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When a commercial mortgage loan provider sets out to enforce a mortgage loan following a borrower default, an essential goal is to identify the most expeditious way in which the lending institution can acquire control and ownership of the underlying security. Under the right set of situations, a deed in lieu of foreclosure can be a much faster and more affordable alternative to the long and lengthy foreclosure process. This article discusses steps and issues loan providers must think about when making the decision to continue with a deed in lieu of foreclosure and how to prevent unexpected threats and difficulties throughout and following the deed-in-lieu procedure.

Consideration
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A crucial element of any contract is guaranteeing there is sufficient consideration. In a basic deal, consideration can quickly be developed through the purchase price, however in a deed-in-lieu circumstance, verifying appropriate 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 typically is the basis for the consideration, and in order for such factor to consider to be considered "adequate," the financial obligation ought to at least equivalent or go beyond the reasonable market price of the subject residential or commercial property. It is important that lending institutions get an independent third-party appraisal to substantiate 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 agreement consist of the customer's express acknowledgement of the reasonable market price of the residential or commercial property in relation to the amount 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 primary rooted in ancient English typical law that a customer who secures a loan with a mortgage on property 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 extinguished through a proper foreclosure. Preserving the debtor's equitable right of redemption is the reason, 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 deals preclude a borrower's equitable right of redemption, nevertheless, steps can be required to structure them to restrict or prevent the danger of a blocking difficulty. First and foremost, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure should occur post-default and can not be pondered by the underlying loan documents. Parties ought to also be careful of a deed-in-lieu arrangement where, following the transfer, there is a continuation of a debtor/creditor relationship, or which ponder that the customer maintains rights to the residential or commercial property, either as a residential or commercial property manager, a tenant or through repurchase options, as any of these plans can develop a risk of the deal being recharacterized as a fair mortgage.

Steps can be required to alleviate versus recharacterization risks. Some examples: if a debtor's residential or commercial property management functions are restricted to ministerial functions rather than substantive choice making, if a lease-back is short term and the payments are plainly structured as market-rate usage and occupancy payments, or if any arrangement for reacquisition of the residential or commercial property by the customer is set up to be totally 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 unequivocal recognition that the transfer of the residential or commercial property is an absolute 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 real estate, it holds an interest in the realty by virtue of being the mortgagee under a mortgage (or a recipient under a deed of trust). If the lending institution then obtains the realty from a defaulting mortgagor, it now also 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 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 cost happens in the absence of evidence of a contrary intent. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is necessary the arrangement clearly shows the parties' intent to retain the mortgage lien estate as distinct from the cost so the lender retains the capability to foreclose the underlying mortgage if there are intervening liens. If the estates combine, then the lending institution's mortgage lien is extinguished and the lending institution loses the ability to deal with 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 contract (and the deed itself) should consist of reveal anti-merger language. Moreover, because there can be no mortgage without a financial obligation, it is customary in a deed-in-lieu situation for the lending institution to deliver a covenant not to take legal action against, rather than 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 customer versus direct exposure from the debt and likewise keeps the lien of the mortgage, therefore enabling the lending institution to maintain the ability to foreclose, ought to it become preferable to remove junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending on the jurisdiction, dealing with transfer tax and the payment thereof in deed-in-lieu transactions can be a substantial sticking point. While a lot of states make the payment of transfer tax a seller obligation, as a practical matter, the lender ends up taking in the expense since the borrower is in a default scenario and usually does not have funds.

How transfer tax is calculated 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 practical 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 quantity of the financial obligation. Some other states, consisting of Washington and Illinois, have simple exemptions for deed-in-lieu deals. In Connecticut, however, while there is an exemption for deed-in-lieu deals it is limited only to a transfer of the customer's individual home.

For a business transaction, the tax will be computed based upon the complete purchase rate, which is expressly defined as including the amount of liability which is presumed 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 unpaid balance of the debt, plus the total quantity of any other surviving liens and any quantities paid by the grantee (although if the loan is completely recourse, the factor to consider is topped at the reasonable market price of the residential or commercial property plus other amounts paid). Keeping in mind the lender will, in the majority of jurisdictions, have to pay this tax once again when eventually offering the residential or commercial property, the specific jurisdiction's rules on transfer tax can be a determinative consider choosing whether a deed-in-lieu transaction is a possible alternative.

Bankruptcy Issues

A major issue for loan providers when figuring out if a deed in lieu is a viable alternative is the concern that if the borrower ends up being a debtor in a personal bankruptcy case after the deed in lieu is total, the insolvency 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 borrower was insolvent (or the transfer rendered the debtor insolvent) and within the 90-day period stated in the Bankruptcy Code, the borrower becomes a debtor in a 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 reserved if it is made within one year prior to a personal bankruptcy filing and the transfer was produced "less than a reasonably comparable value" and if the transferor was insolvent at the time of the transfer, became insolvent since of the transfer, was participated in an organization that maintained an unreasonably low level of capital or intended to incur debts beyond its ability to pay. In order to alleviate against these threats, a loan provider ought to carefully review and assess the customer's financial condition and liabilities and, preferably, need audited financial statements to validate the solvency status of the borrower. Moreover, the deed-in-lieu arrangement ought to consist of representations as to solvency and a covenant from the borrower not to file for bankruptcy during the choice period.

This is yet another reason it is imperative for a lending institution to acquire an appraisal to confirm the worth of the residential or commercial property in relation to the debt. A current appraisal will assist the lending institution refute any claims that the transfer was made for less than fairly equivalent worth.

Title Insurance

As part of the preliminary acquisition of a genuine or commercial property, most owners and their lending institutions will get policies of title insurance coverage to safeguard their particular interests. A loan provider 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 ends up being the charge 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 called insured under the lender's policy.

Since lots of loan providers prefer to have actually title vested in a separate affiliate entity, in order to make sure continued protection under the lending institution's policy, the named lending institution needs to designate the mortgage to the designated affiliate victor prior to, or at the same time with, the transfer of the cost. In the alternative, the loan provider can take title and after that communicate the residential or commercial property by deed for no factor to consider to either its parent company or a wholly owned subsidiary (although in some jurisdictions this might activate transfer tax liability).

Notwithstanding the extension in coverage, a lending institution's policy does not convert to an owner's policy. Once the lending institution 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 supply the very same or an adequate level of defense. Moreover, a lending institution's policy does not obtain any defense for matters which develop after the date of the mortgage loan, leaving the lender exposed to any issues or claims coming from occasions which take place after the original closing.

Due to the reality deed-in-lieu deals are more susceptible to challenge and dangers as outlined above, any title insurance provider releasing an owner's policy is likely to undertake a more extensive review of the deal during the underwriting procedure than they would in a typical third-party purchase and sale deal. The title insurer will inspect 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, thus possibly increasing the time and costs included in closing the transaction, however eventually providing the lender with a higher level of protection than the lending institution would have missing the title company's involvement.

Ultimately, whether a deed-in-lieu deal is a practical alternative for a lender is driven by the particular facts and circumstances 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 proper due diligence and documents is gotten, a deed in lieu can provide the lender with a more effective and less pricey ways to recognize on its security 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 lawyer Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most often work.
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