DEEDS IN LIEU OF FORECLOSURE. Steven R. Davidson and John M. Nolan

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1 DEEDS IN LIEU OF FORECLOSURE Steven R. Davidson and John M. Nolan When the Lender and the Borrower have concluded that a loan modification is not going to work and that it is time for the Borrower to relinquish its ownership interest in a property serving as collateral for a loan (the Property ), each party must evaluate the pros and cons of the different ways in which the transfer can be accomplished. This article will focus primarily on the use of a deed in lieu of foreclosure for the Lender to acquire title to the Property, but will also explore other alternatives. Both a deed in lieu and some of the other alternatives discussed require the Borrower and the Lender to mutually agree on the course of action and associated documents. Of course, if the Borrower and the Lender cannot come to a mutual agreement on how to proceed, the Lender is left with enforcement of its remedies pursuant to the Loan Documents. 1. Advantages of a Deed in Lieu for the Lender Since both parties must agree to a deed in lieu transaction, there have to be perceived benefits to both the Borrower and the Lender when compared to the other alternatives. Here are some of the considerations which may contribute to a Lender deciding it wants to accept a deed in lieu of foreclosure. (While it is fairly common for a Lender to set up a new special purpose entity to take title to the Property, for ease of reference this Article will refer to the Lender taking title regardless of whether it is actually the same legal entity that made the Loan or a wholly owned subsidiary set up just to hold title to the Property.) A. Faster and Less Expensive than a Foreclosure. Because a deed in lieu is a voluntary transaction, it can be accomplished very quickly. The parties are not subject to the procedural steps required to complete a foreclosure or the scheduling challenges of a court with a crowded docket in those states that require a foreclosure to be completed judicially. Since a deed in lieu transaction is essentially an acquisition, there can be wide variations in how long it takes to complete depending on the amount of negotiation of the documents and the time it takes to bring down title and complete other closing requirements. How different the timeline is from a foreclosure depends on the specific state. In some states, non-judicial foreclosure is available and completed in as short as four weeks. In other states a lawsuit must be filed to foreclose the Mortgage or Deed of Trust and even a foreclosure with minimal opposition can take a year or more to complete due to crowded court dockets. The ability to complete a deed in lieu transaction much more quickly than a foreclosure can translate into lower expenses. However, that is not always the case, and prolonged negotiation of the deed in lieu documents can easily wipe out any cost savings that would otherwise be available. B. Prevent Waste of the Asset. Often, one of the attractions of the deed in lieu can be the Lender s ability to take control of the Property more quickly and therefore mitigate any deterioration in the physical or economic condition of the Property in which the Borrower no longer has any economic interest. Depending on the state, the Lender may be able to get a receiver appointed relatively quickly to achieve a similar goal, but a

2 receiver does not work for the Lender and may not necessarily take all actions that the Lender requests. Also, there are fees associated with having a receiver in place. C. Private Transaction with Less Stigma. Unlike a judicial foreclosure, which involves public court filings or a non-judicial foreclosure, which involves public advertisements, a deed in lieu is a private transaction. In the past, the parties viewed this aspect of the deed in lieu transaction as a significant advantage because of the fear that a foreclosure would have a negative effect on the Property. While to some degree that fear is justified, the market has come to recognize the realities of foreclosure proceedings as they become more and more prevalent. D. Opportunity for Lender to Avoid Potential Consequences of Document Problems. Often, as a Lender reviews its files once a loan has gone into default, it discovers issues with the original documentation. Depending on the severity of those issues there could be a risk associated with enforcement of the Loan Documents. A consensual agreement with the Borrower can help the Lender acquire the asset without the risk of an attack against its lien position. E. Borrower Generally More Cooperative. A Lender that acquires the Property through a consensual transaction often finds the Borrower is more cooperative in the transition of ownership. At a minimum, the negotiation of the Deed in Lieu of Foreclosure Agreement, which is discussed in more detail below, offers the Lender an opportunity to ask for information and documentation, such as delivery of lease files, service contracts, borrower financial statements and similar information, that would be required by any buyer in an acquisition transaction. F. Preservation of Lender s Lien. In most states, the Lender is not required to release its lien in connection with a deed in lieu as long as there is non-merger language in the closing documents. This allows the Lender to benefit from some of the advantages discussed above, without sacrificing its ability to later foreclose its Mortgage or Deed of Trust to eliminate any subordinate liens, such as mechanics liens that may affect the Property. 2. Advantages of a Deed in Lieu for the Borrower. Some of the advantages of a deed in lieu for the Lender, such as less cost and avoidance of the stigma associated with a foreclosure, apply to the Borrower as well. There are, however, other characteristics of a deed in lieu that the Borrower may find attractive. A. Release of Guarantor Liability. Often one of the central terms negotiated by the Borrower is the release of liability under outstanding Guaranties. Depending on the terms of the original loan, the Guarantors may have personal recourse for all or part of the debt, completion obligations in the case of a construction loan, environmental obligations, and other recourse carveouts. The Lender typically has to make a judgment as to the creditworthiness of a Guarantor and its potential liability under the recourse documents for that deal (including the costs and uncertainty associated with any - 2 -

