Lender Considerations In Deed-in-Lieu Transactions

When an industrial mortgage loan provider sets out to impose a mortgage loan following a borrower default, a crucial objective is to identify the most expeditious way in which the lending institution 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 post talks about actions and issues lenders must consider when deciding to proceed with a deed in lieu of foreclosure and how to prevent unexpected risks and difficulties throughout and following the deed-in-lieu process.


Consideration


An essential element of any agreement is making sure there is adequate factor to consider. In a basic deal, consideration can easily be developed through the purchase price, but in a deed-in-lieu situation, verifying adequate consideration is not as simple.


In a deed-in-lieu situation, the amount 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 deemed "appropriate," the debt ought to a minimum of equivalent or go beyond the reasonable market value of the subject residential or commercial property. It is crucial that lenders acquire an independent third-party appraisal to corroborate the value of the residential or commercial property in relation to the quantity of debt being forgiven. In addition, its recommended the deed-in-lieu agreement include the debtor's express recognition of the fair market price of the residential or commercial property in relation to the amount of the financial obligation 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 customer who protects a loan with a mortgage on realty holds an unqualified right to redeem that residential or commercial property from the loan provider by repaying the financial obligation up till the point when the right of redemption is legally snuffed out through a proper 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 lender.


Deed-in-lieu deals preclude a borrower's fair right of redemption, nevertheless, steps can be taken to structure them to limit or avoid the risk of a clogging challenge. Primarily, the contemplation 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 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 maintains rights to the residential or commercial property, either as a residential or commercial property supervisor, a tenant or through repurchase choices, as any of these plans can produce a risk of the transaction being recharacterized as an equitable mortgage.


Steps can be required to reduce versus recharacterization risks. 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 clearly structured as market-rate usage and tenancy payments, or if any provision for reacquisition of the residential or commercial property by the customer is established to be totally 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 recognition 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 lending institution makes a loan secured by a mortgage on genuine estate, it holds an interest in the real estate by virtue of being the mortgagee under a mortgage (or a recipient under a deed of trust). If the loan provider then obtains the real estate from a defaulting mortgagor, it now likewise holds an interest in the residential or commercial property by virtue of being the cost owner and getting the mortgagor's equity of redemption.


The general rule on this problem offers that, where a mortgagee acquires 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 cost happens in the absence of proof of a contrary intention. Accordingly, when and documenting a deed in lieu of foreclosure, it is necessary the arrangement clearly shows the parties' intent to keep the mortgage lien estate as unique from the cost so the loan provider maintains the ability to foreclose the underlying mortgage if there are stepping in liens. If the estates merge, then the loan provider's mortgage lien is extinguished and the lender loses the ability to handle stepping in liens by foreclosure, which might leave the lending institution in a possibly worse position than if the lending institution pursued a foreclosure from the beginning.


In order to clearly reflect the celebrations' intent on this point, the deed-in-lieu contract (and the deed itself) ought to consist of express anti-merger language. Moreover, due to the fact that there can be no mortgage without a debt, it is customary in a deed-in-lieu circumstance for the lending institution 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 debtor versus exposure from the debt and likewise keeps the lien of the mortgage, thereby permitting the loan provider to keep the ability to foreclose, ought to it become desirable to remove junior encumbrances after the deed in lieu is complete.


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 many states make the payment of transfer tax a seller obligation, as a practical matter, the lending institution ends up taking in the cost since the debtor remains in a default circumstance 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 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 approximately the amount of the debt. Some other states, consisting of Washington and Illinois, have simple exemptions for deed-in-lieu transactions. In Connecticut, however, while there is an exemption for deed-in-lieu transactions it is restricted just to a transfer of the borrower's individual house.


For a commercial deal, the tax will be computed based on the full purchase rate, which is expressly defined as consisting of the amount of liability which is presumed or to which the real estate is subject. Similarly, however much more potentially drastic, New york city bases the quantity of the transfer tax on "consideration," which is defined as the overdue balance of the financial obligation, plus the total quantity of any other making it through liens and any amounts paid by the grantee (although if the loan is totally option, the factor to consider is topped at the fair market price of the residential or commercial property plus other amounts paid). Bearing in mind the lending institution will, in a lot of jurisdictions, have 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 element in choosing whether a deed-in-lieu transaction is a practical alternative.


Bankruptcy Issues


A major concern for lenders when determining if a deed in lieu is a feasible alternative is the issue that if the debtor ends up being a debtor in an insolvency case after the deed in lieu is complete, the personal 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 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 borrower was insolvent (or the transfer rendered the customer insolvent) and within the 90-day period set forth in the Bankruptcy Code, the debtor ends up being a debtor in an insolvency 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 an insolvency filing and the transfer was produced "less than a fairly equivalent 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 service that preserved an unreasonably low level of capital or meant to incur financial obligations beyond its capability to pay. In order to reduce against these risks, a lending institution needs to thoroughly examine and evaluate the borrower's monetary condition and liabilities and, ideally, need audited financial declarations to confirm the solvency status of the debtor. Moreover, the deed-in-lieu contract ought to include representations regarding solvency and a covenant from the debtor not to apply for bankruptcy during the preference duration.


This is yet another reason why it is vital for a loan provider to procure an appraisal to confirm the worth of the residential or commercial property in relation to the financial obligation. A present appraisal will help the loan provider refute any allegations that the transfer was made for less than reasonably comparable worth.


Title Insurance


As part of the preliminary acquisition of a genuine residential or commercial property, most owners and their loan providers will acquire policies of title insurance to secure their particular interests. A loan provider 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 lending institution's policy when it ends up being 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 guaranteed under the loan provider's policy.


Since numerous loan providers choose to have title vested in a different affiliate entity, in order to ensure ongoing coverage under the loan provider's policy, the called lending institution must appoint the mortgage to the intended affiliate title holder prior to, or at the same time with, the transfer of the fee. In the option, the lender can take title and then communicate the residential or commercial property by deed for no consideration to either its moms and dad business or a wholly owned subsidiary (although in some jurisdictions this could set off transfer tax liability).


Notwithstanding the continuation in coverage, a lender'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 provide the exact same or an appropriate level of security. Moreover, a loan provider's policy does not get any protection for matters which arise after the date of the mortgage loan, leaving the loan provider exposed to any problems or claims originating from occasions which occur after the initial closing.


Due to the reality deed-in-lieu deals are more vulnerable to challenge and risks as detailed above, any title insurance provider releasing an owner's policy is likely to undertake a more rigorous review of the deal throughout the underwriting procedure than they would in a normal third-party purchase and sale deal. The title insurance provider will scrutinize the celebrations and the deed-in-lieu documents in order to recognize and alleviate dangers presented by problems such as merger, clogging, recharacterization and insolvency, thereby potentially increasing the time and expenses involved in closing the deal, however eventually supplying the lender with a higher level of protection than the lending institution would have missing the title company's involvement.


Ultimately, whether a deed-in-lieu deal is a practical alternative for a lending institution is driven by the particular facts and circumstances of not only the loan and the residential or commercial property, but the celebrations involved as well. Under the right set of situations, therefore long as the appropriate due diligence and documentation is obtained, a deed in lieu can offer the loan provider with a more effective and less costly ways to recognize on its collateral when a loan enters into default.


Harris Beach Murtha's Commercial Realty Practice Group is experienced with deed in lieu of foreclosures. If you need 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.