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 lending institution can obtain control and belongings of the underlying security. Under the right set of situations, a deed in lieu of foreclosure can be a quicker and more economical option to the long and drawn-out foreclosure procedure. This post talks about steps and concerns lending institutions need to think about when deciding to proceed with a deed in lieu of foreclosure and how to prevent unexpected threats and challenges throughout and following the deed-in-lieu procedure.

Consideration

A key aspect of any contract is ensuring there is appropriate factor to consider. In a basic transaction, consideration can quickly be established through the purchase rate, however in a deed-in-lieu circumstance, confirming adequate consideration is not as simple.

In a deed-in-lieu circumstance, the amount of the underlying debt that is being forgiven by the lender usually is the basis for the factor to consider, and in order for such factor to consider to be considered "adequate," the financial obligation should a minimum of equivalent or surpass the reasonable market price of the subject residential or commercial property. It is imperative that lenders get an independent third-party appraisal to substantiate the value of the residential or commercial property in relation to the quantity of debt being forgiven. In addition, its recommended the deed-in-lieu agreement consist of the customer's reveal recognition of the fair market price of the residential or commercial property in relation to the quantity of the financial obligation and a waiver of any possible claims associated with the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English common law that a debtor who secures a loan with a mortgage on real estate holds an unqualified right to redeem that residential or commercial property from the lender by paying back the financial obligation up till the point when the right of redemption is lawfully extinguished through a correct foreclosure. Preserving the debtor's fair right of redemption is the reason why, 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 transactions preclude a customer's equitable right of redemption, however, steps can be taken to structure them to limit or avoid the threat of a clogging difficulty. Most importantly, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure should occur post-default and can not be considered by the underlying loan files. Parties ought to likewise be cautious of a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which contemplate that the customer maintains rights to the residential or commercial property, either as a residential or commercial property supervisor, an occupant or through repurchase alternatives, as any of these plans can produce a danger of the deal being recharacterized as a fair mortgage.

Steps can be taken to alleviate versus recharacterization risks. Some examples: if a customer's residential or commercial property management functions are restricted 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 provision for reacquisition of the residential or commercial property by the customer is set up to be completely independent of the condition for the deed in lieu.

While not determinative, it is advised that deed-in-lieu agreements consist of the parties' clear and unquestionable recognition that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security functions only.

Merger of Title

When a lender makes a loan secured by a mortgage on realty, it holds an interest in the property by virtue of being the mortgagee under a mortgage (or a recipient 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 cost owner and acquiring the mortgagor's equity of redemption.

The general rule on this issue offers that, where a mortgagee obtains the charge 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 objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is essential the contract clearly reflects the parties' intent to retain the mortgage lien estate as unique from the cost so the lender keeps the ability to foreclose the underlying mortgage if there are stepping in liens. If the estates combine, then the lender's mortgage lien is snuffed out and the loan provider loses the ability to handle stepping in liens by foreclosure, which could leave the lender in a potentially even worse position than if the lending institution pursued a foreclosure from the beginning.

In order to clearly reflect the celebrations' intent on this point, the deed-in-lieu agreement (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 financial obligation, it is customary in a deed-in-lieu scenario for the lender to provide a covenant not to sue, rather than a straight-forward release of the debt. The covenant not to sue furnishes factor to consider for the deed in lieu, secures the customer against direct exposure from the debt and also maintains the lien of the mortgage, thereby permitting the lending institution to preserve the ability to foreclose, must it end up being preferable to remove junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending on the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu deals can be a considerable sticking point. While most states make the payment of transfer tax a seller obligation, as a practical matter, the lender winds up taking in the cost since the debtor is in a default circumstance and generally does not have funds.

How transfer tax is determined on a deed-in-lieu deal is reliant on the jurisdiction and can be a driving force in determining if a deed in lieu is a feasible 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 amount of the debt. Some other states, including Washington and Illinois, have simple exemptions for deed-in-lieu transactions. In Connecticut, however, while there is an exemption for deed-in-lieu transactions it is restricted only to a transfer of the customer's personal home.