3 suit brought on the Guaranty), versus the efficiencies and other advantages noted above of completing a deed in lieu transaction. In some transactions, the Lender is willing to release the Guarantors from all obligations. In other transactions the Lender may insist on retaining certain limited obligations, such as the environmental indemnity or recourse carveouts. If the Guarantors and the Lender cannot agree on whether there should be surviving obligations, sometimes a sunset provision can be helpful. Under this type of provision, the Guarantor remains liable for a limited period of time. With respect to the typical carveouts, a sunset provision gives the Lender some time after it takes over the Property to discover if any of the actions that might give rise to carveout liability have taken place. With respect to environmental obligations, the issues are much the same as when a sunset is agreed to up front. The thinking is that if a problem has not been discovered within a specified period of time then it will be difficult to establish when the problem developed. Once the decision is made as to the extent the Guarantors will be relieved of liability, the parties must then address whether this decision will be effected through the delivery of a release or a covenant not to sue. That issue is discussed below. B. Borrower Avoids Negative Consequences of Foreclosure. Just as the Lender may be concerned about the negative effects on the Property of a pending foreclosure, so may the Borrower. In addition, the Borrower may be thinking ahead to when the markets turn more favorable, and it may not want to report a prior foreclosure when it applies for future loans. C. Lender Payment of Expenses. In addition to the potential release of personal liability of the Borrower and its sponsors, the Lender may actually pay something just for the benefit of the Borrower walking quietly from the Property. This payment typically would be in the form of paying certain expenses associated with the deed in lieu transaction. D. Borrower May Be Retained to Provide Future Services. Another opportunity for the Borrower who cooperates with the Lender in effecting a deed in lieu of foreclosure may be getting retained to provide future services such as management and/or leasing services for the Property. Often, the Borrower knows the Property the best and its lack of success is market driven rather than poor management or leasing activities. If that is the case, then the Borrower has a good opportunity to pitch its capabilities to perform these services when it negotiates the deed in lieu of transaction. As long as the Borrower is paid a market rate and, in the Lender s estimation, is performing as well as could be expected of a third party provider, the Lender may be willing to retain the Borrower (or one of its affiliates) to perform these services. 3. Disadvantages of a Deed in Lieu of Foreclosure. A. Does not Alter or Affect Others Having an Interest in the Property. Perhaps the biggest disadvantage of a deed in lieu is that the Lender takes subject to all other encumbrances and interests in the Property. Therefore if there is a second mortgage, for example, a deed in lieu would likely not be a viable strategy. There can be other interests in the Property, such as mechanics' liens, that need to discharged through foreclosure that - 3 -

