shofle

When a business mortgage lending institution sets out to enforce a mortgage loan following a debtor default, an essential goal is to identify the most expeditious manner in which the loan provider can get control and possession of the underlying collateral. Under the right set of scenarios, a deed in lieu of foreclosure can be a faster and more cost-effective alternative to the long and lengthy foreclosure procedure. This post talks about steps and issues lending institutions should consider when making the choice to continue with a deed in lieu of foreclosure and how to prevent unanticipated risks and obstacles throughout and following the deed-in-lieu process.
bloglines.com
Consideration

A crucial aspect of any agreement is ensuring there is appropriate consideration. In a standard transaction, consideration can easily be established through the purchase cost, but in a deed-in-lieu situation, validating sufficient factor to consider is not as straightforward.

In a deed-in-lieu scenario, the amount of the underlying debt that is being forgiven by the lender usually is the basis for the factor to consider, and in order for such factor to consider to be considered "appropriate," the financial obligation needs to a minimum of equivalent or go beyond the fair market worth of the subject residential or commercial property. It is crucial that lenders obtain an independent third-party appraisal to substantiate the worth of the residential or commercial property in relation to the quantity of financial obligation being forgiven. In addition, its recommended the deed-in-lieu agreement consist of the borrower's reveal acknowledgement 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 principal rooted in ancient English common law that a debtor who protects 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 financial obligation up until the point when the right of redemption is lawfully extinguished through a proper foreclosure. Preserving the debtor's fair 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 transactions prevent a customer's fair right of redemption, however, steps can be required to structure them to restrict or avoid the risk of a clogging difficulty. Most importantly, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure should take place post-default and can not be pondered by the underlying loan files. Parties should also be cautious of a deed-in-lieu plan where, following the transfer, there is a continuation of a debtor/creditor relationship, or which contemplate that the debtor retains rights to the residential or commercial property, either as a residential or commercial property supervisor, an occupant or through repurchase choices, as any of these plans can develop a threat of the deal being recharacterized as a fair mortgage.

Steps can be taken to alleviate versus recharacterization risks. Some examples: if a borrower's residential or commercial property management functions are restricted 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 occupancy payments, or if any arrangement 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 contracts consist of the celebrations' clear and unequivocal recognition 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 realty, it holds an interest in the genuine estate by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the loan provider then acquires the realty from a defaulting mortgagor, it now also 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 rule 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 charge occurs in the lack of proof of a contrary intent. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is essential the arrangement clearly shows the celebrations' intent to retain the mortgage lien estate as unique from the fee so the loan provider keeps the ability to foreclose the hidden mortgage if there are stepping in liens. If the estates combine, then the lender's mortgage lien is extinguished and the lender loses the ability to deal with stepping in liens by foreclosure, which could leave the loan provider in a potentially even worse position than if the loan provider pursued a foreclosure from the outset.

In order to plainly show the celebrations' intent on this point, the deed-in-lieu contract (and the deed itself) ought to include reveal anti-merger language. Moreover, because there can be no mortgage without a debt, it is popular in a deed-in-lieu circumstance for the lending institution to provide a covenant not to take legal action against, rather than a straight-forward release of the financial obligation. The covenant not to sue furnishes factor to consider for the deed in lieu, protects the borrower against exposure from the financial obligation and likewise keeps the lien of the mortgage, thereby enabling the lender to keep the ability to foreclose, should it end up being desirable to remove 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 substantial sticking point. While many states make the payment of transfer tax a seller responsibility, as a practical matter, the lender ends up taking in the cost given that the debtor 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 figuring out if a deed in lieu is a feasible option. In California, for instance, 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 debt. Some other states, consisting of Washington and Illinois, have simple exemptions for deed-in-lieu deals. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu transactions it is limited only to a transfer of the debtor's personal house.

For a commercial transaction, the tax will be calculated based upon the complete purchase rate, which is specifically defined as consisting of the amount of liability which is assumed or to which the real estate is subject. Similarly, but much more possibly drastic, New York bases the quantity of the transfer tax on "consideration," which is specified as the unsettled balance of the financial obligation, plus the total amount of any other making it through liens and any amounts paid by the grantee (although if the loan is completely option, the consideration 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 most jurisdictions, need to pay this tax again when eventually selling the residential or commercial property, the specific jurisdiction's rules on transfer tax can be a determinative element in choosing whether a deed-in-lieu deal is a possible alternative.

Bankruptcy Issues

A major issue for lenders when determining if a deed in lieu is a viable option is the issue that if the borrower becomes a debtor in an case after the deed in lieu is complete, the bankruptcy court can trigger the transfer to be unwound or set aside. Because a deed-in-lieu transaction 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 customer insolvent) and within the 90-day duration set forth in the Bankruptcy Code, the borrower ends up being a debtor in a bankruptcy case, then the deed in lieu is at threat 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 personal bankruptcy 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, ended up being insolvent due to the fact that of the transfer, was taken part in an organization that maintained an unreasonably low level of capital or intended to incur debts beyond its capability to pay. In order to alleviate against these dangers, a lending institution must thoroughly review and examine the debtor's monetary condition and liabilities and, preferably, require audited monetary statements to verify the solvency status of the debtor. Moreover, the deed-in-lieu contract must consist of representations regarding solvency and a covenant from the debtor not to declare insolvency throughout the choice duration.

This is yet another reason that it is vital for a lending institution to acquire an appraisal to confirm the value of the residential or commercial property in relation to the debt. An existing appraisal will assist the lender refute any claims that the transfer was produced less than reasonably comparable value.

Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, many owners and their loan providers will obtain policies of title insurance to protect their particular interests. A lender considering taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can depend on its lender's policy when it ends up being the cost 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 exact same entity that is the called guaranteed under the lending institution's policy.

Since lots of loan providers prefer to have actually title vested in a separate affiliate entity, in order to make sure continued coverage under the lender's policy, the named lender needs to assign the mortgage to the desired affiliate victor prior to, or simultaneously with, the transfer of the charge. In the option, the lender can take title and then 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 activate transfer tax liability).

Notwithstanding the extension in coverage, a lender's policy does not transform to an owner's policy. Once the lending institution 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 supply the exact same or a sufficient level of security. Moreover, a lending institution's policy does not obtain any defense for matters which arise after the date of the mortgage loan, leaving the lender exposed to any issues or claims stemming from occasions which take place after the initial closing.

Due to the reality deed-in-lieu transactions are more prone to challenge and dangers as laid out above, any title insurance provider providing an owner's policy is likely to carry out a more strenuous review of the transaction during the underwriting process than they would in a common third-party purchase and sale deal. The title insurer will inspect the parties and the deed-in-lieu files in order to recognize and mitigate threats presented by concerns such as merger, clogging, recharacterization and insolvency, therefore potentially increasing the time and costs associated with closing the transaction, but ultimately supplying the lender with a higher level of defense than the loan provider would have absent the title business's participation.

Ultimately, whether a deed-in-lieu transaction is a practical choice for a lending institution is driven by the particular realities and situations of not only the loan and the residential or commercial property, however the parties included as well. Under the right set of scenarios, and so long as the appropriate due diligence and documents is obtained, a deed in lieu can supply the loan provider with a more efficient and cheaper means to realize on its security when a loan goes into default.

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