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When a business mortgage lender sets out to enforce a mortgage loan following a customer default, an essential goal is to recognize the most expeditious manner in which the lending institution can get control and belongings 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 protracted foreclosure procedure. This short article discusses actions and issues loan providers need to think about when making the choice to continue with a deed in lieu of foreclosure and how to prevent unexpected dangers and difficulties throughout and following the deed-in-lieu procedure.

Consideration

A crucial element of any agreement is ensuring there is sufficient consideration. In a standard transaction, factor to consider can easily be developed through the purchase rate, however in a deed-in-lieu situation, validating sufficient consideration is not as simple.

In a deed-in-lieu scenario, the amount of the underlying debt that is being forgiven by the lending institution normally is the basis for the consideration, and in order for such consideration to be deemed "adequate," the financial obligation ought to a minimum of equal or exceed the fair market value of the subject residential or commercial property. It is imperative that lenders obtain an independent third-party appraisal to substantiate the worth of the residential or commercial property in relation to the amount of financial obligation being forgiven. In addition, its advised the deed-in-lieu contract consist of the debtor's express 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 possible claims connected to 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 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 financial obligation up until the point when the right of redemption is legally snuffed out through an appropriate foreclosure. Preserving the customer'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 loan provider.

Deed-in-lieu transactions preclude a debtor's fair right of redemption, nevertheless, actions can be required to structure them to limit or avoid the danger of an obstructing difficulty. Most importantly, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure should take location post-default and can not be contemplated by the underlying loan files. Parties need to also watch out for a deed-in-lieu arrangement where, following the transfer, there is a continuation of a debtor/creditor relationship, or which ponder that the debtor keeps rights to the residential or commercial property, either as a residential or commercial property manager, a tenant or through repurchase alternatives, as any of these plans can produce a threat of the transaction being recharacterized as an equitable mortgage.

Steps can be required 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 use and tenancy payments, or if any provision for reacquisition of the residential or commercial property by the borrower is set up to be completely independent of the condition for the deed in lieu.

While not determinative, it is recommended that deed-in-lieu contracts consist of the parties' clear and indisputable recognition 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 loan provider 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 recipient under a deed of trust). If the lender then acquires the property 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 rule on this concern provides that, where a mortgagee gets the cost or equity of redemption in the mortgaged residential or commercial property, and there is no intermediate estate, merger of the mortgage interest into the cost takes place in the lack of evidence of a contrary objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is necessary the arrangement plainly reflects the celebrations' intent to keep the mortgage lien estate as unique from the cost so the loan provider keeps the ability 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 lender loses the ability to deal with stepping in liens by foreclosure, which might leave the lender in a potentially even worse position than if the lender pursued a foreclosure from the beginning.

In order to plainly reflect the celebrations' intent on this point, the deed-in-lieu agreement (and the deed itself) ought to include reveal anti-merger language. Moreover, since there can be no mortgage without a financial obligation, it is popular in a deed-in-lieu circumstance for the lender to provide a covenant not to take legal action against, 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, protects the borrower versus direct exposure from the financial obligation and also maintains the lien of the mortgage, thereby permitting the lending institution to maintain the capability to foreclose, ought to it become preferable to get rid of junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending upon the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu deals can be a considerable sticking point. While the majority of states make the payment of transfer tax a seller commitment, as a useful matter, the lender ends up absorbing the expense considering that the customer remains in a default circumstance and typically lacks funds.

How transfer tax is computed on a deed-in-lieu transaction is dependent 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 up to 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 deals it is restricted just to a transfer of the borrower's personal house.

For a business transaction, the tax will be calculated based on the full purchase cost, 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 drastic, New york city bases the amount of the transfer tax on "factor to consider," which is defined as the unsettled balance of the financial obligation, plus the total amount of any other making it through liens and any amounts paid by the beneficiary (although if the loan is completely option, the factor to consider is topped at the reasonable market worth of the residential or commercial property plus other quantities paid). Bearing in mind the lending institution will, in many jurisdictions, have to pay this tax once again when ultimately offering the residential or commercial property, the specific jurisdiction's guidelines on transfer tax can be a determinative factor in deciding whether a deed-in-lieu transaction is a .

Bankruptcy Issues

A significant issue for loan providers when determining if a deed in lieu is a viable alternative is the issue that if the customer becomes a debtor in a bankruptcy 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 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 duration set forth in the Bankruptcy Code, the borrower ends up being a debtor in a personal bankruptcy 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 bankruptcy filing and the transfer was produced "less than a fairly comparable value" and if the transferor was insolvent at the time of the transfer, ended up being insolvent because of the transfer, was engaged in a service that kept an unreasonably low level of capital or intended to sustain debts beyond its capability to pay. In order to reduce against these risks, a lending institution should carefully review and assess the debtor's monetary condition and liabilities and, preferably, need audited financial statements to verify the solvency status of the debtor. Moreover, the deed-in-lieu agreement must include representations as to solvency and a covenant from the debtor not to apply for bankruptcy during the preference period.

This is yet another factor why it is necessary for a loan provider to procure an appraisal to verify the value of the residential or commercial property in relation to the financial obligation. A current appraisal will assist the lending institution refute any allegations that the transfer was made for less than fairly comparable value.

Title Insurance

As part of the initial acquisition of a real residential or commercial property, the majority of owners and their lending institutions will obtain policies of title insurance coverage to secure their respective interests. A lender 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 loan provider'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 guaranteed under the loan provider's policy.

Since numerous lenders prefer to have actually title vested in a different affiliate entity, in order to guarantee ongoing protection under the lending institution's policy, the named lender must assign the mortgage to the designated affiliate title holder 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 business 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 lender's policy would not offer the exact same or an appropriate level of protection. Moreover, a lender's policy does not get any protection for matters which develop after the date of the mortgage loan, leaving the lending institution exposed to any concerns or claims stemming from events which happen after the initial closing.

Due to the fact deed-in-lieu deals are more vulnerable to challenge and dangers as laid out above, any title insurance provider providing an owner's policy is likely to carry out a more strenuous review of the deal during the underwriting procedure than they would in a common third-party purchase and sale deal. The title insurer will scrutinize the parties and the deed-in-lieu files in order to determine and alleviate risks presented by concerns such as merger, blocking, recharacterization and insolvency, thereby possibly increasing the time and expenses involved in closing the deal, but eventually providing the lending institution with a greater level of defense than the loan provider would have absent the title business's participation.

Ultimately, whether a deed-in-lieu deal is a viable option for a loan provider is driven by the specific truths and scenarios of not just the loan and the residential or commercial property, however the parties involved also. Under the right set of scenarios, therefore long as the appropriate due diligence and documentation is obtained, a deed in lieu can provide the lender with a more effective and more economical methods 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 support with such matters, please reach out to lawyer Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most frequently work.