When a commercial mortgage lending institution sets out to implement a mortgage loan following a customer default, an essential objective is to identify the most expeditious manner in which the lender can obtain control and belongings 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 option to the long and lengthy foreclosure procedure. This post discusses actions and problems lending institutions ought to consider when deciding to proceed with a deed in lieu of foreclosure and how to avoid unexpected threats and obstacles during and following the deed-in-lieu procedure.

Consideration

A crucial aspect of any contract is making sure there is adequate factor to consider. In a standard transaction, consideration can quickly be established through the purchase rate, but in a deed-in-lieu circumstance, confirming appropriate factor to consider is not as uncomplicated.

In a deed-in-lieu situation, 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 consideration to be considered "sufficient," the debt must a minimum of equal or surpass the fair market worth of the subject residential or commercial property. It is essential that loan providers obtain an independent third-party appraisal to substantiate 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 contract consist of the borrower's reveal acknowledgement of the fair market value of the residential or commercial property in relation to the amount of the financial obligation and a waiver of any potential claims associated with the adequacy of the factor to consider.

Clogging and Recharacterization Issues

Clogging is shorthand for a principal rooted in ancient English common law that a debtor who protects a loan with a mortgage on property 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 a correct foreclosure. Preserving the customer's fair right of redemption is the factor why, prior to default, mortgage loans can not be structured to ponder the voluntary transfer of the residential or commercial property to the lending institution.

Deed-in-lieu transactions prevent a customer's equitable right of redemption, however, steps can be required to structure them to limit or avoid the danger of an obstructing obstacle. Most importantly, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure should happen post-default and can not be contemplated by the underlying loan documents. Parties ought to likewise watch out for a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which contemplate that the debtor maintains rights to the residential or commercial property, either as a residential or commercial property supervisor, a tenant or through repurchase alternatives, as any of these arrangements can create a threat of the transaction being recharacterized as an equitable mortgage.

Steps can be required to alleviate against recharacterization dangers. Some examples: if a borrower's residential or commercial property management functions are limited to ministerial functions instead of substantive choice making, if a lease-back is short term and the payments are plainly structured as market-rate use and occupancy payments, or if any arrangement 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 advised that deed-in-lieu contracts consist of 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

When a lender 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 recipient under a deed of trust). If the lending institution then acquires the real estate from a defaulting mortgagor, it now also holds an interest in the residential or commercial property by virtue of being the charge owner and obtaining the mortgagor's equity of redemption.

The general rule on this concern supplies that, where a mortgagee obtains 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 evidence of a contrary intention. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is important the arrangement plainly reflects the celebrations' intent to keep the mortgage lien estate as distinct from the fee so the lender retains the capability to foreclose the hidden mortgage if there are intervening liens. If the estates merge, then the lending institution's mortgage lien is snuffed out and the lending institution loses the capability to handle intervening liens by foreclosure, which might leave the lender in a possibly worse position than if the lender pursued a foreclosure from the start.

In order to clearly reflect the celebrations' intent on this point, the deed-in-lieu arrangement (and the deed itself) must include express anti-merger language. Moreover, due to the fact that there can be no mortgage without a debt, it is popular in a deed-in-lieu circumstance for the loan provider to deliver a covenant not to sue, rather than a straight-forward release of the debt. The covenant not to sue furnishes consideration for the deed in lieu, safeguards the debtor against exposure from the financial obligation and likewise retains the lien of the mortgage, therefore enabling the loan provider to preserve the ability to foreclose, should it end up being desirable to eliminate 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 deals can be a substantial sticking point. While a lot of states make the payment of transfer tax a seller commitment, as a practical matter, the lending institution winds up absorbing the expense considering that the debtor remains in a default scenario and typically lacks funds.

How transfer tax is computed on a deed-in-lieu deal depends on the jurisdiction and can be a driving force in identifying if a deed in lieu is a viable alternative. 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 as much as the quantity of the financial obligation. Some other states, including Washington and Illinois, have simple exemptions for deed-in-lieu deals. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu transactions it is limited only to a transfer of the borrower's individual house.

