Deeds in Lieu of Foreclosure: Practical and Legal Considerations

Wednesday, February 15, 2012

PANELISTS: Dianne S. Coscarelli Thompson Hine LLP Cleveland, OH George Kurlyandchik Womble, Carlyle Sandridge & Rice, LLP Atlanta, GA

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THE DEED IN LIEU OF FORECLOSURE Ten Questions for Lender's Counsel By Dianne S. Coscarelli When choosing whether to foreclose on a troubled mortgage asset or to accept a deed in lieu of a foreclosure, how does a lender decide? In jurisdictions where foreclosures can be done quickly and without complication, the lender's choice is often a simple decision to proceed with a foreclosure. But in jurisdictions where foreclosures take a long time, prudent lenders will at least consider whether, in the alternative, to accept a deed in lieu. This article will provide guidance to lenders and their counsel in making that decision. It will also discuss the documentation of the deed in lieu transaction. Advantages of a Deed in Lieu of Foreclosure From the lender's perspective, taking a deed in lieu of foreclosure can have multiple advantages over a foreclosure. For example: 

Expeditious process results in the lender gaining quicker control of the asset, thereby minimizing risk of deterioration, cash flow misdirection, and property mismanagement. Earlier control of the asset also can lead to swifter access to the market for sale of the property.

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The deed in lieu process is less disruptive to tenants and other third parties that might have to be named in a foreclosure action.

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The deed in lieu process is less expensive than a foreclosure action or a receivership appointment, which will involve court costs, legal fees, and receiver fees.

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The borrower is often more cooperative, knowing that it will soon be relieved of its ownership obligations; this cooperative spirit can facilitate the lender's due diligence investigation of the property.

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Final resolution of the lender's claims, especially its deficiency claims that might not be addressed in a foreclosure action.

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There is less stigma for the property and for the borrower because of the private nature of the deed in lieu transaction as compared to a public foreclosure or receiver sale. Preliminary Questions to Ask

1.

Are There Subordinate Encumbrances?

The lender's first step should be to order updated title and UCC financing statement searches. These searches will determine whether, and to what extent, the property is encumbered -11

Reprinted with permission from Probate & Property November/December 2011 (American Bar Association) Copyright © 2011 American Bar Association

with liens that have been filed after the recording of the mortgage. Subordinate encumbrances create a drawback for the lender, who still may need to initiate a foreclosure action to terminate the undesirable subordinate encumbrances because the deed in lieu transaction will not wipe out junior liens. Thus, existence of subordinate liens is probably the lender's most common reason for deciding against taking a deed in lieu. But before dismissing a deed in lieu opportunity because of subordinate matters, several questions should be asked. First, are favorably drafted intercreditor agreements in place? If so, lender's counsel should review them to confirm the contractual status of the subordinate encumbrances as among the parties to the intercreditor agreements. Second, how significant are the subordinate encumbrances in relation to the debt and value of the property? Depending on the relative size of the subordinate liens, it still may be more practical and less expensive for the lender to proceed with a deed in lieu. Minor mechanic's and similar liens often can be privately addressed without resorting to a foreclosure action. The threat of foreclosure under the lender's unreleased first mortgage lien can be a valuable bargaining tool in negotiating settlements to release subordinate mechanic's liens and unfavorable subordinate tenant leases that do not enjoy nondisturbance protection. A word of caution: if the lender decides to pursue the deed in lieu notwithstanding the existence of subordinate liens, it must be careful to preserve, and not inadvertently release, its mortgage. More about that below. 2.

Is the Borrower Using the Deed in Lieu as a Delay Tactic?

A deed in lieu loses one of its main advantages if it does not march along at a quick and steady pace. Therefore, the thoughtful lender must be cautious that the borrower does not use a deed in lieu transaction as a delay tactic. If the parties cannot reach an agreement within a reasonable period of time, the lender still may have to institute a foreclosure action – which defeats the purpose of a deed in lieu in the first place. The lender should establish a schedule at the outset of the process and memorialize it in a pre-negotiation letter setting forth the terms of the deed in lieu transaction. This letter also will pin down the salient business terms, thereby expediting the documentation phase. If the lender is especially at-risk, it can gain leverage by commencing a foreclosure action at the same time as it negotiates and documents the deed in lieu. The lender can agree to dismiss the foreclosure action on execution of the deed in lieu documentation before the foreclosure sale date. Unfortunately, the disadvantage of this dual-track approach is the double expense of the simultaneous occurrence of a deed in lieu process and a foreclosure action. 3.

