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Lender Considerations In Deed-in-Lieu Transactions

When a business mortgage loan provider sets out to enforce a mortgage loan following a borrower default, a key goal is to recognize the most expeditious way in which the lending institution can get control and ownership of the underlying collateral. Under the right set of scenarios, a deed in lieu of foreclosure can be a much faster and more cost-effective option to the long and lengthy foreclosure process. This short article discusses actions and concerns lenders ought to consider when making the decision to continue with a deed in lieu of foreclosure and how to prevent unforeseen threats and obstacles during and following the deed-in-lieu procedure.

Consideration

A key aspect of any contract is making sure there is sufficient consideration. In a standard deal, consideration can easily be established through the purchase cost, but in a deed-in-lieu circumstance, confirming adequate consideration is not as uncomplicated.

In a deed-in-lieu scenario, the quantity of the underlying debt that is being forgiven by the lending institution normally is the basis for the factor to consider, and in order for such factor to consider to be considered "appropriate," 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 lending institutions get an independent third-party appraisal to validate the value of the residential or commercial property in relation to the quantity of debt being forgiven. In addition, its suggested the deed-in-lieu arrangement consist of the borrower's express recognition 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 prospective claims connected to the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English typical law that a customer who secures a loan with a mortgage on property holds an unqualified right to redeem that residential or commercial property from the lending institution by repaying the debt up until the point when the right of redemption is lawfully extinguished through a proper foreclosure. Preserving the borrower's equitable right of redemption is the factor why, prior to default, mortgage loans can not be structured to consider the voluntary transfer of the residential or commercial property to the lender.

Deed-in-lieu deals preclude a debtor's equitable right of redemption, however, steps can be required to structure them to limit or prevent the threat of a blocking obstacle. Firstly, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure need to take place post-default and can not be pondered by the underlying loan documents. Parties need to likewise be cautious of a deed-in-lieu arrangement where, following the transfer, there is a continuation of a debtor/creditor relationship, or which ponder that the debtor retains rights to the residential or commercial property, either as a residential or commercial property manager, a renter or through repurchase options, as any of these arrangements can produce a risk of the deal being recharacterized as an equitable mortgage.

Steps can be taken to reduce against recharacterization dangers. Some examples: if a debtor's residential or commercial property management functions are restricted 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 occupancy payments, or if any arrangement for reacquisition of the residential or commercial property by the customer is established to be completely independent of the condition for the deed in lieu.

While not determinative, it is advised that deed-in-lieu contracts include the celebrations' clear and indisputable acknowledgement that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security purposes just.

Merger of Title

When a lending institution makes a loan secured by a mortgage on real estate, 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 loan provider 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 acquiring the mortgagor's equity of redemption.

The basic rule on this issue offers 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 intention. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is important the contract clearly shows the parties' intent to retain the mortgage lien estate as distinct from the fee so the lending institution retains the capability to foreclose the underlying mortgage if there are stepping in liens. If the estates merge, then the loan provider's mortgage lien is snuffed out and the lender loses the ability to deal with intervening liens by foreclosure, which could leave the loan provider in a potentially even worse position than if the lending institution pursued a foreclosure from the start.

In order to clearly reflect the parties' intent on this point, the deed-in-lieu agreement (and the deed itself) must include express anti-merger language. Moreover, since there can be no mortgage without a financial obligation, it is popular in a deed-in-lieu circumstance for the lending institution to deliver a covenant not to sue, instead of a straight-forward release of the financial obligation. The covenant not to take legal action against furnishes consideration for the deed in lieu, safeguards the borrower versus direct exposure from the financial obligation and likewise retains the lien of the mortgage, thus enabling the lending institution to maintain the capability to foreclose, needs to it end up being preferable to get rid of junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending upon the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu transactions can be a considerable sticking point. While a lot of states make the payment of transfer tax a seller commitment, as a practical matter, the lending institution winds up taking in the expense since the borrower is in a default scenario and typically lacks funds.

