When an industrial mortgage lending institution sets out to implement a mortgage loan following a borrower default, a crucial goal is to determine the most expeditious manner in which the lender can get control and ownership of the underlying collateral. Under the right set of situations, a deed in lieu of foreclosure can be a much faster and more economical alternative to the long and drawn-out foreclosure process. This post discusses steps and issues lending institutions should consider when deciding to continue with a deed in lieu of foreclosure and how to avoid unexpected risks and obstacles throughout and following the deed-in-lieu process.

Consideration

A key element of any contract is making sure there is appropriate factor to consider. In a basic deal, consideration can quickly be developed through the purchase price, but in a deed-in-lieu situation, verifying sufficient factor to consider is not as straightforward.

In a deed-in-lieu scenario, the amount of the underlying debt that is being forgiven by the lender typically is the basis for the consideration, and in order for such consideration to be deemed "appropriate," the debt ought to a minimum of equal or surpass the reasonable market price of the subject residential or commercial property. It is crucial that obtain an independent third-party appraisal to corroborate the worth of the residential or commercial property in relation to the amount of financial obligation being forgiven. In addition, its recommended the deed-in-lieu contract 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 prospective claims connected to the adequacy of the factor to consider.

Clogging and Recharacterization Issues

Clogging is shorthand for a principal rooted in ancient English typical law that a debtor 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 debt 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 that, 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 deals preclude a borrower's equitable right of redemption, nevertheless, steps can be required to structure them to limit or prevent the risk of an obstructing obstacle. First and foremost, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure need to happen post-default and can not be pondered by the underlying loan files. Parties must likewise be wary 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 manager, an occupant or through repurchase choices, as any of these arrangements can create a threat of the transaction being recharacterized as an equitable mortgage.

Steps can be required to alleviate against recharacterization dangers. Some examples: if a debtor's residential or commercial property management functions are restricted to ministerial functions rather than substantive choice making, if a lease-back is brief term and the payments are plainly structured as market-rate usage and occupancy 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 recommended that deed-in-lieu arrangements include the parties' clear and unquestionable recognition that the transfer of the residential or commercial property is an absolute conveyance and not a transfer of for security purposes only.

Merger of Title

When a lending institution makes a loan secured by a mortgage on realty, 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 obtains the property from a defaulting mortgagor, it now likewise holds an interest in the residential or commercial property by virtue of being the charge owner and getting the mortgagor's equity of redemption.

The basic rule on this issue provides 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 takes place in the lack of proof of a contrary objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is necessary the contract plainly reflects the parties' intent to maintain the mortgage lien estate as unique from the charge so the lender maintains the ability to foreclose the underlying mortgage if there are stepping in liens. If the estates combine, then the lending institution's mortgage lien is snuffed out and the lending institution loses the ability to handle intervening liens by foreclosure, which might leave the loan provider in a possibly worse position than if the loan provider pursued a foreclosure from the beginning.

In order to plainly reflect the celebrations' intent on this point, the deed-in-lieu contract (and the deed itself) need to include reveal anti-merger language. Moreover, because there can be no mortgage without a financial obligation, it is traditional in a deed-in-lieu circumstance for the lender to provide a covenant not to sue, rather than 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 versus exposure from the debt and likewise retains the lien of the mortgage, consequently allowing the lender to keep the capability to foreclose, needs to it end up being desirable to eliminate 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 transactions can be a significant sticking point. While a lot of states make the payment of transfer tax a seller commitment, as a practical matter, the lending institution ends up soaking up the cost given that the borrower remains in a default situation and generally does not have funds.

How transfer tax is computed on a deed-in-lieu transaction is reliant on the jurisdiction and can be a driving force in identifying if a deed in lieu is a practical 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 as much as the quantity of the debt. Some other states, consisting of Washington and Illinois, have straightforward exemptions for deed-in-lieu transactions. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu transactions it is restricted only to a transfer of the debtor's personal home.

