When a commercial mortgage lender sets out to enforce a mortgage loan following a borrower default, a crucial goal is to determine the most expeditious manner in which the lending institution can obtain control and belongings of the underlying collateral. Under the right set of scenarios, a deed in lieu of foreclosure can be a quicker and more economical alternative to the long and protracted foreclosure process. This article discusses actions and problems loan providers need to consider when making the choice to continue with a deed in lieu of foreclosure and how to avoid unforeseen threats and challenges throughout and following the deed-in-lieu procedure.

Consideration

An essential aspect of any contract is making sure there is adequate consideration. In a standard transaction, consideration can quickly 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 circumstance, the quantity of the underlying financial obligation that is being forgiven by the lending institution typically is the basis for the consideration, and in order for such consideration to be considered "sufficient," the financial obligation ought to a minimum of equivalent or go beyond the reasonable market price of the subject residential or commercial property. It is essential that loan providers get 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 suggested the deed-in-lieu arrangement consist of the debtor's reveal recognition of the fair market price 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 common 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 loan provider by paying back the financial obligation up till the point when the right of redemption is lawfully snuffed out through a correct foreclosure. Preserving the customer's equitable right of redemption is the reason, prior to default, mortgage loans can not be structured to contemplate the voluntary transfer of the residential or commercial property to the lending institution.
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Deed-in-lieu deals preclude a debtor's fair right of redemption, nevertheless, steps can be required to structure them to restrict or avoid the danger of a clogging obstacle. First and foremost, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure should happen post-default and can not be contemplated by the underlying loan files. Parties need to likewise be cautious of a deed-in-lieu arrangement where, following the transfer, there is a continuation of a debtor/creditor relationship, or which ponder that the customer retains rights to the residential or commercial property, either as a residential or commercial property supervisor, a tenant or through repurchase options, as any of these plans can produce a risk of the transaction being recharacterized as a fair mortgage.

Steps can be required to alleviate versus recharacterization risks. Some examples: if a customer's residential or commercial property management functions are restricted 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 tenancy 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 suggested that deed-in-lieu contracts include the celebrations' clear and unquestionable 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 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 realty from a defaulting mortgagor, it now also holds an interest in the residential or commercial property by virtue of being the cost owner and acquiring the mortgagor's equity of redemption.

The general guideline on this concern provides 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 cost occurs in the lack of proof of a contrary intention. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is very important the contract plainly reflects the celebrations' intent to maintain the mortgage lien estate as distinct from the fee so the lending institution retains the ability 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 loan provider loses the capability to handle stepping in liens by foreclosure, which could leave the lending institution in a potentially even worse position than if the lending institution pursued a foreclosure from the outset.

In order to clearly reflect the celebrations' intent on this point, the deed-in-lieu arrangement (and the deed itself) must include reveal anti-merger language. Moreover, due to the fact that there can be no mortgage without a debt, it is traditional 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 customer versus exposure from the debt and likewise retains the lien of the mortgage, consequently permitting the loan provider to maintain the ability to foreclose, ought to it end up being preferable to remove junior encumbrances after the deed in lieu is complete.

Transfer Tax

Depending upon the jurisdiction, dealing with transfer tax and the payment thereof in deed-in-lieu transactions can be a considerable sticking point. While most states make the payment of transfer tax a seller obligation, as a practical matter, the lender ends up absorbing the cost considering that the borrower is in a default scenario and normally lacks funds.

How transfer tax is computed on a deed-in-lieu deal is on the jurisdiction and can be a driving force in identifying if a deed in lieu is a viable alternative. In California, for example, a conveyance or transfer from the mortgagor to the mortgagee as an outcome of a foreclosure or a deed in lieu will be exempt up to the quantity of the debt. Some other states, consisting of Washington and Illinois, have uncomplicated exemptions for deed-in-lieu deals. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu deals it is limited only to a transfer of the borrower's individual house.

For a business deal, the tax will be computed based on the complete purchase cost, which is expressly defined as consisting of the quantity of liability which is assumed or to which the real estate is subject. Similarly, however a lot more possibly oppressive, New York bases the quantity of the transfer tax on "consideration," which is defined as the overdue balance of the debt, plus the total quantity of any other enduring liens and any amounts paid by the beneficiary (although if the loan is totally option, the consideration is capped at the fair market value of the residential or commercial property plus other amounts paid). Bearing in mind the lending institution will, in many jurisdictions, have 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 aspect in choosing whether a deed-in-lieu transaction is a possible choice.

Bankruptcy Issues

A major issue for lending institutions when identifying if a deed in lieu is a feasible alternative is the issue that if the customer ends up being a debtor in an insolvency case after the deed in lieu is complete, the insolvency 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 financial obligation, 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 stated in the Bankruptcy Code, the customer ends up being a debtor in an insolvency case, then the deed in lieu is at danger 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 made for "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 business that kept an unreasonably low level of capital or meant to incur financial obligations beyond its capability to pay. In order to alleviate against these risks, a loan provider must carefully evaluate and examine the debtor's financial condition and liabilities and, preferably, need audited monetary statements to validate the solvency status of the customer. Moreover, the deed-in-lieu agreement needs to include representations as to solvency and a covenant from the debtor not to declare insolvency throughout the preference period.

This is yet another reason that it is necessary for a lender to obtain an appraisal to validate the worth of the residential or commercial property in relation to the debt. A present appraisal will assist the lender refute any accusations that the transfer was made for less than fairly comparable worth.
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Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, the majority of owners and their lending institutions will get policies of title insurance coverage to protect their particular interests. A loan provider considering taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can rely on its lender's policy when it ends up being the charge owner. Coverage under a loan provider's policy of title insurance coverage can continue 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 lots of lenders prefer to have title vested in a different affiliate entity, in order to guarantee ongoing coverage under the lender's policy, the named lender needs to designate the mortgage to the intended affiliate title holder prior to, or simultaneously with, the transfer of the fee. In the option, the lender can take title and after that communicate 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 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 provide the same or an appropriate level of protection. Moreover, a loan provider's policy does not avail any protection for matters which occur after the date of the mortgage loan, leaving the lender exposed to any concerns or claims originating from occasions which happen after the initial closing.

Due to the reality deed-in-lieu transactions are more susceptible to challenge and threats as described above, any title insurance provider providing an owner's policy is likely to carry out a more strenuous review of the deal throughout the underwriting process than they would in a typical third-party purchase and sale transaction. The title insurer will inspect the celebrations and the deed-in-lieu files in order to recognize and alleviate threats presented by concerns such as merger, clogging, recharacterization and insolvency, thereby potentially increasing the time and expenses included in closing the deal, but eventually supplying the lender with a greater level of defense than the loan provider would have missing the title business's involvement.

Ultimately, whether a deed-in-lieu transaction is a viable alternative for a lender is driven by the particular facts and circumstances of not just the loan and the residential or commercial property, however the parties involved also. Under the right set of scenarios, therefore long as the correct due diligence and documents is obtained, a deed in lieu can supply the loan provider with a more efficient and less pricey methods to recognize on its collateral 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 help with such matters, please reach out to lawyer Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most frequently work.