When a business mortgage loan provider sets out to impose a mortgage loan following a customer default, an essential goal is to determine the most expeditious way in which the lending institution can acquire control and possession of the underlying collateral. Under the right set of circumstances, a deed in lieu of foreclosure can be a quicker and more economical alternative to the long and lengthy foreclosure procedure. This article discusses actions and concerns loan providers need to think about when making the decision to continue with a deed in lieu of foreclosure and how to avoid unanticipated risks and challenges throughout and following the deed-in-lieu process.
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Consideration

A key component of any agreement is ensuring there is sufficient factor to consider. In a basic transaction, factor to consider can quickly be established through the purchase price, however in a deed-in-lieu scenario, verifying adequate consideration is not as simple.

In a deed-in-lieu circumstance, the quantity of the underlying financial obligation that is being forgiven by the lending institution typically is the basis for the factor to consider, and in order for such consideration to be deemed "adequate," the debt needs to at least equivalent or surpass the reasonable market worth of the subject residential or commercial property. It is essential 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 financial obligation being forgiven. In addition, its advised the deed-in-lieu contract include the debtor's reveal acknowledgement of the reasonable market value 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 factor to consider.

Clogging and Recharacterization Issues

Clogging is shorthand for a principal rooted in ancient English common law that a customer who secures a loan with a mortgage on realty holds an unqualified right to redeem that residential or commercial property from the loan provider by repaying the debt up until the point when the right of redemption is legally extinguished through an appropriate 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 loan provider.

Deed-in-lieu deals preclude a customer's equitable right of redemption, nevertheless, actions can be required to structure them to restrict or avoid the threat of an obstructing obstacle. Firstly, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure need to take place post-default and can not be considered by the underlying loan files. Parties ought to likewise be careful of a deed-in-lieu plan where, following the transfer, there is a continuation of a debtor/creditor relationship, or which consider 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 produce a risk of the transaction being recharacterized as an equitable mortgage.

Steps can be required to mitigate versus recharacterization risks. Some examples: if a customer'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 clearly structured as market-rate use and tenancy payments, or if any provision for reacquisition of the residential or commercial property by the debtor is established to be completely independent of the condition for the deed in lieu.

While not determinative, it is recommended that deed-in-lieu agreements consist of the parties' clear and unequivocal acknowledgement that the transfer of the residential or commercial property is an absolute conveyance and not a transfer of for only.

Merger of Title

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 beneficiary under a deed of trust). If the lender then acquires 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 problem supplies that, where a mortgagee acquires 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 occurs in the absence of evidence of a contrary intent. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is essential the agreement clearly shows the parties' intent to maintain the mortgage lien estate as distinct from the charge so the loan provider retains the ability to foreclose the hidden mortgage if there are stepping in liens. If the estates merge, then the lender's mortgage lien is snuffed out and the loan provider loses the capability to handle stepping in liens by foreclosure, which might leave the loan provider in a possibly worse position than if the lending institution pursued a foreclosure from the start.

In order to plainly reflect the celebrations' intent on this point, the deed-in-lieu contract (and the deed itself) should include express anti-merger language. Moreover, since there can be no mortgage without a debt, it is popular in a deed-in-lieu circumstance for the lender to deliver a covenant not to take legal action against, instead of a straight-forward release of the financial obligation. The covenant not to sue furnishes consideration for the deed in lieu, safeguards the debtor versus direct exposure from the debt and also keeps the lien of the mortgage, therefore enabling the loan provider to maintain the ability to foreclose, must it end up being desirable to get rid of junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending on the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu transactions can be a substantial sticking point. While the majority of states make the payment of transfer tax a seller obligation, as a useful matter, the lender winds up soaking up the expense considering that the debtor is in a default circumstance and generally does not have 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 feasible 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 approximately the amount of the debt. Some other states, consisting of 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 borrower's personal house.

For an industrial deal, the tax will be calculated based upon the complete purchase rate, which is specifically defined as consisting of the quantity of liability which is assumed or to which the real estate is subject. Similarly, but much more possibly extreme, New york city bases the quantity of the transfer tax on "consideration," which is specified as the overdue balance of the financial obligation, plus the overall amount of any other making it through liens and any amounts paid by the grantee (although if the loan is completely recourse, the consideration is topped at the fair market worth of the residential or commercial property plus other quantities paid). Keeping in mind the loan provider will, in the majority 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 element in choosing whether a deed-in-lieu transaction is a possible alternative.

Bankruptcy Issues

A significant issue for loan providers when determining if a deed in lieu is a viable alternative is the concern that if the customer becomes a debtor in a bankruptcy case after the deed in lieu is total, the personal 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 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 duration set forth in the Bankruptcy Code, the customer ends up being a debtor in an insolvency 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 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 due to the fact that of the transfer, was participated in a business that kept an unreasonably low level of capital or planned to incur debts beyond its ability to pay. In order to reduce versus these risks, a lender needs to thoroughly examine and assess the customer's monetary condition and liabilities and, ideally, need audited monetary statements to verify the solvency status of the customer. Moreover, the deed-in-lieu agreement needs to consist of representations as to solvency and a covenant from the customer not to file for insolvency during the preference duration.

This is yet another reason that it is necessary for a lender to acquire an appraisal to confirm the value of the residential or commercial property in relation to the financial obligation. An existing appraisal will help the loan provider refute any accusations that the transfer was produced less than reasonably comparable value.

Title Insurance

As part of the initial acquisition of a real residential or commercial property, a lot of owners and their lenders will obtain policies of title insurance to safeguard their particular interests. A lender considering taking title to a residential or commercial property by virtue of a deed in lieu might ask whether it can rely on its lender's policy when it ends up being the charge 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 same entity that is the called insured under the loan provider's policy.

Since lots of lenders prefer to have actually title vested in a different affiliate entity, in order to make sure ongoing coverage under the loan provider's policy, the named loan provider needs to appoint the mortgage to the designated affiliate victor prior to, or simultaneously with, the transfer of the cost. In the option, the lending institution can take title and after that convey the residential or commercial property by deed for no consideration to either its parent business or a wholly owned subsidiary (although in some jurisdictions this could trigger transfer tax liability).

Notwithstanding the extension 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 provide the same or an adequate level of protection. Moreover, a lender's policy does not obtain any protection for matters which develop after the date of the mortgage loan, leaving the loan provider exposed to any problems or claims stemming from occasions which happen after the original closing.

Due to the reality deed-in-lieu transactions are more susceptible to challenge and threats as outlined above, any title insurance company releasing an owner's policy is most likely to carry out a more rigorous review of the transaction throughout the underwriting procedure than they would in a typical third-party purchase and sale deal. The title insurance company will inspect the celebrations and the deed-in-lieu files in order to determine and reduce risks presented by problems such as merger, clogging, recharacterization and insolvency, thereby possibly increasing the time and costs associated with closing the transaction, however ultimately providing the loan provider with a greater level of defense than the loan provider would have missing the title business's participation.

Ultimately, whether a deed-in-lieu transaction is a viable alternative for a lender is driven by the specific truths and circumstances of not just the loan and the residential or commercial property, but the celebrations involved as well. Under the right set of situations, and so long as the correct due diligence and documents is acquired, a deed in lieu can supply the lender with a more efficient and cheaper ways to understand on its collateral when a loan goes into default.

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