How transfer tax is computed on a deed-in-lieu deal depends on the jurisdiction and can be a driving force in identifying if a deed in lieu is a practical alternative. In California, for example, a conveyance or transfer from the mortgagor to the mortgagee as an outcome of a foreclosure or a deed in lieu will be exempt approximately the quantity of the financial obligation. Some other states, including Washington and Illinois, have simple exemptions for deed-in-lieu deals. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu deals it is restricted just to a transfer of the customer's personal residence.

For a business transaction, the tax will be computed based on the full purchase rate, which is specifically defined as consisting of the amount of liability which is presumed or to which the real estate is subject. Similarly, but a lot more possibly draconian, New York bases the amount of the transfer tax on "factor to consider," which is specified as the overdue balance of the financial obligation, plus the total amount of any other enduring liens and any amounts paid by the grantee (although if the loan is fully recourse, the consideration is capped at the fair market worth of the residential or commercial property plus other amounts paid). Bearing in mind the lending institution will, in a lot of jurisdictions, need to pay this tax once again when ultimately offering the residential or commercial property, the particular jurisdiction's guidelines on transfer tax can be a determinative factor in choosing whether a deed-in-lieu deal is a feasible alternative.

Bankruptcy Issues

A significant issue for loan providers when figuring out if a deed in lieu is a viable option is the issue that if the customer ends up being a debtor in an insolvency case after the deed in lieu is total, the personal bankruptcy court can cause the transfer to be unwound or reserved. Because a deed-in-lieu deal 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 borrower insolvent) and within the 90-day duration stated in the Bankruptcy Code, the borrower ends up being 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 reserved if it is made within one year prior to a bankruptcy filing and the transfer was produced "less than a reasonably equivalent value" and if the transferor was insolvent at the time of the transfer, became insolvent because of the transfer, was engaged in an organization that kept an unreasonably low level of capital or planned to sustain debts beyond its ability to pay. In order to alleviate against these dangers, a lending institution must carefully review and examine the debtor's financial condition and liabilities and, ideally, require audited financial statements to confirm the solvency status of the borrower. Moreover, the deed-in-lieu contract must consist of representations as to solvency and a covenant from the customer not to submit for personal bankruptcy during the choice duration.

This is yet another reason it is essential for a loan provider to acquire an appraisal to verify the worth of the residential or commercial property in relation to the debt. An existing appraisal will assist the loan provider refute any accusations that the transfer was produced less than reasonably comparable value.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, a lot of owners and their lenders will obtain policies of title insurance to secure 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 count on its lending institution's policy when it becomes the fee 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 lending institution's policy.

Since numerous lenders choose to have title vested in a separate affiliate entity, in order to make sure continued coverage under the loan provider's policy, the called loan provider should appoint the mortgage to the desired affiliate title holder prior to, or all at once with, the transfer of the cost. In the alternative, the lending institution can take title and after that convey the residential or commercial property by deed for no factor to consider to either its parent business or a wholly 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 lender 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 offer the exact same or a sufficient level of protection. Moreover, a loan provider's policy does not avail any protection for matters which occur after the date of the mortgage loan, leaving the loan provider exposed to any issues or claims coming from events which happen after the original closing.

Due to the reality deed-in-lieu transactions are more susceptible to challenge and risks as laid out above, any title insurance company providing an owner's policy is likely to carry out a more strenuous evaluation of the transaction during the underwriting process than they would in a typical third-party purchase and sale deal. The title insurer will inspect the celebrations and the deed-in-lieu documents in order to determine and alleviate dangers provided by problems such as merger, clogging, recharacterization and insolvency, thus potentially increasing the time and costs associated with closing the deal, but eventually offering the lending institution with a higher level of defense than the lender would have missing the title company's involvement.

Ultimately, whether a deed-in-lieu transaction is a feasible alternative for a lending institution is driven by the specific truths and scenarios of not only the loan and the residential or commercial property, however the celebrations included as well. Under the right set of situations, therefore long as the correct due diligence and paperwork is obtained, a deed in lieu can provide the lending institution with a more efficient and less costly ways to realize on its collateral 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 assistance 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.

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