When an industrial mortgage loan provider sets out to implement a mortgage loan following a borrower default, a key goal is to determine the most expeditious way in which the lending institution can acquire control and belongings of the underlying collateral. Under the right set of circumstances, a deed in lieu of foreclosure can be a faster and more affordable alternative to the long and lengthy foreclosure process. This article talks about steps and problems lending institutions need to consider when deciding to continue with a deed in lieu of foreclosure and how to avoid unexpected risks and obstacles throughout and following the deed-in-lieu process.

Consideration
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An essential component of any agreement is ensuring there is sufficient factor to consider. In a basic transaction, factor to consider can quickly be developed through the purchase cost, however in a deed-in-lieu scenario, validating appropriate consideration is not as uncomplicated.

In a deed-in-lieu situation, the quantity of the underlying debt that is being forgiven by the lender typically is the basis for the factor to consider, and in order for such factor to consider to be considered "appropriate," the debt must at least equivalent or surpass the reasonable market price of the subject residential or commercial property. It is important that lending institutions obtain an independent third-party appraisal to corroborate the value of the residential or commercial property in relation to the quantity of debt being forgiven. In addition, its advised the deed-in-lieu agreement consist of the borrower's reveal recognition of the fair market worth of the residential or commercial property in relation to the quantity of the financial obligation and a waiver of any potential claims connected to the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a principal rooted in ancient English typical law that a debtor who protects a loan with a mortgage on realty holds an unqualified right to redeem that residential or commercial property from the lender by repaying the debt up till the point when the right of redemption is legally snuffed out through an appropriate foreclosure. Preserving the debtor's equitable right of redemption is the reason, prior to default, mortgage loans can not be structured to contemplate 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, however, steps can be required to structure them to limit or avoid the risk of a clogging obstacle. Primarily, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure should occur post-default and can not be pondered by the underlying loan documents. Parties should also watch out for a deed-in-lieu plan where, following the transfer, there is a continuation of a debtor/creditor relationship, or which contemplate that the customer maintains rights to the residential or commercial property, either as a residential or commercial property manager, a tenant or through repurchase choices, as any of these plans can produce a danger of the transaction being recharacterized as a fair mortgage.

Steps can be required to reduce versus recharacterization dangers. Some examples: if a debtor's residential or commercial property management functions are restricted to ministerial functions instead of substantive decision making, if a lease-back is short term and the payments are clearly structured as market-rate use and occupancy payments, or if any arrangement for reacquisition of the residential or commercial property by the customer is established to be entirely independent of the condition for the deed in lieu.

While not determinative, it is advised that deed-in-lieu agreements include the celebrations' clear and indisputable acknowledgement that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security purposes just.

Merger of Title

When a lending institution makes a loan protected by a mortgage on realty, 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 lending institution then acquires the property from a defaulting mortgagor, it now likewise holds an interest in the residential or commercial property by virtue of being the charge owner and obtaining the mortgagor's equity of redemption.
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The basic rule on this problem 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 charge happens in the absence of proof of a contrary intent. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is important the agreement clearly shows the celebrations' intent to retain the estate as unique from the fee so the loan provider retains the ability to foreclose the underlying mortgage if there are stepping in liens. If the estates combine, then the lender's mortgage lien is extinguished and the lender loses the capability to handle intervening liens by foreclosure, which could leave the lender in a potentially even worse position than if the loan provider pursued a foreclosure from the outset.

In order to plainly show the parties' intent on this point, the deed-in-lieu contract (and the deed itself) need to consist of reveal anti-merger language. Moreover, because there can be no mortgage without a financial obligation, it is traditional in a deed-in-lieu scenario for the lender to provide a covenant not to sue, instead of a straight-forward release of the financial obligation. The covenant not to take legal action against furnishes factor to consider for the deed in lieu, safeguards the borrower versus direct exposure from the debt and also keeps the lien of the mortgage, therefore enabling the lending institution to preserve the capability to foreclose, ought to it end up being desirable to remove junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending on the jurisdiction, dealing with transfer tax and the payment thereof in deed-in-lieu deals can be a substantial sticking point. While many states make the payment of transfer tax a seller commitment, as a useful matter, the lender winds up absorbing the cost considering that the customer remains in a default circumstance and typically does not have funds.

