When a business mortgage lender sets out to impose a mortgage loan following a debtor default, a crucial objective is to determine the most expeditious way in which the loan provider can obtain control and belongings of the underlying collateral. Under the right set of situations, a deed in lieu of foreclosure can be a quicker and more economical option to the long and drawn-out foreclosure procedure. This post talks about steps and concerns lending institutions must think about when making the choice to continue with a deed in lieu of foreclosure and how to prevent unforeseen threats and challenges during and following the deed-in-lieu process.
Consideration
A crucial element of any contract is ensuring there is sufficient factor to consider. In a basic deal, consideration can easily be established through the purchase rate, however in a deed-in-lieu circumstance, verifying sufficient factor to consider is not as simple.
In a deed-in-lieu situation, the quantity of the underlying financial obligation that is being forgiven by the lender normally is the basis for the factor to consider, and in order for such consideration to be considered "adequate," the financial obligation needs to a minimum of equivalent or surpass the fair market worth of the subject residential or commercial property. It is essential that lending institutions obtain an independent third-party appraisal to substantiate 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 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 debt and a waiver of any prospective claims associated with 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 protects a loan with a mortgage on realty 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 snuffed out through a correct foreclosure. Preserving the borrower's equitable right of redemption is the reason why, prior to default, mortgage loans can not be structured to contemplate the voluntary transfer of the residential or commercial property to the lender.
Deed-in-lieu transactions preclude a debtor's fair right of redemption, nevertheless, steps can be taken to structure them to limit or avoid the threat of a clogging challenge. Firstly, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure should take place post-default and can not be considered by the underlying loan documents. Parties ought to also be cautious of a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which ponder that the borrower maintains 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 danger of the deal being recharacterized as an equitable mortgage.
Steps can be taken to mitigate against recharacterization risks. Some examples: if a customer's residential or commercial property management functions are restricted to ministerial functions instead of substantive choice making, if a lease-back is short term and the payments are clearly structured as market-rate use and occupancy payments, or if any provision for reacquisition of the residential or commercial property by the debtor is set up to be completely independent of the condition for the deed in lieu.
While not determinative, it is advised that deed-in-lieu contracts consist of the parties' clear and indisputable 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 lender makes a loan protected by a mortgage on genuine 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 loan provider then acquires 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 obtaining the mortgagor's equity of redemption.
The general guideline on this issue provides that, where a mortgagee obtains 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 fee happens in the absence of evidence of a contrary objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is essential the arrangement clearly shows the celebrations' intent to maintain the mortgage lien estate as distinct from the fee so the loan provider maintains the ability to foreclose the hidden mortgage if there are intervening liens. If the estates merge, then the lender's mortgage lien is snuffed out and the loan provider loses the capability to deal with intervening liens by foreclosure, which might leave the loan provider in a possibly worse position than if the lending institution pursued a foreclosure from the outset.
In order to clearly reflect the celebrations' intent on this point, the deed-in-lieu agreement (and the deed itself) should consist of express anti-merger language. Moreover, due to the fact that there can be no mortgage without a debt, it is traditional in a deed-in-lieu scenario for the lending institution to provide a covenant not to sue, instead of a straight-forward release of the debt. The covenant not to sue 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, thereby allowing the loan provider to preserve the ability to foreclose, ought to it become preferable to remove junior encumbrances after the deed in lieu is complete.
Transfer Tax
Depending on the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu deals can be a considerable sticking point. While most states make the payment of transfer tax a seller obligation, as a useful matter, the lender winds up taking in the cost considering that the debtor remains in a default scenario and normally does not have 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 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 up to the quantity of the financial obligation. Some other states, consisting of Washington and Illinois, have straightforward exemptions for deed-in-lieu deals. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu transactions it is limited just to a transfer of the debtor's personal house.
For an industrial deal, the tax will be calculated based upon the full purchase price, which is specifically defined as including the amount of liability which is assumed or to which the real estate is subject. Similarly, however much more possibly draconian, New york city bases the amount of the transfer tax on "consideration," which is specified as the overdue balance of the debt, plus the total amount of any other enduring liens and any amounts paid by the grantee (although if the loan is completely option, the consideration is capped at the reasonable market price of the residential or commercial property plus other amounts paid). Remembering the lender will, in the majority of jurisdictions, have to pay this tax again when ultimately selling the residential or commercial property, the particular jurisdiction's rules on transfer tax can be a determinative consider deciding whether a deed-in-lieu deal is a practical choice.
Bankruptcy Issues
A significant concern for lenders when figuring out if a deed in lieu is a practical alternative is the issue that if the borrower becomes a debtor in an insolvency case after the deed in lieu is total, the bankruptcy court can trigger 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 directly within subsection (b)( 2) of Section 547 of the Bankruptcy Code dealing with preferential transfers. Accordingly, if the transfer was made when the debtor was insolvent (or the transfer rendered the debtor insolvent) and within the 90-day period stated in the Bankruptcy Code, the customer ends up being a debtor in a 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 set aside 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 since of the transfer, was taken part in a business that preserved an unreasonably low level of capital or planned to incur financial obligations beyond its ability to pay. In order to mitigate against these threats, a loan provider should carefully evaluate and examine the borrower's monetary condition and liabilities and, preferably, require audited financial statements to validate the solvency status of the borrower. Moreover, the deed-in-lieu agreement must consist of representations as to solvency and a covenant from the customer not to file for insolvency throughout the preference duration.
This is yet another reason that it is necessary for a lender to obtain an appraisal to validate 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 reasonably equivalent worth.
Title Insurance
As part of the initial acquisition of a genuine residential or commercial property, a lot of owners and their lending institutions will get policies of title insurance to safeguard their particular interests. A lending institution thinking about taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can depend on its loan provider's policy when it becomes 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 named guaranteed under the lending institution's policy.
Since numerous lending institutions prefer to have title vested in a different affiliate entity, in order to make sure continued protection under the lending institution's policy, the called loan provider needs to appoint the mortgage to the designated affiliate title holder prior to, or concurrently with, the transfer of the charge. In the option, the lender can take title and after that convey the residential or commercial property by deed for no consideration to either its parent company or an entirely owned subsidiary (although in some jurisdictions this might activate transfer tax liability).
Notwithstanding the extension in coverage, a lending institution'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 loan provider's policy would not supply the exact same or an adequate level of protection. Moreover, a lender's policy does not avail any protection for matters which arise after the date of the mortgage loan, leaving the loan provider exposed to any issues or claims stemming from events which happen after the original closing.
Due to the reality deed-in-lieu transactions are more vulnerable to challenge and threats as laid out above, any title insurance company releasing an owner's policy is most likely to undertake a more extensive evaluation of the deal throughout the underwriting process than they would in a normal third-party purchase and sale transaction. The title insurance company will inspect the celebrations and the deed-in-lieu files in order to determine and alleviate risks provided by issues such as merger, clogging, recharacterization and insolvency, thereby potentially increasing the time and costs associated with closing the transaction, however eventually providing the lending institution with a greater level of protection than the lender would have absent the title business's participation.
Ultimately, whether a deed-in-lieu deal is a viable option for a lending institution is driven by the particular truths and scenarios of not just the loan and the residential or commercial property, but the parties involved also. Under the right set of situations, and so long as the correct due diligence and paperwork is acquired, a deed in lieu can offer the lending institution with a more effective and less costly methods to recognize on its collateral when a loan goes 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 attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most regularly work.