4 prevent the parties from choosing a deed in lieu transaction. Similarly, the Borrower may have entered into contracts giving third parties valuable rights in connection with the Property that would be eliminated in a foreclosure because the contract rights would be subordinate to the Mortgage. In a deed in lieu transaction, those rights would survive. These issues are not always determinative. As discussed in more detail below, there are ways a Lender can still retain some protections while acquiring title through a deed in lieu, such as by keeping its Mortgage in place. B. A Deed in Lieu is Not Always as Easy as it Sounds. Sometimes the Lender and the Borrower start by thinking they will complete a deed in lieu transaction but then the negotiation of the documents becomes more time consuming and expensive than either side anticipated. For this reason a Lender may choose to proceed on parallel paths and commence the steps necessary for a foreclosure while also negotiating a deed in lieu transaction. C. Potential Liabilities. Depending on local law, there may be potential successor developer liabilities, particularly in a condominium project, for a person who becomes a successor owner by conveyance. In this situation, the Lender will typically prefer to foreclose and lessen its risk of being considered a successor developer with the associated liabilities. D. A Deed in Lieu May Be Subject to Being Set Aside. The Lender always has to consider the risk that if a bankruptcy proceeding is later filed by or against the Borrower, the conveyance may be set aside either as a preference or a fraudulent conveyance. In order for a transfer to constitute a preferential transfer, the transfer must be for the benefit of a creditor, for or on account of an antecedent debt, while the debtor was insolvent, and enable the creditor to obtain more than it would have received in a Chapter 7 liquidation if the transfer had not been made. It is this last requirement that a Lender can often most easily establish was not met, assuming, as is often the case, that the property conveyed to the Lender was worth much less than the debt. While the preference period is only ninety days unless the lender is an insider, it is also possible for a deed in lieu to be set aside as a fraudulent conveyance if the transfer was made for less than reasonable equivalent value and if the transferor was insolvent at the time of transfer, became insolvent because of the transfer, was engaged in a business that maintained an unreasonable low level of capital, or intended to incur debt beyond its ability to pay. In this case the look back is one year and even longer under state fraudulent conveyance statutes. While a transfer pursuant to a foreclosure can also be a fraudulent conveyance, there is helpful case law in many jurisdictions which holds that a regularly conducted foreclosure sale is a transfer for reasonably equivalent value. Given the recent unavailability of the creditors rights endorsement to protect against these risks, Lenders have to seriously evaluate the risk of a deed in lieu being set aside before proceeding. E. Transfer Taxes. The transfer tax laws vary from state to state, but it is possible that a transfer pursuant to a foreclosure is exempt from transfer taxes, whereas a conveyance in lieu of foreclosure may not be covered by an exemption. The payment of Author Comment: Note: in Nevada, it is the opposite. A deed in lieu is calculated in a way that very often reduces the tax when compared to a trustee's deed on which the transfer tax is based on the bid.

5 transfer tax could easily offset any cost savings associated with doing a deed in lieu of foreclosure. 4. Alternatives to a Deed in Lieu of Foreclosure. In addition to weighing the advantages and disadvantages of a deed in lieu transaction, the lawyers must be prepared to discuss with their clients the possible alternatives. While often the parties think in terms of either negotiating a deed in lieu or proceeding with a conventional foreclosure, they may wish to consider the following alternatives. A. Consensual Foreclosure. In some states a separate statutory procedure exists for a consensual foreclosure. However, even if the state where the Property is located does not have such a procedure, the parties can negotiate a consent foreclosure agreement under which the Borrower agrees to cooperate and not oppose any actions taken by the Lender to foreclose and obtain the appointment of a receiver. While such an agreement does not eliminate the procedural steps to accomplish the foreclosure, it can substantially shorten the timeline. For example, in one such proceeding currently pending, a special referee has been appointed who does not have the same busy docket as the judges typically handling foreclosures, thus eliminating the substantial wait to have motions heard, such as those in connection with the receivership. In the Consent Foreclosure Agreement the Borrower can negotiate for the same types of releases that it might have negotiated in the context of a Deed in Lieu of Foreclosure Agreement. B. Sale of the Property by the Receiver. Another possible alternative to a deed in lieu transaction is obtaining the appointment of a receiver who has the power to market and sell the Property. The receivership statutes vary widely by state so this alternative may not work everywhere, but it is something that is gaining increasing acceptance. Apart from shortening the timeline to the ultimate disposition of the Property, a sale by the receiver affords the Lender a way to sell the Property without ever having to be in the chain of title. To accomplish a sale through the receiver, the Lender should seek the authority for the receiver to conduct such a sale in the initial order appointing the receiver. It may still be necessary to get the ultimate sale terms approved by the court but if the authority is granted to the receiver at the outset of the proceeding the parties know from the outset that such a sale is a possibility. If the Lender proceeds with this strategy it will need to coordinate with the receiver throughout the sale process, recognizing that it is the receiver--and not the Lender--that is actually selling the Property. Therefore, direct negotiations with potential purchasers should be through the receiver and the receiver s counsel would typically be involved in drafting the sale documents. The receiver will typically consult with the Lender throughout this process since these sales are typically for sale prices below the amount of the debt secured by the Property and therefore can t be closed unless the Lender has approved the amount of the discounted payoff. To the extent a Lender has input into the selection of the receiver, and in many states the Lender s choice is routinely appointed by the court, the Lender should choose a receiver that it thinks will be effective in managing the sale process if it contemplates this type of a disposition of the Property. If a sale through the receiver is contemplated, the title - 5 -

