When a commercial mortgage lender sets out to enforce a mortgage loan following a borrower default, a key goal is to identify the most expeditious manner in which the lender can obtain control and possession of the underlying collateral. Under the right set of circumstances, a deed in lieu of foreclosure can be a faster and more economical alternative to the long and protracted foreclosure process. This article discusses steps and issues lenders should consider when making the decision to proceed with a deed in lieu of foreclosure and how to avoid unexpected risks and challenges during and following the deed-in-lieu process.
Consideration
A key element of any contract is ensuring there is adequate consideration. In a standard transaction, consideration can easily be established through the purchase price, but in a deed-in-lieu situation, confirming adequate consideration is not as straightforward.
In a deed-in-lieu scenario, the amount of the underlying debt that is being forgiven by the lender typically is the basis for the consideration, and in order for such consideration to be deemed “adequate,” the debt should at least equal or exceed the fair market value of the subject property. It is imperative that lenders obtain an independent third-party appraisal to substantiate the value of the property in relation to the amount of debt being forgiven. In addition, its recommended the deed-in-lieu agreement include the borrower’s express acknowledgement of the fair market value of the property in relation to the amount of the debt and a waiver of any potential claims related to the adequacy of the consideration.
Clogging and Recharacterization Issues
Clogging is shorthand for a principal rooted in ancient English common law that a borrower who secures a loan with a mortgage on real estate holds an unqualified right to redeem that property from the lender by repaying the debt up until the point when the right of redemption is legally extinguished through a proper foreclosure. Preserving the borrower’s equitable right of redemption is the reason why, prior to default, mortgage loans cannot be structured to contemplate the voluntary transfer of the property to the lender.
Deed-in-lieu transactions preclude a borrower’s equitable right of redemption, however, steps can be taken to structure them to limit or avoid the risk of a clogging challenge. First and foremost, the contemplation of the transfer of the property in lieu of a foreclosure must take place post-default and cannot be contemplated by the underlying loan documents. Parties should also be wary of a deed-in-lieu arrangement where, following the transfer, there is a continuation of a debtor/creditor relationship, or which contemplate that the borrower retains rights to the property, either as a property manager, a tenant or through repurchase options, as any of these arrangements can create a risk of the transaction being recharacterized as an equitable mortgage.
Steps can be taken to mitigate against recharacterization risks. Some examples: if a borrower’s property management functions are limited to ministerial functions rather than substantive decision 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 property by the borrower is set up to be completely independent of the condition for the deed in lieu.
While not determinative, it is recommended that deed-in-lieu agreements include the parties’ clear and unequivocal acknowledgement that the transfer of the property is an absolute conveyance and not a transfer of for security purposes only.
Merger of Title
When a lender makes a loan secured by a mortgage on real estate, it holds an interest in the real estate by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the lender then acquires the real estate from a defaulting mortgagor, it now also holds an interest in the property by virtue of being the fee owner and acquiring the mortgagor’s equity of redemption.
The general rule on this issue provides that, where a mortgagee acquires the fee or equity of redemption in the mortgaged property, and there is no intermediate estate, merger of the mortgage interest into the fee occurs in the absence of evidence of a contrary intention. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is important the agreement clearly reflects the parties’ intent to retain the mortgage lien estate as distinct from the fee so the lender retains the ability to foreclose the underlying mortgage if there are intervening liens. If the estates merge, then the lender’s mortgage lien is extinguished and the lender loses the ability to deal with intervening liens by foreclosure, which could leave the lender in a potentially worse position than if the lender pursued a foreclosure from the outset.
In order to clearly reflect the parties’ intent on this point, the deed-in-lieu agreement (and the deed itself) should include express anti-merger language. Moreover, because there can be no mortgage without a debt, it is customary in a deed-in-lieu situation for the lender to deliver 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 borrower against exposure from the debt and also retains the lien of the mortgage, thereby allowing the lender to maintain the ability to foreclose, should it become desirable to eliminate 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 significant sticking point. While most states make the payment of transfer tax a seller obligation, as a practical matter, the lender ends up absorbing the cost since the borrower is in a default situation and generally lacks funds.
