When an industrial mortgage lender sets out to implement a mortgage loan following a borrower default, a key goal is to identify the most expeditious manner in which the lender can get control and possession of the underlying security. Under the right set of circumstances, a deed in lieu of foreclosure can be a faster and more economical option to the long and drawn-out foreclosure process. This article discusses actions and problems lending institutions need to consider when deciding to proceed with a deed in lieu of foreclosure and how to avoid unexpected dangers and difficulties during and following the deed-in-lieu process.
Consideration
A crucial element of any agreement is making sure there is sufficient factor to consider. In a basic deal, factor to consider can quickly be established through the purchase price, however in a deed-in-lieu situation, verifying sufficient 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 typically is the basis for the consideration, and in order for such consideration to be considered "adequate," the debt should at least equivalent or exceed the reasonable market price of the subject residential or commercial property. It is vital 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 advised the deed-in-lieu agreement include the borrower's express acknowledgement 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 possible claims related to the adequacy of the consideration.
Clogging and Recharacterization Issues
Clogging is shorthand for a primary rooted in ancient English common law that a borrower who protects a loan with a mortgage on genuine 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 legally snuffed out through a proper foreclosure. Preserving the debtor's fair right of redemption is the reason, 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 transactions prevent a debtor's equitable right of redemption, however, actions can be taken to structure them to limit or avoid the threat of an obstructing difficulty. Primarily, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure need to take location post-default and can not be pondered by the underlying loan documents. Parties must likewise watch out for a deed-in-lieu arrangement where, following the transfer, there is a continuation of a debtor/creditor relationship, or which consider that the customer keeps rights to the residential or commercial property, either as a residential or commercial property manager, a tenant or through repurchase options, as any of these plans can create a danger of the deal being recharacterized as an equitable mortgage.
Steps can be taken to alleviate versus recharacterization dangers. Some examples: if a customer's residential or commercial property management functions are limited to ministerial functions instead of substantive decision making, if a lease-back is short term and the payments are plainly structured as market-rate usage and tenancy payments, or if any provision for reacquisition of the residential or commercial property by the debtor is established to be completely independent of the condition for the deed in lieu.
While not determinative, it is suggested that deed-in-lieu agreements include the parties' clear and unquestionable recognition that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security functions just.
Merger of Title
When a lender 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 gets the property from a defaulting mortgagor, it now also holds an interest in the residential or commercial property by virtue of being the charge owner and acquiring the mortgagor's equity of redemption.
The basic rule on this problem supplies 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 fee takes place in the lack of proof of a contrary intention. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is very important the contract plainly shows the parties' intent to maintain the mortgage lien estate as unique from the charge so the lender maintains the ability to foreclose the underlying mortgage if there are intervening liens. If the estates merge, then the lending institution's mortgage lien is extinguished and the lending institution loses the capability to deal with intervening liens by foreclosure, which might leave the lending institution in a possibly even worse position than if the loan provider pursued a foreclosure from the beginning.
In order to clearly reflect the parties' intent on this point, the deed-in-lieu arrangement (and the deed itself) need to include express anti-merger language. Moreover, since there can be no mortgage without a financial obligation, it is traditional in a deed-in-lieu circumstance for the loan provider to deliver a covenant not to take legal action against, rather than a straight-forward release of the debt. The covenant not to sue furnishes factor to consider for the deed in lieu, protects the debtor versus exposure from the debt and also retains the lien of the mortgage, consequently permitting the lending institution to maintain the capability to foreclose, must it end up being preferable to get rid of junior encumbrances after the deed in lieu is total.
Transfer Tax
Depending upon 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 responsibility, as a practical matter, the lending institution winds up taking in the expense because the debtor remains in a default scenario and typically does not have funds.
How transfer tax is calculated on a deed-in-lieu transaction is dependent on the jurisdiction and can be a driving force in figuring out 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 as much as the quantity of the debt. Some other states, including Washington and Illinois, have straightforward exemptions for deed-in-lieu transactions. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu transactions it is restricted only to a transfer of the house.