6 insurance company shall be consulted early in the process to be sure it is willing to insure title for the buyer based on a conveyance by the receiver. 5. Typical Deed in Lieu Provisions. Author Comment: Are short sales and sales of the loan a different kind of animal? Once the decision is made to proceed with a deed in lieu transaction, the documentation needs to be prepared. Just as a sale is typically governed by a Purchase and Sale Agreement, the Deed in Lieu of Foreclosure Agreement covers similar provisions. Attached to this article as Exhibits A and B are two sample Deed in Lieu of Foreclosure Agreements, but just as there are many forms of sale agreements in use, there are also many ways to draft the Deed in Lieu of Foreclosure Agreement. The form attached as Exhibit A contemplates an Escrow Period during which signed documents are held by an escrow agent before the transaction is completed, whereas the agreement in Exhibit B contemplates a simultaneous closing. A Deed in Lieu of Foreclosure Agreement can also set a closing date in the future without the closing deposits being deposited in escrow until the closing actually occurs. Regardless of form, here are some of the typical provisions addressed in a Deed in Lieu of Foreclosure Agreement. A. Recitals. While often overlooked, the recitals in the Agreement provide an opportunity to recite facts that will help prevent a later challenge to the agreement and the rights of the Lender after it takes title. Examples of helpful recitals are that the entire balance of the loan is due, the property is worth less than the loan balance, and the borrower and guarantors have no current interest in the income, rentals profits or other sums derived from the Property. B. Description of Closing Documents. As with any sale contract, there are a number of closing documents and many practitioners will try to attach these as exhibits to the Deed in Lieu of Foreclosure Agreement if documents are not being delivered simultaneously with the execution of the agreement itself. The parties must agree, among other things, on the type of deed to be used. While from the Lender s perspective a general warranty deed is preferable, often the parties compromise by agreeing the deed will be a special warranty deed which warrants title only against the acts of the Borrower. Assuming the Lender will want to preserve the lien of its mortgage in case it needs to subsequently complete a foreclosure to eliminate any subordinate lien claims, there should be non-merger language included in the deed making that intent clear since the cases in many states refer to intention of the parties as the guiding principle in determining whether or not there has been a merger. Another provision often included in the deed, which is not used in a typical sale, is a provision confirming that the deed is an absolute conveyance to the grantee and is not intended to be a mortgage or security instrument of any type. This is particularly important if the deed will be delivered into an escrow prior to the final closing of the deed in lieu transaction. C. Title Insurance. While a lender s title insurance policy provides some protection to a Lender acquiring title to the mortgaged Property, most deed in lieu transactions require issuance of an owner s title insurance policy to the Lender. One of the primary problems with relying simply on the existing lender s policy is that it provides insurance coverage only as of the date of issuance of the policy. The Lender will take title subject Author Comment: Do you want to mention here or somewhere in the paper that granting the borrower any rights to reacquire the property may taint the conveyance? - 6 -

