When a business mortgage loan provider sets out to implement a mortgage loan following a customer default, a key objective is to identify the most expeditious way in which the lending institution can acquire control and possession of the underlying security. Under the right set of scenarios, a deed in lieu of foreclosure can be a faster and more affordable option to the long and drawn-out foreclosure process. This short article discusses steps and issues lending institutions need to consider when making the decision to proceed with a deed in lieu of foreclosure and how to avoid unforeseen threats and difficulties during and following the deed-in-lieu procedure.

Consideration

A crucial aspect of any contract is guaranteeing there is adequate factor to consider. In a basic transaction, factor to consider can easily be established through the purchase cost, however in a deed-in-lieu scenario, verifying sufficient consideration is not as simple.

In a deed-in-lieu scenario, the amount of the underlying debt that is being forgiven by the loan provider generally is the basis for the consideration, and in order for such consideration to be considered "appropriate," the financial obligation needs to a minimum of equivalent or go beyond the reasonable market worth of the subject residential or commercial property. It is important that lenders obtain an independent third-party appraisal to validate the value of the residential or commercial property in relation to the quantity of financial obligation being forgiven. In addition, its the deed-in-lieu arrangement consist of the borrower's express recognition of the reasonable market price of the residential or commercial property in relation to the quantity of the financial obligation and a waiver of any prospective 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 realty holds an unqualified right to redeem that residential or commercial property from the lender by paying back the debt up till the point when the right of redemption is lawfully extinguished through a proper foreclosure. Preserving the debtor's fair right of redemption is the reason why, prior to default, mortgage loans can not be structured to consider the voluntary transfer of the residential or commercial property to the lender.

Deed-in-lieu deals prevent a debtor's fair right of redemption, however, actions can be taken to structure them to limit or prevent the risk of a blocking challenge. Primarily, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure must happen post-default and can not be contemplated by the underlying loan documents. Parties need to likewise be wary of a deed-in-lieu arrangement where, following the transfer, there is a continuation of a debtor/creditor relationship, or which consider that the customer keeps 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 plans can produce a danger of the deal being recharacterized as an equitable mortgage.

Steps can be taken to mitigate versus recharacterization risks. Some examples: if a customer's residential or commercial property management functions are restricted to ministerial functions instead of substantive decision making, if a lease-back is brief term and the payments are plainly structured as market-rate usage and tenancy payments, or if any arrangement for reacquisition of the residential or commercial property by the borrower 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 parties' clear and indisputable acknowledgement 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 lending institution makes a loan secured by a mortgage on real estate, it holds an interest in the property 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 fee owner and acquiring the mortgagor's equity of redemption.

The general rule on this problem offers that, where a mortgagee acquires 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 occurs in the lack of proof of a contrary intent. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is essential the contract clearly shows the parties' intent to keep the mortgage lien estate as distinct from the charge so the lending institution maintains the capability to foreclose the hidden mortgage if there are stepping in liens. If the estates merge, then the lending institution's mortgage lien is snuffed out and the lender loses the ability to deal with stepping in liens by foreclosure, which could leave the lending institution in a possibly even worse position than if the loan provider pursued a foreclosure from the start.

In order to plainly show the celebrations' intent on this point, the deed-in-lieu arrangement (and the deed itself) ought to include express anti-merger language. Moreover, due to the fact that there can be no mortgage without a debt, it is traditional in a deed-in-lieu circumstance for the lending institution to provide a covenant not to take legal action against, rather than a straight-forward release of the debt. The covenant not to sue furnishes consideration for the deed in lieu, safeguards the customer against exposure from the debt and also maintains the lien of the mortgage, thereby enabling the lending institution to maintain the ability to foreclose, needs to it become preferable to remove 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 transactions can be a considerable sticking point. While many states make the payment of transfer tax a seller responsibility, as a practical matter, the lender ends up soaking up the cost since the customer is in a default situation 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 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 as much as the quantity of the financial obligation. Some other states, including Washington and Illinois, have simple exemptions for deed-in-lieu transactions. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu transactions it is limited just to a transfer of the debtor's individual house.

For an industrial transaction, the tax will be computed based upon the complete purchase cost, which is expressly defined as consisting of the quantity of liability which is presumed or to which the real estate is subject. Similarly, but a lot more potentially exorbitant, 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 amount of any other surviving liens and any quantities paid by the grantee (although if the loan is totally recourse, the factor to consider is capped at the fair market price of the residential or commercial property plus other quantities paid). Bearing in mind the lending institution will, in the majority of jurisdictions, need to pay this tax again when ultimately offering the residential or commercial property, the specific jurisdiction's rules on transfer tax can be a determinative consider deciding whether a deed-in-lieu transaction is a practical alternative.

Bankruptcy Issues

A significant concern for loan providers when identifying if a deed in lieu is a viable alternative is the concern that if the debtor becomes a debtor in an insolvency case after the deed in lieu is total, the bankruptcy 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 debtor was insolvent (or the transfer rendered the borrower insolvent) and within the 90-day duration set forth in the Bankruptcy Code, the debtor becomes a debtor in a bankruptcy 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 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, became insolvent due to the fact that of the transfer, was taken part in a business that preserved an unreasonably low level of capital or meant to incur financial obligations beyond its ability to pay. In order to reduce against these dangers, a lending institution should thoroughly review and assess the customer's financial condition and liabilities and, ideally, require audited monetary statements to validate the solvency status of the customer. Moreover, the deed-in-lieu arrangement must consist of representations as to solvency and a covenant from the customer not to submit for insolvency during the choice duration.

This is yet another reason that it is important for a loan provider to procure an appraisal to validate the worth of the residential or commercial property in relation to the financial obligation. A present appraisal will assist the lender refute any accusations that the transfer was made for less than fairly comparable worth.

Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, many owners and their lending institutions will obtain 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 rely on its lending institution's policy when it becomes the cost 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 named insured under the loan provider's policy.

Since many lenders choose to have title vested in a different affiliate entity, in order to ensure continued protection under the loan provider's policy, the named loan provider must designate the mortgage to the designated affiliate victor prior to, or all at once with, the transfer of the fee. In the alternative, the loan provider can take title and then convey the residential or commercial property by deed for no consideration to either its moms and dad business or an entirely owned subsidiary (although in some jurisdictions this could activate 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 lender's policy would not offer the same or a sufficient level of defense. Moreover, a lender's policy does not avail any protection for matters which develop after the date of the mortgage loan, leaving the lending institution exposed to any concerns or claims coming from occasions which take place after the initial closing.

Due to the fact deed-in-lieu transactions are more vulnerable to challenge and threats as laid out above, any title insurance company providing an owner's policy is likely to carry out a more extensive review of the deal throughout the underwriting procedure than they would in a common third-party purchase and sale transaction. The title insurance provider will inspect the parties and the deed-in-lieu files in order to determine and mitigate dangers provided by problems such as merger, clogging, recharacterization and insolvency, consequently potentially increasing the time and costs associated with closing the transaction, but ultimately supplying the lending institution with a higher level of defense than the lending institution would have absent the title business's involvement.

Ultimately, whether a deed-in-lieu transaction is a viable alternative for a lender is driven by the specific truths and circumstances of not only the loan and the residential or commercial property, however the parties included too. Under the right set of circumstances, therefore long as the proper due diligence and documentation is acquired, a deed in lieu can supply the lending institution with a more efficient and less costly ways to understand on its collateral when a loan enters into default.

Harris Beach Murtha's Commercial Property Practice Group is experienced with deed in lieu of foreclosures. If you require help with such matters, please reach out to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach lawyer with whom you most often work.
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