Will Transfer Taxes Have to Be Paid?

Transfer taxes can add a substantial price to the overall cost of pursuing either a foreclosure or deed in lieu. The taxes are often so significant that they alone can greatly exceed legal and all other costs of carrying out a foreclosure or a deed in lieu. Laws governing the application of transfer taxes vary from state to state. Some jurisdictions exempt foreclosures, including friendly or consensual foreclosures, but do not exempt deed in lieu transactions. Other jurisdictions are to the contrary, exempting deed in lieu transactions, but not foreclosures. -22

Reprinted with permission from Probate & Property November/December 2011 (American Bar Association) Copyright © 2011 American Bar Association

Traditionally, the transferor, or borrower, is required to pay the tax. If the transferor fails to make payment, however, the transferee is obligated to pay the tax on recording the deed. Consequently, with the borrower typically lacking funds, this transfer tax burden often falls on the lender. Even when a deed in lieu is generally exempt from transfer tax, the prerequisites for such exemption need to be carefully considered. For example, in some states the exemption is only available if the transferee named in the deed is the party named as the mortgagee in the mortgage. This can be problematic when the mortgagee wishes to convey title to its designee. In such circumstances, it may be worth preserving the exemption with a two-step conveyance. First, title is conveyed directly to the mortgagee as an exempt transfer. Subsequently, the mortgagee conveys title to the mortgagee's designee under another applicable exemption from transfer tax. Each conveyance should be made with a clear expression of nonmerger intent. 4.

Does the Property Owner Have Authority to Transfer Title Under a Deed in

Lieu? As part of the original mortgage loan closing, lender's counsel will have satisfied himself or herself that the borrower had the requisite authority to enter into the loan and to mortgage its property. This step is a critical component of loan closing due diligence, because lack of authority to mortgage can give the borrower an effective defense to a foreclosure action. But the fact that the borrower had authority at the time of the loan closing to mortgage the property does not necessarily mean that it has authority to subsequently perform a deed in lieu transaction. For example, the controlling percentage interests of the members or partners within the borrowing entity may have shifted after loan closing. This shift could be because of transfers, death, dissension among the ownership ranks for failure to contribute to cash calls, or similar issues among owners of a troubled asset. Also, the level of approval required to mortgage a property may not be as strict as that necessary to transfer title to the property, particularly if the property is the only asset of the borrowing entity. Accordingly, the lender cannot assume that the borrower's authority that was adequate to originally close the loan will be sufficient to permit the borrower to later close a deed in lieu. Lender's counsel should confirm the borrower's authority to transfer title. Such confirmation requires reviewing applicable constituency documents such as partnership, limited liability company, or trust agreements, articles of incorporation, articles of organization, and bylaws, and regulations and related governing state law. As with any real property purchase, the lender may need to obtain confirmation of approvals and consents to the title transfer from shareholders, directors, beneficiaries, members, and partners, including limited partners. The point is to ferret out any lack of consensus at the ownership level well before the lender expends time and expense undertaking a deed in lieu process.

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Reprinted with permission from Probate & Property November/December 2011 (American Bar Association) Copyright © 2011 American Bar Association

5.

Will the Borrower Have Unfavorable Federal Income Tax Consequences?

The lender may not consider the potential for adverse federal income tax consequences to the borrower to be the lender's problem. But, to the extent there are potential adverse tax consequences for the borrower, it is better that the borrower be aware of the situation sooner rather than later. Otherwise the lender risks negotiating a deed in lieu plan that is aborted before closing when the borrower finally consults with its tax advisor. It is often at that late date that the borrower first understands the potential adverse tax ramifications the deed in lieu may pose. The pro-active lender does not wait until the eve of closing to confirm that the borrower has had an opportunity to consult with tax counsel. 6.

What About Potential Bankruptcy Concerns?

