When a commercial mortgage lending institution 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 belongings of the underlying security. Under the right set of situations, a deed in lieu of foreclosure can be a faster and more affordable option to the long and lengthy foreclosure procedure. This short article talks about actions and problems lenders ought to consider when making the decision to proceed with a deed in lieu of foreclosure and how to avoid unforeseen risks and difficulties throughout and following the deed-in-lieu procedure.

Consideration

A crucial element of any agreement is ensuring there is sufficient factor to consider. In a standard transaction, consideration can easily be established through the purchase rate, however in a deed-in-lieu situation, confirming sufficient consideration is not as straightforward.

In a deed-in-lieu situation, the amount 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 deemed "sufficient," the financial obligation needs to a minimum of equal or surpass the reasonable market worth 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 quantity of debt being forgiven. In addition, its suggested the deed-in-lieu agreement include the borrower's express acknowledgement of the reasonable market price of the residential or commercial property in relation to the amount of the financial obligation and a waiver of any possible claims connected to 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 customer who protects a loan with a mortgage on genuine estate holds an unqualified right to redeem that residential or commercial property from the loan provider by repaying the financial obligation up until the point when the right of redemption is legally extinguished through an appropriate foreclosure. Preserving the debtor's equitable right of redemption is the reason, prior to default, mortgage loans can not be structured to consider the voluntary transfer of the residential or commercial property to the lending institution.

Deed-in-lieu deals preclude a borrower's fair right of redemption, nevertheless, actions can be taken to structure them to restrict or avoid the danger of a clogging challenge. Most importantly, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure must occur post-default and can not be considered by the underlying loan files. Parties must likewise be wary of a deed-in-lieu plan where, following the transfer, there is a continuation of a debtor/creditor relationship, or which ponder that the debtor retains 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 arrangements can produce a threat of the deal being recharacterized as a fair mortgage.

Steps can be taken to reduce against recharacterization threats. Some examples: if a debtor's residential or commercial property management functions are limited to ministerial functions rather than 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 arrangement for reacquisition of the residential or commercial property by the debtor is set up to be totally 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 absolute conveyance and not a transfer of for security functions only.

Merger of Title

When a loan provider makes a loan secured by a mortgage on realty, it holds an interest in the real estate by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the loan provider 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 cost owner and obtaining the mortgagor's equity of redemption.

The basic guideline on this issue provides that, where a mortgagee obtains 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 takes place in the lack of proof of a contrary intent. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is essential the agreement plainly shows the parties' intent to retain the mortgage lien estate as distinct from the fee so the loan provider keeps the ability to foreclose the underlying mortgage if there are stepping in liens. If the estates combine, then the loan provider's mortgage lien is snuffed out and the loan provider loses the ability to deal with stepping in liens by foreclosure, which could leave the lender in a potentially even worse position than if the loan provider pursued a foreclosure from the start.

In order to plainly show the parties' intent on this point, the deed-in-lieu arrangement (and the deed itself) ought to consist of express anti-merger language. Moreover, due to the fact that there can be no mortgage without a debt, it is traditional in a deed-in-lieu situation for the loan provider to provide a covenant not to take legal action against, rather than a straight-forward release of the financial obligation. The covenant not to sue furnishes factor to consider for the deed in lieu, secures the debtor against direct exposure from the debt and likewise maintains the lien of the mortgage, therefore permitting the lender to maintain the ability to foreclose, must it become preferable to remove 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 a lot of states make the payment of transfer tax a seller responsibility, as a useful matter, the loan provider ends up soaking up the expense since the customer is in a default scenario and typically lacks funds.

How transfer tax is computed on a deed-in-lieu transaction is dependent on the jurisdiction and can be a driving force in determining if a deed in lieu is a feasible 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 up to the amount of the financial obligation. Some other states, including Washington and Illinois, have uncomplicated exemptions for deed-in-lieu deals. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu transactions it is limited just to a transfer of the customer's personal house.

For a business transaction, the tax will be calculated based on 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, but a lot more potentially draconian, New york city bases the quantity of the transfer tax on "factor to consider," which is defined as the unpaid balance of the financial obligation, plus the overall amount of any other making it through liens and any amounts paid by the grantee (although if the loan is totally recourse, the consideration is topped at the fair market price of the residential or commercial property plus other amounts paid). Keeping in mind the loan provider will, in many jurisdictions, have to pay this tax again when ultimately offering the residential or commercial property, the particular jurisdiction's rules on transfer tax can be a determinative consider deciding whether a deed-in-lieu transaction is a possible alternative.

Bankruptcy Issues

A major concern for lenders when determining if a deed in lieu is a feasible alternative is the issue that if the borrower ends up being a debtor in an insolvency case after the deed in lieu is complete, the 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 directly within subsection (b)( 2) of Section 547 of the Bankruptcy Code dealing with 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 period stated in the Bankruptcy Code, the debtor ends up being a debtor in a bankruptcy case, then the deed in lieu is at threat 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 bankruptcy filing and the transfer was made for "less than a reasonably equivalent worth" and if the transferor was insolvent at the time of the transfer, became insolvent because of the transfer, was taken part in a service that preserved an unreasonably low level of capital or meant to incur debts beyond its capability to pay. In order to alleviate versus these threats, a loan provider needs to carefully examine and assess the borrower's financial condition and liabilities and, preferably, need audited financial declarations to confirm the solvency status of the debtor. Moreover, the deed-in-lieu agreement must include representations regarding solvency and a covenant from the borrower not to file for insolvency throughout the preference period.

This is yet another reason why it is imperative for a loan provider to obtain an appraisal to validate the value of the residential or commercial property in relation to the financial obligation. A current appraisal will help the lender refute any allegations that the transfer was made for less than reasonably comparable value.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, most owners and their lenders will obtain policies of title insurance coverage to safeguard their particular 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 rely on its lending institution's policy when it becomes the cost 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 named insured under the loan provider's policy.

Since many lenders prefer to have actually title vested in a different affiliate entity, in order to make sure continued protection under the lending institution's policy, the called lending institution needs to appoint the mortgage to the designated affiliate victor prior to, or at the same time with, the transfer of the cost. In the alternative, the lending institution can take title and after that convey the residential or commercial property by deed for no factor to consider to either its moms and dad business or a completely owned subsidiary (although in some jurisdictions this might trigger transfer tax liability).

Notwithstanding the extension in protection, 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 offer the exact same or an appropriate level of protection. Moreover, a loan provider's policy does not get any defense for matters which emerge after the date of the mortgage loan, leaving the lending institution exposed to any concerns or claims stemming from events which occur after the initial closing.

Due to the reality deed-in-lieu transactions are more prone to challenge and risks as outlined above, any title insurance company issuing an owner's policy is most likely to undertake a more rigorous review of the transaction during the underwriting procedure than they would in a typical third-party purchase and sale deal. The title insurer will scrutinize the parties and the deed-in-lieu files in order to recognize and mitigate dangers provided by issues such as merger, clogging, recharacterization and insolvency, thus potentially increasing the time and costs associated with closing the deal, but ultimately supplying the lending institution with a greater level of defense than the lender would have missing the title company's involvement.

Ultimately, whether a deed-in-lieu deal is a practical choice for a loan provider is driven by the specific truths and situations of not just the loan and the residential or commercial property, but the parties involved also. Under the right set of circumstances, therefore long as the correct due diligence and documents is obtained, a deed in lieu can provide the lender 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 require assistance with such matters, please connect to lawyer Meghan A. Hayden at (203) 772-7775 and [email protected], or the Harris Beach lawyer with whom you most regularly work.