When a commercial mortgage loan provider sets out to impose a mortgage loan following a customer default, a key objective is to recognize the most expeditious manner in which the loan provider can obtain control and ownership 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 drawn-out foreclosure process. This post talks about actions and concerns loan providers ought to consider when deciding to continue with a deed in lieu of foreclosure and how to prevent unanticipated risks and difficulties throughout and following the deed-in-lieu process.

Consideration

A crucial element of any contract is guaranteeing there is adequate consideration. In a standard deal, factor to consider can quickly be established through the purchase price, however in a deed-in-lieu situation, validating sufficient consideration is not as straightforward.

In a deed-in-lieu circumstance, the quantity of the underlying debt that is being forgiven by the lender normally is the basis for the consideration, and in order for such factor to consider to be deemed "adequate," the debt must at least equivalent or go beyond the reasonable market price of the subject residential or commercial property. It is imperative that lending institutions get an independent third-party appraisal to substantiate the value of the residential or commercial property in relation to the quantity of financial obligation being forgiven. In addition, its suggested the deed-in-lieu agreement include the customer's reveal recognition of the fair market value of the residential or commercial property in relation to the amount of the financial obligation and a waiver of any prospective claims related to 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 protects a loan with a mortgage on real estate holds an unqualified right to redeem that residential or commercial property from the loan provider by paying back the debt up until the point when the right of redemption is legally snuffed out through a correct foreclosure. Preserving the debtor's fair right of redemption is the reason that, prior to default, mortgage loans can not be structured to contemplate the voluntary transfer of the residential or commercial property to the lending institution.

Deed-in-lieu deals prevent a borrower's fair right of redemption, however, actions can be taken to structure them to restrict or prevent the risk of a clogging difficulty. Primarily, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure should happen post-default and can not be pondered by the underlying loan documents. Parties ought to likewise watch out for a deed-in-lieu arrangement 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 supervisor, a tenant or through repurchase alternatives, as any of these arrangements can create a danger of the transaction being recharacterized as a fair mortgage.

Steps can be taken to alleviate against recharacterization threats. Some examples: if a borrower'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 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 established to be entirely independent of the condition for the deed in lieu.

While not determinative, it is advised that deed-in-lieu agreements consist of the parties' clear and indisputable 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 protected by a mortgage on realty, 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 lender then gets the real 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 getting the mortgagor's equity of redemption.

The basic guideline on this issue supplies that, where a mortgagee acquires 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 essential the contract clearly shows the celebrations' intent to retain the mortgage lien estate as unique from the fee so the lender maintains the ability to foreclose the hidden mortgage if there are stepping in liens. If the estates merge, then the lender's mortgage lien is extinguished and the lending institution loses the ability to deal with stepping in liens by foreclosure, which might leave the loan provider in a possibly even worse position than if the lending institution pursued a foreclosure from the beginning.

In order to clearly reflect the celebrations' intent on this point, the deed-in-lieu contract (and the deed itself) need to include express anti-merger language. Moreover, due to the fact that there can be no mortgage without a financial obligation, it is customary in a deed-in-lieu situation for the loan provider to provide a covenant not to take legal action against, instead of a straight-forward release of the financial obligation. The covenant not to take legal action against furnishes consideration for the deed in lieu, protects the debtor against exposure from the financial obligation and also maintains the lien of the mortgage, thereby permitting the loan provider to maintain the capability to foreclose, must it become preferable to eliminate 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 many states make the payment of transfer tax a seller commitment, as a practical matter, the lending institution ends up taking in the expense given that the customer remains in a default circumstance and generally 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 feasible option. In California, for instance, a conveyance or transfer from the mortgagor to the mortgagee as a result of a foreclosure or a deed in lieu will be exempt approximately the amount of the financial obligation. Some other states, including Washington and Illinois, have simple exemptions for deed-in-lieu transactions. In Connecticut, however, while there is an exemption for deed-in-lieu transactions it is restricted only to a transfer of the borrower's individual residence.

