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When a business mortgage lending institution sets out to enforce a mortgage loan following a customer default, a key goal is to identify the most expeditious way in which the lender can get control and ownership of the underlying collateral. Under the right set of scenarios, a deed in lieu of foreclosure can be a much faster and more economical option to the long and lengthy foreclosure procedure. This article goes over actions and issues lending institutions should think about when deciding to continue with a deed in lieu of foreclosure and how to avoid unexpected threats and obstacles throughout and following the deed-in-lieu process.

Consideration

A crucial component of any agreement is guaranteeing there is adequate consideration. In a basic deal, factor to consider can easily be developed through the purchase price, but in a deed-in-lieu scenario, verifying adequate consideration is not as uncomplicated.

In a deed-in-lieu scenario, the quantity of the underlying financial obligation that is being forgiven by the lending institution generally is the basis for the factor to consider, and in order for such consideration to be considered "appropriate," the debt needs to at least equal or surpass the reasonable market price of the subject residential or commercial property. It is vital that lenders acquire an independent third-party appraisal to substantiate 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 arrangement consist of the borrower's express acknowledgement of the reasonable market price of the residential or commercial property in relation to the amount 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 primary rooted in ancient English common law that a debtor who secures 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 financial obligation up till the point when the right of redemption is legally extinguished through a proper foreclosure. Preserving the borrower's fair right of redemption is the reason, 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 debtor's equitable right of redemption, nevertheless, steps can be required to structure them to limit or prevent the danger of an obstructing challenge. Primarily, the reflection 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 should also watch out for a deed-in-lieu plan where, following the transfer, there is an extension of a debtor/creditor relationship, or which contemplate that the borrower maintains rights to the residential or commercial property, either as a residential or commercial property manager, an occupant or through repurchase choices, as any of these plans can develop a danger of the deal being recharacterized as an equitable mortgage.

Steps can be required to alleviate versus recharacterization threats. Some examples: if a borrower's residential or commercial property management functions are restricted to ministerial functions instead of substantive decision making, if a lease-back is short term and the payments are plainly structured as market-rate usage and occupancy payments, or if any arrangement for reacquisition of the residential or commercial property by the borrower is established to be totally independent of the condition for the deed in lieu.

While not determinative, it is suggested that deed-in-lieu contracts include the celebrations' clear and indisputable recognition that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security functions just.

Merger of Title

When a lender makes a loan secured by a mortgage on genuine estate, it holds an interest in the property by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the lender then gets 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 acquiring the mortgagor's equity of redemption.

The basic guideline on this issue provides 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 charge takes place in the lack of proof of a contrary intent. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is essential the agreement clearly reflects the celebrations' intent to retain the mortgage lien estate as unique from the fee so the lender retains the ability to foreclose the underlying mortgage if there are intervening liens. If the estates merge, then the loan provider's mortgage lien is snuffed out and the lender loses the ability to handle stepping in liens by foreclosure, which could leave the lender in a potentially worse position than if the lender pursued a foreclosure from the outset.

In order to plainly reflect the celebrations' intent on this point, the deed-in-lieu agreement (and the deed itself) ought to include reveal anti-merger language. Moreover, because there can be no mortgage without a debt, it is popular in a deed-in-lieu situation for the lending institution to provide 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 consideration for the deed in lieu, safeguards the debtor versus exposure from the financial obligation and also maintains the lien of the mortgage, thus enabling the lending institution to maintain the ability to foreclose, ought to it end up being desirable to get rid of junior encumbrances after the deed in lieu is complete.

Transfer Tax

Depending upon the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu transactions can be a considerable sticking point. While most states make the payment of transfer tax a seller responsibility, as a useful matter, the lender winds up soaking up the cost considering that the debtor is in a default circumstance and usually does not have funds.

How transfer tax is computed on a deed-in-lieu deal is reliant 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 as much as the amount 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 transactions it is restricted only to a transfer of the borrower's individual home.

For a business transaction, the tax will be calculated based on the full purchase price, which is expressly specified as including the amount of liability which is presumed or to which the real estate is subject. Similarly, but much more potentially oppressive, New York bases the quantity of the transfer tax on "consideration," which is specified as the unsettled balance of the financial obligation, plus the total amount of any other making it through liens and any amounts paid by the grantee (although if the loan is totally option, the consideration is topped at the reasonable market value of the residential or commercial property plus other amounts paid). Remembering the lender will, in a lot of jurisdictions, have to pay this tax once again when eventually 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 feasible option.

Bankruptcy Issues

A major issue for lending institutions when determining if a deed in lieu is a practical alternative is the issue that if the debtor becomes a debtor in a bankruptcy case after the deed in lieu is complete, the bankruptcy court can the transfer to be unwound or set aside. 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 handling preferential transfers. Accordingly, if the transfer was made when the debtor was insolvent (or the transfer rendered the debtor insolvent) and within the 90-day period stated in the Bankruptcy Code, the borrower becomes a debtor in a bankruptcy case, then the deed in lieu is at risk 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 personal bankruptcy filing and the transfer was produced "less than a fairly comparable value" and if the transferor was insolvent at the time of the transfer, became insolvent because of the transfer, was participated in a business that kept an unreasonably low level of capital or planned to incur debts beyond its capability to pay. In order to reduce against these threats, a loan provider needs to thoroughly examine and evaluate the debtor's financial condition and liabilities and, preferably, need audited monetary declarations to validate the solvency status of the customer. Moreover, the deed-in-lieu arrangement must consist of representations regarding solvency and a covenant from the debtor not to file for insolvency throughout the preference period.

This is yet another reason it is vital for a lender to acquire an appraisal to validate the worth of the residential or commercial property in relation to the debt. A present appraisal will help the loan provider refute any accusations that the transfer was produced less than reasonably equivalent value.

Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, most owners and their lenders will obtain policies of title insurance to safeguard their particular interests. A lending institution 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 exact same entity that is the named guaranteed under the lending institution's policy.

Since lots of lenders choose to have title vested in a separate affiliate entity, in order to guarantee continued protection under the lender's policy, the named loan provider should appoint the mortgage to the desired affiliate victor prior to, or simultaneously with, the transfer of the cost. In the option, the loan provider can take title and after that convey the residential or commercial property by deed for no consideration to either its moms and dad business or a wholly owned subsidiary (although in some jurisdictions this might trigger transfer tax liability).

Notwithstanding the extension in coverage, a lending institution's policy does not convert to an owner's policy. Once the lender ends up being 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 very same or a sufficient level of defense. Moreover, a loan provider's policy does not obtain any security for matters which arise after the date of the mortgage loan, leaving the loan provider exposed to any problems or claims originating from events which happen after the initial closing.

Due to the fact deed-in-lieu deals are more prone to challenge and dangers as laid out above, any title insurance provider releasing an owner's policy is likely to undertake a more extensive evaluation of the transaction throughout the underwriting process than they would in a typical third-party purchase and sale deal. The title insurance company will inspect the parties and the deed-in-lieu files in order to determine and reduce risks provided by concerns such as merger, obstructing, recharacterization and insolvency, thus possibly increasing the time and expenses associated with closing the transaction, but ultimately supplying the lending institution with a higher level of protection than the lending institution would have missing the title company's involvement.

Ultimately, whether a deed-in-lieu deal is a practical option for a loan provider is driven by the specific facts and scenarios of not just the loan and the residential or commercial property, but the parties included too. Under the right set of situations, therefore long as the proper due diligence and documents is acquired, a deed in lieu can offer the lender with a more effective and cheaper ways 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 connect to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach lawyer with whom you most regularly work.
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