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When an industrial mortgage lending institution sets out to enforce a mortgage loan following a debtor default, an essential goal is to identify the most expeditious way in which the lending institution can acquire control and ownership of the underlying collateral. Under the right set of scenarios, a deed in lieu of foreclosure can be a faster and more cost-effective option to the long and protracted foreclosure process. This article goes over steps and problems loan providers must consider when deciding to proceed with a deed in lieu of foreclosure and how to avoid unforeseen dangers and challenges during and following the deed-in-lieu process.

Consideration

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

In a deed-in-lieu situation, the amount of the underlying financial obligation that is being forgiven by the loan provider typically is the basis for the consideration, and in order for such factor to consider to be deemed "adequate," the debt must a minimum of equivalent or exceed the fair market price of the subject residential or commercial property. It is vital that lending institutions obtain an independent third-party appraisal to substantiate the worth of the residential or commercial property in relation to the quantity of debt being forgiven. In addition, its advised the deed-in-lieu contract include the debtor's express acknowledgement of the reasonable market worth of the residential or commercial property in relation to the quantity of the financial obligation 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 debtor who secures a loan with a mortgage on property holds an unqualified right to redeem that residential or commercial property from the lending institution by repaying the financial obligation up until the point when the right of redemption is lawfully extinguished through an appropriate foreclosure. Preserving the borrower'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 lender.

Deed-in-lieu transactions prevent a debtor's equitable right of redemption, however, actions can be taken to structure them to restrict or avoid the threat of a clogging difficulty. First and foremost, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure must occur post-default and can not be considered by the underlying loan files. Parties need to also be careful of a deed-in-lieu plan where, following the transfer, there is a continuation 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 manager, a tenant 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 required to reduce against recharacterization dangers. Some examples: if a debtor's residential or commercial property management functions are restricted to ministerial functions instead of substantive choice making, if a lease-back is short 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 borrower is set up to be entirely independent of the condition for the deed in lieu.

While not determinative, it is suggested that deed-in-lieu arrangements include the parties' clear and indisputable recognition 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 gets the property 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 guideline on this problem supplies that, where a mortgagee gets the charge 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 takes place in the lack of evidence of a contrary objective. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is crucial the agreement clearly reflects the celebrations' intent to keep the mortgage lien estate as unique from the charge so the lending institution maintains the ability to foreclose the hidden mortgage if there are intervening liens. If the estates combine, then the lending institution's mortgage lien is snuffed out and the the capability to handle intervening liens by foreclosure, which could leave the loan provider in a possibly worse position than if the lender pursued a foreclosure from the start.

In order to clearly show the parties' intent on this point, the deed-in-lieu arrangement (and the deed itself) must include reveal anti-merger language. Moreover, due to the fact that there can be no mortgage without a financial obligation, it is traditional 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, protects the borrower against direct exposure from the financial obligation and likewise retains the lien of the mortgage, thus permitting the lender to preserve the ability to foreclose, needs to it become 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 transactions can be a substantial sticking point. While most states make the payment of transfer tax a seller obligation, as a useful matter, the lending institution ends up absorbing the cost given that the debtor is in a default circumstance and usually lacks funds.

How transfer tax is determined on a deed-in-lieu transaction is reliant on the jurisdiction and can be a driving force in identifying if a deed in lieu is a practical 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 as much as the quantity of the debt. 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 restricted only to a transfer of the debtor's individual house.

For a business deal, the tax will be calculated based on the complete purchase cost, 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 possibly drastic, New York bases the quantity of the transfer tax on "factor to consider," which is specified as the unpaid balance of the debt, plus the overall amount of any other enduring liens and any amounts paid by the beneficiary (although if the loan is fully recourse, the factor to consider is capped at the fair market value of the residential or commercial property plus other quantities paid). Bearing in mind the lending institution will, in a lot of jurisdictions, need to pay this tax once again when eventually offering the residential or commercial property, the specific jurisdiction's guidelines on transfer tax can be a determinative factor in choosing whether a deed-in-lieu transaction is a feasible choice.

Bankruptcy Issues

A significant concern for lenders when figuring out if a deed in lieu is a practical alternative is the concern that if the customer becomes a debtor in a personal bankruptcy case after the deed in lieu is complete, the bankruptcy 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 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 customer was insolvent (or the transfer rendered the debtor insolvent) and within the 90-day period stated in the Bankruptcy Code, the customer 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 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, ended up being insolvent since of the transfer, was participated in an organization that maintained an unreasonably low level of capital or planned to incur financial obligations beyond its ability to pay. In order to alleviate against these threats, a loan provider must thoroughly review and evaluate the borrower's financial condition and liabilities and, ideally, need audited financial statements to confirm the solvency status of the borrower. Moreover, the deed-in-lieu arrangement must include representations as to solvency and a covenant from the customer not to declare personal bankruptcy during the choice duration.

This is yet another reason it is important for a lender to obtain an appraisal to confirm the worth of the residential or commercial property in relation to the financial obligation. An existing appraisal will assist the lending institution refute any claims that the transfer was produced less than fairly equivalent value.

Title Insurance

As part of the preliminary acquisition of a genuine residential or commercial property, a lot of owners and their loan providers will acquire policies of title insurance to protect their respective interests. A lending institution considering taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can count on its loan provider's policy when it becomes the fee 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 called guaranteed under the loan provider's policy.

Since numerous loan providers prefer to have actually title vested in a separate affiliate entity, in order to make sure ongoing protection under the lending institution's policy, the called lending institution needs to designate the mortgage to the desired affiliate title holder prior to, or concurrently with, the transfer of the charge. In the option, the lender can take title and then convey the residential or commercial property by deed for no factor to consider to either its moms and dad business or a wholly owned subsidiary (although in some jurisdictions this could trigger transfer tax liability).

Notwithstanding the continuation in coverage, a lending institution's policy does not convert to an owner's policy. Once the loan provider 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 offer the same or an adequate level of protection. Moreover, a lending institution's policy does not avail any protection for matters which occur after the date of the mortgage loan, leaving the lending institution exposed to any issues or claims stemming from events which take place after the initial closing.

Due to the reality deed-in-lieu transactions are more vulnerable to challenge and threats as outlined above, any title insurer releasing an owner's policy is likely to carry out a more strenuous review of the deal throughout the underwriting procedure than they would in a typical third-party purchase and sale transaction. The title insurer will scrutinize the parties and the deed-in-lieu documents in order to determine and reduce dangers provided by issues such as merger, obstructing, recharacterization and insolvency, therefore possibly increasing the time and costs involved in closing the transaction, however ultimately supplying the lending institution with a higher level of protection than the lender would have missing the title business's participation.
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Ultimately, whether a deed-in-lieu transaction is a viable option for a lending institution is driven by the particular facts and scenarios of not just the loan and the residential or commercial property, however the parties included also. Under the right set of scenarios, and so long as the appropriate due diligence and paperwork is gotten, a deed in lieu can supply the loan provider with a more effective and more economical ways 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 attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most often work.