For a business deal, the tax will be computed based upon the full purchase cost, which is expressly defined as including the quantity of liability which is presumed or to which the real estate is subject. Similarly, however a lot more possibly draconian, New york city bases the amount of the transfer tax on "factor to consider," which is defined as the overdue balance of the financial obligation, plus the total quantity of any other enduring liens and any quantities paid by the beneficiary (although if the loan is totally option, the consideration is capped at the reasonable market price of the residential or commercial property plus other quantities paid). Bearing in mind the lending institution will, in many jurisdictions, have to pay this tax again when ultimately selling the residential or commercial property, the specific jurisdiction's rules on transfer tax can be a determinative factor in choosing whether a deed-in-lieu deal is a feasible alternative.
Bankruptcy Issues
A major concern for lenders when identifying if a deed in lieu is a practical alternative is the concern that if the customer ends up being a debtor in an insolvency case after the deed in lieu is complete, the 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 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 borrower was insolvent (or the transfer rendered the debtor insolvent) and within the 90-day duration set forth in the Bankruptcy Code, the borrower ends up being a debtor in an insolvency 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 fairly comparable worth" and if the transferor was insolvent at the time of the transfer, became insolvent since of the transfer, was taken part in a business that kept an unreasonably low level of capital or meant to sustain debts beyond its ability to pay. In order to alleviate versus these threats, a lender should carefully examine and examine the borrower's financial condition and liabilities and, preferably, require audited monetary statements to validate the solvency status of the borrower. Moreover, the deed-in-lieu contract should include representations as to solvency and a covenant from the customer not to apply for insolvency throughout the preference period.
This is yet another reason that it is necessary for a lender to obtain an appraisal to verify the worth of the residential or commercial property in relation to the debt. An existing appraisal will assist the lending institution refute any accusations that the transfer was produced less than fairly equivalent value.
Title Insurance
As part of the initial acquisition of a real residential or commercial property, most owners and their lending institutions will acquire policies of title insurance coverage to protect their particular interests. A lending institution considering taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can count on its loan provider's policy when it ends up being the fee owner. Coverage under a lender'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 numerous lenders prefer to have title vested in a separate affiliate entity, in order to make sure continued protection under the loan provider's policy, the called lender must designate the mortgage to the desired affiliate victor prior to, or all at once with, the transfer of the fee. In the alternative, the loan provider can take title and after that communicate the residential or commercial property by deed for no factor to consider to either its parent business or a completely owned subsidiary (although in some jurisdictions this might activate transfer tax liability).
Notwithstanding the continuation in coverage, a loan provider's policy does not transform to an owner's policy. Once the loan provider 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 very same or an appropriate level of protection. Moreover, a lending institution's policy does not get any protection for matters which occur after the date of the mortgage loan, leaving the lending institution exposed to any issues or claims originating from events which happen after the original closing.
Due to the reality deed-in-lieu transactions are more susceptible to challenge and risks as outlined above, any title insurer releasing an owner's policy is likely to carry out a more rigorous review of the deal during 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 documents in order to recognize and mitigate threats presented by concerns such as merger, blocking, recharacterization and insolvency, thereby possibly increasing the time and expenses involved in closing the deal, however eventually supplying the loan provider with a higher level of protection than the lender would have missing the title company's participation.
Ultimately, whether a deed-in-lieu transaction is a practical choice for a lender is driven by the specific realities and circumstances of not only the loan and the residential or commercial property, but the parties included as well. Under the right set of circumstances, therefore long as the correct due diligence and documentation is obtained, a deed in lieu can offer the loan provider with a more effective and more economical methods to recognize on its security 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 need support with such matters, please connect to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most regularly work.
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Lender Considerations In Deed-in-Lieu Transactions
Lynette Dunkley edited this page 2025-06-19 21:16:37 +08:00