When a business mortgage lending institution sets out to enforce a mortgage loan following a borrower default, a crucial objective is to determine the most expeditious manner in which the loan provider can acquire control and possession of the underlying security. Under the right set of situations, a deed in lieu of foreclosure can be a quicker and more affordable alternative to the long and protracted foreclosure procedure. This article goes over steps and issues lenders should think about when deciding to continue with a deed in lieu of foreclosure and how to avoid unexpected dangers and difficulties throughout and following the deed-in-lieu procedure.

Consideration

A key element of any agreement is guaranteeing there is appropriate factor to consider. In a standard deal, factor to consider can quickly be developed through the purchase cost, but in a deed-in-lieu scenario, confirming sufficient consideration is not as simple.

In a deed-in-lieu situation, the amount of the underlying financial obligation that is being forgiven by the lending institution generally is the basis for the consideration, and in order for such consideration to be considered "sufficient," the financial obligation should a minimum of equivalent or go beyond the reasonable market price of the subject residential or commercial property. It is essential 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 recommended the deed-in-lieu contract include the borrower's reveal recognition of the reasonable market price of the residential or commercial property in relation to the amount of the financial obligation and a waiver of any potential claims related to the adequacy of the factor to consider.

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 lending institution 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 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 lender.

Deed-in-lieu transactions preclude a customer's equitable right of redemption, however, actions can be required to structure them to limit or prevent the threat of an obstructing obstacle. Firstly, 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 documents. Parties ought to likewise 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 borrower maintains rights to the residential or commercial property, either as a residential or commercial property manager, a renter or through repurchase options, as any of these arrangements can create a danger of the deal being recharacterized as a fair mortgage.

Steps can be required to alleviate versus recharacterization dangers. Some examples: if a borrower's residential or commercial property management functions are limited to ministerial functions rather than substantive decision making, if a lease-back is short term and the payments are clearly structured as market-rate use and tenancy payments, or if any arrangement for reacquisition of the residential or commercial property by the customer is established to be completely independent of the condition for the deed in lieu.

While not determinative, it is recommended that deed-in-lieu agreements include the parties' clear and unequivocal recognition 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 loan provider 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 lender then gets 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 obtaining the mortgagor's equity of redemption.

The basic guideline on this issue offers that, where a mortgagee obtains 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 happens in the lack of evidence of a contrary intention. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is essential the agreement plainly reflects the parties' intent to retain the mortgage lien estate as unique from the fee so the lending institution keeps the ability to foreclose the hidden mortgage if there are stepping in liens. If the estates combine, then the lending institution's mortgage lien is snuffed out and the lending institution loses the ability to handle intervening liens by foreclosure, which could leave the loan provider in a potentially 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 arrangement (and the deed itself) should consist of reveal anti-merger language. Moreover, due to the fact that there can be no mortgage without a financial obligation, it is traditional in a deed-in-lieu situation for the lending institution to provide a covenant not to take legal action against, rather than a straight-forward release of the financial obligation. The covenant not to sue furnishes consideration for the deed in lieu, protects the customer against direct exposure from the debt and also maintains the lien of the mortgage, therefore enabling the loan provider to maintain the capability to foreclose, must it become preferable to remove junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending upon the jurisdiction, dealing with 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 obligation, as a practical matter, the lending institution ends up absorbing the expense considering that the borrower is in a default scenario and usually lacks funds.

How transfer tax is computed on a deed-in-lieu transaction 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 up to the amount of the debt. 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 transactions it is limited just to a transfer of the borrower's personal house.

For an industrial deal, the tax will be calculated based on the full purchase cost, which is specifically defined as including the quantity of liability which is assumed or to which the real estate is subject. Similarly, however a lot more possibly heavy-handed, New York 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 quantity of any other surviving liens and any quantities paid by the grantee (although if the loan is completely option, the consideration is topped at the fair market price of the residential or commercial property plus other quantities paid). Remembering the lending institution will, in many jurisdictions, need to pay this tax once again when eventually selling the residential or commercial property, the particular jurisdiction's rules on transfer tax can be a determinative factor in deciding whether a deed-in-lieu transaction is a feasible choice.

Bankruptcy Issues

A significant concern for lending institutions when identifying if a deed in lieu is a feasible option is the issue that if the customer becomes a debtor in an insolvency case after the deed in lieu is complete, the personal bankruptcy court can trigger 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 borrower was insolvent (or the transfer rendered the debtor insolvent) and within the 90-day period set forth in the Bankruptcy Code, the borrower becomes a debtor in a personal bankruptcy case, then the deed in lieu is at risk of being reserved.

Similarly, under Section 548 of the Bankruptcy Code, a transfer can be set aside if it is made within one year prior to a personal bankruptcy 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 due to the fact that of the transfer, was engaged in a company that maintained an unreasonably low level of capital or intended to incur financial obligations beyond its ability to pay. In order to reduce versus these risks, a loan provider needs to carefully evaluate and evaluate the borrower's monetary condition and liabilities and, ideally, require audited financial statements to confirm the solvency status of the customer. Moreover, the deed-in-lieu agreement ought to consist of representations regarding solvency and a covenant from the borrower not to apply for insolvency throughout the preference period.

This is yet another factor why it is essential for a loan provider to procure an appraisal to confirm the value of the residential or commercial property in relation to the financial obligation. A present appraisal will assist the lender refute any accusations that the transfer was made for less than fairly equivalent value.

Title Insurance

As part of the preliminary acquisition of a genuine residential or commercial property, most owners and their lending institutions will acquire policies of title insurance coverage to safeguard their particular interests. A lending institution considering taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can depend on its lender'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 same entity that is the called insured under the lender's policy.

Since lots of lenders prefer to have actually title vested in a separate affiliate entity, in order to ensure continued coverage under the loan provider's policy, the named lending institution ought to appoint the mortgage to the designated affiliate title holder prior to, or concurrently with, the transfer of the fee. In the option, the lender can take title and then convey the residential or commercial property by deed for no factor to consider to either its parent business or an entirely owned subsidiary (although in some jurisdictions this might activate transfer tax liability).

Notwithstanding the continuation in protection, a loan provider's policy does not convert to an owner's policy. Once the loan provider becomes an owner, the nature and scope of the claims that would be made under a policy are such that the loan provider's policy would not provide the very same or an adequate level of security. Moreover, a lending institution's policy does not get any security for matters which emerge after the date of the mortgage loan, leaving the loan provider exposed to any concerns or claims coming from occasions which occur after the original closing.

Due to the truth deed-in-lieu transactions are more prone to challenge and threats as detailed above, any title insurance provider providing an owner's policy is most likely to undertake a more strenuous evaluation of the transaction during the underwriting procedure than they would in a common third-party purchase and sale deal. The title insurer will scrutinize the celebrations and the deed-in-lieu files in order to determine and mitigate threats provided by concerns such as merger, blocking, recharacterization and insolvency, thereby potentially increasing the time and expenses included in closing the deal, however ultimately providing the lender with a greater level of defense 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 specific truths and situations of not just the loan and the residential or commercial property, but the parties included as well. Under the right set of scenarios, and so long as the proper due diligence and paperwork is gotten, a deed in lieu can supply the lending institution with a more effective and more economical methods to recognize on its collateral when a loan enters into default.

Harris Beach Murtha's Commercial Property Practice Group is experienced with deed in lieu of foreclosures. If you require assistance with such matters, please connect to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach lawyer with whom you most regularly work.