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When an industrial mortgage loan provider sets out to implement a mortgage loan following a borrower default, a crucial objective is to recognize the most expeditious way in which the loan provider can get control and ownership of the underlying security. Under the right set of scenarios, a deed in lieu of foreclosure can be a quicker and more cost-effective alternative to the long and drawn-out foreclosure process. This post talks about steps and concerns lending institutions need to think about when making the decision to continue with a deed in lieu of foreclosure and how to avoid unanticipated risks and obstacles throughout and following the deed-in-lieu process.

Consideration
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A crucial element of any contract is guaranteeing there is sufficient factor to consider. In a basic transaction, consideration can easily be established through the purchase rate, but in a deed-in-lieu situation, validating adequate factor to consider is not as straightforward.

In a deed-in-lieu circumstance, the quantity of the underlying financial obligation that is being forgiven by the lending institution generally is the basis for the consideration, and in order for such consideration to be deemed "sufficient," the financial obligation must at least equivalent or exceed the fair market worth of the subject residential or commercial property. It is vital that lending institutions acquire an independent third-party appraisal to corroborate the value of the residential or commercial property in relation to the quantity of debt being forgiven. In addition, its recommended the deed-in-lieu contract include the debtor's express recognition of the fair market value of the residential or commercial property in relation to the amount of the financial obligation and a waiver of any prospective claims connected to the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English common law that a customer who secures a loan with a mortgage on real estate holds an unqualified right to redeem that residential or commercial property from the loan provider by paying back the debt up till the point when the right of redemption is legally extinguished through a correct foreclosure. Preserving the customer's equitable 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 lender.

Deed-in-lieu deals preclude a customer's equitable right of redemption, however, steps can be required to structure them to restrict or prevent the danger of a blocking difficulty. Primarily, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure need to occur post-default and can not be contemplated by the underlying loan documents. Parties ought to also be wary of a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which contemplate that the customer keeps rights to the residential or commercial property, either as a residential or commercial property manager, a tenant or through repurchase alternatives, as any of these plans can create a danger of the deal being recharacterized as a fair mortgage.

Steps can be taken to reduce against recharacterization dangers. Some examples: if a debtor'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 clearly structured as market-rate usage and tenancy payments, or if any provision for reacquisition of the residential or commercial property by the borrower is established to be totally independent of the condition for the deed in lieu.

While not determinative, it is recommended that deed-in-lieu agreements include the parties' clear and unequivocal acknowledgement 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 lender makes a loan protected by a mortgage on realty, 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 lender then acquires 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 obtaining the mortgagor's equity of redemption.

The basic guideline on this concern offers 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 charge happens in the absence of proof of a contrary intent. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is very important the contract plainly reflects the parties' intent to retain the mortgage lien estate as unique from the fee so the loan provider keeps the capability to foreclose the underlying mortgage if there are intervening liens. If the estates combine, then the loan provider's mortgage lien is snuffed out and the loan provider loses the capability to deal with intervening liens by foreclosure, which could leave the loan provider in a possibly worse position than if the lender pursued a foreclosure from the start.

In order to plainly reflect the parties' intent on this point, the (and the deed itself) need to include express anti-merger language. Moreover, since there can be no mortgage without a debt, it is customary in a deed-in-lieu situation for the lending institution to deliver a covenant not to sue, rather than a straight-forward release of the financial obligation. The covenant not to take legal action against furnishes factor to consider for the deed in lieu, protects the customer against direct exposure from the debt and also keeps the lien of the mortgage, consequently allowing the lending institution to maintain the capability to foreclose, must 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 substantial sticking point. While many states make the payment of transfer tax a seller obligation, as a useful matter, the loan provider ends up taking in the expense because the debtor remains in a default situation and usually does not have funds.

