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When a commercial mortgage lending institution sets out to enforce a mortgage loan following a debtor default, a crucial goal is to determine the most expeditious way in which the lender can get control and possession of the underlying security. Under the right set of scenarios, a deed in lieu of foreclosure can be a quicker and more affordable option to the long and protracted foreclosure procedure. This article talks about steps and concerns lenders need to consider when making the decision to proceed with a deed in lieu of foreclosure and how to avoid unanticipated risks and challenges throughout and following the deed-in-lieu procedure.

Consideration
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A crucial aspect of any contract is making sure there is adequate consideration. In a standard transaction, consideration can easily be established through the purchase price, however in a deed-in-lieu situation, confirming appropriate factor to consider is not as uncomplicated.

In a deed-in-lieu scenario, the amount of the underlying financial obligation that is being forgiven by the lender typically is the basis for the factor to consider, and in order for such consideration to be considered "adequate," the debt needs to a minimum of equal or surpass the fair market worth of the subject residential or commercial property. It is necessary that loan providers acquire an independent third-party appraisal to validate the worth of the residential or commercial property in relation to the amount of financial obligation being forgiven. In addition, its advised the deed-in-lieu arrangement consist of the customer's express acknowledgement of the fair market value of the residential or commercial property in relation to the amount of the debt and a waiver of any potential 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 customer who protects a loan with a mortgage on real estate 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 lawfully snuffed out through a proper foreclosure. Preserving the borrower's fair right of redemption is the reason that, prior to default, mortgage loans can not be structured to ponder the voluntary transfer of the residential or commercial property to the loan provider.

Deed-in-lieu deals prevent a debtor's equitable right of redemption, however, steps can be taken to structure them to limit or prevent the danger of an obstructing obstacle. First and primary, 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 should also be careful of a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which that the borrower keeps rights to the residential or commercial property, either as a residential or commercial property manager, a renter or through repurchase options, as any of these arrangements can produce a threat of the transaction being recharacterized as a fair mortgage.

Steps can be required to mitigate versus recharacterization dangers. Some examples: if a customer's residential or commercial property management functions are limited to ministerial functions rather than substantive choice making, if a lease-back is brief term and the payments are plainly structured as market-rate use and occupancy payments, or if any arrangement for reacquisition of the residential or commercial property by the debtor is set up to be completely independent of the condition for the deed in lieu.

While not determinative, it is recommended that deed-in-lieu agreements include the celebrations' clear and unquestionable recognition that the transfer of the residential or commercial property is an absolute conveyance and not a transfer of for security functions just.

Merger of Title

When a lending institution makes a loan protected by a mortgage on realty, it holds an interest in the realty by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the lending institution then acquires the realty from a defaulting mortgagor, it now likewise 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 general guideline on this issue supplies that, where a mortgagee obtains 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 fee takes place in the lack of evidence of a contrary intent. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is very important the contract plainly shows the celebrations' intent to retain the mortgage lien estate as distinct from the cost so the loan provider maintains the capability to foreclose the hidden mortgage if there are intervening liens. If the estates combine, then the loan provider's mortgage lien is extinguished and the lending institution loses the capability to deal with stepping in liens by foreclosure, which could leave the lender in a possibly even worse position than if the lender pursued a foreclosure from the outset.

In order to clearly reflect the parties' intent on this point, the deed-in-lieu agreement (and the deed itself) ought to consist of reveal anti-merger language. Moreover, since there can be no mortgage without a debt, it is popular in a deed-in-lieu circumstance for the lending institution to provide a covenant not to take legal action against, instead of a straight-forward release of the debt. The covenant not to sue furnishes factor to consider for the deed in lieu, secures the borrower against exposure from the financial obligation and also keeps the lien of the mortgage, thereby enabling the loan provider to maintain the ability to foreclose, should it become desirable to get rid of junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending on the jurisdiction, dealing with transfer tax and the payment thereof in deed-in-lieu transactions can be a substantial sticking point. While a lot of states make the payment of transfer tax a seller commitment, as a useful matter, the lender winds up absorbing the cost since the customer is in a default circumstance and usually does not have funds.

How transfer tax is determined on a deed-in-lieu transaction is dependent on the jurisdiction and can be a driving force in determining if a deed in lieu is a viable alternative. 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 amount of the debt. Some other states, consisting of Washington and Illinois, have simple exemptions for deed-in-lieu deals. In Connecticut, however, while there is an exemption for deed-in-lieu deals it is limited only to a transfer of the debtor's personal home.

