When a business mortgage lender sets out to impose a mortgage loan following a borrower default, a crucial objective is to identify the most expeditious manner in which the lending institution can get control and possession of the underlying collateral. Under the right set of situations, a deed in lieu of foreclosure can be a much faster and more cost-effective option to the long and drawn-out foreclosure process. This article goes over steps and problems lending institutions should consider when making the choice to proceed with a deed in lieu of foreclosure and how to avoid unforeseen threats and obstacles during and following the deed-in-lieu process.

Consideration

A crucial element of any contract is guaranteeing there is appropriate factor to consider. In a standard transaction, factor to consider can easily be established through the purchase price, however in a deed-in-lieu scenario, confirming adequate factor to consider is not as straightforward.

In a deed-in-lieu circumstance, the amount of the underlying debt that is being forgiven by the lender typically is the basis for the consideration, and in order for such factor to consider to be deemed "sufficient," the debt must a minimum of equivalent or go beyond the reasonable market price of the subject residential or commercial property. It is important that loan providers acquire an independent third-party appraisal to validate the value of the residential or commercial property in relation to the amount of financial obligation being forgiven. In addition, its suggested the deed-in-lieu arrangement consist of the customer's reveal acknowledgement of the fair market price of the residential or commercial property in relation to the amount of the debt and a waiver of any prospective claims connected to the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English common law that a borrower who secures a loan with a mortgage on realty holds an unqualified right to redeem that residential or commercial property from the loan provider by paying back the financial obligation up till the point when the right of redemption is lawfully snuffed out through a correct foreclosure. Preserving the debtor's fair right of redemption is the reason, prior to default, mortgage loans can not be structured to ponder the voluntary transfer of the residential or commercial property to the loan provider.

Deed-in-lieu transactions preclude a customer's fair right of redemption, however, actions can be taken to structure them to limit or prevent the risk of an obstructing difficulty. Firstly, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure need to happen post-default and can not be pondered by the underlying loan files. Parties need to likewise be cautious of a deed-in-lieu plan where, following the transfer, there is a continuation of a debtor/creditor relationship, or which consider 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 plans can develop a danger of the transaction being recharacterized as a fair mortgage.

Steps can be required to reduce against recharacterization dangers. Some examples: if a debtor's residential or commercial property management functions are limited to ministerial functions instead of substantive choice making, if a lease-back is short term and the payments are clearly structured as market-rate use and occupancy payments, or if any arrangement 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 arrangements include the celebrations' clear and unequivocal recognition that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security purposes only.

Merger of Title

When a lender makes a loan secured by a mortgage on realty, 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 lending institution then acquires the realty from a defaulting mortgagor, it now also 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 basic rule on this problem supplies 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 charge happens in the absence of proof of a contrary intention. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is necessary the contract clearly reflects the parties' intent to retain the mortgage lien estate as distinct from the charge so the lender maintains the ability to foreclose the hidden mortgage if there are intervening liens. If the estates combine, then the loan provider's mortgage lien is extinguished and the lender loses the capability to deal with stepping in liens by foreclosure, which might leave the loan provider in a possibly worse position than if the loan provider 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) ought to include express anti-merger language. Moreover, due to the fact that there can be no mortgage without a financial obligation, it is customary in a deed-in-lieu circumstance for the lender to deliver a covenant not to sue, rather than a straight-forward release of the financial obligation. The covenant not to take legal action against furnishes factor to consider for the deed in lieu, protects the borrower against direct exposure from the debt and likewise keeps the lien of the mortgage, thus enabling the lender to preserve the ability to foreclose, needs to it become preferable to get rid of 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 transactions can be a significant sticking point. While many states make the payment of transfer tax a seller commitment, as a practical matter, the lender ends up absorbing the expense because the borrower remains in a default scenario and typically does not have funds.

How transfer tax is calculated 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 practical alternative. 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 debt. Some other states, including Washington and Illinois, have uncomplicated exemptions for deed-in-lieu transactions. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu deals it is restricted only to a transfer of the debtor's individual home.

For an industrial deal, the tax will be computed based upon the complete purchase price, which is expressly specified as consisting of the amount of liability which is assumed or to which the real estate is subject. Similarly, but a lot more potentially severe, New York bases the quantity of the transfer tax on "factor to consider," which is defined as the overdue balance of the debt, plus the overall quantity of any other making it through liens and any amounts paid by the grantee (although if the loan is completely option, the consideration is topped at the fair market worth of the residential or commercial property plus other amounts paid). Bearing in mind the loan provider will, in many jurisdictions, have to pay this tax once again when ultimately offering the residential or commercial property, the particular jurisdiction's rules on transfer tax can be a determinative consider choosing whether a deed-in-lieu transaction is a practical choice.

Bankruptcy Issues

A major issue for lenders when identifying if a deed in lieu is a viable alternative is the issue that if the debtor becomes a debtor in an insolvency case after the deed in lieu is total, the personal bankruptcy 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 duration set forth in the Bankruptcy Code, the customer becomes a debtor in a bankruptcy 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 set aside if it is made within one year prior to an insolvency filing and the transfer was produced "less than a reasonably equivalent worth" and if the transferor was insolvent at the time of the transfer, ended up being insolvent because of the transfer, was taken part in an organization that maintained an unreasonably low level of capital or planned to sustain debts beyond its capability to pay. In order to mitigate versus these threats, a lender should carefully evaluate and examine the debtor's monetary condition and liabilities and, preferably, need audited monetary statements to verify the solvency status of the borrower. Moreover, the deed-in-lieu agreement needs to include representations regarding solvency and a covenant from the customer not to apply for personal bankruptcy throughout the choice duration.

This is yet another reason that it is crucial for a lender to acquire an appraisal to validate the value of the residential or commercial property in relation to the financial obligation. A present appraisal will help the lending institution refute any accusations that the transfer was made for less than fairly comparable worth.

Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, the majority of owners and their loan providers will obtain 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 depend on its lender'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 exact same entity that is the named insured under the lender's policy.

Since numerous loan providers choose to have title vested in a separate affiliate entity, in order to guarantee continued coverage under the lender's policy, the named loan provider must assign the mortgage to the desired affiliate victor prior to, or concurrently with, the transfer of the fee. In the alternative, the loan provider can take title and after that communicate the residential or commercial property by deed for no consideration to either its moms and dad company or a completely owned subsidiary (although in some jurisdictions this could trigger transfer tax liability).

Notwithstanding the continuation 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 supply the same or an appropriate level of protection. Moreover, a lender's policy does not avail any security for matters which develop after the date of the mortgage loan, leaving the loan provider exposed to any problems or claims coming from occasions which occur after the initial closing.

Due to the fact deed-in-lieu deals are more prone to challenge and dangers as detailed above, any title insurer issuing an owner's policy is likely to undertake a more extensive review of the deal during the underwriting procedure than they would in a common third-party purchase and sale deal. The title insurance provider will inspect the parties and the deed-in-lieu files in order to recognize and alleviate risks provided by concerns such as merger, obstructing, recharacterization and insolvency, thereby potentially increasing the time and costs associated with closing the transaction, but ultimately offering the lender with a greater level of protection than the lending institution would have missing the title company's involvement.

Ultimately, whether a deed-in-lieu transaction is a viable alternative for a lending institution is driven by the specific truths and situations of not only the loan and the residential or commercial property, however the celebrations included as well. Under the right set of situations, and so long as the appropriate due diligence and documentation is obtained, a deed in lieu can offer the loan provider with a more effective and less pricey ways to realize 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 need help 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 often work.