When an industrial mortgage lending institution sets out to enforce a mortgage loan following a customer default, a crucial objective is to recognize the most expeditious manner in which the loan provider can acquire control and ownership of the underlying security. Under the right set of circumstances, a deed in lieu of foreclosure can be a faster and more cost-effective alternative to the long and drawn-out foreclosure process. This article talks about actions and problems lenders need to consider when deciding to proceed with a deed in lieu of foreclosure and how to prevent unexpected dangers and challenges throughout and following the deed-in-lieu procedure.

Consideration

A crucial element of any agreement is ensuring there is sufficient consideration. In a standard deal, consideration can quickly be developed through the purchase price, however in a deed-in-lieu scenario, validating sufficient factor to consider is not as uncomplicated.

In a deed-in-lieu scenario, the quantity of the underlying debt that is being forgiven by the loan provider usually is the basis for the factor to consider, and in order for such factor to consider to be deemed "adequate," the financial obligation needs to a minimum of equal or exceed the fair market worth of the subject residential or commercial property. It is crucial that loan providers get an independent third-party appraisal to corroborate 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 contract include the borrower's reveal recognition of the fair market price of the residential or commercial property in relation to the amount of the debt and a waiver of any possible claims related to the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a principal rooted in ancient English common law that a borrower who secures a loan with a mortgage on property holds an unqualified right to redeem that residential or commercial property from the loan provider by paying back the financial obligation up until the point when the right of redemption is legally extinguished through an appropriate foreclosure. Preserving the borrower's fair 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 lending institution.

Deed-in-lieu transactions preclude a debtor's equitable right of redemption, nevertheless, actions can be required to structure them to limit or avoid the risk of a clogging difficulty. Primarily, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure must take location post-default and can not be contemplated by the underlying loan files. Parties ought to likewise 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 debtor keeps rights to the residential or commercial property, either as a residential or commercial property supervisor, a renter or through repurchase choices, as any of these arrangements can develop a danger of the deal being recharacterized as an equitable mortgage.

Steps can be taken to alleviate against recharacterization threats. Some examples: if a debtor's residential or commercial property management functions are limited to ministerial functions instead of substantive decision making, if a lease-back is brief term and the payments are plainly structured as market-rate usage and tenancy payments, or if any provision for reacquisition of the residential or commercial property by the customer is set up to be entirely independent of the condition for the deed in lieu.

While not determinative, it is suggested that deed-in-lieu contracts 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 just.

Merger of Title

When a lending institution makes a loan secured by a mortgage on property, it holds an interest in the genuine estate by virtue of being the mortgagee under a mortgage (or a recipient under a deed of trust). If the lending institution then obtains the property from a defaulting mortgagor, it now likewise holds an interest in the residential or commercial property by virtue of being the cost owner and acquiring the mortgagor's equity of redemption.

The basic rule on this problem 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 lack of proof of a contrary objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is essential the arrangement clearly reflects the parties' intent to keep the mortgage lien estate as distinct from the fee so the lender keeps the capability to foreclose the hidden mortgage if there are stepping in liens. If the estates combine, then the lender's mortgage lien is extinguished and the lender loses the ability to handle stepping in liens by foreclosure, which could leave the loan provider in a possibly even worse position than if the lender pursued a foreclosure from the start.

In order to clearly show the parties' intent on this point, the deed-in-lieu contract (and the deed itself) need to include express anti-merger language. Moreover, due to the fact that there can be no mortgage without a financial obligation, it is popular in a deed-in-lieu circumstance for the lender 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 factor to consider for the deed in lieu, protects the borrower against direct exposure from the financial obligation and likewise maintains the lien of the mortgage, thereby allowing the lending institution to keep the capability to foreclose, must 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 deals can be a considerable sticking point. While the majority of states make the payment of transfer tax a seller responsibility, as a useful matter, the lending institution ends up soaking up the cost given that the debtor is in a default scenario and typically lacks funds.

How transfer tax is determined 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 viable 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 approximately the amount 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 restricted just to a transfer of the debtor's personal home.

For a commercial deal, the tax will be determined based upon the full purchase cost, which is specifically defined as consisting of the quantity of liability which is assumed or to which the real estate is subject. Similarly, but much more potentially draconian, 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 quantity of any other surviving liens and any quantities paid by the beneficiary (although if the loan is totally option, the consideration is capped at the fair market price of the residential or commercial property plus other quantities paid). Keeping in mind the lender will, in a lot of jurisdictions, have to pay this tax again when eventually offering 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 deal is a practical choice.

Bankruptcy Issues

A significant concern for lending institutions when figuring out if a deed in lieu is a practical alternative is the issue that if the borrower becomes a debtor in an insolvency case after the deed in lieu is total, the 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 directly within subsection (b)( 2) of Section 547 of the Bankruptcy Code dealing with 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 becomes a debtor in a bankruptcy case, then the deed in lieu is at danger 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 personal bankruptcy filing and the transfer was made for "less than a fairly equivalent worth" and if the transferor was insolvent at the time of the transfer, ended up being insolvent due to the fact that of the transfer, was participated in a business that maintained an unreasonably low level of capital or intended to sustain debts beyond its capability to pay. In order to reduce versus these risks, a lender must thoroughly examine and evaluate the borrower's financial condition and liabilities and, ideally, require audited financial statements to validate the solvency status of the borrower. Moreover, the deed-in-lieu contract should include representations regarding solvency and a covenant from the debtor not to declare insolvency during the choice duration.

This is yet another reason that it is essential for a lending institution to procure an appraisal to validate the value of the residential or commercial property in relation to the financial obligation. An existing appraisal will assist the loan provider refute any allegations 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 loan providers will obtain policies of title insurance coverage to secure their respective interests. A lending institution considering taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can depend on its lending institution's policy when it ends up being the charge 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 loan provider's policy.

Since lots of lenders prefer to have actually title vested in a different affiliate entity, in order to make sure continued coverage under the loan provider's policy, the named lending institution should designate the mortgage to the designated affiliate title holder prior to, or concurrently with, the transfer of the cost. In the alternative, the lender can take title and then 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 could trigger transfer tax liability).

Notwithstanding the continuation in protection, a lender's policy does not transform to an owner's policy. Once the loan provider becomes 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 provide the same or a sufficient level of defense. Moreover, a lending institution's policy does not get any defense for matters which occur after the date of the mortgage loan, leaving the loan provider exposed to any concerns or claims coming from events which occur after the initial closing.

Due to the reality deed-in-lieu deals are more prone to challenge and risks as detailed above, any title insurance company releasing an owner's policy is most likely to carry out a more extensive evaluation of the transaction during the underwriting procedure than they would in a typical third-party purchase and sale transaction. The title insurance provider will inspect the celebrations and the deed-in-lieu documents in order to identify and mitigate dangers provided by problems such as merger, clogging, recharacterization and insolvency, therefore potentially increasing the time and expenses involved in closing the deal, but eventually supplying the loan provider with a higher level of defense than the lending institution would have absent the title business's participation.

Ultimately, whether a deed-in-lieu transaction is a feasible choice for a loan provider is driven by the particular realities and scenarios of not only the loan and the residential or commercial property, however the parties included too. Under the right set of situations, and so long as the appropriate due diligence and documentation is gotten, a deed in lieu can provide the lending institution with a more effective and less pricey methods to understand 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 connect to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most often work.