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Lender Considerations In Deed-in-Lieu Transactions

When a business mortgage loan provider sets out to implement a mortgage loan following a borrower default, a key goal is to identify the most expeditious manner in which the loan provider can obtain control and possession of the underlying collateral. Under the right set of scenarios, a deed in lieu of foreclosure can be a quicker and more affordable alternative to the long and protracted foreclosure procedure. This article discusses steps and concerns lending institutions must consider when deciding to proceed with a deed in lieu of foreclosure and how to avoid unexpected dangers and challenges during and following the deed-in-lieu procedure.

Consideration

An essential aspect of any contract is guaranteeing there is sufficient factor to consider. In a basic transaction, consideration can quickly be developed through the purchase rate, however in a deed-in-lieu situation, verifying sufficient consideration is not as uncomplicated.

In a deed-in-lieu situation, the quantity of the underlying financial obligation that is being forgiven by the lending institution typically 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 exceed the reasonable market price of the subject residential or commercial property. It is imperative that lending institutions get an independent third-party appraisal to corroborate the value of the residential or commercial property in relation to the amount of debt being forgiven. In addition, its advised the deed-in-lieu agreement consist of the customer’s reveal recognition of the fair market price of the residential or commercial property in relation to the quantity of the debt and a waiver of any possible claims related to the adequacy of the factor to consider.

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 genuine estate 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 debtor’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 lender.

Deed-in-lieu transactions prevent a borrower’s fair right of redemption, however, steps can be required to structure them to restrict or prevent the danger of an obstructing difficulty. Most importantly, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure must take place post-default and can not be contemplated by the underlying loan documents. Parties ought to likewise be careful of a deed-in-lieu arrangement where, following the transfer, there is a continuation of a debtor/creditor relationship, or which ponder that the customer keeps rights to the residential or commercial property, either as a residential or commercial property supervisor, a tenant or through repurchase alternatives, as any of these arrangements can produce a risk of the transaction being recharacterized as an equitable mortgage.

Steps can be taken to reduce versus recharacterization dangers. Some examples: if a customer’s residential or commercial property management functions are limited to ministerial functions instead of substantive choice making, if a lease-back is brief term and the payments are plainly structured as market-rate usage and tenancy payments, or if any arrangement for reacquisition of the residential or commercial property by the customer is set up to be completely independent of the condition for the deed in lieu.

While not determinative, it is suggested that deed-in-lieu agreements consist of the parties’ clear and unequivocal 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 lender makes a loan protected by a mortgage on real estate, it holds an interest in the genuine estate by virtue of being the mortgagee under a mortgage (or a recipient under a deed of trust). If the lending institution then acquires the realty 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 provides that, where a mortgagee gets the charge 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 lack of evidence of a contrary intention. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is necessary the arrangement plainly reflects the parties’ intent to keep the mortgage lien estate as distinct from the fee so the lender keeps the ability to foreclose the hidden mortgage if there are intervening liens. If the estates merge, then the lender’s mortgage lien is extinguished and the lending institution loses the ability to handle stepping in liens by foreclosure, which could leave the loan provider in a possibly worse position than if the lending institution pursued a foreclosure from the outset.

In order to plainly show the parties’ intent on this point, the deed-in-lieu contract (and the deed itself) ought to include reveal anti-merger language. Moreover, due to the fact that there can be no mortgage without a financial obligation, it is traditional in a deed-in-lieu situation 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, protects the customer versus direct exposure from the debt and likewise retains the lien of the mortgage, consequently enabling the loan provider to preserve the ability to foreclose, should it become preferable to eliminate 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 deals can be a substantial sticking point. While a lot of states make the payment of transfer tax a seller obligation, as a useful matter, the winds up absorbing the expense given that the debtor remains in a default scenario and usually does not have funds.

How transfer tax is determined on a deed-in-lieu transaction depends on the jurisdiction and can be a driving force in figuring out if a deed in lieu is a viable option. 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 amount of the financial obligation. Some other states, including Washington and Illinois, have uncomplicated exemptions for deed-in-lieu transactions. In Connecticut, however, while there is an exemption for deed-in-lieu transactions it is limited just to a transfer of the borrower’s personal house.

For a commercial transaction, the tax will be calculated based upon the complete purchase cost, which is specifically defined as including the quantity of liability which is presumed or to which the real estate is subject. Similarly, however even more possibly severe, New York bases the amount of the transfer tax on «consideration,» which is specified as the overdue balance of the debt, plus the total quantity of any other enduring liens and any amounts paid by the beneficiary (although if the loan is fully option, the consideration is capped at the fair market value of the residential or commercial property plus other amounts paid). Remembering the lending institution will, in a lot of jurisdictions, have to pay this tax again when ultimately offering 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 practical option.

Bankruptcy Issues

A significant concern for loan providers when determining if a deed in lieu is a feasible alternative is the issue that if the customer becomes a debtor in an insolvency case after the deed in lieu is total, the insolvency 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 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 customer insolvent) and within the 90-day duration set forth in the Bankruptcy Code, the borrower becomes a debtor in an insolvency case, then the deed in lieu is at danger 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 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, became insolvent since of the transfer, was participated in a service that maintained an unreasonably low level of capital or intended to incur debts beyond its ability to pay. In order to alleviate versus these dangers, a lending institution needs to carefully examine and evaluate the customer’s financial condition and liabilities and, ideally, need audited monetary declarations to confirm the solvency status of the customer. Moreover, the deed-in-lieu arrangement should consist of representations as to solvency and a covenant from the borrower not to declare bankruptcy during the preference duration.

This is yet another reason it is important for a lending institution to procure an appraisal to verify the worth of the residential or commercial property in relation to the debt. An existing appraisal will help the lender refute any claims that the transfer was made for less than fairly comparable value.

Title Insurance

As part of the preliminary acquisition of a genuine residential or commercial property, the majority of owners and their lenders will obtain policies of title insurance coverage to protect their respective interests. A lender thinking about taking title to a residential or commercial property by virtue of a deed in lieu may 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 coverage can continue after the acquisition of title if title is taken by the same entity that is the called guaranteed under the loan provider’s policy.

Since numerous lending institutions choose to have title vested in a separate affiliate entity, in order to make sure ongoing protection under the lender’s policy, the called lender needs to designate the mortgage to the designated affiliate title holder prior to, or concurrently with, the transfer of the charge. In the alternative, the lending institution can take title and after that communicate the residential or commercial property by deed for no consideration to either its moms and dad business or an entirely owned subsidiary (although in some jurisdictions this could set off transfer tax liability).

Notwithstanding the extension in protection, a lender’s policy does not convert 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 same or an adequate level of defense. Moreover, a lender’s policy does not get any defense for matters which arise after the date of the mortgage loan, leaving the lender exposed to any problems or claims coming from occasions which occur after the original closing.

Due to the truth deed-in-lieu transactions are more prone to challenge and threats as outlined above, any title insurance provider issuing an owner’s policy is likely to carry out a more extensive review of the deal during the underwriting procedure than they would in a normal third-party purchase and sale transaction. The title insurance company will scrutinize the parties and the deed-in-lieu files in order to recognize and reduce risks provided by problems such as merger, blocking, recharacterization and insolvency, therefore potentially increasing the time and costs associated with closing the transaction, but eventually providing the lending institution with a greater level of security than the loan provider would have absent the title company’s involvement.

Ultimately, whether a deed-in-lieu deal is a practical choice for a lender is driven by the specific truths and situations of not just the loan and the residential or commercial property, however the parties involved too. Under the right set of scenarios, therefore long as the proper due diligence and paperwork is gotten, a deed in lieu can offer 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 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.