When a commercial mortgage loan provider sets out to implement a mortgage loan following a debtor default, an essential goal is to determine the most expeditious way in which the lender can get control and possession of the underlying security. Under the right set of scenarios, a deed in lieu of foreclosure can be a quicker and more affordable option to the long and drawn-out foreclosure process. This short article discusses steps and concerns lending institutions should consider when making the choice to proceed with a deed in lieu of foreclosure and how to avoid unanticipated risks and challenges throughout and following the deed-in-lieu process.
Consideration
A crucial element of any contract is ensuring there is appropriate factor to consider. In a basic transaction, factor to consider can quickly be established through the purchase cost, but in a deed-in-lieu scenario, validating appropriate factor to consider is not as simple.
In a deed-in-lieu circumstance, the amount of the underlying financial obligation that is being forgiven by the lender usually is the basis for the consideration, and in order for such consideration to be deemed "appropriate," the debt ought to a minimum of equivalent or exceed the reasonable market worth of the subject residential or commercial property. It is important that lenders acquire an independent third-party appraisal to corroborate 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 agreement consist of the borrower's express recognition of the fair market value of the residential or commercial property in relation to the amount of the debt and a waiver of any potential claims connected to the adequacy of the factor to consider.
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 real estate holds an unqualified right to redeem that residential or commercial property from the lending institution by repaying the debt up till the point when the right of redemption is lawfully extinguished through a correct foreclosure. Preserving the debtor's equitable right of redemption is the factor why, 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 borrower's equitable right of redemption, however, actions can be taken to structure them to limit or prevent the threat of a blocking difficulty. Most importantly, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure must happen post-default and can not be considered by the underlying loan documents. Parties need to also watch out for a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which consider that the debtor keeps 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 develop a risk of the deal being recharacterized as an equitable mortgage.
Steps can be required to alleviate against recharacterization risks. Some examples: if a customer's residential or commercial property management functions are limited to ministerial functions rather than substantive decision making, if a lease-back is brief term and the payments are clearly structured as market-rate usage and tenancy payments, or if any provision for reacquisition of the residential or commercial property by the borrower is set up to be entirely independent of the condition for the deed in lieu.
While not determinative, it is advised that deed-in-lieu agreements include the celebrations' clear and indisputable recognition 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 real estate, it holds an interest in the property by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the loan provider 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 obtaining the mortgagor's equity of redemption.
The basic guideline on this problem offers 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 fee happens in the absence of evidence of a contrary objective. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is necessary the arrangement plainly shows the celebrations' intent to keep the mortgage lien estate as unique from the cost so the loan provider keeps the capability to foreclose the underlying mortgage if there are intervening liens. If the estates combine, then the loan provider's mortgage lien is extinguished and the lender loses the ability to deal with intervening liens by foreclosure, which could leave the lending institution in a possibly even worse position than if the lending institution pursued a foreclosure from the start.
In order to clearly 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 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 consideration for the deed in lieu, safeguards the customer against exposure from the debt and also maintains the lien of the mortgage, thereby allowing the loan provider to keep the ability to foreclose, should 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 transactions can be a considerable sticking point. While most states make the payment of transfer tax a seller obligation, as a practical matter, the lender ends up soaking up the expense because the customer remains in a default circumstance and usually 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 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 up to the quantity 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 transactions it is restricted just to a transfer of the borrower's personal residence.
For a business deal, the tax will be computed based on the full purchase price, which is specifically defined as including the quantity of liability which is assumed or to which the real estate is subject. Similarly, however much more possibly oppressive, New york city bases the amount of the transfer tax on "factor to consider," which is specified as the overdue balance of the financial obligation, plus the overall quantity of any other making it through liens and any quantities paid by the grantee (although if the loan is totally recourse, the factor to consider is capped at the fair market value 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 particular 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 major concern for lending institutions when identifying if a deed in lieu is a feasible option is the concern that if the customer ends up being a debtor in a bankruptcy case after the deed in lieu is complete, the personal bankruptcy court can cause 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 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 stated in the Bankruptcy Code, the borrower ends up being a debtor in a personal bankruptcy case, then the deed in lieu is at threat 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 an insolvency filing and the transfer was made for "less than a reasonably comparable value" and if the transferor was insolvent at the time of the transfer, became insolvent due to the fact that of the transfer, was taken part in a service that preserved an unreasonably low level of capital or intended to incur debts beyond its ability to pay. In order to reduce versus these threats, a lending institution needs to thoroughly review and assess the borrower's monetary condition and liabilities and, ideally, require audited monetary statements to validate the solvency status of the customer. Moreover, the deed-in-lieu contract needs to consist of representations as to solvency and a covenant from the customer not to submit for personal bankruptcy throughout the preference period.
This is yet another reason that it is crucial for a lender to acquire an appraisal to verify the value of the residential or commercial property in relation to the debt. An existing appraisal will help the lending institution refute any claims that the transfer was made for less than fairly equivalent value.
Title Insurance
As part of the preliminary acquisition of a real residential or commercial property, many owners and their lenders will acquire policies of title insurance to safeguard their particular interests. A lender considering 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 becomes the cost owner. Coverage under a loan provider's policy of title insurance can continue after the acquisition of title if title is taken by the exact same entity that is the named insured under the loan provider's policy.
Since lots of loan providers choose to have title vested in a separate affiliate entity, in order to guarantee continued coverage under the lender's policy, the called lender should designate the mortgage to the intended affiliate victor prior to, or all at once with, the transfer of the fee. In the option, the lender can take title and after that communicate the residential or commercial property by deed for no consideration to either its parent business or an entirely owned subsidiary (although in some jurisdictions this could set off transfer tax liability).
Notwithstanding the continuation in protection, a lending institution's policy does not convert 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 lender's policy would not offer the same or an adequate level of security. Moreover, a lender's policy does not obtain any security for matters which occur after the date of the mortgage loan, leaving the lending institution exposed to any problems or claims coming from occasions which occur after the original closing.
Due to the fact deed-in-lieu transactions are more vulnerable to challenge and risks as described above, any title insurer releasing an owner's policy is likely to carry out a more rigorous review of the deal throughout the underwriting process than they would in a common third-party purchase and sale transaction. The title insurance provider will inspect the parties and the deed-in-lieu files in order to determine and reduce threats provided by issues such as merger, clogging, recharacterization and insolvency, thereby possibly increasing the time and expenses associated with closing the deal, however the lender with a greater level of protection than the loan provider would have missing the title company's involvement.
Ultimately, whether a deed-in-lieu deal is a practical option for a lending institution is driven by the particular truths and situations of not only the loan and the residential or commercial property, however the parties included too. Under the right set of situations, therefore long as the correct due diligence and paperwork is acquired, a deed in lieu can supply the lender with a more efficient and cheaper methods to recognize on its collateral when a loan goes into default.
Harris Beach Murtha's Commercial Property Practice Group is experienced with deed in lieu of foreclosures. If you require support 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 often work.
