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When an industrial mortgage loan provider sets out to implement a mortgage loan following a customer default, a crucial goal is to determine the most expeditious way in which the lending institution can get control and possession of the underlying security. Under the right set of situations, a deed in lieu of foreclosure can be a much faster and more affordable alternative to the long and drawn-out foreclosure process. This article goes over steps and problems lending institutions ought to consider when deciding to continue with a deed in lieu of foreclosure and how to avoid unforeseen risks and challenges during and following the deed-in-lieu procedure.

Consideration

An essential element of any contract is ensuring there is sufficient factor to consider. In a standard deal, factor to consider can quickly be established through the purchase rate, but in a deed-in-lieu scenario, verifying adequate factor to consider is not as uncomplicated.

In a deed-in-lieu scenario, the amount of the underlying debt that is being forgiven by the lender normally is the basis for the consideration, and in order for such consideration to be considered "sufficient," the financial obligation ought to a minimum of equivalent or exceed the reasonable market price of the subject residential or commercial property. It is essential that loan providers acquire an independent third-party appraisal to substantiate 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 contract consist of the debtor's reveal acknowledgement of the reasonable market price of the residential or commercial property in relation to the quantity of the financial obligation and a waiver of any potential claims connected to 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 realty 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 lawfully snuffed out through a correct foreclosure. Preserving the borrower's fair right of redemption is the reason that, 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 customer's fair right of redemption, however, actions can be required to structure them to limit or avoid the danger of a clogging obstacle. Firstly, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure need to occur post-default and can not be pondered by the underlying loan documents. Parties must also watch out for a deed-in-lieu plan 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 manager, an occupant or through repurchase alternatives, as any of these plans can create a risk of the deal being recharacterized as a fair mortgage.

Steps can be taken to mitigate against recharacterization threats. Some examples: if a borrower's residential or commercial property management functions are restricted to ministerial functions instead of substantive decision making, if a lease-back is short 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 borrower is established 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 celebrations' 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 loan provider makes a loan secured by a mortgage on property, 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 lender then gets 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 obtaining the mortgagor's equity of redemption.

The basic guideline on this concern 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 cost occurs in the lack of evidence of a contrary objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is necessary the agreement plainly shows the celebrations' intent to keep the mortgage lien estate as unique from the cost so the loan provider maintains the ability to foreclose the hidden mortgage if there are stepping in liens. If the estates merge, then the lender's mortgage lien is extinguished and the lender loses the ability to deal with stepping in liens by foreclosure, which might leave the lending institution in a potentially even worse position than if the lender pursued a foreclosure from the outset.

In order to clearly reflect the parties' intent on this point, the deed-in-lieu contract (and the deed itself) must consist of reveal anti-merger language. Moreover, since there can be no mortgage without a financial obligation, it is traditional in a deed-in-lieu situation for the loan provider to provide a covenant not to take legal action against, instead of a straight-forward release of the debt. The covenant not to take legal action against furnishes factor to consider for the deed in lieu, safeguards the borrower against exposure from the debt and also retains the lien of the mortgage, thus permitting the lending institution to keep the ability to foreclose, ought to it become desirable to eliminate junior encumbrances after the deed in lieu is complete.

Transfer Tax

Depending upon the jurisdiction, dealing with transfer tax and the payment thereof in deed-in-lieu deals can be a substantial sticking point. While many states make the payment of transfer tax a seller commitment, as a practical matter, the lending institution winds up absorbing the cost considering that the debtor remains in a default circumstance and usually lacks 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 viable option. In California, for instance, a conveyance or transfer from the mortgagor to the mortgagee as an outcome 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 uncomplicated exemptions for deed-in-lieu transactions. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu transactions it is restricted just to a transfer of the debtor's personal residence.

For an industrial transaction, the tax will be calculated based on the complete 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 much more potentially oppressive, New York bases the amount of the transfer tax on "consideration," which is specified as the unpaid balance of the debt, plus the overall amount of any other enduring liens and any quantities paid by the grantee (although if the loan is completely recourse, the consideration is topped at the reasonable market price of the residential or commercial property plus other amounts paid). Keeping in mind the lending institution will, in many jurisdictions, need 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 deciding whether a deed-in-lieu deal is a possible choice.

Bankruptcy Issues

A significant issue for loan providers when figuring out if a deed in lieu is a practical option is the issue that if the borrower becomes a debtor in a personal bankruptcy case after the deed in lieu is total, the bankruptcy court can trigger the transfer to be unwound or set aside. 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 debtor was insolvent (or the transfer rendered the borrower insolvent) and within the 90-day duration set forth in the Bankruptcy Code, the borrower ends up being a debtor in a bankruptcy case, then the deed in lieu is at danger 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 reasonably equivalent value" and if the transferor was insolvent at the time of the transfer, became insolvent since of the transfer, was engaged in a service that maintained an unreasonably low level of capital or meant to sustain debts beyond its ability to pay. In order to alleviate against these dangers, a lender needs to carefully review and assess the borrower's financial condition and liabilities and, preferably, require audited monetary statements to verify the solvency status of the debtor. Moreover, the deed-in-lieu arrangement needs to include representations as to solvency and a covenant from the borrower not to declare bankruptcy during the preference period.

This is yet another factor why it is crucial for a loan provider to obtain an appraisal to verify the worth of the residential or commercial property in relation to the debt. A current appraisal will assist the lender refute any accusations that the transfer was produced less than fairly comparable value.

Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, a lot of owners and their loan providers will get policies of title insurance coverage to protect their particular 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 depend on its loan provider's policy when it becomes the cost owner. Coverage under a lender's policy of title insurance coverage can continue after the acquisition of title if title is taken by the same entity that is the called guaranteed under the lending institution's policy.

Since numerous loan providers prefer to have title vested in a different affiliate entity, in order to make sure ongoing coverage under the lending institution's policy, the named loan provider must designate the mortgage to the desired affiliate title holder prior to, or at the same time with, the transfer of the charge. In the alternative, the loan provider can take title and then convey the residential or by deed for no consideration to either its moms and dad business or a completely owned subsidiary (although in some jurisdictions this could trigger transfer tax liability).

Notwithstanding the extension 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 provide the same or a sufficient level of protection. Moreover, a loan provider's policy does not obtain any security for matters which arise after the date of the mortgage loan, leaving the loan provider exposed to any issues or claims originating from occasions which happen after the initial closing.

Due to the fact deed-in-lieu deals are more vulnerable to challenge and threats as described above, any title insurance provider releasing an owner's policy is most likely to undertake a more extensive evaluation of the transaction throughout the underwriting process than they would in a normal third-party purchase and sale transaction. The title insurance provider will scrutinize the celebrations and the deed-in-lieu documents in order to identify and mitigate risks presented by concerns such as merger, blocking, recharacterization and insolvency, consequently potentially increasing the time and expenses included in closing the deal, but eventually providing the lender with a higher level of protection than the lending institution would have absent the title company's involvement.

Ultimately, whether a deed-in-lieu transaction is a viable choice for a lending institution is driven by the specific facts and scenarios of not only the loan and the residential or commercial property, however the parties involved also. Under the right set of circumstances, therefore long as the appropriate due diligence and documentation is obtained, a deed in lieu can supply the lender with a more efficient and more economical means to recognize on its collateral when a loan enters 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 reach out to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most regularly work.