For an industrial deal, the tax will be determined based on the full purchase rate, which is specifically defined as including the amount of liability which is presumed or to which the real estate is subject. Similarly, however even more possibly oppressive, New york city bases the amount of the transfer tax on "factor to consider," which is defined as the overdue balance of the debt, plus the total quantity of any other surviving liens and any quantities paid by the grantee (although if the loan is completely option, the factor to consider is topped at the reasonable market value of the residential or commercial property plus other quantities paid). Bearing in mind the lending institution will, in the majority of jurisdictions, have to pay this tax once again when ultimately offering the residential or commercial property, the particular jurisdiction's rules on transfer tax can be a determinative consider choosing whether a deed-in-lieu deal is a practical option.

Bankruptcy Issues

A major concern for lenders when identifying if a deed in lieu is a feasible alternative is the concern that if the debtor becomes a debtor in a personal bankruptcy case after the deed in lieu is total, the personal 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 debt, it falls squarely within subsection (b)( 2) of Section 547 of the Bankruptcy Code handling 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 customer becomes a debtor in a personal bankruptcy case, then the deed in lieu is at threat of being reserved.

Similarly, under Section 548 of the Bankruptcy Code, a transfer can be set aside if it is made within one year prior to a bankruptcy filing and the transfer was produced "less than a reasonably comparable worth" and if the transferor was insolvent at the time of the transfer, ended up being insolvent due to the fact that of the transfer, was engaged in a company that preserved an unreasonably low level of capital or meant to incur financial obligations beyond its ability to pay. In order to reduce versus these dangers, a loan provider should thoroughly review and assess the debtor's financial condition and liabilities and, ideally, need audited monetary statements to verify the solvency status of the borrower. Moreover, the deed-in-lieu agreement needs to include representations regarding solvency and a covenant from the customer not to apply for personal bankruptcy throughout the preference period.

This is yet another reason it is crucial for a loan provider to acquire an appraisal to verify the value of the residential or commercial property in relation to the debt. A present appraisal will help the loan provider refute any accusations that the transfer was made for less than reasonably equivalent worth.

Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, a lot of owners and their lending institutions will get policies of title insurance to secure their particular interests. A lender considering taking title to a residential or commercial property by virtue of a deed in lieu might ask whether it can count on its lender's policy when it becomes the cost owner. Coverage under a lender's policy of title insurance can continue after the acquisition of title if title is taken by the same entity that is the called guaranteed under the lender's policy.

Since lots of lending institutions prefer to have actually title vested in a separate affiliate entity, in order to ensure ongoing protection under the loan provider's policy, the named loan provider ought to appoint the mortgage to the designated affiliate title holder prior to, or all at once with, the transfer of the fee. In the option, the loan provider can take title and after that communicate the residential or commercial property by deed for no factor to consider to either its moms and dad company or a wholly owned subsidiary (although in some jurisdictions this might activate transfer tax liability).

Notwithstanding the extension in coverage, a lending institution'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 lending institution's policy would not offer the exact same or a sufficient level of protection. Moreover, a lender's policy does not obtain any security for matters which emerge after the date of the mortgage loan, leaving the loan provider exposed to any concerns or claims stemming from occasions which occur after the initial closing.

Due to the reality deed-in-lieu deals are more prone to challenge and dangers as detailed above, any title insurance provider releasing an owner's policy is most likely to undertake a more extensive evaluation of the deal throughout the underwriting process than they would in a common third-party purchase and sale deal. The title insurance provider will inspect the celebrations and the deed-in-lieu documents in order to identify and reduce risks provided by issues such as merger, obstructing, recharacterization and insolvency, thereby possibly increasing the time and expenses associated with closing the transaction, however eventually providing the loan provider with a higher level of security than the lending institution would have absent the title company's involvement.
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Ultimately, whether a deed-in-lieu deal is a practical choice for a lender is driven by the particular realities and situations of not just the loan and the residential or commercial property, however the parties involved too. Under the right set of scenarios, therefore long as the appropriate due diligence and documentation is obtained, a deed in lieu can provide the lending institution with a more efficient and more economical means 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 need support with such matters, please connect to lawyer Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most regularly work.