How transfer tax is calculated on a deed-in-lieu transaction is dependent on the jurisdiction and can be a driving force in determining if a deed in lieu is a viable 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 up to the amount of the debt. Some other states, including Washington and Illinois, have straightforward exemptions for deed-in-lieu transactions. In Connecticut, however, while there is an exemption for deed-in-lieu transactions it is limited only to a transfer of the borrower’s personal residence.
For a commercial transaction, the tax will be calculated based on the full purchase price, which is expressly defined as including the amount of liability which is assumed or to which the realty is subject. Similarly, but even more potentially draconian, New York bases the amount of the transfer tax on “consideration,” which is defined as the unpaid balance of the debt, plus the total amount of any other surviving liens and any amounts paid by the grantee (although if the loan is fully recourse, the consideration is capped at the fair market value of the property plus other amounts paid). Bearing in mind the lender will, in most jurisdictions, have to pay this tax again when ultimately selling the property, the particular jurisdiction’s rules on transfer tax can be a determinative factor in deciding whether a deed-in-lieu transaction is a feasible option.
Bankruptcy Issues
A major concern for lenders when determining if a deed in lieu is a viable alternative is the concern that if the borrower becomes a debtor in a bankruptcy case after the deed in lieu is complete, the bankruptcy court can cause 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 squarely within subsection (b)(2) of Section 547 of the Bankruptcy Code dealing with preferential transfers. Accordingly, if the transfer was made when the borrower was insolvent (or the transfer rendered the borrower insolvent) and within the 90-day period set forth in the Bankruptcy Code, the borrower becomes a debtor in a bankruptcy case, then the deed in lieu is at risk 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 a bankruptcy filing and the transfer was made for “less than a reasonably equivalent value” and if the transferor was insolvent at the time of the transfer, became insolvent because of the transfer, was engaged in a business that maintained an unreasonably low level of capital or intended to incur debts beyond its ability to pay. In order to mitigate against these risks, a lender should carefully review and assess the borrower’s financial condition and liabilities and, preferably, require audited financial statements to confirm the solvency status of the borrower. Moreover, the deed-in-lieu agreement should include representations as to solvency and a covenant from the borrower not to file for bankruptcy during the preference period.
This is yet another reason why it is imperative for a lender to procure an appraisal to confirm the value of the property in relation to the debt. A current appraisal will help the lender refute any allegations that the transfer was made for less than reasonably equivalent value.
Title Insurance
As part of the initial acquisition of a real property, most owners and their lenders will obtain policies of title insurance to protect their respective interests. A lender considering taking title to a property by virtue of a deed in lieu may ask whether it can rely on its lender’s policy when it becomes 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 same entity that is the named insured under the lender’s policy.
Since many lenders prefer to have title vested in a separate affiliate entity, in order to ensure continued coverage under the lender’s policy, the named lender should assign the mortgage to the intended affiliate title holder prior to, or simultaneously with, the transfer of the fee. In the alternative, the lender can take title and then convey the property by deed for no consideration to either its parent company or a wholly owned subsidiary (although in some jurisdictions this could trigger transfer tax liability).
Notwithstanding the continuation in coverage, a lender’s policy does not convert to an owner’s policy. Once the lender 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 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 lender exposed to any issues or claims stemming from events which occur after the original closing.
Due to the fact deed-in-lieu transactions are more susceptible to challenge and risks as outlined above, any title insurer issuing an owner’s policy is likely to undertake a more rigorous review of the transaction during the underwriting process than they would in a typical third-party purchase and sale transaction. The title insurer will scrutinize the parties and the deed-in-lieu documents in order to identify and mitigate risks presented by issues such as merger, clogging, recharacterization and insolvency, thereby potentially increasing the time and costs involved in closing the transaction, but ultimately providing the lender with a greater level of protection than the lender would have absent the title company’s involvement.
Ultimately, whether a deed-in-lieu transaction is a viable option for a lender is driven by the specific facts and circumstances of not only the loan and the property, but the parties involved as well. Under the right set of circumstances, and so long as the proper due diligence and documentation is obtained, a deed in lieu can provide the lender with a more efficient and less expensive means to realize on its collateral when a loan goes into default.