A deed in lieu or other workout always poses the risk that the transaction arranged between the borrower and the lender could be avoided as a preferential transfer or a fraudulent transfer. The risk of that avoidance is minimized when the property is worth less than the debt to the lender. A deed in lieu may constitute a fraudulent conveyance if it is made for less than "reasonably equivalent value," such as when the property is worth more than the mortgage debt. For these reasons, it is important that the lender obtain an independent appraisal to demonstrate the value of the property before it accepts the deed in lieu. The title company issuing the lender's title evidence also will request a copy of the appraisal. The lender should require a confidentiality letter when sharing a copy of its appraisal with the title company. Questions to Ask When Drafting 7.

Will the Transfer Be Voluntary?

The deed in lieu of foreclosure cannot be forced or coerced. The transfer must be voluntary on the part of the borrower, and the documentation should recite that it is a voluntary act undertaken at the request of the borrower. Without this documentation, there is risk that the transaction will be unwound and that the lender will have liability for damages if it exerted pressure, duress, or unconscionable advantage in inducing the borrower to grant the deed. The lender must also bear in mind the age-old doctrine of "clogging the equity of redemption." This doctrine provides that the borrower has the right to redeem its property on full payment of its obligations within a specified time. To avoid clogging the borrower's equity of redemption, the lender should not take a deed to the property unless such deed is voluntarily given for an adequate consideration after a default under the mortgage. See John C. Murray, Clogging Revisited, 33 Real Prop. Prob. & Tr. J. 279 (1998), for an excellent discussion of clogging issues. 8.

Will the Transfer Be Deemed an Equitable Mortgage?

Along this same line, the lender must prevent the construction of the deed as a continuing security device or equitable mortgage. All evidence should point toward an unequivocal conveyance. Deeds in escrow have been the source of challenge as equitable mortgages. See John C. Murray, Mortgage Workouts: Deeds in Escrow, 41 Real Prop. Prob. & Tr. J. 185 -44

Reprinted with permission from Probate & Property November/December 2011 (American Bar Association) Copyright © 2011 American Bar Association

(2006), for a superb discussion on deeds in escrow. If the transaction is structured properly, such challenges can be averted. Lender's counsel should avoid including provisions in the deed in lieu documentation that grant the borrower the right to receive the reconveyance of the property at a later date on payment of the debt, the right to share in the proceeds of a subsequent sale of the property, options or rights of first refusal to repurchase, or a continued right to remain in possession of the property. 9.

Has the Lender Preserved Its Mortgage Lien?

Even if there are no known subordinate encumbrances at the time of the deed in lieu transaction, there is no guarantee that a currently unknown lien will not later surface. Furthermore, especially when there are subordinate liens and the lender has decided to proceed with a deed in lieu, lender's counsel must be certain to preserve the mortgage as a mortgage. The trap to avoid is the common law doctrine of merger. That doctrine provides that when a greater estate in land, such as fee simple ownership, and a lesser estate, such as a mortgage lien, are combined in a single person with no intervening interest, the lesser estate is extinguished and merged into the greater estate. If the mortgage lien is extinguished, there is no basis to institute a foreclosure action. Although some jurisdictions may permit the mortgage holder to take title in its own name and still foreclose on its own mortgage, it may be safer to follow these steps: 

take title in the name of a designee, which can be an affiliate of the lender;



show a clear intent not to merge by adding anti-merger language to the deed or other instrument of conveyance and in the deed in lieu agreement; and



if state law permits, do not release the mortgage of record, at least not until the property is ultimately sold to a bona fide third-party purchaser.

The incentive for a borrower to offer a deed in lieu is often the promise of being released from liability for the debt. It is critical, however, that the lender not extinguish the lien or the debt because they may be essential to foreclose on the mortgage lien at a later time. In drafting the deed in lieu agreement, lender's counsel must be careful to provide that the debt is not cancelled or extinguished. This provision can be made effectively as follows: instead of forgiving the debt in a release instrument, the lender should agree to provide the borrower with a covenant not to sue for a deficiency judgment. Such a covenant should be conditioned on the borrower's continuing to cooperate by fulfilling its covenants and warranties under the deed in lieu agreement. The covenant not to sue should clearly provide that if necessary for foreclosure purposes, the borrower will cooperate so that enforcement of the mortgage lien is not hampered by the covenant not to sue.

