Deeds in Lieu of Foreclosure: Practical and Legal Considerations

Transcription

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
American Bar Association
Section of Real Property, Trust and Estate Law
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Deeds in Lieu of Foreclosure: Practical and Legal Considerations
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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.

The deed in lieu process is less disruptive to tenants and other third parties that might
have to be named in a foreclosure action.

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.

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.

Final resolution of the lender's claims, especially its deficiency claims that might not
be addressed in a foreclosure action.

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
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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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
(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.
-55
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

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
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
-77
DEEDS IN LIEU OF FORECLOSURE:
Practical and Legal Considerations
George A. Kurlyandchik
Attorney at Law
8
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
2
9
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
6
13
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
7
14
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
• 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
9
16
• 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
10
17
• 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
11
18
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
12
19
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
13
20
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
14
21
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
15
22

Deeds in Lieu of Foreclosure: Practical and Legal Considerations

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