For a commercial deal, the tax will be calculated based on the complete purchase cost, which is expressly defined as consisting of the amount of liability which is presumed or to which the real estate is subject. Similarly, but a lot more possibly draconian, New york city bases the quantity of the transfer tax on "consideration," which is specified as the unsettled balance of the debt, plus the total quantity of any other enduring liens and any quantities paid by the grantee (although if the loan is totally recourse, the factor to consider is topped at the fair market price of the residential or commercial property plus other amounts paid). Remembering the lending institution will, in many 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 aspect in choosing whether a deed-in-lieu transaction is a possible option.

Bankruptcy Issues

A major concern for lending institutions when determining if a deed in lieu is a viable option is the concern that if the borrower ends up being a debtor in a personal bankruptcy case after the deed in lieu is total, the bankruptcy court can cause the transfer to be unwound or set aside. Because a deed-in-lieu transaction 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 dealing with preferential transfers. Accordingly, if the transfer was made when the customer was insolvent (or the transfer rendered the customer insolvent) and within the 90-day duration stated in the Bankruptcy Code, the debtor becomes a debtor in a personal 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 produced "less than a reasonably equivalent worth" and if the transferor was insolvent at the time of the transfer, became insolvent because of the transfer, was taken part in an organization that maintained an unreasonably low level of capital or meant to incur financial obligations beyond its capability to pay. In order to mitigate versus these dangers, a loan provider needs to thoroughly evaluate and assess the customer's financial condition and liabilities and, ideally, need audited monetary declarations to confirm the solvency status of the customer. Moreover, the deed-in-lieu arrangement must consist of representations as to solvency and a covenant from the borrower not to file for bankruptcy during the choice duration.

This is yet another reason that 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 debt. An existing appraisal will assist the loan provider refute any accusations that the transfer was produced less than reasonably equivalent value.

Title Insurance

As part of the initial acquisition of a real residential or commercial property, most owners and their loan providers will obtain policies of title insurance to secure 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 loan provider's policy when it becomes the cost owner. Coverage under a lending institution's policy of title insurance can continue after the of title if title is taken by the exact same entity that is the named guaranteed under the loan provider's policy.

Since lots of loan providers choose to have title vested in a different affiliate entity, in order to ensure ongoing protection under the lending institution's policy, the called lending institution needs to assign the mortgage to the intended affiliate victor prior to, or at the same time with, the transfer of the charge. In the alternative, the lending institution can take title and then convey the residential or commercial property by deed for no factor to consider to either its parent business or a completely owned subsidiary (although in some jurisdictions this could set off transfer tax liability).

Notwithstanding the extension in protection, a lender'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 supply the same or an appropriate level of defense. Moreover, a lending institution's policy does not avail any defense for matters which emerge after the date of the mortgage loan, leaving the lender exposed to any problems or claims coming from events which happen after the original closing.

Due to the fact deed-in-lieu transactions are more vulnerable to challenge and dangers as outlined above, any title insurance provider releasing an owner's policy is most likely to undertake a more extensive evaluation of the deal during the underwriting procedure than they would in a typical third-party purchase and sale transaction. The title insurance company will scrutinize the celebrations and the deed-in-lieu files in order to determine and mitigate threats presented by issues such as merger, clogging, recharacterization and insolvency, thereby possibly increasing the time and expenses associated with closing the deal, but eventually supplying the lender with a greater level of protection than the lender would have missing the title company's involvement.

Ultimately, whether a deed-in-lieu deal is a practical option for a lending institution is driven by the specific facts and situations of not just the loan and the residential or commercial property, however the parties included too. Under the right set of scenarios, and so long as the appropriate due diligence and documents is acquired, a deed in lieu can supply the loan provider with a more efficient and cheaper means to recognize on its security when a loan enters into default.

Harris Beach Murtha's Commercial Realty Practice Group is experienced with deed in lieu of foreclosures. If you require help with such matters, please reach out 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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