For an industrial transaction, the tax will be calculated based upon the complete purchase rate, which is expressly defined as consisting of the quantity of liability which is assumed or to which the real estate is subject. Similarly, but a lot more potentially heavy-handed, New york city bases the amount of the transfer tax on "factor to consider," which is specified as the overdue balance of the financial obligation, plus the overall amount of any other surviving liens and any amounts paid by the beneficiary (although if the loan is totally option, the consideration is topped at the fair market price of the residential or plus other amounts paid). Keeping in mind the loan provider will, in a lot of jurisdictions, need to pay this tax again when ultimately selling the residential or commercial property, the specific jurisdiction's guidelines on transfer tax can be a determinative consider deciding whether a deed-in-lieu deal is a possible alternative.

Bankruptcy Issues

A significant issue for lenders when figuring out if a deed in lieu is a practical option 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 transaction 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 borrower was insolvent (or the transfer rendered the debtor insolvent) and within the 90-day period set forth in the Bankruptcy Code, the customer ends up being a debtor in a bankruptcy case, then the deed in lieu is at threat of being set aside.

Similarly, under Section 548 of the Bankruptcy Code, a transfer can be set aside if it is made within one year prior to an insolvency filing and the transfer was made for "less than a fairly comparable value" and if the transferor was insolvent at the time of the transfer, became insolvent since of the transfer, was taken part in a service that kept an unreasonably low level of capital or meant to sustain debts beyond its capability to pay. In order to reduce versus these dangers, a lending institution should thoroughly review and examine the debtor's financial condition and liabilities and, preferably, require audited financial declarations to validate the solvency status of the debtor. Moreover, the deed-in-lieu contract should consist of representations regarding solvency and a covenant from the borrower not to apply for personal bankruptcy throughout the choice period.

This is yet another factor why it is essential for a loan provider to acquire an appraisal to validate 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 produced less than fairly equivalent worth.

Title Insurance

As part of the initial acquisition of a real residential or commercial property, many owners and their lending institutions will acquire policies of title insurance coverage to safeguard their particular 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 lending institution's policy when it ends up being the charge owner. Coverage under a loan provider's policy of title insurance can continue after the acquisition of title if title is taken by the very same entity that is the called guaranteed under the lending institution's policy.

Since lots of loan providers choose to have title vested in a different affiliate entity, in order to ensure continued coverage under the loan provider's policy, the named loan provider should assign the mortgage to the intended affiliate victor prior to, or simultaneously with, the transfer of the fee. In the alternative, the lender can take title and after that convey the residential or commercial property by deed for no consideration to either its moms and dad company or a completely owned subsidiary (although in some jurisdictions this could activate transfer tax liability).

Notwithstanding the extension in protection, a loan provider's policy does not transform to an owner's policy. Once the lender 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 provide the exact same or an adequate level of protection. Moreover, a lending institution's policy does not obtain any protection for matters which emerge after the date of the mortgage loan, leaving the lender exposed to any problems or claims stemming from occasions which take place after the initial closing.

Due to the truth deed-in-lieu transactions are more prone to challenge and dangers as detailed above, any title insurer releasing an owner's policy is likely to undertake a more extensive evaluation of the transaction during the underwriting process than they would in a normal third-party purchase and sale deal. The title insurer will inspect the celebrations and the deed-in-lieu files in order to determine and mitigate threats provided by problems such as merger, obstructing, recharacterization and insolvency, consequently possibly increasing the time and expenses associated with closing the transaction, but ultimately providing the lending institution with a higher level of security than the lending institution would have absent the title company's involvement.
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Ultimately, whether a deed-in-lieu transaction is a feasible option for a loan provider is driven by the particular facts and scenarios of not just the loan and the residential or commercial property, but the celebrations involved as well. Under the right set of circumstances, therefore long as the appropriate due diligence and paperwork is obtained, a deed in lieu can offer the lender with a more efficient and less costly ways to realize 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 assistance with such matters, please connect to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most frequently work.