When a business mortgage lending institution sets out to implement a mortgage loan following a customer default, a crucial goal is to recognize the most expeditious manner in which the loan provider can acquire control and ownership of the underlying security. Under the right set of circumstances, a deed in lieu of foreclosure can be a faster and more affordable alternative to the long and lengthy foreclosure procedure. This short article talks about actions and problems lending institutions should think about when making the decision to continue with a deed in lieu of foreclosure and how to prevent unexpected risks and obstacles throughout and following the deed-in-lieu procedure.

Consideration

A key component of any agreement is making sure there is appropriate consideration. In a basic transaction, factor to consider can quickly be developed through the purchase cost, however in a deed-in-lieu situation, validating appropriate factor to consider is not as simple.

In a deed-in-lieu situation, the quantity of the underlying financial obligation that is being forgiven by the lending institution typically is the basis for the consideration, and in order for such factor to consider to be deemed "appropriate," the debt ought to a minimum of equal or go beyond the reasonable market worth of the subject residential or commercial property. It is imperative that lending institutions obtain an independent third-party appraisal to substantiate the value of the residential or commercial property in relation to the amount of financial obligation being forgiven. In addition, its recommended the deed-in-lieu arrangement consist of the borrower's reveal recognition of the fair market price of the residential or commercial property in relation to the quantity of the financial obligation and a waiver of any prospective 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 debtor who protects a loan with a mortgage on property holds an unqualified right to redeem that residential or commercial property from the lender by repaying the financial obligation up till the point when the right of redemption is legally snuffed out through a correct foreclosure. Preserving the customer's equitable right of redemption is the reason, 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 deals preclude a borrower's equitable right of redemption, nevertheless, actions can be taken to structure them to restrict or prevent the danger of a clogging obstacle. Firstly, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure need to take place post-default and can not be contemplated by the underlying loan documents. Parties should likewise watch out for 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 supervisor, an occupant or through repurchase options, as any of these arrangements can create a threat of the transaction being recharacterized as an equitable mortgage.

Steps can be taken to reduce 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 usage and tenancy payments, or if any arrangement for reacquisition of the residential or commercial property by the debtor is established to be entirely independent of the condition for the deed in lieu.

While not determinative, it is advised that deed-in-lieu arrangements include the parties' clear and unquestionable acknowledgement that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security functions only.

Merger of Title

When a lender makes a loan protected by a mortgage on real estate, 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 loan provider then acquires the realty 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 general rule 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 absence of evidence of a contrary objective. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is necessary the arrangement plainly shows the celebrations' intent to retain the mortgage lien estate as unique from the fee so the loan provider maintains the ability to foreclose the underlying mortgage if there are intervening liens. If the estates combine, then the lending institution's mortgage lien is snuffed out and the lender loses the capability to deal with intervening liens by foreclosure, which might leave the lending institution in a potentially even worse position than if the lender 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) must include reveal anti-merger language. Moreover, since there can be no mortgage without a financial obligation, it is customary in a deed-in-lieu circumstance for the lending institution to provide a covenant not to take legal action against, rather than a straight-forward release of the debt. The covenant not to sue furnishes consideration for the deed in lieu, secures the borrower versus exposure from the debt and likewise retains the lien of the mortgage, therefore enabling the lender to keep the capability to foreclose, needs to it end up being desirable to remove 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 most states make the payment of transfer tax a seller obligation, as a practical matter, the loan provider winds up taking in the expense given that the customer is in a default situation and normally does not have funds.

How transfer tax is determined on a deed-in-lieu transaction is reliant on the jurisdiction and can be a driving force in figuring out if a deed in lieu is a viable alternative. 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 as much as the amount of the financial obligation. Some other states, consisting of Washington and Illinois, have straightforward exemptions for deed-in-lieu deals. In Connecticut, however, while there is an exemption for deed-in-lieu deals it is restricted just to a transfer of the customer's personal residence.

For a business transaction, the tax will be calculated based on the full purchase rate, which is specifically defined as consisting of the quantity of liability which is presumed or to which the real estate is subject. Similarly, but much more possibly drastic, New York bases the amount of the transfer tax on "factor to consider," which is specified as the unsettled balance of the debt, plus the total amount of any other enduring liens and any amounts paid by the beneficiary (although if the loan is totally recourse, the consideration is capped at the reasonable market price of the residential or commercial property plus other quantities paid). Bearing in mind the lending institution will, in most jurisdictions, need to pay this tax again when eventually selling the residential or commercial property, the specific jurisdiction's rules on transfer tax can be a determinative consider deciding whether a deed-in-lieu deal is a possible option.

Bankruptcy Issues

A major concern for lenders when identifying if a deed in lieu is a feasible option is the issue that if the debtor becomes a debtor in a bankruptcy 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 transaction is a transfer made on, or account of, an antecedent financial obligation, 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 debtor was insolvent (or the transfer rendered the customer insolvent) and within the 90-day duration stated in the Bankruptcy Code, the borrower 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 reserved if it is made within one year prior to a bankruptcy filing and the transfer was produced "less than a fairly equivalent worth" and if the transferor was insolvent at the time of the transfer, became insolvent because of the transfer, was engaged in a company that kept an unreasonably low level of capital or planned to sustain financial obligations beyond its capability to pay. In order to mitigate against these threats, a loan provider should carefully review and assess the debtor's monetary condition and liabilities and, preferably, require audited financial statements to validate the solvency status of the borrower. Moreover, the deed-in-lieu contract must include representations regarding solvency and a covenant from the debtor not to declare bankruptcy throughout the choice period.

This is yet another reason that it is vital for a loan provider to obtain an appraisal to confirm the worth of the residential or commercial property in relation to the financial obligation. A present appraisal will assist the lending institution refute any accusations that the transfer was produced less than reasonably equivalent worth.

Title Insurance

As part of the preliminary acquisition of a genuine residential or commercial property, many owners and their lending institutions will acquire policies of title insurance 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 rely on its lending institution's policy when it becomes the cost owner. Coverage under a lender'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 loan providers prefer to have actually title vested in a different affiliate entity, in order to make sure continued coverage under the lending institution's policy, the called loan provider should assign the mortgage to the designated affiliate title holder prior to, or concurrently with, the transfer of the charge. In the option, the lender can take title and after that convey the residential or commercial property by deed for no consideration to either its parent company or an entirely owned subsidiary (although in some jurisdictions this might trigger transfer tax liability).

Notwithstanding the extension in protection, a lending institution's policy does not convert 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 offer the exact same or a sufficient level of protection. Moreover, a lender's policy does not avail any protection for matters which emerge after the date of the mortgage loan, leaving the loan provider exposed to any issues or claims coming from events which occur after the initial closing.

Due to the reality deed-in-lieu deals are more vulnerable to challenge and dangers as detailed above, any title insurance company issuing an owner's policy is most likely to undertake a more rigorous review of the transaction during the underwriting procedure than they would in a typical third-party purchase and sale transaction. The title insurer will scrutinize the parties and the deed-in-lieu files in order to identify and reduce risks provided by issues such as merger, blocking, recharacterization and insolvency, therefore potentially increasing the time and expenses associated with closing the transaction, however eventually providing the loan provider with a greater level of protection than the lender would have absent the title business's involvement.

Ultimately, whether a deed-in-lieu transaction is a feasible alternative for a loan provider is driven by the particular truths and circumstances of not only the loan and the residential or commercial property, but the parties included too. Under the right set of scenarios, and so long as the appropriate due diligence and documents is acquired, a deed in lieu can supply the loan provider with a more efficient and more economical ways to recognize 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 attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most often work.