When a business mortgage lender sets out to implement a mortgage loan following a borrower default, an essential goal is to identify the most expeditious manner in which the lending institution can acquire control and ownership of the underlying collateral. Under the right set of circumstances, a deed in lieu of foreclosure can be a much faster and more affordable option to the long and lengthy foreclosure process. This article discusses actions and problems lenders need to think about when deciding to proceed with a deed in lieu of foreclosure and how to prevent unforeseen threats and obstacles during and following the deed-in-lieu process.

Consideration

A crucial element of any agreement is making sure there is sufficient factor to consider. In a standard transaction, factor to consider can easily be developed through the purchase cost, however in a deed-in-lieu circumstance, verifying sufficient consideration is not as uncomplicated.

In a deed-in-lieu circumstance, the amount of the underlying debt that is being forgiven by the loan provider generally is the basis for the factor to consider, and in order for such factor to consider to be considered "adequate," the debt should a minimum of equal or surpass the reasonable market price of the subject residential or commercial property. It is crucial that lenders get an independent third-party appraisal to corroborate the value of the residential or commercial property in relation to the quantity of debt being forgiven. In addition, its advised the deed-in-lieu arrangement consist of the debtor's reveal recognition 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 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 loan provider by repaying the debt up till the point when the right of redemption is lawfully snuffed out 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 contemplate the voluntary transfer of the residential or commercial property to the lender.

Deed-in-lieu transactions preclude a customer's fair right of redemption, nevertheless, actions can be required to structure them to limit or avoid the threat of an obstructing obstacle. 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 contemplated by the underlying loan documents. Parties ought to likewise be careful of 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 renter or through repurchase choices, as any of these arrangements can develop a threat of the deal being recharacterized as a fair mortgage.

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

While not determinative, it is advised that deed-in-lieu agreements consist of the celebrations' clear and indisputable acknowledgement that the transfer of the residential or commercial property is an absolute conveyance and not a transfer of for security functions only.

Merger of Title

When a lending institution makes a loan protected by a mortgage on genuine estate, 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 lender 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 basic rule on this issue offers that, where a mortgagee gets 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 cost takes place in the absence of proof of a contrary intent. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is crucial the arrangement clearly shows the parties' intent to keep the mortgage lien estate as unique from the cost so the lender maintains the capability to foreclose the hidden mortgage if there are stepping in liens. If the estates combine, then the lender's mortgage lien is extinguished and the lender loses the ability to handle stepping in liens by foreclosure, which could leave the lender in a potentially even worse position than if the loan provider pursued a foreclosure from the beginning.

In order to plainly reflect the celebrations' intent on this point, the deed-in-lieu arrangement (and the deed itself) should consist of express anti-merger language. Moreover, since there can be no mortgage without a debt, it is customary in a deed-in-lieu situation for the lender to provide a covenant not to take legal action against, rather than a straight-forward release of the financial obligation. The covenant not to sue furnishes factor to consider for the deed in lieu, secures the borrower against exposure from the debt and also maintains the lien of the mortgage, thereby permitting the lender to maintain the capability to foreclose, should it become preferable to eliminate junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending upon the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu deals can be a considerable sticking point. While a lot of states make the payment of transfer tax a seller commitment, as a practical matter, the loan provider ends up taking in the expense since the debtor is in a default scenario and typically lacks funds.

How transfer tax is determined on a deed-in-lieu transaction depends on the jurisdiction and can be a driving force in figuring out if a deed in lieu is a feasible 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, consisting of Washington and Illinois, have uncomplicated exemptions for deed-in-lieu transactions. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu deals it is limited just to a transfer of the debtor's personal house.

For a commercial deal, the tax will be determined based on the complete purchase rate, which is specifically specified as including the quantity of liability which is presumed or to which the real estate is subject. Similarly, but even more potentially heavy-handed, New york city bases the amount of the transfer tax on "consideration," which is defined as the unpaid balance of the financial obligation, plus the total quantity of any other enduring liens and any quantities paid by the beneficiary (although if the loan is totally option, the factor to consider is topped at the fair market worth of the residential or commercial property plus other quantities paid). Bearing in mind the lending institution will, in a lot of jurisdictions, have 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 consider whether a deed-in-lieu transaction is a possible choice.
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Bankruptcy Issues

A significant concern for lenders when figuring out if a deed in lieu is a viable alternative is the issue that if the debtor becomes a debtor in an insolvency case after the deed in lieu is complete, the insolvency court can trigger the transfer to be unwound or set aside. Because a deed-in-lieu transaction is a transfer made on, or account of, an antecedent financial obligation, 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 customer insolvent) and within the 90-day period stated in the Bankruptcy Code, the customer becomes a debtor in a personal bankruptcy case, then the deed in lieu is at risk 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 fairly equivalent worth" and if the transferor was insolvent at the time of the transfer, became insolvent since of the transfer, was taken part in a service that maintained an unreasonably low level of capital or intended to incur debts beyond its ability to pay. In order to reduce against these dangers, a lending institution must thoroughly review and evaluate the borrower's monetary condition and liabilities and, preferably, require audited financial declarations to confirm the solvency status of the debtor. Moreover, the deed-in-lieu arrangement should include representations regarding solvency and a covenant from the customer not to apply for insolvency during the preference period.

This is yet another reason it is necessary for a lender to obtain an appraisal to verify the worth of the residential or commercial property in relation to the debt. An existing appraisal will help the loan provider refute any accusations that the transfer was produced less than fairly comparable value.

Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, most owners and their lending institutions will acquire policies of title insurance coverage to protect their respective interests. A lender considering taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can depend on its lending institution's policy when it ends up being the charge owner. Coverage under a lending institution's policy of title insurance can continue after the acquisition of title if title is taken by the exact same entity that is the named guaranteed under the lender's policy.
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Since many loan providers choose to have actually title vested in a different affiliate entity, in order to guarantee ongoing coverage under the lending institution's policy, the called lender ought to designate the mortgage to the designated affiliate title holder prior to, or concurrently with, the transfer of the cost. In the alternative, 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 extension in protection, a lender's policy does not transform 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 lender's policy would not supply the exact same or a sufficient level of protection. Moreover, a lending institution's policy does not avail any security for matters which occur after the date of the mortgage loan, leaving the loan provider exposed to any issues or claims stemming from events which happen after the initial closing.

Due to the fact deed-in-lieu transactions are more prone to challenge and dangers as outlined above, any title insurance company providing an owner's policy is most likely to undertake a more strenuous evaluation of the transaction throughout the underwriting procedure than they would in a typical third-party purchase and sale deal. The title insurance provider will inspect the celebrations and the deed-in-lieu files in order to determine and mitigate dangers presented by issues such as merger, clogging, recharacterization and insolvency, therefore possibly increasing the time and costs involved in closing the deal, however ultimately supplying the loan provider with a greater level of security than the lending institution would have absent the title company's participation.

Ultimately, whether a deed-in-lieu deal is a feasible alternative for a lending institution is driven by the specific realities and situations of not only the loan and the residential or commercial property, however the celebrations involved too. Under the right set of circumstances, and so long as the appropriate due diligence and documentation is gotten, 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 support with such matters, please reach out to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most regularly work.