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When a business mortgage lending institution sets out to enforce a mortgage loan following a customer default, a key goal is to identify the most expeditious way in which the lending institution can acquire control and belongings of the underlying collateral. Under the right set of scenarios, a deed in lieu of foreclosure can be a much faster and more cost-effective option to the long and protracted foreclosure procedure. This article discusses actions and problems lending institutions need to consider when making the decision to continue with a deed in lieu of foreclosure and how to avoid unanticipated threats and difficulties during and following the deed-in-lieu procedure.

Consideration

A crucial element of any agreement is making sure there is sufficient consideration. In a basic transaction, consideration can easily be established through the purchase cost, but in a deed-in-lieu scenario, confirming appropriate consideration is not as simple.

In a deed-in-lieu scenario, the amount of the underlying financial obligation that is being forgiven by the lender normally is the basis for the factor to consider, and in order for such consideration to be considered "appropriate," the debt must a minimum of equal or exceed the reasonable market value of the subject residential or commercial property. It is crucial that lending institutions acquire 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 contract consist of the customer's express acknowledgement of the reasonable market price of the residential or commercial property in relation to the quantity of the debt 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 debtor who protects a loan with a mortgage on genuine estate holds an unqualified right to redeem that residential or commercial property from the lending institution by repaying the debt up till the point when the right of redemption is legally snuffed out through a proper foreclosure. Preserving the customer's equitable 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 transactions prevent a customer's equitable right of redemption, however, steps can be required to structure them to restrict or prevent the threat of an obstructing challenge. Most importantly, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure must occur post-default and can not be pondered by the underlying loan files. Parties must likewise be careful of a deed-in-lieu arrangement where, following the transfer, there is a continuation of a debtor/creditor relationship, or which ponder that the borrower retains 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 plans can develop a danger of the deal being recharacterized as an equitable mortgage.

Steps can be taken to mitigate versus 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 plainly structured as market-rate use and occupancy payments, or if any arrangement for reacquisition of the residential or commercial property by the customer is established to be totally independent of the condition for the deed in lieu.

While not determinative, it is advised that deed-in-lieu agreements include the celebrations' clear and indisputable recognition that the transfer of the residential or commercial property is an absolute 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 property by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the loan provider then obtains the realty from a defaulting mortgagor, it now also holds an interest in the residential or commercial property by virtue of being the fee owner and acquiring the mortgagor's equity of redemption.

The general guideline on this concern offers that, where a mortgagee gets the fee 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 happens in the lack of evidence of a contrary objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is essential the arrangement plainly reflects the parties' intent to keep the mortgage lien estate as distinct from the charge so the loan provider maintains the ability to foreclose the underlying mortgage if there are stepping in liens. If the estates combine, then the loan provider's mortgage lien is extinguished and the lending institution loses the ability to deal with stepping in liens by foreclosure, which could leave the lender in a potentially worse position than if the lender pursued a foreclosure from the beginning.

In order to clearly show the celebrations' intent on this point, the deed-in-lieu agreement (and the deed itself) must consist of express anti-merger language. Moreover, since there can be no mortgage without a financial obligation, it is traditional in a deed-in-lieu scenario for the lending institution to provide a covenant not to take legal action against, instead of a straight-forward release of the financial obligation. The covenant not to sue furnishes factor to consider for the deed in lieu, safeguards the customer against direct exposure from the debt and likewise retains the lien of the mortgage, therefore allowing the lender to maintain the capability to foreclose, needs to it become preferable to remove junior encumbrances after the deed in lieu is total.

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 the majority of states make the payment of transfer tax a seller responsibility, as a practical matter, the lending institution winds up taking in the cost since the customer remains in a default circumstance and normally lacks funds.

How transfer tax is determined 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 practical 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 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 restricted only to a transfer of the customer's individual home.

For an industrial transaction, the tax will be determined based on the complete purchase rate, which is specifically defined as including the quantity of liability which is assumed or to which the real estate is subject. Similarly, but even more potentially severe, New york city bases the quantity of the transfer tax on "factor to consider," which is specified as the unpaid balance of the debt, plus the overall amount of any other liens and any amounts paid by the grantee (although if the loan is totally option, the consideration is topped at the reasonable market worth of the residential or commercial property plus other amounts paid). Remembering the loan provider will, in the majority of jurisdictions, need to pay this tax once again when eventually offering the residential or commercial property, the specific jurisdiction's rules on transfer tax can be a determinative aspect in deciding whether a deed-in-lieu transaction is a possible alternative.

Bankruptcy Issues

A significant concern for loan providers when identifying if a deed in lieu is a feasible alternative is the issue that if the borrower becomes a debtor in an insolvency case after the deed in lieu is total, 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 financial obligation, it falls squarely within subsection (b)( 2) of Section 547 of the Bankruptcy Code handling preferential transfers. Accordingly, if the transfer was made when the borrower was insolvent (or the transfer rendered the customer insolvent) and within the 90-day period stated in the Bankruptcy Code, the borrower becomes a debtor in a bankruptcy case, then the deed in lieu is at risk 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 personal 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, became insolvent due to the fact that of the transfer, was taken part in a business that preserved an unreasonably low level of capital or intended to incur financial obligations beyond its ability to pay. In order to reduce against these risks, a lending institution must thoroughly examine and assess the borrower's monetary condition and liabilities and, preferably, require audited financial declarations to confirm the solvency status of the customer. Moreover, the deed-in-lieu arrangement must include representations as to solvency and a covenant from the debtor not to declare bankruptcy throughout the preference period.

This is yet another factor why it is important for a lender to obtain an appraisal to validate the worth of the residential or commercial property in relation to the financial obligation. An existing appraisal will help the loan provider refute any allegations that the transfer was made for less than reasonably comparable value.

Title Insurance

As part of the preliminary acquisition of a genuine residential or commercial property, the majority of owners and their lending institutions will get policies of title insurance coverage to secure 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 depend on its loan provider's policy when it ends up being the cost 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 called insured under the lender's policy.

Since many lenders choose to have title vested in a different affiliate entity, in order to guarantee continued coverage under the lending institution's policy, the called lender must assign the mortgage to the intended affiliate victor prior to, or at the same time with, the transfer of the fee. In the alternative, the lending institution can take title and after that communicate the residential or commercial property by deed for no factor to consider to either its parent company or a wholly 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 transform 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 offer the very same or a sufficient level of protection. Moreover, a loan provider's policy does not get any protection for matters which emerge after the date of the mortgage loan, leaving the lender exposed to any issues or claims originating from occasions which occur after the initial closing.

Due to the reality deed-in-lieu transactions are more prone to challenge and dangers as detailed above, any title insurance company issuing an owner's policy is likely to carry out a more rigorous review 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 parties and the deed-in-lieu documents in order to determine and alleviate risks presented by issues such as merger, clogging, recharacterization and insolvency, thus possibly increasing the time and expenses associated with closing the transaction, but ultimately providing the loan provider with a higher level of security than the lending institution would have missing the title business's participation.

Ultimately, whether a deed-in-lieu transaction is a practical option for a lender is driven by the particular truths and scenarios of not just the loan and the residential or commercial property, but the celebrations involved also. Under the right set of scenarios, therefore long as the appropriate due diligence and documents is acquired, a deed in lieu can offer the loan provider with a more effective and cheaper methods to recognize on its security when a loan enters into default.

Harris Beach Murtha's Commercial Realty Practice Group is experienced with deed in lieu of foreclosures. If you require assistance with such matters, please reach out to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most often work.