When a commercial mortgage lending institution sets out to implement a mortgage loan following a debtor default, a key goal is to recognize the most expeditious way in which the lending institution can obtain control and possession of the underlying collateral. Under the right set of scenarios, a deed in lieu of foreclosure can be a quicker and more affordable option to the long and drawn-out foreclosure process. This post goes over steps and issues loan providers ought to think about when making the choice to continue with a deed in lieu of foreclosure and how to avoid unexpected dangers and difficulties during and following the deed-in-lieu process.

Consideration
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A crucial element of any contract is making sure there is sufficient consideration. In a basic deal, consideration can quickly be established through the purchase rate, but in a deed-in-lieu situation, confirming appropriate consideration is not as simple.

In a deed-in-lieu scenario, the quantity of the underlying debt that is being forgiven by the lender typically is the basis for the consideration, and in order for such factor to consider to be deemed "appropriate," the debt needs to a minimum of equal or go beyond the fair market worth of the subject residential or commercial property. It is crucial that lending institutions obtain 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 suggested the deed-in-lieu contract include the debtor's express recognition of the fair market value of the residential or commercial property in relation to the amount of the debt and a waiver of any possible claims related to the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a principal rooted in ancient English typical law that a debtor 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 debt up until the point when the right of redemption is lawfully snuffed out through a correct foreclosure. Preserving the debtor's fair 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 loan provider.

Deed-in-lieu deals prevent a customer's fair right of redemption, nevertheless, steps can be taken to structure them to limit or prevent the threat of an obstructing obstacle. First and primary, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure need to occur post-default and can not be contemplated by the underlying loan documents. Parties need to also be wary of a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which consider that the borrower retains rights to the residential or commercial property, either as a residential or commercial property manager, an occupant or through repurchase alternatives, as any of these arrangements can develop a danger of the transaction being recharacterized as a fair mortgage.

Steps can be required to reduce against recharacterization dangers. Some examples: if a borrower'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 arrangement for reacquisition of the residential or commercial property by the borrower is established to be totally independent of the condition for the deed in lieu.

While not determinative, it is suggested that deed-in-lieu arrangements consist of the celebrations' clear and unequivocal acknowledgement 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 loan provider 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 lending institution then gets 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 obtaining the mortgagor's equity of redemption.

The general rule 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 documenting a deed in lieu of foreclosure, it is crucial the agreement clearly reflects the parties' intent to retain the mortgage lien estate as unique from the fee so the lending institution keeps the capability to foreclose the underlying mortgage if there are intervening liens. If the estates combine, then the lender's mortgage lien is snuffed out and the lending institution loses the capability to deal with intervening liens by foreclosure, which could leave the loan provider in a potentially even worse position than if the loan provider 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) should consist of 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 circumstance for the loan provider to deliver a covenant not to sue, rather than a straight-forward release of the financial obligation. 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 keeps the lien of the mortgage, thereby allowing the lending institution to maintain the ability to foreclose, ought to it become preferable to remove junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending on the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu deals can be a significant sticking point. While the majority of states make the payment of transfer tax a seller obligation, as a practical matter, the lender winds up soaking up the cost given that the borrower remains in a default circumstance and typically does not have funds.

How transfer tax is 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 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 as much as the amount of the financial obligation. 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 restricted only to a transfer of the customer's personal house.

For a commercial deal, the tax will be calculated based upon the full purchase cost, which is expressly specified as consisting of the quantity of liability which is assumed or to which the real estate is subject. Similarly, however much more potentially draconian, New York bases the amount of the transfer tax on "consideration," which is defined as the unpaid balance of the debt, plus the overall amount of any other making it through liens and any amounts paid by the beneficiary (although if the loan is fully option, the consideration is topped at the fair market worth of the residential or commercial property plus other amounts paid). Bearing in mind the lender will, in a lot of jurisdictions, have to pay this tax again when eventually selling the residential or commercial property, the specific jurisdiction's guidelines on transfer tax can be a determinative aspect in deciding whether a deed-in-lieu transaction is a feasible option.

Bankruptcy Issues
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A significant issue for lenders when figuring out if a deed in lieu is a feasible alternative is the concern that if the borrower becomes a debtor in a personal bankruptcy case after the deed in lieu is complete, the bankruptcy 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 squarely 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 debtor insolvent) and within the 90-day period stated in the Bankruptcy Code, the customer becomes a debtor in an insolvency case, then the deed in lieu is at risk 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 a bankruptcy filing and the transfer was made for "less than a reasonably comparable value" and if the transferor was insolvent at the time of the transfer, ended up being insolvent since of the transfer, was engaged in a business that kept an unreasonably low level of capital or intended to sustain debts beyond its capability to pay. In order to alleviate versus these dangers, a loan provider should thoroughly examine and evaluate the customer's monetary condition and liabilities and, preferably, require audited financial statements to verify the solvency status of the borrower. Moreover, the deed-in-lieu contract must include representations as to solvency and a covenant from the debtor not to apply for insolvency throughout the choice duration.

This is yet another reason 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 lending institution refute any claims that the transfer was produced less than fairly comparable value.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, a lot of owners and their lenders will obtain policies of title insurance to safeguard their particular interests. A loan provider considering taking title to a residential or commercial property by virtue of a deed in lieu might ask whether it can rely on its lending institution's policy when it becomes the cost owner. Coverage under a lending institution's policy of title insurance 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 lots of lending institutions prefer to have title vested in a separate affiliate entity, in order to guarantee continued coverage under the lender's policy, the called lender ought to assign the mortgage to the designated affiliate victor prior to, or concurrently with, the transfer of the fee. In the option, the loan provider can take title and then communicate the residential or commercial property by deed for no consideration to either its parent company or a completely owned subsidiary (although in some jurisdictions this might set off transfer tax liability).

Notwithstanding the extension in coverage, a lending institution's policy does not convert to an owner's policy. Once the lender ends up being 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 supply the very same or an adequate level of defense. Moreover, a lender's policy does not get any security for matters which arise after the date of the mortgage loan, leaving the lender exposed to any concerns or claims coming from occasions which occur after the initial closing.

Due to the truth deed-in-lieu transactions are more susceptible to challenge and dangers as detailed above, any title insurance provider releasing an owner's policy is likely to undertake a more rigorous review of the deal throughout the underwriting process than they would in a common third-party purchase and sale deal. The title insurer will inspect the celebrations and the deed-in-lieu files in order to determine and alleviate risks provided by problems such as merger, obstructing, recharacterization and insolvency, thus potentially increasing the time and expenses associated with closing the transaction, but ultimately supplying the loan provider with a greater level of protection than the lending institution would have missing the title company's participation.

Ultimately, whether a deed-in-lieu transaction is a feasible alternative for a lender is driven by the particular facts and situations of not only the loan and the residential or commercial property, however the parties included as well. Under the right set of scenarios, and so long as the correct due diligence and paperwork is gotten, a deed in lieu can offer the lending institution with a more efficient and more economical methods to realize on its collateral when a loan enters into default.

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