7 to all liens, encumbrances, and other exceptions occurring subsequent to the date of the original policy. Also, there is a difference between a lender s policy and an owner s policy in how a potential loss is determined should a claim arise. An owner s policy issued as of when the deed is recorded also insures the execution, delivery and recording of the deed conveying title to the Lender. As noted below, the expense of obtaining this title insurance is often borne by the Lender. D. Contracts Affecting the Property. The Deed in Lieu of Foreclosure Agreement provides a means for assigning contracts that the Lender deems favorable while requiring the Borrower to terminate other contracts prior to closing. The closing documents will include an assignment of the surviving contracts and will often require the Borrower to sign a letter to the various vendors confirming the termination or assignment, as the case may be, of their contracts. E. Letters to the Tenants. The Deed in Lieu of Foreclosure Agreement should require the Borrower to execute a letter to tenants similar to the form that would be used in any sale transaction. This letter informs the tenant of the change in title and gives the tenant instructions for where to send its rent payments. F. Prorations. A typical sale contract contains specific provisions as to how to prorate income and expenses from the Property. It is not uncommon in a deed in lieu transaction that the Lender has already put cash management in place and is monitoring the use of cash flow from the Property before the parties agree to the deed in lieu transaction. Typically the Borrower is unwilling to put new cash into the deal beyond what is coming in from the Property and the Lender is not likely to let the Borrower take any cash out by way of a proration credit. Accordingly, it would not be unusual for a proration section to provide for the cash to continue to be used as it had been under the existing cash management arrangement with no further prorations as a result of the transfer of title. G. Closing Expense. Related to the topic of prorations is which party pays for various closing expenses, including the costs of updated title, survey and environmental reports, transfer taxes if there is no applicable exemption, and other closing items. As noted above, the Borrower will typically resist coming up with money beyond the revenues derived from the operation of the Property. Since all of the revenues are already pledged to the Lender the result is that the Lender typically bears most of the closing expenses, whether directly or indirectly. H. Representations and Warranties. Most deed in lieu agreements contain some borrower representations. How meaningful they are depends on what credit stands behind those representations. In many cases the parties spend time negotiating those representations, but they are made by a single purpose entity that has no assets beyond the interest in the Property being conveyed. Unlike a sale transaction, in which cash is paid to the seller at closing, typically there is no significant payment to the Borrower in a deed in lieu transaction that can be retained in the Borrower to satisfy any claims for breaches of representations and warranties. Most lenders will still want to get as many - 7 -

8 representations as they can, especially if they are dealing with a reputable borrower who they think will put some effort into being sure that the representations are correct even though there may be few if any assets supporting those representations. One thing a lender should consider is whether certain representations are important enough to be backed by a guarantor. An example of a representation that some lenders are beginning to seek from guarantors is one that no cash was distributed from the Property during some specified time period prior to the closing of the deed in lieu. The Lender argues that it is entitled to be protected as to the revenue generated from the Property, even though that revenue was not sufficient to pay all of the Property expenses and debt service. This type of representation is not very valuable if obtained only from the Borrower. The form of Deed in Lieu of Foreclosure Agreement attached as Exhibit A contemplates the Key Principal being a party to the agreement and making a number of representations (See Section 6b of that form) and also agreeing to a number of covenants. Many Borrowers will not agree to have Key Principals included as a party to the Deed in Lieu of Foreclosure Agreement and the best the Lender may be able to do is to get them to confirm their liability for very limited items such as the representation about no distributions of cash from the Property. I. Releases and Covenants Not to Sue. Most deed in lieu agreements contemplate the delivery of mutual releases. Typically the Lender receives a full release signed by the Borrower and Guarantors assuring the Lender that no claims will be brought against it for any of its actions pertaining to the Property and the Loan. With respect to the Borrower's request for a release given by the Lender, as noted earlier, the Lender may resist giving the Borrower and Guarantors a full release at closing. One potential concern is the nonrecourse carveout for misapplication of funds. The longer that active cash management has been in place, the less this may be a concern. One possibility, if the Lender has a concern, is to obtain an audit for the period prior to the time that the deed in lieu transaction closes; often, however, the Lender is attempting to close as quickly as possible for the reasons discussed earlier. A potential compromise is for the Borrower and Guarantors to have continuing liability for a period of time to enable the Lender to determine if there are any issues. For example, in a recent deed in lieu closing, the agreement provided that the Guarantor would be released from all liability under the recourse carveouts ninety days after the closing as long as no claims were discovered during that period. Another concern of the Lender is the environmental obligations of the Guarantor. These obligations typically would survive even full payment of the Loan so it is hard for the Lender to justify agreeing to a release of those obligations at a time when its environmental risk is actually increasing by taking title to the Property. Once the parties agree upon what continuing liabilities there might be for the Borrower and Guarantors following the closing, the Lender must decide whether to deliver a release or a covenant not to sue. There is no single correct answer to that question. Many lenders only give a covenant not to sue and argue that, since there are circumstances (such as the filing of a bankruptcy proceeding by the Borrower) that would typically nullify any release of liability, it is better not to release the liability but simply agree not to commence any action to enforce those liabilities. That way, should such circumstances arise, there is no need to reinstate an obligation that has previously been - 8 -

