When a commercial mortgage lender sets out to enforce a mortgage loan following a borrower default, a key objective is to determine the most expeditious way in which the loan provider can acquire control and possession of the underlying security. Under the right set of situations, a deed in lieu of foreclosure can be a quicker and more cost-effective option to the long and protracted foreclosure procedure. This article talks about actions and problems lending institutions ought to think about when deciding to proceed with a deed in lieu of foreclosure and how to avoid unexpected dangers and difficulties throughout and following the deed-in-lieu procedure.

Consideration
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A crucial element of any contract is ensuring there is sufficient consideration. In a standard deal, factor to consider can quickly be established through the purchase cost, however in a deed-in-lieu circumstance, confirming sufficient consideration is not as uncomplicated.

In a deed-in-lieu scenario, the amount of the underlying financial obligation that is being forgiven by the lender usually is the basis for the factor to consider, and in order for such factor to consider to be considered "adequate," the debt must at least equivalent or exceed the reasonable market price of the subject residential or commercial property. It is imperative that loan providers obtain an independent third-party appraisal to corroborate the value of the residential or commercial property in relation to the amount of financial obligation being forgiven. In addition, its suggested the deed-in-lieu arrangement include the borrower's express acknowledgement of the reasonable market value 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 customer who protects a loan with a mortgage on realty holds an unqualified right to redeem that residential or commercial property from the lending institution by paying back the debt up till the point when the right of redemption is legally snuffed out through a correct foreclosure. Preserving the customer's fair right of redemption is the reason that, prior to default, mortgage loans can not be structured to consider the voluntary transfer of the residential or commercial property to the lending institution.

Deed-in-lieu deals preclude a borrower's fair right of redemption, nevertheless, steps can be taken to structure them to restrict or prevent the danger of a clogging obstacle. First and foremost, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure must happen post-default and can not be pondered by the underlying loan files. Parties need to likewise 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 supervisor, a renter or through repurchase alternatives, as any of these arrangements can create a threat of the deal being recharacterized as an equitable mortgage.

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

While not determinative, it is suggested 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 purposes only.

Merger of Title

When a loan provider makes a loan protected by a mortgage on genuine estate, it holds an interest in the real estate by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the loan provider then obtains the realty 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 issue provides that, where a mortgagee gets 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 very important the agreement plainly shows the parties' intent to maintain the mortgage lien estate as unique from the fee so the lending institution retains the capability 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 lending institution pursued a foreclosure from the outset.

In order to clearly reflect the celebrations' intent on this point, the deed-in-lieu arrangement (and the deed itself) ought to include reveal anti-merger language. Moreover, since there can be no mortgage without a financial obligation, it is customary in a deed-in-lieu circumstance for the lending institution 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 factor to consider for the deed in lieu, safeguards the customer versus direct exposure from the debt and also retains the lien of the mortgage, consequently permitting the lender to preserve the ability to foreclose, needs to it end up being desirable to get rid of junior encumbrances after the deed in lieu is complete.

Transfer Tax

Depending on the jurisdiction, dealing with transfer tax and the payment thereof in deed-in-lieu transactions can be a considerable sticking point. While a lot of states make the payment of transfer tax a seller responsibility, as a useful matter, the lending institution ends up soaking up the cost since the borrower is in a default circumstance and generally does not have funds.

How transfer tax is computed on a deed-in-lieu transaction is dependent on the jurisdiction and can be a driving force in determining if a deed in lieu is a practical alternative. 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 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, however, while there is an exemption for deed-in-lieu deals it is restricted only to a transfer of the borrower's personal home.

For a business transaction, the tax will be computed based on the complete purchase cost, which is specifically specified as including the amount of liability which is assumed or to which the real estate is subject. Similarly, however much more potentially drastic, 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 enduring liens and any quantities paid by the grantee (although if the loan is completely option, the factor to consider is topped at the reasonable market price of the residential or commercial property plus other quantities paid). Remembering the loan provider will, in most jurisdictions, need to pay this tax again when ultimately offering the residential or commercial property, the particular jurisdiction's guidelines on transfer tax can be a determinative consider choosing whether a deed-in-lieu transaction is a feasible option.

Bankruptcy Issues

A significant concern for lenders when identifying if a deed in lieu is a practical alternative is the concern that if the borrower becomes a debtor in a bankruptcy case after the deed in lieu is total, the personal bankruptcy court can trigger the transfer to be unwound or reserved. Because a deed-in-lieu transaction 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 borrower insolvent) and within the 90-day duration set forth 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 reserved.

Similarly, under Section 548 of the Bankruptcy Code, a transfer can be reserved if it is made within one year prior to a personal bankruptcy 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, ended up being insolvent due to the fact that of the transfer, was taken part in a company that kept an unreasonably low level of capital or intended to incur financial obligations beyond its ability to pay. In order to reduce versus these risks, a lender ought to carefully examine and examine the customer's financial condition and liabilities and, ideally, require audited financial statements to validate the solvency status of the customer. Moreover, the deed-in-lieu arrangement must include representations as to solvency and a covenant from the customer not to submit for insolvency throughout the preference duration.

This is yet another reason that it is essential for a lending institution to procure an appraisal to validate the worth of the residential or commercial property in relation to the financial obligation. An existing appraisal will help the lending institution refute any allegations that the transfer was made for less than reasonably 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 obtain policies of title insurance to secure their particular interests. A loan provider thinking about 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 lending institution's policy of title insurance coverage can continue after the acquisition of title if title is taken by the same entity that is the called guaranteed under the lender's policy.

Since lots of lenders choose to have actually title vested in a separate affiliate entity, in order to ensure continued protection under the lending institution's policy, the called lending institution ought to designate the mortgage to the desired affiliate title holder prior to, or simultaneously with, the transfer of the charge. In the option, the lender can take title and then communicate the residential or commercial property by deed for no factor to consider to either its moms and dad company or an entirely owned subsidiary (although in some jurisdictions this might set off transfer tax liability).

Notwithstanding the extension in protection, a lending institution's policy does not convert to an owner's policy. Once the lending institution 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 very same or an appropriate level of defense. Moreover, a lending institution's policy does not get any protection for matters which occur after the date of the mortgage loan, leaving the loan provider exposed to any concerns or claims stemming from events which happen after the initial closing.

Due to the reality 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 strenuous evaluation of the deal during the underwriting process than they would in a typical third-party purchase and sale deal. The title insurer will inspect the parties and the deed-in-lieu files in order to identify and mitigate dangers provided by problems such as merger, clogging, recharacterization and insolvency, therefore potentially increasing the time and costs involved in closing the deal, however ultimately providing the lending institution with a higher level of protection than the loan provider would have absent the title company's involvement.

Ultimately, whether a deed-in-lieu deal is a viable choice 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 celebrations 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 provide the loan provider with a more effective and more economical ways to recognize on its collateral when a loan goes into default.

Harris Beach Murtha's Commercial Real Estate Practice Group is experienced with deed in lieu of foreclosures. If you need assistance 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.
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