When an industrial mortgage lender sets out to impose a mortgage loan following a debtor default, a key objective is to identify the most expeditious way in which the lender can obtain control and belongings of the underlying collateral. Under the right set of scenarios, a deed in lieu of foreclosure can be a faster and more cost-effective option to the long and drawn-out foreclosure process. This post discusses steps and problems lenders should consider when making the decision to proceed with a deed in lieu of foreclosure and how to prevent unanticipated risks and challenges during and following the deed-in-lieu procedure.

Consideration

A crucial element of any agreement is guaranteeing there is sufficient consideration. In a standard transaction, consideration can quickly be developed through the purchase price, however in a deed-in-lieu scenario, confirming adequate consideration is not as straightforward.

In a deed-in-lieu situation, 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 factor to consider to be deemed "sufficient," the debt should at least equivalent or go beyond the reasonable market value of the subject residential or commercial property. It is important that lending institutions get an independent third-party appraisal to validate the value of the residential or commercial property in relation to the amount of financial obligation being forgiven. In addition, its suggested the deed-in-lieu agreement include the customer's express acknowledgement of the fair market worth of the residential or commercial property in relation to the quantity of the financial obligation and a waiver of any potential claims associated with 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 genuine estate holds an unqualified right to redeem that residential or commercial property from the loan provider by paying back the financial obligation up until the point when the right of redemption is legally snuffed out through a correct foreclosure. Preserving the borrower'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 lending institution.

Deed-in-lieu deals preclude a debtor's equitable right of redemption, nevertheless, actions can be required to structure them to restrict or prevent the danger of a clogging challenge. Most importantly, the contemplation 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 must also watch out for a deed-in-lieu plan where, following the transfer, there is a continuation of a debtor/creditor relationship, or which consider that the borrower maintains rights to the residential or commercial property, either as a residential or commercial property supervisor, an occupant or through repurchase alternatives, as any of these plans can develop a threat of the deal being recharacterized as an equitable mortgage.

Steps can be required to reduce against recharacterization threats. Some examples: if a debtor'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 use and occupancy payments, or if any provision for reacquisition of the residential or commercial property by the borrower is established to be entirely independent of the condition for the deed in lieu.

While not determinative, it is suggested that deed-in-lieu contracts consist of the celebrations' clear and unquestionable 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 lender makes a loan secured by a mortgage on property, 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 gets the real estate 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 general rule on this problem supplies 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 happens in the lack of proof of a contrary intent. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is very important the arrangement plainly reflects the parties' intent to keep the mortgage lien estate as unique from the cost so the loan provider maintains the ability to foreclose the underlying mortgage if there are stepping in liens. If the estates combine, then the lender's mortgage lien is extinguished and the lender loses the capability to deal with 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 clearly reflect the parties' intent on this point, the deed-in-lieu arrangement (and the deed itself) need to include express anti-merger language. Moreover, due to the fact that there can be no mortgage without a financial obligation, it is customary in a deed-in-lieu situation for the lending institution to provide a covenant not to sue, instead of a straight-forward release of the financial obligation. The covenant not to sue furnishes consideration for the deed in lieu, secures the borrower against direct exposure from the debt and likewise retains the lien of the mortgage, therefore permitting the loan provider to keep the ability to foreclose, should it become 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 deals 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 lending institution ends up taking in the expense considering that the borrower is in a default situation and usually does not have funds.

How transfer tax is calculated 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 option. 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 quantity of the debt. Some other states, consisting of Washington and Illinois, have uncomplicated exemptions for deed-in-lieu deals. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu deals it is limited just to a transfer of the customer's personal residence.

For an industrial deal, the tax will be calculated based upon 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, however even more possibly oppressive, New York bases the quantity of the transfer tax on "consideration," which is specified as the unpaid balance of the debt, plus the overall amount of any other surviving liens and any amounts paid by the grantee (although if the loan is totally option, the factor to consider is capped at the reasonable market price of the residential or commercial property plus other amounts paid). Remembering the loan provider will, in most jurisdictions, need to pay this tax again when ultimately offering the residential or commercial property, the particular jurisdiction's guidelines on transfer tax can be a determinative consider deciding whether a deed-in-lieu transaction is a practical alternative.

Bankruptcy Issues

A for lending institutions when identifying if a deed in lieu is a practical alternative is the concern that if the borrower ends up being a debtor in a bankruptcy case after the deed in lieu is complete, the bankruptcy court can cause the transfer to be unwound or reserved. Because a deed-in-lieu deal 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 period stated in the Bankruptcy Code, the customer becomes 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 reserved if it is made within one year prior to an insolvency 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 since of the transfer, was participated in an organization that maintained an unreasonably low level of capital or intended to incur financial obligations beyond its capability to pay. In order to mitigate against these dangers, a lender must carefully examine and examine the customer's monetary condition and liabilities and, ideally, require audited monetary declarations to validate the solvency status of the borrower. Moreover, the deed-in-lieu arrangement must consist of representations regarding solvency and a covenant from the debtor not to declare personal bankruptcy throughout the preference duration.

This is yet another reason that it is essential for a lender to obtain an appraisal to confirm the worth of the residential or commercial property in relation to the debt. A present appraisal will help the lender refute any claims that the transfer was produced less than reasonably equivalent worth.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, the majority of owners and their lending institutions will get policies of title insurance to protect their respective interests. A loan provider considering taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can count on its lending institution's policy when it becomes the charge owner. Coverage under a lender'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 choose to have actually title vested in a different affiliate entity, in order to guarantee continued protection under the lending institution's policy, the named lending institution ought to designate the mortgage to the intended affiliate title holder prior to, or at the same time with, the transfer of the fee. In the alternative, the lender can take title and after that convey the residential or commercial property by deed for no consideration to either its parent company or a wholly owned subsidiary (although in some jurisdictions this might trigger transfer tax liability).

Notwithstanding the continuation in coverage, a loan provider's policy does not transform to an owner's policy. Once the lender becomes an owner, the nature and scope of the claims that would be made under a policy are such that the loan provider's policy would not offer the same or a sufficient level of security. Moreover, a lending institution's policy does not avail any protection for matters which occur after the date of the mortgage loan, leaving the lending institution exposed to any issues or claims stemming from events which take place after the original closing.

Due to the fact deed-in-lieu deals are more prone to challenge and dangers as described above, any title insurer providing an owner's policy is likely to carry out a more rigorous review of the transaction during the underwriting procedure than they would in a common third-party purchase and sale transaction. The title insurance company will scrutinize the celebrations and the deed-in-lieu documents in order to identify and alleviate dangers provided by problems such as merger, obstructing, recharacterization and insolvency, thus potentially increasing the time and costs included in closing the transaction, however eventually supplying the lending institution with a greater level of defense than the lender would have absent the title company's involvement.

Ultimately, whether a deed-in-lieu deal is a practical alternative for a loan provider is driven by the specific facts and circumstances of not only the loan and the residential or commercial property, but the parties involved as well. Under the right set of circumstances, therefore long as the appropriate due diligence and paperwork is acquired, a deed in lieu can provide the lender with a more effective and cheaper methods to recognize on its security 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 connect to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most regularly work.