For a business deal, the tax will be calculated based upon the complete purchase rate, which is expressly specified as consisting of the quantity of liability which is presumed or to which the real estate is subject. Similarly, but even more possibly exorbitant, New york city bases the quantity of the transfer tax on "consideration," which is defined as the overdue balance of the debt, plus the total amount of any other making it through liens and any amounts paid by the grantee (although if the loan is fully option, the factor to consider is capped at the reasonable market price of the residential or commercial property plus other amounts paid). Remembering the lending institution will, in many jurisdictions, have to pay this tax again when ultimately selling the residential or commercial property, the specific jurisdiction's guidelines on transfer tax can be a determinative factor in choosing whether a deed-in-lieu deal is a feasible option.

Bankruptcy Issues

A major concern for lenders when identifying if a deed in lieu is a practical option is the concern that if the customer becomes a debtor in an insolvency case after the deed in lieu is total, the bankruptcy court can trigger 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 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 debtor insolvent) and within the 90-day period stated in the Bankruptcy Code, the borrower becomes a debtor in a personal 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 set aside if it is made within one year prior to a bankruptcy filing and the transfer was produced "less than a reasonably comparable worth" and if the transferor was insolvent at the time of the transfer, ended up being insolvent since of the transfer, was engaged in an organization that maintained an unreasonably low level of capital or planned to incur financial obligations beyond its capability to pay. In order to reduce against these threats, a lending institution must thoroughly examine and assess the debtor's financial condition and liabilities and, ideally, need audited monetary declarations to verify the solvency status of the customer. Moreover, the deed-in-lieu arrangement must include representations as to solvency and a covenant from the customer not to apply for bankruptcy throughout the preference duration.

This is yet another reason that it is crucial for a lender to acquire an appraisal to validate the worth of the residential or commercial property in relation to the financial obligation. A current appraisal will help the lending institution refute any accusations that the transfer was made for less than fairly comparable worth.

Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, most owners and their lending institutions will acquire policies of title insurance coverage to protect their respective interests. A loan provider 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 lending institution's policy when it ends up being the charge owner. Coverage under a lender's policy of title insurance coverage can continue after the acquisition of title if title is taken by the exact same entity that is the called guaranteed under the lender's policy.

Since numerous lending institutions prefer to have title vested in a different affiliate entity, in order to make sure ongoing coverage under the lender's policy, the called lender should appoint the mortgage to the designated affiliate title holder prior to, or all at once with, the transfer of the charge. In the option, the loan provider can take title and then communicate the residential or commercial property by deed for no factor to consider to either its parent business or a completely owned subsidiary (although in some jurisdictions this could set off transfer tax liability).

Notwithstanding the extension in coverage, a lending institution's policy does not convert 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 lending institution's policy would not supply the same or an appropriate level of defense. Moreover, a lending institution's policy does not obtain any security for matters which develop after the date of the mortgage loan, leaving the lending institution exposed to any concerns or claims stemming from events which take place after the initial closing.

Due to the truth deed-in-lieu transactions are more prone to challenge and threats as outlined above, any title insurer providing an owner's policy is likely to undertake a more extensive evaluation of the transaction throughout the underwriting procedure than they would in a common third-party purchase and sale transaction. The title insurance provider will scrutinize the celebrations and the deed-in-lieu files in order to identify and alleviate dangers provided by issues such as merger, clogging, recharacterization and insolvency, thus possibly increasing the time and costs associated with closing the transaction, however eventually offering the loan provider with a greater level of defense than the lending institution would have missing the title company's involvement.

Ultimately, whether a deed-in-lieu deal is a feasible option for a loan provider is driven by the specific facts and scenarios of not just the loan and the residential or commercial property, but the celebrations included too. Under the right set of scenarios, therefore long as the correct due diligence and documentation is gotten, a deed in lieu can offer the loan provider with a more effective and less pricey means to understand on its collateral when a loan enters into default.

Harris Beach Murtha's Commercial Realty Practice Group is experienced with deed in lieu of foreclosures. If you require help with such matters, please reach out to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most frequently work.