When an industrial mortgage lending institution sets out to implement a mortgage loan following a borrower default, a crucial objective is to determine the most expeditious way in which the lending institution can obtain control and possession of the underlying security. 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 procedure. This post discusses steps and issues lenders need to consider when deciding to proceed with a deed in lieu of foreclosure and how to avoid unexpected threats and challenges throughout and following the deed-in-lieu procedure.

Consideration

A crucial element of any agreement is guaranteeing there is adequate consideration. In a basic deal, consideration can quickly be established through the purchase cost, however in a deed-in-lieu situation, confirming adequate factor to consider is not as simple.

In a deed-in-lieu situation, the quantity of the underlying financial obligation that is being forgiven by the loan provider usually is the basis for the factor to consider, and in order for such consideration to be considered "adequate," the debt ought to at least equivalent or surpass the fair market value of the subject residential or commercial property. It is crucial that lending institutions get 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 recommended the deed-in-lieu arrangement consist of the borrower's reveal acknowledgement of the reasonable market worth of the residential or commercial property in relation to the amount of the debt and a waiver of any prospective claims related to the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary 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 loan provider by repaying the debt up till the point when the right of redemption is lawfully snuffed out through a proper 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 lender.

Deed-in-lieu transactions prevent a borrower's fair right of redemption, nevertheless, actions can be required to structure them to limit or prevent the risk of a clogging challenge. Primarily, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure should happen post-default and can not be pondered by the underlying loan documents. Parties should also watch out for a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which ponder that the debtor keeps rights to the residential or commercial property, either as a residential or commercial property supervisor, a tenant or through repurchase choices, as any of these arrangements can create a threat of the deal being recharacterized as an equitable mortgage.

Steps can be taken to mitigate against recharacterization dangers. 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 arrangement for reacquisition of the residential or commercial property by the debtor is established 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 recognition 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 loan provider makes a loan secured by a mortgage on property, 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 loan provider then obtains the property from a defaulting mortgagor, it now likewise holds an interest in the residential or commercial property by virtue of being the cost owner and obtaining the mortgagor's equity of redemption.

The basic guideline on this issue provides 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 happens in the lack of evidence of a contrary intention. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is very important the arrangement clearly shows the celebrations' intent to maintain the mortgage lien estate as unique from the charge so the lender keeps the capability to foreclose the hidden mortgage if there are intervening liens. If the estates merge, then the lender's mortgage lien is snuffed out and the lending institution loses the capability to handle stepping in liens by foreclosure, which could leave the loan provider in a possibly even worse position than if the lender pursued a foreclosure from the start.

In order to plainly show the celebrations' intent on this point, the deed-in-lieu contract (and the deed itself) ought to consist of reveal anti-merger language. Moreover, due to the fact that there can be no mortgage without a debt, it is customary in a deed-in-lieu scenario 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, protects the debtor versus direct exposure from the financial obligation and also retains the lien of the mortgage, therefore permitting the lender to maintain the ability to foreclose, should it end up being preferable to get rid of 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 transactions can be a considerable sticking point. While the majority of states make the payment of transfer tax a seller responsibility, as a useful matter, the lender ends up absorbing the expense because the customer remains in a default scenario and usually lacks funds.

How transfer tax is computed 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 practical alternative. In California, for instance, 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 amount of the debt. Some other states, including Washington and Illinois, have uncomplicated exemptions for deed-in-lieu deals. In Connecticut, however, while there is an exemption for deed-in-lieu transactions it is limited only to a transfer of the customer's personal home.

For a commercial deal, the tax will be computed based on the full purchase cost, which is specifically specified as including the amount of liability which is assumed or to which the real estate is subject. Similarly, however much more potentially oppressive, New york city bases the quantity of the transfer tax on "factor to consider," which is specified as the unsettled balance of the debt, plus the overall amount of any other surviving liens and any quantities paid by the beneficiary (although if the loan is fully recourse, the consideration is topped at the fair market price of the residential or commercial property plus other amounts paid). Keeping in mind the lender will, in many jurisdictions, need to pay this tax again when eventually 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 practical alternative.

Bankruptcy Issues

A major concern for loan providers when identifying if a deed in lieu is a practical option is the concern that if the debtor becomes a debtor in a personal bankruptcy case after the deed in lieu is complete, the personal bankruptcy court can trigger the transfer to be unwound or reserved. Because a deed-in-lieu transaction is a transfer made on, or account of, an antecedent debt, 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 customer 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 personal 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 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 company that preserved an unreasonably low level of capital or planned to incur debts beyond its ability to pay. In order to alleviate against these dangers, a lender ought to thoroughly review and examine the borrower's financial condition and liabilities and, preferably, need audited financial declarations to verify the solvency status of the debtor. Moreover, the deed-in-lieu contract must consist of representations as to solvency and a covenant from the borrower not to declare bankruptcy throughout the choice period.

This is yet another reason that it is crucial for a loan provider to obtain an appraisal to confirm the worth of the residential or commercial property in relation to the financial obligation. A present appraisal will help the lender refute any accusations that the transfer was made for less than fairly equivalent value.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, the majority of owners and their lending institutions will acquire policies of title insurance to safeguard their particular interests. A lending institution 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 can continue after the acquisition of title if title is taken by the very same entity that is the named guaranteed under the lender's policy.

Since lots of loan providers prefer to have title vested in a different affiliate entity, in order to make sure ongoing coverage under the loan provider's policy, the called lender must assign the mortgage to the desired affiliate title holder prior to, or all at once with, the transfer of the charge. In the alternative, the lender can take title and then communicate the residential or commercial property by deed for no factor to consider to either its moms and dad business or a completely owned subsidiary (although in some jurisdictions this could activate transfer tax liability).

Notwithstanding the extension in protection, a loan provider'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 provide the same or an appropriate level of protection. Moreover, a loan provider'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 problems or claims coming from occasions which take place after the original closing.

Due to the fact deed-in-lieu transactions are more prone to challenge and risks as detailed above, any title insurance provider providing an owner's policy is likely to carry out a more strenuous review of the deal during the underwriting process than they would in a typical third-party purchase and sale deal. The title insurer will scrutinize the parties and the deed-in-lieu documents in order to determine and alleviate threats provided by issues such as merger, blocking, recharacterization and insolvency, therefore potentially increasing the time and expenses involved in closing the deal, but eventually offering the lender with a greater level of defense than the lender would have missing the title company's participation.

Ultimately, whether a deed-in-lieu deal is a viable alternative for a lending institution is driven by the specific realities and circumstances of not only the loan and the residential or commercial property, however the parties included as well. Under the right set of situations, and so long as the appropriate due diligence and documentation is acquired, a deed in lieu can supply the loan provider with a more efficient and more economical ways to recognize 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 assistance with such matters, please connect to lawyer Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach lawyer with whom you most regularly work.