How transfer tax is computed on a deed-in-lieu deal is dependent on the jurisdiction and can be a driving force in figuring out if a deed in lieu is a viable option. 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 quantity 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 deals it is restricted just to a transfer of the customer's personal home.

For a business transaction, the tax will be computed based upon the complete purchase price, which is specifically specified as consisting of the amount of liability which is assumed or to which the real estate is subject. Similarly, but a lot more potentially oppressive, New York bases the amount of the transfer tax on "factor to consider," which is defined as the overdue balance of the financial obligation, plus the overall quantity of any other surviving liens and any amounts paid by the grantee (although if the loan is totally option, the factor to consider is capped at the reasonable market price of the residential or commercial property plus other quantities paid). Remembering the loan provider will, in a lot of jurisdictions, need to pay this tax again when eventually offering the residential or commercial property, the specific jurisdiction's guidelines on transfer tax can be a determinative consider choosing whether a deed-in-lieu deal is a practical option.

Bankruptcy Issues

A significant concern for lenders when figuring out if a deed in lieu is a viable alternative is the issue that if the customer becomes a debtor in a personal bankruptcy case after the deed in lieu is complete, the insolvency court can trigger the transfer to be unwound or reserved. 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 debtor was insolvent (or the transfer rendered the customer 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 risk of being set aside.

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 made for "less than a reasonably comparable value" and if the transferor was insolvent at the time of the transfer, became insolvent since of the transfer, was participated in a service that preserved an unreasonably low level of capital or planned to incur financial obligations beyond its capability to pay. In order to alleviate against these dangers, a loan provider needs to carefully review and examine the debtor's monetary condition and liabilities and, ideally, need audited financial declarations to confirm the solvency status of the customer. Moreover, the deed-in-lieu contract ought to consist of representations regarding solvency and a covenant from the debtor not to declare personal bankruptcy during the choice period.

This is yet another reason that it is necessary for a lending institution to procure an appraisal to validate the worth of the residential or commercial property in relation to the debt. An existing appraisal will help the lender refute any claims that the transfer was produced less than reasonably equivalent worth.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, a lot of owners and their lending institutions will acquire policies of title insurance coverage to secure their particular interests. A lending institution considering taking title to a residential or commercial property by virtue of a deed in lieu might ask whether it can count on its lending institution's policy when it ends up being the fee 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 exact same entity that is the named guaranteed under the lending institution's policy.

Since many lenders prefer to have actually title vested in a different affiliate entity, in order to make sure ongoing protection under the lender's policy, the named lender needs to appoint the mortgage to the intended affiliate victor prior to, or at the same time with, the transfer of the charge. In the alternative, the loan provider can take title and after that communicate the residential or commercial property by deed for no consideration to either its moms and dad company or a completely owned subsidiary (although in some jurisdictions this might set off transfer tax liability).

Notwithstanding the continuation in protection, a loan provider's policy does not convert 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 a sufficient level of protection. Moreover, a lender's policy does not avail any security for matters which arise after the date of the mortgage loan, leaving the loan provider exposed to any issues or claims originating from events which take place after the initial closing.

Due to the truth deed-in-lieu deals are more vulnerable to challenge and risks as outlined above, any title insurance provider issuing an owner's policy is most likely to undertake a more rigorous review of the deal throughout the underwriting process than they would in a typical third-party purchase and sale transaction. The title insurer will inspect the parties and the deed-in-lieu files in order to determine and mitigate threats presented by concerns such as merger, obstructing, recharacterization and insolvency, thus potentially increasing the time and expenses involved in closing the deal, but eventually supplying the lending institution with a higher level of defense than the lender would have missing the title company's participation.

Ultimately, whether a deed-in-lieu deal is a viable choice for a lending institution is driven by the specific facts and circumstances of not just the loan and the residential or commercial property, however the celebrations included as well. Under the right set of circumstances, and so long as the proper due diligence and documentation is obtained, a deed in lieu can provide the lending institution with a more effective and less pricey methods to realize on its security when a loan enters into default.

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