When a business mortgage loan provider sets out to impose a mortgage loan following a customer default, a key goal is to determine the most expeditious manner in which the loan provider can get 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 economical option to the long and lengthy foreclosure procedure. This article goes over steps and problems lending institutions should consider when making the decision to proceed with a deed in lieu of foreclosure and how to prevent unanticipated dangers and challenges during and following the deed-in-lieu process.

Consideration

An essential element of any contract is guaranteeing there is adequate consideration. In a basic transaction, factor to consider can easily be established through the purchase rate, but in a deed-in-lieu circumstance, validating sufficient consideration is not as uncomplicated.

In a deed-in-lieu scenario, the amount of the underlying debt that is being forgiven by the lending institution usually is the basis for the consideration, and in order for such consideration to be deemed "sufficient," the debt must at least equal or surpass the reasonable market price of the subject residential or commercial property. It is necessary that lending institutions obtain an independent third-party appraisal to substantiate the worth of the residential or commercial property in relation to the quantity of debt being forgiven. In addition, its recommended the deed-in-lieu contract consist of the borrower's express acknowledgement of the fair market value of the residential or commercial property in relation to the amount of the financial obligation and a waiver of any prospective claims related to the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English typical law that a borrower who protects a loan with a mortgage on property 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 borrower's fair right of redemption is the reason, prior to default, mortgage loans can not be structured to ponder the voluntary transfer of the residential or commercial property to the lending institution.

Deed-in-lieu deals prevent a debtor's fair right of redemption, nevertheless, steps can be required to structure them to restrict or avoid the threat of a blocking difficulty. First and foremost, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure should happen post-default and can not be considered by the underlying loan files. Parties need to also be wary of a deed-in-lieu arrangement where, following the transfer, there is a continuation of a debtor/creditor relationship, or which contemplate that the borrower retains 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 create a threat of the transaction being recharacterized as a fair mortgage.

Steps can be required to alleviate against recharacterization threats. Some examples: if a borrower'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 clearly structured as market-rate use and tenancy payments, or if any arrangement 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 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 just.

Merger of Title

When a loan provider makes a loan protected by a mortgage on property, it holds an interest in the realty 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 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 rule on this issue supplies that, where a mortgagee obtains the cost 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 evidence of a contrary objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is necessary the agreement clearly reflects the parties' intent to retain the mortgage lien estate as distinct from the cost so the lender keeps the capability to foreclose the hidden mortgage if there are intervening liens. If the estates combine, then the lending institution's mortgage lien is extinguished and the lending institution loses the capability to deal with intervening liens by foreclosure, which could leave the loan provider in a potentially worse position than if the lending institution pursued a foreclosure from the start.

In order to plainly show the parties' intent on this point, the deed-in-lieu contract (and the deed itself) must consist of reveal 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 scenario for the lending institution to deliver a covenant not to sue, rather than a straight-forward release of the financial obligation. The covenant not to sue furnishes consideration for the deed in lieu, secures the customer against direct exposure from the financial obligation and also retains the lien of the mortgage, therefore permitting the lending institution to keep the ability to foreclose, ought to it end up being preferable to eliminate junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending on the jurisdiction, dealing with transfer tax and the payment thereof in deed-in-lieu deals can be a significant sticking point. While many states make the payment of transfer tax a seller commitment, as a useful matter, the lender winds up soaking up the expense since the debtor remains 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 identifying if a deed in lieu is a practical alternative. 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 up to the quantity of the debt. Some other states, consisting of Washington and Illinois, have straightforward exemptions for deed-in-lieu deals. In Connecticut, however, while there is an exemption for deed-in-lieu deals it is limited just to a transfer of the customer's individual residence.

For a business transaction, the tax will be determined based on the complete purchase cost, which is expressly specified as including the quantity of liability which is presumed or to which the real estate is subject. Similarly, but much more potentially drastic, New York bases the amount of the transfer tax on "factor to consider," which is specified as the unpaid balance of the financial obligation, plus the total quantity of any other enduring liens and any quantities paid by the grantee (although if the loan is completely option, the factor to consider is topped at the fair market worth of the residential or commercial property plus other amounts paid). Bearing in mind the loan provider will, in a lot of jurisdictions, need to pay this tax once 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 option.

Bankruptcy Issues

A major concern for loan providers when identifying if a deed in lieu is a feasible option is the concern that if the customer becomes a debtor in a personal bankruptcy case after the deed in lieu is total, the personal 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 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 duration stated in the Bankruptcy Code, the borrower becomes 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 personal 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 because of the transfer, was engaged in a business that preserved an unreasonably low level of capital or planned to incur debts beyond its capability to pay. In order to mitigate against these threats, a loan provider should carefully evaluate and evaluate the borrower's monetary condition and liabilities and, ideally, require audited monetary declarations to verify the solvency status of the borrower. Moreover, the deed-in-lieu agreement ought to include representations as to solvency and a covenant from the debtor not to submit for bankruptcy throughout the choice period.

This is yet another reason that it is important for a lending institution to acquire an appraisal to validate the worth of the residential or commercial property in relation to the debt. A present appraisal will assist the lending institution refute any allegations that the transfer was made for less than fairly equivalent value.

Title Insurance

As part of the initial acquisition of a real residential or commercial property, a lot of owners and their loan providers will get policies of title insurance to protect their respective interests. A lender considering taking title to a residential or commercial property by virtue of a deed in lieu might ask whether it can count on its lending institution's policy when it ends up being the charge owner. Coverage under a loan provider's policy of title insurance can continue after the acquisition of title if title is taken by the same entity that is the called insured under the lender's policy.

Since many lending institutions prefer to have title vested in a separate affiliate entity, in order to guarantee ongoing coverage under the loan provider's policy, the called lending institution ought to assign the mortgage to the desired affiliate title holder prior to, or all at once 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 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 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 supply the same or a sufficient level of protection. Moreover, a lender's policy does not get any defense for matters which emerge after the date of the mortgage loan, leaving the lender exposed to any problems or claims originating from events which happen after the original closing.

Due to the truth deed-in-lieu deals are more susceptible to challenge and dangers as laid out 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 procedure than they would in a common third-party purchase and sale deal. The title insurer will scrutinize the parties and the deed-in-lieu files in order to recognize and alleviate threats presented by concerns such as merger, obstructing, recharacterization and insolvency, consequently potentially increasing the time and expenses included in closing the deal, however eventually supplying the lending institution with a greater level of protection than the lender would have missing the title business's participation.

Ultimately, whether a deed-in-lieu deal is a viable option for a loan provider is driven by the specific realities and circumstances of not just the loan and the residential or commercial property, but the parties included also. Under the right set of scenarios, therefore long as the correct due diligence and paperwork is acquired, a deed in lieu can provide the loan provider with a more effective and cheaper ways to understand on its security when a loan goes into default.

Harris Beach Murtha's Commercial Realty 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 lawyer with whom you most regularly work.