When a commercial mortgage lending institution sets out to impose a mortgage loan following a customer default, an essential goal is to identify the most expeditious way in which the loan provider can get control and ownership of the underlying collateral. Under the right set of scenarios, a deed in lieu of foreclosure can be a faster and more economical option to the long and protracted foreclosure process. This post discusses steps and issues lending institutions should consider when making the decision to proceed with a deed in lieu of foreclosure and how to prevent unanticipated threats and difficulties throughout and following the deed-in-lieu process.

Consideration

A key component of any agreement is making sure there is sufficient consideration. In a basic deal, consideration can easily be established through the purchase rate, however in a deed-in-lieu circumstance, confirming adequate consideration is not as simple.

In a deed-in-lieu situation, the amount of the underlying debt that is being forgiven by the lending institution typically is the basis for the consideration, and in order for such factor to consider to be deemed "adequate," the financial obligation ought to a minimum of equivalent or go beyond the fair market worth of the subject residential or commercial property. It is necessary that lenders obtain an independent third-party appraisal to substantiate the worth of the residential or commercial property in relation to the quantity of financial obligation being forgiven. In addition, its advised the deed-in-lieu contract include the debtor's reveal acknowledgement of the reasonable market worth 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 principal 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 lending institution by paying back the financial obligation up until the point when the right of redemption is lawfully extinguished through an appropriate foreclosure. Preserving the borrower's fair 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 loan provider.

Deed-in-lieu transactions preclude a customer's equitable right of redemption, however, actions can be required to structure them to limit or avoid the danger of a blocking difficulty. First and foremost, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure should take location post-default and can not be considered by the underlying loan documents. Parties ought to likewise watch out for a deed-in-lieu plan where, following the transfer, there is a continuation of a debtor/creditor relationship, or which contemplate that the debtor keeps rights to the residential or commercial property, either as a residential or commercial property supervisor, a renter or through repurchase alternatives, as any of these plans can create a risk of the transaction being recharacterized as a fair mortgage.

Steps can be taken to mitigate against recharacterization threats. Some examples: if a customer'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 tenancy payments, or if any arrangement for reacquisition of the residential or commercial property by the debtor is established 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 recognition that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security functions only.

Merger of Title

When a lending institution makes a loan secured by a mortgage on real estate, it holds an interest in the realty by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the loan provider then acquires the genuine 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 problem supplies 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 fee occurs in the lack of evidence of a contrary objective. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is very important the arrangement plainly reflects the celebrations' intent to maintain the mortgage lien estate as unique from the charge so the lending institution retains the ability to foreclose the hidden mortgage if there are intervening liens. If the estates combine, then the lender's mortgage lien is extinguished and the lender loses the capability to deal with intervening liens by foreclosure, which might leave the loan provider in a possibly worse position than if the lending institution pursued a foreclosure from the start.

In order to clearly show the parties' intent on this point, the deed-in-lieu contract (and the deed itself) need to include express 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 lender to provide a covenant not to sue, instead of a straight-forward release of the debt. The covenant not to take legal action against furnishes consideration for the deed in lieu, safeguards the borrower against exposure from the financial obligation and also maintains the lien of the mortgage, thereby permitting the lender to maintain the ability to foreclose, should it end up being preferable to get rid of junior encumbrances after the deed in lieu is complete.

Transfer Tax

Depending upon the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu transactions can be a significant sticking point. While most states make the payment of transfer tax a seller obligation, as a useful matter, the lender ends up taking in the expense considering that the customer remains in a default situation and generally does not have funds.

How transfer tax is computed on a deed-in-lieu transaction depends on the jurisdiction and can be a driving force in figuring out if a deed in lieu is a feasible option. 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 amount of the debt. Some other states, consisting of Washington and Illinois, have straightforward exemptions for deed-in-lieu deals. In Connecticut, however, while there is an exemption for deed-in-lieu transactions it is limited just to a transfer of the borrower's personal home.

For a business deal, the tax will be computed based upon the complete purchase price, which is expressly defined as including the amount of liability which is assumed or to which the real estate is subject. Similarly, but much more possibly extreme, New york city bases the amount of the transfer tax on "consideration," which is specified as the overdue balance of the financial obligation, plus the overall quantity of any other surviving liens and any quantities paid by the grantee (although if the loan is totally option, the factor to consider is capped at the reasonable market price of the residential or commercial property plus other quantities paid). Keeping in mind the lender will, in many jurisdictions, have to pay this tax again when eventually offering the residential or commercial property, the specific jurisdiction's rules on transfer tax can be a determinative aspect in choosing whether a deed-in-lieu transaction is a possible alternative.

Bankruptcy Issues

A significant issue for lenders when determining if a deed in lieu is a practical option is the issue that if the borrower ends up being a debtor in an insolvency case after the deed in lieu is complete, 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 financial obligation, it falls squarely 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 borrower insolvent) and within the 90-day duration set forth in the Bankruptcy Code, the borrower becomes 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 reserved if it is made within one year prior to a personal 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 participated in a service that preserved an unreasonably low level of capital or planned to incur debts beyond its capability to pay. In order to mitigate versus these threats, a lending institution needs to thoroughly review and assess the customer's monetary condition and liabilities and, ideally, require audited financial declarations to confirm the solvency status of the customer. Moreover, the deed-in-lieu contract needs to include representations as to solvency and a covenant from the debtor not to file for bankruptcy during the choice period.

This is yet another reason that it is essential for a lending institution to acquire 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 reasonably comparable value.

Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, many owners and their lending institutions will obtain policies of title insurance coverage to protect their particular interests. A lender thinking about 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 very same entity that is the called insured under the loan provider's policy.

Since lots of lending institutions choose to have title vested in a different affiliate entity, in order to ensure continued coverage under the lender's policy, the called ought to assign the mortgage to the intended affiliate title holder prior to, or at the same time with, the transfer of the cost. In the option, 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 company or an entirely owned subsidiary (although in some jurisdictions this could trigger transfer tax liability).

Notwithstanding the extension in coverage, a lender's policy does not convert to an owner's policy. Once the loan provider becomes 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 supply the exact same or an adequate level of defense. Moreover, a loan provider's policy does not obtain any security for matters which emerge after the date of the mortgage loan, leaving the lending institution exposed to any concerns or claims stemming from events which occur after the original closing.

Due to the truth deed-in-lieu deals are more susceptible to challenge and threats as outlined above, any title insurance provider providing an owner's policy is most likely to carry out a more rigorous evaluation of the transaction throughout the underwriting process than they would in a normal third-party purchase and sale deal. The title insurance provider will scrutinize the celebrations and the deed-in-lieu documents in order to recognize and alleviate threats provided by problems such as merger, blocking, recharacterization and insolvency, consequently potentially increasing the time and expenses included in closing the deal, however ultimately offering the loan provider with a greater level of protection than the lending institution would have missing the title business's participation.

Ultimately, whether a deed-in-lieu deal is a feasible alternative for a lender is driven by the particular truths and circumstances of not just the loan and the residential or commercial property, however the celebrations included as well. Under the right set of scenarios, and so long as the correct due diligence and documents is obtained, a deed in lieu can offer the lending institution with a more efficient and more economical ways to understand on its security when a loan goes 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 attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach lawyer with whom you most frequently work.