When an industrial mortgage lending institution sets out to impose a mortgage loan following a customer default, a key objective is to identify the most expeditious way in which the lender can get control and belongings of the underlying collateral. Under the right set of circumstances, a deed in lieu of foreclosure can be a faster and more economical alternative to the long and lengthy foreclosure process. This short article discusses actions and problems loan providers ought to think about when making the choice to continue with a deed in lieu of foreclosure and how to prevent unexpected risks and challenges throughout and following the deed-in-lieu process.

Consideration

A key aspect of any contract is guaranteeing there is appropriate consideration. In a basic transaction, factor to consider can easily be established through the purchase cost, however in a deed-in-lieu situation, verifying adequate factor to consider is not as simple.

In a deed-in-lieu circumstance, the amount of the underlying debt that is being forgiven by the loan provider normally is the basis for the consideration, and in order for such consideration to be deemed "appropriate," the financial obligation should at least equal or go beyond the reasonable market price of the subject residential or commercial property. It is necessary that loan providers acquire an independent third-party appraisal to validate the value of the residential or commercial property in relation to the amount of debt being forgiven. In addition, its suggested the deed-in-lieu agreement consist of the borrower's express recognition of the fair market price of the residential or commercial property in relation to the amount of the financial obligation and a waiver of any potential claims associated with the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English common law that a borrower who secures a loan with a mortgage on realty holds an unqualified right to redeem that residential or commercial property from the loan provider by paying back the financial obligation up till the point when the right of redemption is legally snuffed out through a proper foreclosure. Preserving the borrower's fair right of redemption is the reason why, 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 preclude a debtor's fair right of redemption, however, steps can be required to structure them to restrict or avoid the risk of a blocking difficulty. Primarily, the contemplation 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 documents. Parties must also be cautious of a deed-in-lieu plan where, following the transfer, there is an extension 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, an occupant or through repurchase options, as any of these arrangements can create a danger of the deal being recharacterized as a fair mortgage.

Steps can be taken to mitigate versus recharacterization threats. Some examples: if a debtor's residential or commercial property management functions are limited to ministerial functions rather than substantive decision making, if a lease-back is short 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 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 include the celebrations' clear and unequivocal recognition that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security purposes only.

Merger of Title

When a lending institution makes a loan secured 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 acquires the property from a defaulting mortgagor, it now also holds an interest in the residential or commercial property by virtue of being the fee owner and getting the mortgagor's equity of redemption.

The basic rule on this issue provides that, where a mortgagee gets 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 takes place in the lack of evidence of a contrary objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is necessary the contract clearly shows the parties' intent to keep the mortgage lien estate as unique from the cost so the loan provider keeps the capability to foreclose the hidden mortgage if there are stepping in liens. If the estates merge, then the lender's mortgage lien is snuffed out and the loan provider loses the ability to handle stepping in liens by foreclosure, which could leave the lending institution in a possibly even worse position than if the lending institution pursued a foreclosure from the start.

In order to plainly reflect the parties' intent on this point, the deed-in-lieu contract (and the deed itself) need to consist of express anti-merger language. Moreover, since there can be no mortgage without a financial obligation, it is customary in a deed-in-lieu circumstance for the lender to provide a covenant not to take legal action against, instead of a straight-forward release of the debt. The covenant not to take legal action against furnishes consideration for the deed in lieu, secures the customer versus direct exposure from the financial obligation and likewise retains the lien of the mortgage, therefore enabling the lending institution to preserve the ability to foreclose, ought to it become preferable to remove junior encumbrances after the deed in lieu is complete.

Transfer Tax

Depending on the jurisdiction, dealing with 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 obligation, as a practical matter, the lending institution winds up taking in the expense considering that the debtor remains in a default circumstance and typically does not have funds.

How transfer tax is computed on a deed-in-lieu deal depends on the jurisdiction and can be a driving force in determining if a deed in lieu is a feasible 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 as much as 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 borrower's personal residence.

For an industrial deal, the tax will be calculated based upon the complete purchase price, which is expressly defined as consisting of the quantity of liability which is assumed or to which the real estate is subject. Similarly, however much more potentially heavy-handed, New York bases the quantity of the transfer tax on "factor to consider," which is specified as the unsettled balance of the financial obligation, plus the total amount of any other surviving liens and any quantities paid by the (although if the loan is fully option, the factor to consider is capped at the reasonable market price of the residential or commercial property plus other amounts paid). Bearing in mind the loan provider will, in a lot of jurisdictions, have to pay this tax once again when ultimately selling the residential or commercial property, the specific jurisdiction's guidelines on transfer tax can be a determinative consider choosing whether a deed-in-lieu transaction is a possible option.

Bankruptcy Issues
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A significant concern for lenders when identifying if a deed in lieu is a viable option is the issue that if the customer becomes a debtor in an insolvency case after the deed in lieu is total, the personal bankruptcy court can cause 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 dealing with preferential transfers. Accordingly, if the transfer was made when the debtor was insolvent (or the transfer rendered the customer insolvent) and within the 90-day period set forth in the Bankruptcy Code, the debtor ends up being a debtor in an insolvency 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 fairly equivalent value" and if the transferor was insolvent at the time of the transfer, became insolvent because of the transfer, was taken part in an organization that kept an unreasonably low level of capital or intended 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 financial declarations to verify the solvency status of the customer. Moreover, the deed-in-lieu agreement needs to consist of representations regarding solvency and a covenant from the debtor not to apply for bankruptcy during the preference period.

This is yet another reason why it is imperative for a lending institution to obtain an appraisal to validate the worth of the residential or commercial property in relation to the debt. A current appraisal will assist the lender refute any accusations that the transfer was produced less than fairly comparable worth.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, a lot of owners and their lenders will acquire policies of title insurance coverage to safeguard their respective interests. A lender considering taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can count on its lending institution'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 exact same entity that is the named insured under the lending institution's policy.

Since many lending institutions choose to have actually title vested in a different affiliate entity, in order to make sure ongoing protection under the lender's policy, the called lending institution needs to assign the mortgage to the designated affiliate victor prior to, or at the same time with, the transfer of the cost. In the alternative, the lending institution can take title and then communicate the residential or commercial property by deed for no factor to consider to either its moms and dad business or an entirely owned subsidiary (although in some jurisdictions this might activate transfer tax liability).

Notwithstanding the extension in protection, a loan provider'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 very same or an appropriate level of security. Moreover, a lending institution's policy does not get any protection for matters which develop after the date of the mortgage loan, leaving the lending institution exposed to any concerns or claims originating from events which occur after the original closing.

Due to the fact deed-in-lieu deals are more vulnerable to challenge and dangers as outlined above, any title insurer providing an owner's policy is most likely to undertake a more strenuous review of the transaction during the underwriting process than they would in a typical third-party purchase and sale deal. The title insurance company will inspect the celebrations and the deed-in-lieu files in order to identify and alleviate threats provided by problems such as merger, clogging, recharacterization and insolvency, thus possibly increasing the time and costs associated with closing the deal, however eventually supplying the lender with a higher 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 choice for a lender is driven by the particular facts and scenarios of not just the loan and the residential or commercial property, however the parties involved as well. Under the right set of situations, and so long as the appropriate due diligence and documentation is gotten, a deed in lieu can provide the lending institution with a more efficient and cheaper ways to realize on its security when a loan goes into default.

Harris Beach Murtha's Commercial Realty Practice Group is experienced with deed in lieu of foreclosures. If you require 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.