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When an industrial mortgage lender sets out to impose a mortgage loan following a debtor default, a crucial goal is to determine the most expeditious way in which the loan provider can acquire control and ownership of the underlying security. Under the right set of scenarios, a deed in lieu of foreclosure can be a faster and more cost-effective alternative to the long and protracted foreclosure process. This post goes over steps and concerns lenders must consider when making the choice to proceed with a deed in lieu of foreclosure and how to prevent unanticipated dangers and difficulties during and following the deed-in-lieu procedure.

Consideration

An essential component of any agreement is making sure there is adequate consideration. In a basic transaction, consideration can easily be developed through the purchase rate, but in a deed-in-lieu situation, validating adequate consideration is not as simple.

In a deed-in-lieu scenario, the quantity of the underlying debt that is being forgiven by the loan provider usually is the basis for the consideration, and in order for such factor to consider to be deemed "sufficient," the debt ought to a minimum of equal or exceed the fair market value of the subject residential or commercial property. It is important that lenders acquire an independent third-party appraisal to corroborate the worth of the residential or commercial property in relation to the quantity of debt being forgiven. In addition, its suggested the deed-in-lieu agreement include the debtor's express recognition of the fair market worth of the residential or commercial property in relation to the quantity of the financial obligation and a waiver of any potential claims associated with the adequacy of the factor to consider.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English common law that a borrower who secures a loan with a mortgage on property holds an unqualified right to redeem that residential or commercial property from the loan provider by paying back the debt up till the point when the right of redemption is lawfully extinguished through an appropriate 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 lending institution.

Deed-in-lieu transactions prevent a customer's fair right of redemption, however, steps can be taken to structure them to restrict or avoid the threat of a clogging difficulty. Primarily, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure must occur post-default and can not be considered by the underlying loan files. Parties ought to likewise be careful of a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which ponder that the borrower maintains 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 arrangements can produce a risk of the transaction being recharacterized as a fair mortgage.

Steps can be required to reduce versus recharacterization dangers. Some examples: if a borrower's residential or commercial property management functions are limited to ministerial functions instead of substantive decision 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 set up to be entirely 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 unequivocal 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 property, it holds an interest in the genuine estate by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the lending institution then obtains the property from a defaulting mortgagor, it now likewise holds an interest in the residential or commercial property by virtue of being the charge owner and acquiring the mortgagor's equity of redemption.

The basic rule on this problem offers that, where a mortgagee obtains 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 charge takes place in the lack of evidence of a contrary objective. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is essential the arrangement clearly shows the celebrations' intent to maintain the mortgage lien estate as distinct from the charge so the lending institution retains the capability 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 lender loses the capability to handle intervening liens by foreclosure, which could leave the lending institution in a possibly worse position than if the loan provider pursued a foreclosure from the outset.

In order to clearly reflect the parties' intent on this point, the deed-in-lieu contract (and the deed itself) need to consist of reveal 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, instead of a straight-forward release of the debt. The covenant not to take legal action against furnishes factor to consider for the deed in lieu, secures the borrower versus exposure from the debt and likewise keeps the lien of the mortgage, consequently permitting the lending institution to keep the ability to foreclose, needs to it become desirable to eliminate 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 most states make the payment of transfer tax a seller responsibility, as a useful matter, the loan provider winds up soaking up the cost given that the customer remains in a default situation and generally does not have funds.

How transfer tax is determined 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 option. In California, for example, a conveyance or transfer from the mortgagor to the mortgagee as a result of a foreclosure or a deed in lieu will be exempt as much as the amount of the financial obligation. Some other states, including 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 only to a transfer of the debtor's individual residence.

For an industrial deal, the tax will be computed based on the complete purchase cost, which is specifically defined as consisting of the amount of liability which is assumed or to which the real estate is subject. Similarly, but a lot more potentially oppressive, New York bases the amount of the transfer tax on "consideration," which is defined as the overdue balance of the financial obligation, plus the total quantity of any other making it through liens and any amounts paid by the beneficiary (although if the loan is totally option, the consideration is topped at the reasonable market value of the residential or commercial property plus other amounts paid). Remembering the lending institution will, in most jurisdictions, have to pay this tax again when eventually offering the residential or commercial property, the particular jurisdiction's rules on transfer tax can be a determinative consider choosing whether a deed-in-lieu transaction is a practical choice.

Bankruptcy Issues

A significant issue for lending institutions when figuring out if a deed in lieu is a viable option is the issue that if the customer ends up being a debtor in a personal bankruptcy case after the deed in lieu is complete, the personal bankruptcy court can cause the transfer to be unwound or reserved. Because a deed-in-lieu deal 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 handling preferential transfers. Accordingly, if the transfer was made when the customer was insolvent (or the transfer rendered the customer insolvent) and within the 90-day period stated 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.
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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 produced "less than a reasonably equivalent value" 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 an organization that preserved an unreasonably low level of capital or intended to sustain debts beyond its ability to pay. In order to reduce versus these threats, a lending institution ought to thoroughly review and examine the borrower's monetary condition and liabilities and, ideally, require audited financial statements to confirm the solvency status of the debtor. Moreover, the deed-in-lieu agreement needs to include representations regarding solvency and a covenant from the customer not to submit for personal bankruptcy during the preference period.

This is yet another factor why it is imperative for a lending institution to procure an appraisal to verify the worth of the residential or commercial property in relation to the debt. A current appraisal will help the lending institution refute any accusations that the transfer was made for less than reasonably equivalent worth.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, many owners and their lenders will acquire 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 depend on its loan provider's policy when it becomes the fee owner. Coverage under a lending institution'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 insured under the lending institution's policy.

Since numerous lending institutions prefer to have title vested in a different affiliate entity, in order to make sure ongoing protection under the loan provider's policy, the named loan provider ought to appoint the mortgage to the designated affiliate title holder prior to, or all at once with, the transfer of the fee. In the option, the loan provider can take title and after that communicate the residential or commercial property by deed for no consideration to either its parent company or a wholly owned subsidiary (although in some jurisdictions this could trigger transfer tax liability).

Notwithstanding the extension in protection, a lending institution's policy does not transform 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 lending institution's policy would not provide the exact same or a sufficient level of protection. Moreover, a loan provider's policy does not obtain any defense for matters which occur after the date of the mortgage loan, leaving the lending institution exposed to any problems or claims stemming from events which happen after the initial closing.

Due to the truth deed-in-lieu deals are more vulnerable to challenge and threats as described above, any title insurance company providing an owner's policy is most likely to undertake a more rigorous review of the transaction during the underwriting process than they would in a normal third-party purchase and sale deal. The title insurance provider will inspect the celebrations and the deed-in-lieu files in order to identify and alleviate risks provided by problems such as merger, clogging, recharacterization and insolvency, thus potentially increasing the time and costs included in closing the transaction, but eventually supplying the lending institution with a higher level of protection than the lending institution would have absent the title company's involvement.

Ultimately, whether a deed-in-lieu transaction is a practical choice for a loan provider is driven by the and situations of not just the loan and the residential or commercial property, but the celebrations included also. Under the right set of situations, therefore long as the proper due diligence and documentation is obtained, a deed in lieu can supply the lending institution with a more efficient and cheaper means to understand 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 require 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 regularly work.