When an industrial mortgage lender sets out to enforce a mortgage loan following a debtor default, a crucial goal is to recognize the most expeditious way in which the loan provider can get control and possession of the underlying collateral. Under the right set of situations, a deed in lieu of foreclosure can be a quicker and more cost-effective option to the long and protracted foreclosure procedure. This short article talks about steps and problems loan providers ought to consider when making the choice to proceed with a deed in lieu of foreclosure and how to prevent unexpected risks and obstacles throughout and following the deed-in-lieu process.

Consideration

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 scenario, confirming adequate consideration is not as uncomplicated.

In a deed-in-lieu circumstance, the quantity of the underlying debt that is being forgiven by the lender generally is the basis for the consideration, and in order for such factor to consider to be considered "appropriate," the financial obligation ought to a minimum of equivalent or exceed the reasonable market price of the subject residential or commercial property. It is imperative that loan providers obtain an independent third-party appraisal to substantiate the worth of the residential or commercial property in relation to the amount of debt being forgiven. In addition, its advised the deed-in-lieu agreement consist of the debtor's express acknowledgement of the fair market price of the residential or commercial property in relation to the quantity of the debt and a waiver of any possible claims connected to 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 debtor who protects a loan with a mortgage on realty holds an unqualified right to redeem that residential or commercial property from the lending institution by repaying the financial obligation up till the point when the right of redemption is legally extinguished through an appropriate foreclosure. Preserving the debtor's equitable right of redemption is the reason that, 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 transactions preclude a borrower's fair right of redemption, nevertheless, steps can be taken to structure them to restrict or avoid the risk of a clogging difficulty. Most importantly, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure need to happen post-default and can not be pondered by the underlying loan files. Parties must likewise be wary of a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which consider that the borrower 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 transaction being recharacterized as a fair mortgage.

Steps can be required to alleviate against recharacterization threats. Some examples: if a borrower's residential or commercial property management functions are restricted to ministerial functions rather than substantive choice making, if a lease-back is short term and the payments are clearly structured as market-rate use and occupancy payments, or if any provision for reacquisition of the residential or commercial property by the customer is set up to be completely independent of the condition for the deed in lieu.

While not determinative, it is advised that deed-in-lieu arrangements include the celebrations' clear and unequivocal acknowledgement 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 loan provider makes a loan secured by a mortgage on realty, it holds an interest in the genuine estate by virtue of being the mortgagee under a mortgage (or a recipient under a deed of trust). If the lender 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 cost owner and obtaining the mortgagor's equity of redemption.

The general rule on this problem provides that, where a mortgagee obtains 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 occurs in the absence of evidence of a contrary intent. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is very important the arrangement clearly shows the parties' intent to keep the mortgage lien estate as distinct from the charge so the lending institution retains the capability to foreclose the underlying mortgage if there are stepping in liens. If the estates merge, then the lending institution's mortgage lien is extinguished and the lender loses the ability to handle stepping in liens by foreclosure, which might leave the lending institution in a potentially 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) ought to include express anti-merger language. Moreover, due to the fact that there can be no mortgage without a financial obligation, it is traditional in a deed-in-lieu circumstance for the lender to deliver a covenant not to take legal action against, instead of a straight-forward release of the financial obligation. The covenant not to sue furnishes consideration for the deed in lieu, protects the debtor against direct exposure from the debt and also keeps the lien of the mortgage, therefore allowing the lender to keep the ability to foreclose, must it end up being desirable to get rid of 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 deals can be a substantial sticking point. While many states make the payment of transfer tax a seller responsibility, as a practical matter, the lender winds up taking in the expense since the debtor remains in a default circumstance and typically does not have funds.

How transfer tax is calculated on a deed-in-lieu deal depends on the jurisdiction and can be a driving force in identifying 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, 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 just to a transfer of the debtor's personal house.

For a business transaction, the tax will be calculated based upon the full purchase cost, which is expressly specified 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 bases the amount of the transfer tax on "factor to consider," which is defined as the unpaid balance of the financial obligation, plus the overall amount of any other enduring liens and any amounts paid by the beneficiary (although if the loan is fully recourse, the consideration is topped at the reasonable market price of the residential or commercial property plus other amounts paid). Remembering the lender will, in most jurisdictions, need to pay this tax again when ultimately offering the residential or commercial property, the specific jurisdiction's guidelines on transfer tax can be a determinative factor in deciding whether a deed-in-lieu deal is a feasible alternative.

Bankruptcy Issues

A significant concern for loan providers when figuring out if a deed in lieu is a practical option is the concern that if the borrower 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 set aside. 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 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 period set forth in the Bankruptcy Code, the debtor 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 personal bankruptcy filing and the transfer was produced "less than a reasonably equivalent value" and if the transferor was insolvent at the time of the transfer, ended up being insolvent because of the transfer, was participated in a service that kept an unreasonably low level of capital or planned to sustain debts beyond its ability to pay. In order to reduce versus these risks, a loan provider ought to carefully evaluate and evaluate the borrower's financial condition and liabilities and, ideally, need audited financial declarations to verify the solvency status of the debtor. Moreover, the deed-in-lieu arrangement needs to include representations regarding solvency and a covenant from the customer not to apply for insolvency throughout the preference duration.

This is yet another reason it is imperative for a loan provider to procure an appraisal to confirm the value of the residential or commercial property in relation to the financial obligation. A current appraisal will assist the loan provider refute any allegations that the transfer was made for less than reasonably equivalent value.

Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, the majority of owners and their loan providers 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 might ask whether it can count on its loan provider's policy when it ends up being the fee owner. Coverage under a lender's policy of title insurance can after the acquisition of title if title is taken by the same entity that is the named guaranteed under the lending institution's policy.

Since numerous lenders prefer to have title vested in a different affiliate entity, in order to make sure ongoing protection under the loan provider's policy, the named lending institution must appoint the mortgage to the desired affiliate victor prior to, or simultaneously with, the transfer of the charge. In the option, the loan provider can take title and then convey the residential or commercial property by deed for no consideration to either its moms and dad company or an entirely owned subsidiary (although in some jurisdictions this could set off transfer tax liability).

Notwithstanding the extension in protection, a lending institution's policy does not convert to an owner's policy. Once the loan provider ends up being 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 provide the exact same or a sufficient level of protection. Moreover, a lender's policy does not obtain any protection for matters which arise after the date of the mortgage loan, leaving the lending institution exposed to any issues or claims coming from events which happen after the original closing.

Due to the reality deed-in-lieu deals are more susceptible to challenge and risks as laid out above, any title insurance provider issuing an owner's policy is likely to undertake a more strenuous evaluation of the transaction throughout the underwriting process than they would in a normal third-party purchase and sale transaction. The title insurer will inspect the celebrations and the deed-in-lieu documents in order to determine and alleviate threats provided by issues such as merger, clogging, recharacterization and insolvency, thereby possibly increasing the time and costs associated with closing the transaction, but ultimately providing the loan provider with a higher level of protection than the lender would have missing the title company's participation.
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Ultimately, whether a deed-in-lieu deal is a viable option for a lending institution is driven by the particular truths and scenarios of not only the loan and the residential or commercial property, however the celebrations included too. Under the right set of circumstances, therefore long as the correct due diligence and documentation is obtained, a deed in lieu can supply the loan provider with a more effective and less costly means 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 support 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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