How transfer tax is calculated on a deed-in-lieu transaction is dependent on the jurisdiction and can be a driving force in identifying if a deed in lieu is a practical 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 up to the amount of the debt. Some other states, including Washington and Illinois, have straightforward exemptions for deed-in-lieu deals. In Connecticut, however, while there is an exemption for deed-in-lieu deals it is limited just to a transfer of the customer's individual house.

For a business deal, the tax will be computed based on the complete purchase price, which is specifically specified as including the quantity of liability which is presumed or to which the real estate is subject. Similarly, but even more potentially extreme, New York bases the amount of the transfer tax on "factor to consider," which is specified as the unpaid balance of the debt, plus the total amount of any other surviving liens and any amounts paid by the beneficiary (although if the loan is totally recourse, the factor to consider is topped at the fair market worth of the residential or commercial property plus other quantities paid). Remembering the lending institution will, in a lot of jurisdictions, have to pay this tax again when ultimately selling the residential or commercial property, the particular jurisdiction's rules on transfer tax can be a determinative consider deciding whether a deed-in-lieu transaction is a feasible choice.

Bankruptcy Issues

A major issue for lenders when figuring out if a deed in lieu is a practical alternative is the concern that if the borrower ends up being a debtor in a personal 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 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 borrower was insolvent (or the transfer rendered the borrower insolvent) and within the 90-day period set forth in the Bankruptcy Code, the customer becomes a debtor in a bankruptcy case, then the deed in lieu is at risk 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 a bankruptcy filing and the transfer was made for "less than a fairly equivalent 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 business that preserved an unreasonably low level of capital or meant to sustain debts beyond its capability to pay. In order to reduce against these dangers, a loan provider must carefully examine and assess the customer's monetary condition and liabilities and, preferably, need audited financial statements to confirm the solvency status of the debtor. Moreover, the deed-in-lieu arrangement must include representations as to solvency and a covenant from the customer not to declare bankruptcy during the choice period.

This is yet another reason why it is essential for a lending institution to acquire an appraisal to confirm the value of the residential or commercial property in relation to the financial obligation. A current appraisal will help the lending institution refute any accusations that the transfer was produced less than reasonably comparable value.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, many owners and their loan providers will get policies of title insurance coverage to safeguard their respective interests. A loan provider considering taking title to a residential or commercial property by virtue of a deed in lieu might ask whether it can rely on its loan provider's policy when it ends up being 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 exact same entity that is the called guaranteed under the lending institution's policy.

Since many lending institutions prefer to have actually title vested in a separate affiliate entity, in order to guarantee continued coverage under the loan provider's policy, the named lending institution should designate the mortgage to the intended affiliate victor prior to, or concurrently with, the transfer of the cost. In the option, the loan provider can take title and then convey the residential or commercial property by deed for no factor to consider to either its moms and dad company or an entirely owned subsidiary (although in some jurisdictions this might set off transfer tax liability).

Notwithstanding the extension in coverage, a lending institution's policy does not convert to an owner's policy. Once the lender ends up being 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 supply the same or an appropriate level of security. Moreover, a loan provider's policy does not get any defense for matters which emerge after the date of the mortgage loan, leaving the lending institution 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 vulnerable to challenge and dangers as detailed above, any title insurance company providing an owner's policy is most likely to undertake a more extensive review of the deal throughout the underwriting procedure than they would in a common third-party purchase and sale transaction. The title insurer will scrutinize the celebrations and the deed-in-lieu files in order to identify and alleviate dangers provided by concerns such as merger, blocking, recharacterization and insolvency, consequently potentially increasing the time and costs involved in closing the deal, however ultimately supplying the loan provider with a higher level of protection than the lender would have absent the title company's involvement.
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Ultimately, whether a deed-in-lieu transaction is a feasible alternative for a lending institution is driven by the specific truths and circumstances of not only the loan and the residential or commercial property, however the celebrations involved as well. Under the right set of situations, and so long as the correct due diligence and paperwork is acquired, a deed in lieu can offer the lending institution with a more effective and less costly ways to realize 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 support with such matters, please connect to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach lawyer with whom you most regularly work.