When a commercial mortgage loan provider sets out to enforce a mortgage loan following a customer default, a crucial goal 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 circumstances, a deed in lieu of foreclosure can be a quicker and more affordable alternative to the long and lengthy foreclosure process. This short article discusses steps and problems loan providers must consider when deciding to continue with a deed in lieu of foreclosure and how to avoid unexpected threats and challenges during and following the deed-in-lieu procedure.

Consideration

A crucial element of any contract is ensuring there is adequate consideration. In a standard transaction, factor to consider can easily be developed through the purchase cost, but in a deed-in-lieu circumstance, validating adequate factor to consider is not as uncomplicated.

In a deed-in-lieu situation, the amount of the underlying debt that is being forgiven by the lending institution usually is the basis for the consideration, and in order for such factor to consider to be deemed "sufficient," the debt should at least equal or go beyond the reasonable market price of the subject residential or commercial property. It is essential that lending institutions obtain an independent third-party appraisal to corroborate the value of the residential or commercial property in relation to the amount of financial obligation being forgiven. In addition, its recommended the deed-in-lieu arrangement include the customer's reveal acknowledgement of the fair market worth of the residential or commercial property in relation to the amount of the financial obligation and a waiver of any potential claims associated with the adequacy of the factor to consider.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English common law that a debtor who protects a loan with a mortgage on genuine estate 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 proper foreclosure. Preserving the customer's equitable right of redemption is the reason why, 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 prevent a debtor's fair right of redemption, however, actions can be taken to structure them to restrict or avoid the threat of a clogging obstacle. Most importantly, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure must occur post-default and can not be pondered by the underlying loan documents. Parties need to likewise be cautious of a deed-in-lieu plan where, following the transfer, there is an extension of a debtor/creditor relationship, or which contemplate that the debtor keeps rights to the residential or commercial property, either as a residential or commercial property manager, an occupant or through repurchase options, as any of these plans can create a threat of the transaction being recharacterized as an equitable mortgage.

Steps can be taken to alleviate versus recharacterization dangers. Some examples: if a borrower'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 plainly 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 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 indisputable acknowledgement 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 lender makes a loan protected by a mortgage on genuine estate, it holds an interest in the realty by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the lending institution then gets 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 acquiring the mortgagor's equity of redemption.

The basic guideline on this problem supplies 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 fee takes place in the lack of evidence of a contrary intent. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is very important the agreement plainly reflects the celebrations' intent to keep the mortgage lien estate as unique from the cost so the lender maintains the ability to foreclose the underlying mortgage if there are stepping in liens. If the estates merge, then the lending institution's mortgage lien is extinguished and the lending institution loses the capability to handle stepping in liens by foreclosure, which might leave the lending institution in a possibly even worse position than if the lending institution pursued a foreclosure from the outset.

In order to clearly show the celebrations' intent on this point, the deed-in-lieu arrangement (and the deed itself) ought to consist of reveal anti-merger language. Moreover, because there can be no mortgage without a financial obligation, it is popular in a deed-in-lieu situation for the lender to provide a covenant not to sue, instead of a straight-forward release of the financial obligation. The covenant not to sue furnishes factor to consider for the deed in lieu, secures the customer versus direct exposure from the financial obligation and likewise retains the lien of the mortgage, consequently allowing the loan provider to maintain the ability to foreclose, ought to it end up being 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 significant sticking point. While many states make the payment of transfer tax a seller commitment, as a useful matter, the loan provider winds up absorbing the cost because the debtor remains in a default circumstance and usually lacks funds.

How transfer tax is calculated on a deed-in-lieu transaction depends on the jurisdiction and can be a driving force in figuring out if a deed in lieu is a viable option. 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 up to the quantity of the debt. Some other states, consisting of Washington and Illinois, have straightforward exemptions for deed-in-lieu deals. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu transactions it is limited only to a transfer of the debtor's individual home.

For an industrial transaction, the tax will be calculated based on the full purchase rate, which is expressly defined as consisting of the amount of liability which is presumed or to which the real estate is subject. Similarly, however a lot more potentially heavy-handed, New York bases the quantity of the transfer tax on "factor to consider," which is specified as the overdue balance of the debt, plus the total amount of any other enduring liens and any quantities paid by the grantee (although if the loan is fully option, the factor to consider is topped at the fair market price of the residential or commercial property plus other amounts paid). Keeping in mind the lender will, in a lot of jurisdictions, have 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
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A major issue for lending institutions when identifying if a deed in lieu is a practical alternative is the concern that if the borrower ends up being a debtor in a bankruptcy case after the deed in lieu is complete, the personal bankruptcy court can trigger 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 squarely within subsection (b)( 2) of Section 547 of the Bankruptcy Code handling preferential transfers. Accordingly, if the transfer was made when the customer was insolvent (or the transfer rendered the borrower insolvent) and within the 90-day duration 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 bankruptcy filing and the transfer was made for "less than a fairly equivalent value" and if the transferor was insolvent at the time of the transfer, ended up being insolvent because of the transfer, was participated in a service that preserved an unreasonably low level of capital or intended to incur debts beyond its ability to pay. In order to mitigate versus these risks, a loan provider must carefully evaluate and evaluate the customer's monetary condition and liabilities and, ideally, 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 apply for bankruptcy throughout the choice duration.

This is yet another reason that it is crucial for a lending institution to procure an appraisal to confirm the worth of the residential or commercial property in relation to the debt. An existing appraisal will assist the loan provider refute any accusations that the transfer was produced less than reasonably equivalent worth.

Title Insurance

As part of the preliminary acquisition of a genuine residential or commercial property, many owners and their lending institutions will acquire policies of title insurance coverage to secure their respective 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 count on its lending institution's policy when it ends up being the fee 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 very same entity that is the named insured under the lender's policy.

Since many lenders choose to have title vested in a separate affiliate entity, in order to make sure ongoing coverage under the lending institution's policy, the called lender should assign the mortgage to the intended affiliate victor prior to, or simultaneously 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 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 coverage, a loan provider's policy does not convert to an owner's policy. Once the loan provider ends up being an owner, the nature and scope of the claims that would be made under a policy are such that the lending institution's policy would not supply the exact same or an appropriate level of protection. Moreover, a lending institution's policy does not avail any protection for matters which emerge after the date of the mortgage loan, leaving the lending institution exposed to any problems or claims coming from occasions which happen after the initial closing.

Due to the truth deed-in-lieu deals are more prone to challenge and threats as outlined above, any title insurance provider issuing an owner's policy is likely to undertake a more rigorous evaluation of the deal throughout the underwriting process than they would in a typical third-party purchase and sale transaction. The title insurance provider will inspect the parties and the deed-in-lieu documents in order to recognize and alleviate risks provided by issues such as merger, blocking, recharacterization and insolvency, thereby possibly increasing the time and expenses included in closing the transaction, but ultimately providing the loan provider with a greater level of security than the lending institution would have absent 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 facts and circumstances of not just the loan and the residential or commercial property, but the celebrations included as well. Under the right set of circumstances, and so long as the proper due diligence and documentation is obtained, a deed in lieu can supply the lender with a more effective and less costly means to realize on its collateral when a loan goes into default.

Harris Beach Murtha's Commercial Realty 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 mhayden@harrisbeachmurtha.com, or the Harris Beach lawyer with whom you most often work.
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