When a commercial mortgage loan provider sets out to impose a mortgage loan following a borrower default, a crucial goal is to identify the most expeditious manner in which the loan provider can get control and ownership 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 lengthy foreclosure procedure. This post talks about steps and issues lending institutions should consider when deciding to proceed with a deed in lieu of foreclosure and how to avoid unexpected risks and challenges throughout and following the deed-in-lieu procedure.

Consideration

A key element of any contract is guaranteeing there is sufficient consideration. In a standard transaction, consideration can quickly be developed through the purchase price, but in a deed-in-lieu situation, confirming adequate 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 lender typically is the basis for the consideration, and in order for such factor to consider to be considered "adequate," the debt should at least equivalent or surpass the fair market price of the subject residential or commercial property. It is vital that loan providers obtain an independent third-party appraisal to substantiate the value of the residential or commercial property in relation to the quantity of financial obligation being forgiven. In addition, its advised the deed-in-lieu arrangement include the customer's express recognition of the fair market worth of the residential or commercial property in relation to the quantity of the debt and a waiver of any potential 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 customer who secures 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 until the point when the right of redemption is lawfully extinguished through a correct foreclosure. Preserving the debtor's equitable right of redemption is the factor why, prior to default, mortgage loans can not be structured to ponder the voluntary transfer of the residential or commercial property to the lender.

Deed-in-lieu deals prevent a debtor's fair right of redemption, nevertheless, steps can be required to structure them to limit or prevent the danger of a blocking difficulty. Primarily, the reflection 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 files. Parties ought to also be careful of a deed-in-lieu plan where, following the transfer, there is an extension 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 supervisor, a renter or through repurchase options, as any of these plans can produce a threat of the deal being recharacterized as an equitable mortgage.

Steps can be required to mitigate versus recharacterization risks. Some examples: if a customer's residential or commercial property management functions are limited to ministerial functions instead of substantive choice making, if a lease-back is brief term and the payments are clearly structured as market-rate use and occupancy payments, or if any provision 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 recommended that deed-in-lieu agreements include the parties' clear and indisputable recognition that the transfer of the residential or commercial property is an absolute conveyance and not a transfer of for security functions only.

Merger of Title

When a lending institution makes a loan secured 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 lending institution 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 fee owner and acquiring the mortgagor's equity of redemption.

The basic guideline 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 fee occurs in the lack of proof of a contrary intent. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is crucial the arrangement clearly reflects the parties' intent to retain the mortgage lien estate as distinct from the fee so the lender keeps the capability to foreclose the hidden mortgage if there are intervening liens. If the estates merge, then the lender's mortgage lien is snuffed out and the lending institution loses the capability to handle intervening liens by foreclosure, which might leave the lender in a potentially worse position than if the loan provider pursued a foreclosure from the start.

In order to plainly show the celebrations' intent on this point, the deed-in-lieu contract (and the deed itself) ought to include reveal anti-merger language. Moreover, because there can be no mortgage without a debt, it is popular in a deed-in-lieu situation for the lending institution to deliver a covenant not to take legal action against, instead of a straight-forward release of the financial obligation. The covenant not to sue furnishes consideration for the deed in lieu, protects the customer versus direct exposure from the debt and likewise keeps the lien of the mortgage, consequently allowing the lending institution to preserve the ability to foreclose, must it end up being preferable to eliminate junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending upon the jurisdiction, handling 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 commitment, as a useful matter, the lender winds up taking in the cost given that the debtor is in a default circumstance and typically lacks funds.

How transfer tax is computed on a deed-in-lieu deal depends on the jurisdiction and can be a driving force in identifying if a deed in lieu is a practical 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 approximately the quantity of the debt. Some other states, including Washington and Illinois, have straightforward exemptions for deed-in-lieu transactions. In Connecticut, however, while there is an exemption for deed-in-lieu transactions it is limited just to a transfer of the customer's personal residence.

For a commercial deal, the tax will be computed based on the full purchase rate, which is specifically specified as consisting of the quantity of liability which is presumed or to which the real estate is subject. Similarly, but a lot more possibly exorbitant, New york city bases the amount of the transfer tax on "consideration," which is defined as the overdue balance of the financial obligation, plus the overall quantity of any other enduring liens and any amounts paid by the grantee (although if the loan is fully recourse, the consideration is capped at the reasonable market price of the residential or commercial property plus other quantities paid). Keeping in mind the lending institution will, in many jurisdictions, need to pay this tax once again when ultimately selling the residential or commercial property, the specific jurisdiction's guidelines on transfer tax can be a determinative aspect in deciding whether a deed-in-lieu transaction is a possible choice.

Bankruptcy Issues

A significant concern for loan providers when determining if a deed in lieu is a practical option is the issue that if the borrower becomes a debtor in a personal bankruptcy case after the deed in lieu is complete, the personal bankruptcy court can cause 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 dealing with preferential transfers. Accordingly, if the transfer was made when the debtor was insolvent (or the transfer rendered the debtor insolvent) and within the 90-day period stated in the Bankruptcy Code, the customer ends up being a debtor in an insolvency case, then the deed in lieu is at threat 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 reasonably 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 engaged in a business that kept an unreasonably low level of capital or intended to incur financial obligations beyond its ability to pay. In order to alleviate against these threats, a loan provider needs to thoroughly review and examine the borrower's financial condition and liabilities and, preferably, require audited financial statements to confirm the solvency status of the customer. Moreover, the deed-in-lieu arrangement needs to consist of representations as to solvency and a covenant from the customer not to submit for insolvency throughout the preference period.

This is yet another reason it is vital for a lending institution to procure an appraisal to validate 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 produced less than reasonably equivalent worth.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, the majority of owners and their loan providers will obtain policies of title insurance to secure their respective 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 depend on its lender's policy when it ends up being the cost owner. Coverage under a lender's policy of title insurance can continue after the acquisition of title if title is taken by the exact same entity that is the named guaranteed under the loan provider's policy.

Since lots of loan providers prefer to have title vested in a different affiliate entity, in order to guarantee ongoing protection under the lender's policy, the called lender should designate the mortgage to the desired 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 a wholly owned subsidiary (although in some jurisdictions this could set off transfer tax liability).

Notwithstanding the extension in protection, a lending institution's policy does not transform 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 loan provider's policy would not offer the same or an adequate level of protection. Moreover, a loan provider's policy does not obtain any security for matters which develop after the date of the mortgage loan, leaving the loan provider exposed to any concerns or claims stemming from occasions which occur after the initial closing.

Due to the reality deed-in-lieu deals are more vulnerable to challenge and dangers as described above, any title insurer releasing an owner's policy is likely to carry out a more strenuous evaluation of the deal throughout the underwriting procedure than they would in a normal third-party purchase and sale transaction. The title insurer will scrutinize the celebrations and the deed-in-lieu files in order to determine and alleviate dangers provided by problems such as merger, blocking, recharacterization and insolvency, thereby possibly increasing the time and expenses included in closing the transaction, however eventually supplying the loan provider with a higher level of defense than the lender would have absent the title company's involvement.

Ultimately, whether a deed-in-lieu deal is a feasible option for a lender is driven by the particular realities and situations of not just the loan and the residential or commercial property, however the celebrations included as well. Under the right set of scenarios, therefore long as the appropriate due diligence and documentation is obtained, a deed in lieu can supply the loan provider with a more effective and less costly methods 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 attorney Meghan A. Hayden at (203) 772-7775 and [email protected], or the Harris Beach attorney with whom you most often work.