When a commercial mortgage lending institution sets out to impose a mortgage loan following a borrower default, a key objective is to determine the most expeditious way in which the loan provider can obtain control and belongings of the underlying security. Under the right set of situations, a deed in lieu of foreclosure can be a faster and more economical option to the long and drawn-out foreclosure process. This article goes over steps and problems lending institutions should think about when deciding to proceed with a deed in lieu of foreclosure and how to avoid unforeseen threats and obstacles throughout and following the deed-in-lieu process.

Consideration

A crucial element of any agreement is making sure there is sufficient factor to consider. In a basic deal, factor to consider can easily be developed through the purchase cost, however in a deed-in-lieu situation, confirming sufficient consideration is not as simple.

In a deed-in-lieu circumstance, the amount of the underlying financial obligation that is being forgiven by the loan provider normally is the basis for the consideration, and in order for such factor to consider to be considered "appropriate," the debt must at least equivalent or exceed the fair market price of the subject residential or commercial property. It is essential that lenders acquire an independent third-party appraisal to corroborate 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 contract include the borrower's express acknowledgement of the reasonable market price of the residential or commercial property in relation to the amount of the debt and a waiver of any prospective claims connected to the adequacy of the factor to consider.

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 property holds an unqualified right to redeem that residential or commercial property from the lender by paying back the financial obligation up until the point when the right of redemption is lawfully snuffed out through a . Preserving the borrower's fair right of redemption is the factor why, prior to default, mortgage loans can not be structured to ponder the voluntary transfer of the residential or commercial property to the lender.

Deed-in-lieu deals preclude a debtor's fair right of redemption, however, actions can be required to structure them to restrict or prevent the danger of a blocking challenge. Most importantly, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure must take place post-default and can not be pondered by the underlying loan files. Parties ought to also be cautious of a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which contemplate that the borrower retains rights to the residential or commercial property, either as a residential or commercial property manager, an occupant or through repurchase options, as any of these plans can develop a danger of the deal being recharacterized as a fair mortgage.

Steps can be required to mitigate against recharacterization dangers. Some examples: if a debtor's residential or commercial property management functions are restricted to ministerial functions rather than substantive decision making, if a lease-back is brief term and the payments are plainly structured as market-rate usage and occupancy payments, or if any provision 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 recommended that deed-in-lieu agreements consist of the parties' clear and unquestionable recognition that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security purposes just.

Merger of Title

When a loan provider makes a loan protected 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 loan provider then obtains the real estate from a defaulting mortgagor, it now also holds an interest in the residential or commercial property by virtue of being the fee owner and obtaining the mortgagor's equity of redemption.

The basic guideline on this concern provides 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 occurs in the lack of evidence of a contrary intention. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is necessary the agreement clearly reflects the celebrations' intent to maintain the mortgage lien estate as distinct 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 lending institution's mortgage lien is extinguished and the lending institution loses the ability to deal with stepping in liens by foreclosure, which could leave the loan provider in a potentially 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) must consist of reveal anti-merger language. Moreover, because there can be no mortgage without a financial obligation, it is traditional in a deed-in-lieu circumstance for the loan provider to deliver a covenant not to take legal action against, rather than a straight-forward release of the financial obligation. The covenant not to take legal action against furnishes consideration for the deed in lieu, protects the debtor against direct exposure from the debt and also retains the lien of the mortgage, consequently allowing the lending institution to keep the ability to foreclose, should it end up being preferable to remove 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 deals can be a considerable sticking point. While most states make the payment of transfer tax a seller obligation, as a useful matter, the loan provider winds up absorbing the cost because the borrower remains in a default circumstance and normally does not have funds.

How transfer tax is calculated on a deed-in-lieu transaction depends on the jurisdiction and can be a driving force in determining if a deed in lieu is a feasible alternative. In California, for instance, 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 uncomplicated exemptions for deed-in-lieu transactions. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu deals it is restricted just to a transfer of the customer's personal home.

For an industrial transaction, the tax will be calculated based upon the complete purchase cost, which is expressly defined as consisting of the amount of liability which is assumed or to which the real estate is subject. Similarly, however even more potentially oppressive, New york city bases the quantity of the transfer tax on "factor to consider," which is specified as the unpaid balance of the debt, plus the overall amount of any other making it through liens and any amounts paid by the beneficiary (although if the loan is completely recourse, the consideration is capped at the reasonable market price of the residential or commercial property plus other quantities paid). Bearing in mind the loan provider will, in most jurisdictions, need 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 factor in deciding whether a deed-in-lieu transaction is a possible option.

Bankruptcy Issues

A major issue for lenders when identifying if a deed in lieu is a practical option is the issue that if the borrower ends up being a debtor in a personal bankruptcy case after the deed in lieu is complete, the insolvency 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 squarely within subsection (b)( 2) of Section 547 of the Bankruptcy Code handling preferential transfers. Accordingly, if the transfer was made when the borrower was insolvent (or the transfer rendered the customer insolvent) and within the 90-day duration set forth in the Bankruptcy Code, the debtor becomes a debtor in a personal bankruptcy 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 fairly equivalent value" and if the transferor was insolvent at the time of the transfer, ended up being insolvent since of the transfer, was engaged in a service that preserved an unreasonably low level of capital or meant to sustain financial obligations beyond its ability to pay. In order to reduce against these risks, a lender should thoroughly evaluate and assess the customer's monetary condition and liabilities and, ideally, need audited monetary statements to verify the solvency status of the borrower. Moreover, the deed-in-lieu agreement must consist of representations as to solvency and a covenant from the borrower not to declare personal bankruptcy during the preference period.

This is yet another reason it is crucial for a lending institution to procure an appraisal to validate the worth of the residential or commercial property in relation to the debt. A current appraisal will help the lender refute any claims 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, the majority of owners and their lending institutions will acquire policies of title insurance coverage to secure their respective 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 count on its lender's policy when it ends up being the fee owner. Coverage under a lending institution's policy of title insurance can continue after the acquisition of title if title is taken by the same entity that is the named guaranteed under the loan provider's policy.

Since many lenders choose to have actually title vested in a separate affiliate entity, in order to make sure ongoing protection under the lending institution's policy, the named loan provider ought to designate the mortgage to the intended affiliate title holder prior to, or all at once with, the transfer of the cost. In the alternative, the lender can take title and then convey the residential or commercial property by deed for no consideration to either its parent business or a completely owned subsidiary (although in some jurisdictions this could trigger transfer tax liability).

Notwithstanding the continuation in coverage, a lending institution's policy does not convert 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 offer the exact same or a sufficient level of security. Moreover, a loan provider's policy does not obtain any protection for matters which occur after the date of the mortgage loan, leaving the loan provider exposed to any issues or claims coming from events which take place after the original closing.

Due to the truth deed-in-lieu transactions are more vulnerable to challenge and dangers as described above, any title insurance company releasing an owner's policy is most likely to undertake a more rigorous review of the transaction during the underwriting process 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 recognize and alleviate risks presented by problems such as merger, obstructing, recharacterization and insolvency, therefore possibly increasing the time and expenses involved in closing the deal, however eventually providing the lending institution with a greater level of protection than the loan provider would have absent the title company's involvement.

Ultimately, whether a deed-in-lieu deal is a viable option for a lender is driven by the particular facts and situations of not just the loan and the residential or commercial property, but the parties included as well. Under the right set of circumstances, therefore long as the correct due diligence and documentation is gotten, a deed in lieu can supply the lender with a more efficient and cheaper ways to understand 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 assistance 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.
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