When a business mortgage lender sets out to implement a mortgage loan following a debtor default, an essential objective is to determine the most expeditious manner in which the lending institution can get control and belongings of the underlying collateral. Under the right set of situations, a deed in lieu of foreclosure can be a and more economical alternative to the long and lengthy foreclosure process. This post talks about steps and problems loan providers ought to consider when deciding to proceed with a deed in lieu of foreclosure and how to avoid unforeseen dangers and difficulties during and following the deed-in-lieu procedure.

Consideration

A crucial element of any agreement is ensuring there is adequate consideration. In a basic transaction, factor to consider can easily be established through the purchase price, but in a deed-in-lieu situation, validating adequate factor to consider is not as simple.

In a deed-in-lieu circumstance, the amount of the underlying debt that is being forgiven by the lending institution usually is the basis for the consideration, and in order for such consideration to be considered "sufficient," the debt needs to a minimum of equivalent or go beyond the fair market price of the subject residential or commercial property. It is necessary that lenders acquire an independent third-party appraisal to validate the value of the residential or commercial property in relation to the amount of debt being forgiven. In addition, its advised the deed-in-lieu contract include the customer's reveal recognition of the reasonable market price of the residential or commercial property in relation to the amount of the financial obligation and a waiver of any possible claims associated with 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 secures a loan with a mortgage on genuine estate holds an unqualified right to redeem that residential or commercial property from the loan provider by paying back the financial obligation up till the point when the right of redemption is legally extinguished through a proper foreclosure. Preserving the debtor's fair right of redemption is the reason why, 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 customer's fair right of redemption, nevertheless, 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 occur post-default and can not be considered by the underlying loan files. Parties must also watch out for a deed-in-lieu arrangement where, following the transfer, there is a continuation of a debtor/creditor relationship, or which contemplate that the debtor retains rights to the residential or commercial property, either as a residential or commercial property manager, a renter or through repurchase alternatives, as any of these plans can develop a danger of the transaction being recharacterized as an equitable mortgage.

Steps can be taken to alleviate against recharacterization risks. Some examples: if a borrower's residential or commercial property management functions are limited to ministerial functions rather than substantive choice making, if a lease-back is brief 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 set up to be totally 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 unequivocal acknowledgement that the transfer of the residential or commercial property is an absolute conveyance and not a transfer of for security purposes just.

Merger of Title
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When a lender makes a loan protected by a mortgage on genuine estate, it holds an interest in the genuine 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 realty from a defaulting mortgagor, it now likewise holds an interest in the residential or commercial property by virtue of being the fee owner and getting the mortgagor's equity of redemption.

The basic guideline on this issue offers 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 fee occurs in the absence of proof of a contrary objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is very important the agreement plainly reflects the parties' intent to keep the mortgage lien estate as distinct from the cost so the lending institution keeps the ability to foreclose the hidden mortgage if there are stepping in liens. If the estates merge, then the lender's mortgage lien is extinguished and the loan provider loses the ability to handle intervening liens by foreclosure, which could leave the loan provider in a potentially even worse position than if the lending institution pursued a foreclosure from the beginning.

In order to plainly reflect the celebrations' intent on this point, the deed-in-lieu contract (and the deed itself) should consist of reveal anti-merger language. Moreover, due to the fact that there can be no mortgage without a debt, it is customary in a deed-in-lieu situation for the lender 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, protects the customer against exposure from the debt and also retains the lien of the mortgage, therefore allowing the lender to maintain the capability to foreclose, ought to it become preferable 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 transactions can be a significant sticking point. While most states make the payment of transfer tax a seller commitment, as a practical matter, the lender winds up soaking up the expense given that the customer remains in a default scenario and generally 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 figuring out if a deed in lieu is a practical alternative. 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 up to the quantity of the financial obligation. Some other states, including Washington and Illinois, have simple exemptions for deed-in-lieu transactions. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu deals it is restricted only to a transfer of the debtor's individual home.

For an industrial transaction, the tax will be calculated based upon the full purchase rate, which is specifically specified as consisting of the amount of liability which is presumed or to which the real estate is subject. Similarly, but a lot more potentially heavy-handed, New York bases the quantity of the transfer tax on "consideration," which is defined as the unsettled balance of the financial obligation, plus the overall 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 quantities paid). Remembering the lender 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 choice.

Bankruptcy Issues

A major issue for lending institutions when determining if a deed in lieu is a feasible alternative is the issue that if the borrower becomes a debtor in a personal bankruptcy case after the deed in lieu is complete, the 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 handling 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 stated in the Bankruptcy Code, the debtor ends up being a debtor in a bankruptcy case, then the deed in lieu is at threat 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 a personal bankruptcy filing and the transfer was produced "less than a fairly comparable worth" and if the transferor was insolvent at the time of the transfer, ended up being insolvent because of the transfer, was taken part in a service that kept an unreasonably low level of capital or intended to sustain financial obligations beyond its capability to pay. In order to mitigate against these dangers, a loan provider should thoroughly evaluate and assess the borrower's monetary condition and liabilities and, preferably, need audited monetary declarations to confirm the solvency status of the customer. Moreover, the deed-in-lieu arrangement should include representations as to solvency and a covenant from the debtor not to apply for personal bankruptcy throughout the preference period.

This is yet another factor why it is essential for a loan provider to acquire an appraisal to validate the worth of the residential or commercial property in relation to the financial obligation. A current appraisal will help the lender refute any accusations that the transfer was produced less than reasonably comparable worth.

Title Insurance

As part of the preliminary acquisition of a genuine residential or commercial property, the majority of owners and their loan providers will acquire policies of title insurance coverage to protect their respective interests. A loan provider considering taking title to a residential or commercial property by virtue of a deed in lieu might ask whether it can rely on its lending institution's policy when it becomes the charge owner. Coverage under a lending institution's policy of title insurance 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 many lending institutions choose to have actually title vested in a different affiliate entity, in order to make sure ongoing coverage under the lending institution's policy, the called loan provider ought to appoint the mortgage to the designated affiliate victor prior to, or simultaneously with, the transfer of the charge. In the option, 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 a completely owned subsidiary (although in some jurisdictions this could trigger transfer tax liability).

Notwithstanding the continuation in coverage, a lending institution's policy does not transform to an owner's policy. Once the loan provider 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 adequate level of security. Moreover, a loan provider's policy does not obtain any protection for matters which occur after the date of the mortgage loan, leaving the lender exposed to any issues or claims stemming from occasions which occur after the original closing.

Due to the reality deed-in-lieu transactions are more susceptible to challenge and dangers as outlined above, any title insurer providing an owner's policy is likely to carry out a more rigorous review of the transaction during the underwriting procedure than they would in a common third-party purchase and sale transaction. The title insurer will scrutinize the parties and the deed-in-lieu files in order to recognize and mitigate risks presented by problems such as merger, blocking, recharacterization and insolvency, thereby possibly increasing the time and expenses included in closing the deal, but ultimately supplying the lending institution with a greater level of security than the lender would have absent the title company's involvement.

Ultimately, whether a deed-in-lieu transaction is a practical alternative for a lending institution is driven by the particular truths and situations of not only the loan and the residential or commercial property, but the parties included also. Under the right set of situations, therefore long as the correct due diligence and documents is acquired, a deed in lieu can supply the lending institution with a more effective and more economical methods to understand on its collateral 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 assistance with such matters, please reach out to lawyer Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach lawyer with whom you most frequently work.