder prior to, or all at once with, the transfer of the fee. In the alternative, the loan provider can take title and then communicate the residential or commercial property by deed for no consideration to either its parent company or an entirely owned subsidiary (although in some jurisdictions this might set off transfer tax liability).

Notwithstanding the extension in coverage, a loan provider'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 loan provider's policy would not provide the same or an adequate level of security. Moreover, a lending institution's policy does not get any defense for matters which emerge after the date of the mortgage loan, leaving the lender exposed to any problems or claims coming from occasions which occur after the original closing.

Due to the deed-in-lieu deals are more susceptible to challenge and risks as laid out above, any title insurance company issuing an owner's policy is most likely to carry out a more strenuous evaluation of the deal throughout the underwriting process than they would in a normal third-party purchase and sale deal. The title insurance provider will scrutinize the parties and the deed-in-lieu documents in order to identify and mitigate dangers provided by concerns such as merger, blocking, recharacterization and insolvency, thus possibly increasing the time and costs involved in closing the transaction, but eventually supplying the lender with a greater level of security than the lending institution would have missing the title business's participation.

Ultimately, whether a deed-in-lieu deal is a practical option for a loan provider is driven by the specific truths and circumstances of not only the loan and the residential or commercial property, however the parties involved too. Under the right set of situations, therefore long as the correct due diligence and paperwork is acquired, a deed in lieu can supply the lending institution with a more efficient and less pricey means to realize on its security when a loan enters into default.

Harris Beach Murtha's Commercial Property Practice Group is experienced with deed in lieu of foreclosures. If you require 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.