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Reprinted with permission from Probate & Property November/December 2011 (American Bar Association) Copyright © 2011 American Bar Association

If crafted properly, the following benefits should be available to the lender: 

the mortgage will remain available for a subsequent foreclosure action to terminate undesirable subordinate encumbrances that lack nondisturbance protection;



the mortgage will be preserved if the transaction is set aside by a bankruptcy court; and

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the designee of the lender can bear the risk of environmental and other concerns, thereby insulating the lender from the risk of ownership.

Of course, the risk of vicarious liability exists if the designee is not distinctly separate from the lender. 10.

What to Include in the Deed in Lieu Agreement?

In addition to stating the amount of the debt and the value of the property, that the deed in lieu agreement should confirm, at a minimum, that the loan is in default, that the deed in lieu is voluntary, that the lender is released from possible lender liability and other claims, that the debt is not extinguished, that there is no intent to merge the mortgage into the deed, and that the borrower has no rights to control, approve, or pass on the manner in which the lender subsequently disposes of the property. What about the borrower's representations and warranties that are so often heavily negotiated? Lender's counsel should consider the potential viability of the borrower following the closing. Especially in the case of a single purpose entity borrower that is without any other assets or cash, such representations and warranties may not be worth the trouble to draft and negotiate. If the lender does not intend to release any guarantors at the time of the deed in lieu, then to avoid reliance and other possible defenses by the guarantors the lender should have them consent to the deed in lieu. Depending on the situation, there should be a clear statement that the guarantors continue to be liable for any deficiency, for recourse carve-outs, and for indemnities such as environmental indemnities. Another option is to have the guarantors remain liable for a specific period of time, usually enough time for the lender to determine whether it has any potential claims against the guarantors. The lender must bear in mind the relative bargaining positions of the parties. In a nonrecourse loan, unless the lender can prove waste or other liability under a carve-out from the nonrecourse provisions, the borrower may have the upper hand. If the lender's covenant not to enforce the loan documents is not adequate consideration, the lender may need to consider making a cash payment to the nonrecourse borrower so there is adequate consideration. The deed in lieu agreement should transfer to the lender or its designee all rights to pending claims for real property tax reductions, prepaid insurance premiums, security deposits, prepaid tenant rents, and tenant common area maintenance, tax, and insurance payments. -66

Reprinted with permission from Probate & Property November/December 2011 (American Bar Association) Copyright © 2011 American Bar Association

Because the lender will have a loss even after taking a deed in lieu, it is unlikely to permit prorations that would allow the borrower to take cash out of the property. The lender also will need to consider the termination of employees and the transfer of franchise rights, liquor licenses, and similar rights and permits. If an unpaid real property tax burden is significant, consider a manageable installment payment plan with the local taxing authorities until a sale to a third party can be arranged and sale proceeds are available. Conclusion The deed in lieu transaction has its advantages. It can be a particularly effective way for a lender to quickly obtain title to property in those states where the foreclosure process is long or complex. With careful thought and planning, the lender and its counsel can work their way through the special issues and concerns posed by the deed in lieu transaction. By doing so they can minimize the risks and reap the benefits of this alternative to the foreclosure process.

Dianne S. Coscarelli is a partner in the Cleveland, Ohio, office of Thompson Hine LLP and a member of the Section's Real Property Division Council. 11645593.1

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Reprinted with permission from Probate & Property November/December 2011 (American Bar Association) Copyright © 2011 American Bar Association

DEEDS IN LIEU OF FORECLOSURE: Practical and Legal Considerations George A. Kurlyandchik Attorney at Law

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What’s in it for lenders? • Has the potential to reduce negative publicity, which can adversely affect market value • Can (but doesn’t always) reduce costs • Allows lenders to obtain their borrowers’ cooperation, which can make the transition more orderly and, therefore, reduce losses • Gives lenders a way to clean up potential documentation inadequacies