For a business transaction, the tax will be calculated based upon the full purchase rate, which is expressly specified as consisting of the amount of liability which is presumed or to which the real estate is subject. Similarly, but even more potentially extreme, New york city bases the quantity of the transfer tax on "factor to consider," which is specified as the unpaid balance of the financial obligation, plus the total amount of any other enduring liens and any amounts paid by the beneficiary (although if the loan is fully recourse, the consideration is topped at the fair market price of the residential or commercial property plus other quantities paid). Keeping in mind the lending institution will, in most jurisdictions, need to pay this tax again when ultimately offering the residential or commercial property, the specific jurisdiction's guidelines on transfer tax can be a determinative consider deciding whether a deed-in-lieu deal is a practical option.

Bankruptcy Issues

A significant issue for lenders when identifying if a deed in lieu is a practical alternative is the concern that if the customer ends up being a debtor in a personal bankruptcy case after the deed in lieu is complete, the bankruptcy court can trigger the transfer to be unwound or reserved. 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 handling preferential transfers. Accordingly, if the transfer was made when the customer was insolvent (or the transfer rendered the debtor insolvent) and within the 90-day period set forth in the Bankruptcy Code, the debtor ends up being a debtor in a personal 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 an insolvency filing and the transfer was produced "less than a fairly equivalent worth" and if the transferor was insolvent at the time of the transfer, became insolvent since of the transfer, was participated in an organization that kept an unreasonably low level of capital or intended to sustain financial obligations beyond its capability to pay. In order to mitigate versus these risks, a loan provider should thoroughly review and evaluate the customer's financial condition and liabilities and, ideally, need audited financial statements to verify the solvency status of the debtor. Moreover, the deed-in-lieu contract needs to consist of representations as to solvency and a covenant from the debtor not to declare bankruptcy during the preference period.

This is yet another reason why it is imperative for a lender to acquire an appraisal to verify the value of the residential or commercial property in relation to the financial obligation. A current appraisal will assist the lender refute any accusations that the transfer was made for less than reasonably equivalent value.

Title Insurance

As part of the preliminary acquisition of a genuine residential or commercial property, most owners and their lending institutions will acquire policies of title insurance to protect 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 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 called guaranteed under the lending institution's policy.

Since many lending institutions prefer to have title vested in a different affiliate entity, in order to guarantee continued protection under the loan provider's policy, the named lending institution should assign the mortgage to the designated affiliate title holder prior to, or concurrently with, the transfer of the fee. In the alternative, the lender can take title and then convey the residential or commercial property by deed for no factor to consider to either its moms and dad company or an entirely owned subsidiary (although in some jurisdictions this might trigger transfer tax liability).

Notwithstanding the continuation in protection, a loan provider'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 lender's policy would not supply the same or an adequate level of defense. Moreover, a lending institution's policy does not obtain any defense for matters which occur after the date of the mortgage loan, leaving the lending institution exposed to any problems or claims stemming from occasions which happen after the initial closing.

Due to the truth deed-in-lieu transactions are more vulnerable to challenge and threats as laid out above, any title insurance provider providing an owner's policy is likely to undertake a more extensive review of the deal during the underwriting process than they would in a normal third-party purchase and sale deal. The title insurance company will inspect the parties and the deed-in-lieu documents in order to recognize and alleviate risks presented by issues such as merger, obstructing, recharacterization and insolvency, thus possibly increasing the time and costs included in closing the transaction, however ultimately offering the lender with a greater level of defense than the loan provider would have missing the title business's participation.

Ultimately, whether a deed-in-lieu transaction is a practical option for a lender is driven by the specific truths and scenarios of not only the loan and the residential or commercial property, but the parties involved also. Under the right set of situations, and so long as the correct due diligence and documents is gotten, a deed in lieu can supply the lender with a more efficient and less pricey methods to recognize on its security 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 help with such matters, please connect to lawyer Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach lawyer with whom you most regularly work.