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When an industrial mortgage loan provider sets out to implement a mortgage loan following a customer default, a key goal is to recognize the most expeditious manner in which the lending institution can get control and possession of the underlying collateral. Under the right set of situations, a deed in lieu of foreclosure can be a faster and more affordable option to the long and lengthy foreclosure process. This short article talks about steps and problems lending institutions must think about when deciding to continue with a deed in lieu of foreclosure and how to avoid unexpected threats and challenges during and following the deed-in-lieu procedure.
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Consideration

An essential of any agreement is guaranteeing there is appropriate factor to consider. In a standard deal, consideration can quickly be developed 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 lender usually 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 worth of the subject residential or commercial property. It is important that lenders obtain an independent third-party appraisal to validate the worth of the residential or commercial property in relation to the quantity of financial obligation being forgiven. In addition, its recommended the deed-in-lieu arrangement include the debtor'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 associated with the adequacy of the factor to consider.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English typical law that a customer who protects a loan with a mortgage on property holds an unqualified right to redeem that residential or commercial property from the lending institution by repaying the financial obligation up until the point when the right of redemption is legally snuffed out through a correct foreclosure. Preserving the customer's fair right of redemption is the reason, 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 customer's equitable right of redemption, nevertheless, actions can be taken to structure them to restrict or avoid the threat of a blocking difficulty. Most importantly, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure should take location post-default and can not be considered by the underlying loan documents. Parties ought to also be careful of a deed-in-lieu arrangement where, following the transfer, there is a continuation 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 manager, a renter or through repurchase choices, as any of these plans can develop a danger of the transaction being recharacterized as a fair mortgage.

Steps can be required to alleviate versus 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 brief 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 customer is established to be entirely independent of the condition for the deed in lieu.

While not determinative, it is recommended 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 real 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 loan provider 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 charge owner and getting the mortgagor's equity of redemption.

The basic rule on this problem provides that, where a mortgagee acquires 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 fee occurs in the lack of evidence of a contrary objective. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is necessary the arrangement clearly reflects the parties' intent to keep the mortgage lien estate as unique from the fee so the lender retains the capability to foreclose the underlying mortgage if there are stepping in liens. If the estates combine, then the loan provider's mortgage lien is extinguished and the lending institution loses the capability to handle 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 beginning.

In order to clearly show the parties' intent on this point, the deed-in-lieu arrangement (and the deed itself) must consist of reveal anti-merger language. Moreover, since there can be no mortgage without a debt, it is traditional in a deed-in-lieu scenario for the lending institution to deliver a covenant not to sue, instead of a straight-forward release of the debt. The covenant not to sue furnishes factor to consider for the deed in lieu, protects the customer versus exposure from the financial obligation and also keeps the lien of the mortgage, thereby enabling the loan provider to maintain the ability to foreclose, must it end up being preferable to remove junior encumbrances after the deed in lieu is complete.

Transfer Tax

Depending on the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu transactions 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 lending institution ends up soaking up the cost given that the debtor remains in a default circumstance and usually lacks funds.

How transfer tax is determined on a deed-in-lieu transaction is reliant on the jurisdiction and can be a driving force in figuring out if a deed in lieu is a viable 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 as much as the quantity of the financial obligation. Some other states, including Washington and Illinois, have straightforward exemptions for deed-in-lieu transactions. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu deals it is restricted only to a transfer of the customer's personal house.

For a commercial deal, the tax will be computed based upon the complete purchase cost, which is expressly specified as consisting of the amount of liability which is assumed or to which the real estate is subject. Similarly, however a lot more potentially extreme, New York bases the amount of the transfer tax on "consideration," which is specified as the unpaid balance of the financial obligation, plus the overall quantity of any other making it through liens and any amounts paid by the grantee (although if the loan is completely recourse, the consideration is topped at the fair market value of the residential or commercial property plus other quantities paid). Keeping in mind the lender will, in most jurisdictions, have to pay this tax once again when ultimately offering the residential or commercial property, the specific jurisdiction's guidelines on transfer tax can be a determinative element in choosing whether a deed-in-lieu transaction is a practical alternative.

Bankruptcy Issues

A major issue for loan providers when identifying if a deed in lieu is a viable option is the concern that if the customer 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 set forth in the Bankruptcy Code, the debtor becomes a debtor in an insolvency case, then the deed in lieu is at danger 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 an insolvency 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, ended up being insolvent because of the transfer, was taken part in a service that preserved an unreasonably low level of capital or meant to sustain debts beyond its capability to pay. In order to alleviate against these dangers, a lender should thoroughly review and assess the borrower's financial condition and liabilities and, ideally, need audited monetary declarations to confirm the solvency status of the customer. Moreover, the deed-in-lieu agreement should include representations as to solvency and a covenant from the customer not to apply for insolvency during the choice period.

This is yet another factor why it is essential for a lender to procure an appraisal to confirm the value of the residential or commercial property in relation to the financial obligation. An existing appraisal will help the lending institution refute any allegations that the transfer was made for less than fairly equivalent value.

Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, many owners and their lending institutions will get policies of title insurance coverage to safeguard their respective 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 rely on its lending institution's policy when it ends up being the cost 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 called insured under the lending institution's policy.

Since numerous lending institutions prefer to have actually title vested in a separate affiliate entity, in order to make sure continued protection under the lending institution's policy, the called lender must designate the mortgage to the intended affiliate title holder prior to, or concurrently with, the transfer of the cost. In the option, the lender can take title and then convey the residential or commercial property by deed for no factor to consider to either its parent business or an entirely owned subsidiary (although in some jurisdictions this might trigger transfer tax liability).

Notwithstanding the extension in protection, a lending institution's policy does not transform to an owner's policy. Once the loan provider becomes an owner, the nature and scope of the claims that would be made under a policy are such that the lending institution's policy would not supply the same or an appropriate level of defense. Moreover, a loan provider's policy does not avail any security for matters which develop after the date of the mortgage loan, leaving the loan provider exposed to any problems or claims originating from events which occur after the initial closing.

Due to the reality deed-in-lieu deals are more vulnerable to challenge and threats as described above, any title insurance company providing an owner's policy is likely to undertake a more extensive evaluation of the deal during the underwriting process than they would in a common third-party purchase and sale deal. The title insurance company will inspect the celebrations and the deed-in-lieu documents in order to recognize and mitigate threats presented by issues such as merger, obstructing, recharacterization and insolvency, therefore potentially increasing the time and costs included in closing the deal, but eventually supplying the lender with a greater level of defense than the loan provider would have missing the title company's involvement.

Ultimately, whether a deed-in-lieu transaction is a viable choice for a loan provider is driven by the particular truths and scenarios of not just the loan and the residential or commercial property, however the celebrations involved too. Under the right set of situations, and so long as the appropriate due diligence and documentation is obtained, a deed in lieu can offer the loan provider with a more effective and less costly ways to recognize on its security when a loan enters into default.

Harris Beach Murtha's Commercial Real Estate Practice Group is experienced with deed in lieu of foreclosures. If you need 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 frequently work.