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Why shouldn’t lenders agree to it? • A deed in lieu does not extinguish junior liens and encumbrances • In some states, it can be faster and less costly to foreclose than to go through the due diligence and negotiations associated with a deed in lieu • If the borrower/counsel on the other side are inexperienced, this can turn into a very difficult, time consuming and expensive process • Deficiency judgment considerations 3 10

Due Diligence Considerations • Examine the borrower’s authority • Obtain a recent, detailed statement showing the borrower’s financial condition • Obtain an estoppel affidavit from the borrower to verify solvency – Single asset borrowing entities seeking to return properties are often insolvent. Even under these circumstances, the lender should not be subject to a preferential transfer or fraudulent conveyance challenge if the lender has established that the debtor has no equity in the property and the transaction was not fraudulent or collusive 4 11

Due Diligence, ctd. • Environmental testing – The borrower’s liability for environmental issues should arise upon discovery of an unacceptable environmental condition, not upon realization of a loss • The lender should obtain an owner’s title insurance policy effective on the date of the conveyance • Independent appraisal – establishes adequacy of consideration – establishes that the conveyance is not being made for less than a reasonably equivalent value while the borrower is insolvent or undercapitalized 5 12

Due Diligence, ctd. • Copies of all books and records reflecting the management of the property • Leases and rent rolls – Are leases assignable? Do they terminate upon foreclosure/deed in lieu?

• Contracts and management agreements • Existing environmental reports and surveys • ADA compliance and other engineering reports

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Essential elements • Borrower’s authorization to enter into the transaction • Ratification and confirmation of loan obligations • All financial information submitted by the obligors to the lender is true and correct • The transaction does not render the borrower insolvent. The borrower does not intend to hinder, delay or defraud any of its creditors • All obligations of the borrower associated with the property are listed

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Essential elements, ctd. • Environmental indemnity • Property insurance is still in place • All brokerage, listing, management, service, equipment, supply, security, maintenance and other agreements that affect the property are listed • All the leases, subleases, licenses, concession agreements are listed • Security deposits and pre-paid rent • Status of real estate taxes is shown 8 15

Essential elements, ctd. • No notice of any pending condemnation or threatened rezoning • No notice or knowledge of any other violations of any statute, law or ordinance • Any reserve/escrow account maintained by the lender in connection with the loan can be retained by the lender and applied against the loan • Closing cost allocations

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Essential elements, ctd. • Covenant not to sue, provided obligors strictly comply with the terms of the settlement agreement and no court determines that the transfer constitutes a preference or a fraudulent conveyance – The settlement agreement and the deed should not state that the mortgage debt is canceled or extinguished

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Essential elements, ctd. • All obligors absolutely and irrevocably release and waive any claims against the lender, any future property purchaser and related parties. This provision survives the closing or earlier termination of the settlement agreement • If the borrower is given the right to continue to manage the property, the lender should have the right to terminate the management duties at any time – The borrower’s management duties, if any, should never include the ability to control the development or sale of the property

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No Merger • Generally, when one party holds both record title to property and a mortgage thereon, the legal interests merge and the mortgage ceases to be an encumbrance • A merger between the deed in lieu and the mortgage can cause the lender to lose the ability to subsequently foreclose on the property to extinguish junior liens and other encumbrances

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No Merger, ctd. • Unless prohibited by state law, the loan documents continue in full force and effect and remain as a first priority lien against the property – preserves the lender’s lien priority if mechanics’ liens and/or other junior encumbrances are discovered – protects the lender if the deed is later set aside – Note: in some states a merger may occur regardless of the intention of the parties

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No Merger, ctd. • Do not release the mortgage until the property is subsequently sold • The lender retains the right to foreclose • The borrower’s conveyance is absolute and is not intended as a mortgage, trust conveyance, deed of trust or security instrument of any kind – Failure to do this exposes the lender to the risk that the conveyance can be recharacterized as an equitable mortgage

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Title Insurance • Explore whether you can obtain a non-merger title insurance endorsement in your state • Effective March 8, 2010 the American Land Title Association withdrew its creditors’ rights endorsement – Creditors’ rights endorsements have never been available in Florida, New Mexico, New York or Texas – Title companies felt that the issue of the borrower’s financial viability or the issue of proper consideration being paid is not a title matter that an insurer can properly assess by examining public records

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