9 released; the Lender is simply relieved of its covenant not to enforce the particular obligation. A covenant not to sue also addresses the issue of liability for the debt in case the Lender subsequently decides it needs to foreclose its Mortgage, since the covenant not to sue does not release any liability on the debt but is simply a contractual agreement by the Lender not bring an action on the debt other than a foreclosure. Other lenders are less concerned about this distinction and are willing to deliver a release so long as the release contains appropriate provisions to provide protections similar to those afforded in a covenant not to sue, including a provision that the release is deemed null and void if the transfer of title to the Property is ever challenged. J. Non Merger Language. The Deed in Lieu of Foreclosure Agreement should contain non-merger language in addition to such language being in the deed as discussed above. Typically this language will confirm that the fee simple title being acquired is separate and distinct from Lender s interest pursuant to the mortgage or deed of trust. K. Cooperation. The Lender may seek to include a clause obligating the Borrower to cooperate should it choose to file a foreclosure proceeding or seek the appointment of a receiver. It may also want a covenant to cooperate with the Lender in connection with any claims or lawsuits related to the Property, including the processing any insurance claims post-closing. L. Other Typical Sale Agreement Provisions. Since the Deed in Lieu of Foreclosure Agreement is effectively a sale contract, it will contain a number of the provisions typically found in those agreements that are not unique to a deed in lieu transaction such as jury trial waivers, requirements that any modifications be in writing, and other similar provisions. 6. Special Issues for Syndicated Loans. The process of agreeing upon and closing a deed in lieu of foreclosure transaction can be more complicated (and more time-consuming) in a syndicated credit because the multiple lenders must agree on each of the issues. Typically, the Loan Agreement says very little about the mechanics of a deed in lieu of foreclosure agreement. In addition to the negotiation between the lenders and the borrower, the lending group typically wants to take title in a newly created limited liability company in which each lender has a proportionate ownership interest corresponding to its percentage interest in the loan. That necessitates the negotiation of an LLC Agreement by all of the Lenders. While some of the decision making provisions in the original loan agreement can be a guide, the types of decisions that must be made once the lenders take title are different, and therefore there are usually a number of issues that must be resolved. 7. Conclusion. The last several years have been particularly tough for lenders with many properties worth far less than the outstanding loan amounts. There has been much discussion about the extend and pretend strategy that many lenders have taken during this time period pursuant to which loans are extended with no real plan as to how they will ultimately be repaid. As the - 9 -

10 markets begin to show some signs of improvement, lenders are increasingly beginning to face the longer term decisions they must make and often that results in a decision that the best strategy for recovery is to take title to the property. A deed in lieu of foreclosure can be an efficient means for achieving that goal. List of Exhibits Exhibit A: Form of Deed in Lieu Agreement (Escrowed Deed) Exhibit B: Form of Deed in Lieu Agreement (Contemporaneous Closing)

11 EXHIBIT A See attached

12 EXHIBIT B See attached \V