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When a commercial mortgage lender sets out to implement a mortgage loan following a customer default, a key goal is to determine the most expeditious manner in which the loan provider can obtain control and possession of the underlying security. Under the right set of situations, a deed in lieu of foreclosure can be a much faster and more cost-effective alternative to the long and drawn-out foreclosure procedure. This post goes over actions and concerns loan providers ought to consider when making the choice to continue with a deed in lieu of foreclosure and how to avoid unforeseen dangers and challenges throughout and following the deed-in-lieu process.

Consideration
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A crucial element of any agreement is guaranteeing there is adequate factor to consider. In a standard transaction, factor to consider can quickly be developed through the purchase price, however in a deed-in-lieu circumstance, confirming adequate consideration is not as simple.

In a deed-in-lieu circumstance, the amount of the underlying financial obligation that is being forgiven by the loan provider usually is the basis for the consideration, and in order for such consideration to be considered "appropriate," the financial obligation ought to at least equivalent or surpass the reasonable market price of the subject residential or commercial property. It is crucial 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 customer's reveal recognition of the fair market value of the residential or commercial property in relation to the quantity of the debt 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 typical law that a customer who secures a loan with a mortgage on real estate holds an unqualified right to redeem that residential or commercial property from the lender by paying back the financial obligation up till the point when the right of redemption is lawfully snuffed out through a proper foreclosure. Preserving the borrower's equitable right of redemption is the factor why, prior to default, mortgage loans can not be structured to contemplate the voluntary transfer of the residential or commercial property to the lender.

Deed-in-lieu deals preclude a debtor's fair right of redemption, however, actions can be required to structure them to restrict or avoid the danger of a clogging challenge. First and foremost, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure must occur post-default and can not be contemplated by the underlying loan documents. Parties ought to likewise watch out for a deed-in-lieu plan where, following the transfer, there is a continuation of a debtor/creditor relationship, or which contemplate that the debtor maintains 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 develop a threat of the transaction being recharacterized as a fair mortgage.

Steps can be taken 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 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 provision 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 recommended that deed-in-lieu agreements consist of the parties' clear and unquestionable 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 realty, it holds an interest in the property by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the loan provider 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 fee owner and obtaining the mortgagor's equity of redemption.

The basic rule on this problem offers that, where a mortgagee acquires 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 cost occurs in the lack of proof of a contrary intention. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is very important the arrangement plainly shows the celebrations' intent to maintain the mortgage lien estate as unique from the cost so the loan provider retains 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 stepping in liens by foreclosure, which could leave the loan provider in a potentially 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 contract (and the deed itself) should include express anti-merger language. Moreover, because there can be no mortgage without a debt, it is traditional in a deed-in-lieu scenario 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, safeguards the debtor against direct exposure from the debt and likewise keeps the lien of the mortgage, consequently allowing the lending institution to keep the ability to foreclose, ought to it end up being desirable to get rid of junior encumbrances after the deed in lieu is complete.

Transfer Tax

Depending on the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu deals can be a substantial sticking point. While most states make the payment of transfer tax a seller obligation, as a useful matter, the lender winds up soaking up the cost because the borrower remains in a default scenario and typically does not have funds.

How transfer tax is determined on a deed-in-lieu deal is dependent 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 approximately the quantity of the debt. 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 restricted just to a transfer of the customer's individual residence.

For an industrial deal, the tax will be calculated based upon the complete purchase cost, which is specifically specified as including the amount of liability which is assumed or to which the real estate is subject. Similarly, however much more possibly oppressive, New York bases the quantity of the transfer tax on "consideration," which is defined as the overdue balance of the financial obligation, plus the overall amount of any other enduring liens and any amounts paid by the beneficiary (although if the loan is totally option, the consideration is topped at the reasonable market price of the residential or commercial property plus other quantities paid). Remembering the lender will, in the majority of jurisdictions, have to pay this tax again when ultimately selling the residential or commercial property, the particular jurisdiction's rules on transfer tax can be a determinative factor in choosing whether a deed-in-lieu deal is a practical alternative.

Bankruptcy Issues

A significant concern for lenders when figuring out if a deed in lieu is a practical alternative is the issue that if the customer ends up being a debtor in an insolvency case after the deed in lieu is complete, the bankruptcy court can cause the transfer to be unwound or reserved. Because a deed-in-lieu transaction is a transfer made on, or account of, an antecedent debt, 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 borrower was insolvent (or the transfer rendered the customer insolvent) and within the 90-day duration stated in the Bankruptcy Code, the customer ends up being a debtor in a bankruptcy case, then the deed in lieu is at danger 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 made for "less than a fairly comparable worth" and if the transferor was insolvent at the time of the transfer, became insolvent due to the fact that of the transfer, was taken part in a company that maintained an unreasonably low level of capital or meant to sustain financial obligations beyond its ability to pay. In order to mitigate versus these dangers, a loan provider should thoroughly evaluate and the debtor's monetary condition and liabilities and, ideally, require audited monetary declarations to verify the solvency status of the borrower. Moreover, the deed-in-lieu arrangement must consist of representations as to solvency and a covenant from the debtor not to declare bankruptcy throughout the preference period.

This is yet another reason that it is necessary for a lending institution to procure an appraisal to confirm the worth of the residential or commercial property in relation to the financial obligation. A present appraisal will help the lending institution refute any allegations that the transfer was produced less than fairly comparable value.

Title Insurance

As part of the preliminary 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 lender 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 lender's policy when it ends up being the fee owner. Coverage under a lender's policy of title insurance coverage can continue after the acquisition of title if title is taken by the exact same entity that is the named insured under the loan provider's policy.

Since lots of lenders choose to have actually title vested in a different affiliate entity, in order to guarantee ongoing coverage under the lending institution's policy, the called lending institution must appoint the mortgage to the desired affiliate title holder prior to, or all at once with, the transfer of the charge. In the option, the lender can take title and after that communicate 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 set off transfer tax liability).

Notwithstanding the extension in coverage, a loan provider's policy does not convert to an owner's policy. Once the lending institution 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 provide the very same or a sufficient level of security. Moreover, a lending institution's policy does not get any defense for matters which emerge after the date of the mortgage loan, leaving the loan provider exposed to any concerns or claims coming from events which happen after the initial closing.

Due to the truth deed-in-lieu deals are more prone to challenge and dangers as described above, any title insurance company providing an owner's policy is most likely to carry out a more rigorous review of the deal during the underwriting procedure than they would in a common third-party purchase and sale deal. The title insurance company will inspect the parties and the deed-in-lieu documents in order to determine and mitigate dangers presented by issues such as merger, clogging, recharacterization and insolvency, thus possibly increasing the time and costs associated with closing the deal, however eventually offering the loan provider with a greater level of defense than the loan provider would have missing the title business's involvement.

Ultimately, whether a deed-in-lieu deal is a viable option for a loan provider is driven by the particular realities and situations of not only the loan and the residential or commercial property, but the parties involved as well. Under the right set of scenarios, and so long as the proper due diligence and documentation is gotten, a deed in lieu can offer the lender with a more efficient and less costly means to recognize on its collateral when a loan goes into default.

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