Deeds in Lieu of Foreclosure – Current Developments
By John C. Murray*
A deed in lieu of foreclosure has been described as “a transaction in which a borrower, after default, conveys to its lender by absolute deed title to real property pledged as security for the indebtedness. The consideration for this conveyance consists of relieving the borrower of all in personam liability for the loan.” Morrow Dev. Corp. v. Gordon Management, Inc., 875 P.2d 411, 413 n.3 (Okla. 1994). Lenders often are willing to accept deeds in lieu of foreclosure (especially in these difficult economic times) in connection with loan workouts of residential, agricultural and commercial properties. Deeds-in-lieu (and deeds-in-escrow) also are often done in connection with bankruptcy workouts and “prepackaged” bankruptcy plans. Because a deed in lieu of foreclosure cuts off the borrower’s right of redemption prior to foreclosure, the mortgagor may claim that the transaction constitutes an impermissible “clog” of its right of redemption. But because a deed in lieu of foreclosure is subsequent to the original mortgage, and because it is a voluntary conveyance for independent and valuable consideration and serves the socially useful purpose of allowing the mortgagor to avoid a time-consuming, costly, and public foreclosure -- and allows the mortgagor to avoid personal liability on the debt -- an arms-length, fully documented deed-in-lieu transaction should survive a clogging challenge. This article will explore this issue and other issues currently faced by both lenders and title insurance companies in connection with deed-in-lieu transactions.
Concerns (and Requirements) of Lenders and Title Insurers
Lenders and title companies generally share the same concerns about deeds-in-lieu: re-characterization as an equitable mortgage; violation of the “clogging the equity” doctrine (i.e., as noted above, the use of a deed-in-lieu as a means of preventing the borrower from exercising its statutory and/or equitable rights to redeem the property from a foreclosure sale); and setting aside of the transaction as a fraudulent conveyance or preferential transfer under federal bankruptcy or state fraudulent-transfer laws.
Most lenders will not accept a deed-in-lieu unless there are no other mortgage liens or encumbrances on the property and an appraisal (which, depending on the lender’s and/or title insurer’s underwriting requirements, may be either internal or external) has established that there is no equity in the property (i.e., the amount of the outstanding indebtedness clearly exceeds the current appraised value of the property). The title insurance company will want to obtain a copy of the appraisal showing that the value of the property being transferred is less than the debt ---usually by a factor of at least 10-20%. (The title insurer usually will, upon request, supply the lender with a confidentiality letter with respect to the appraisal.)
Most sophisticated lenders have a specific procedure for deeds-in-lieu, including a settlement agreement, deed with non-merger language, assignments, estoppels, etc. The title insurance company will want to receive and review these documents well in advance of the scheduled closing to make sure they comply in all respects with applicable law and the title insurer’s internal underwriting requirements. Many lenders will not cancel the note, but will instead give the borrower a “covenant not to sue.” Consideration for a deed-in-lieu transaction can be either release of the borrower of personal liability or, in connection with a non-recourse loan, forbearance by the lender from exercising or activating its statutory and contractual legal rights and remedies, such as foreclosure and assignment of rents. The lender usually will keep the mortgage of record and not discharge or release it until the property is subsequently resold, or the mortgagee records a release or discharge of the mortgage. As mentioned above, the lender may give the mortgagor a covenant not to sue, as opposed to cancellation of the note, and will keep the mortgage of record when obtaining a deed-in-lieu in connection with a workout of a defaulted mortgage loan, in order to: (i) provide consideration for the transaction; (ii) maintain priority over subordinate liens and the ability to subsequently foreclose its mortgage to eliminate subordinate lien and encumbrances; (iii) preserve its first lien interest if the deed-in-lieu transaction is subsequently set aside as the result of a fraudulent-conveyance or preferential-transfer action by a bankruptcy trustee or other creditors of the mortgagor, or as the result of any state-court action; and (iv) avoid a subsequent argument by the mortgagor or another creditor that the mortgage has in fact been discharged and is void because the note evidencing the underlying indebtedness has been canceled or extinguished.
The validity of attempting to preserve the mortgage lien may depend on whether other creditors would be prohibited from availing themselves of the normal methods of collection that they would otherwise have if the lien were extinguished, and will also depend to a great extent on the intention of the parties as stated in the settlement agreement and the deed. Most states, including Illinois, will enforce such a stated intention.
Where available, and based on applicable law and facts, (and the circumstances of transaction), the title insurer may be willing to issue non-merger endorsement to the Loan Policy, insuring that the mortgage will not be deemed invalid or unenforceable by virtue of title to the property becoming vested in the lender. Recent case law generally supports the ability of a mortgagee to foreclose its mortgage after acceptance of a deed in lieu of foreclosure, at least where the settlement agreement and deed contain an anti-merger provision. See John C. Murray, Deeds in Lieu – Subsequent Foreclosure of Mortgage (2009), available at http://www.firstam.com/listshortcut.cfm?id=3248&menu=676. Courts may not be willing to enforce a non-merger provision in a deed in lieu of foreclosure where rights of innocent third parties may be affected – or even lost – because of fraud or inequitable conduct by parties to deed. (But this is rare and applies only in very complicated and unique factual situations.)
Importance of Obtaining Owner’s Policy
Lenders usually will (and certainly should) obtain a new Owner’s Policy of title insurance upon completion of the deed-in-lieu transaction, rather than rely on continuation of the coverage under the existing Loan Policy (although the Loan Policy should be downdated if the parties express their written intention to keep the mortgage alive and the applicable jurisdiction enforces such intention). This is so because the Loan Policy only covers matters of record at the time of the original loan; it does not insure the validity of the deed-in-lieu transaction or provide coverage for creditors’ rights issues in connection with the transfer of title; and it provides different claim coverage than a new Owner’s Policy (i.e., unlike an Owner’s Policy, which provides for payment upon proof of loss because of the diminution in value of the estate caused by the title defect, a lender insured under a Loan Policy must first establish that a loan default and an actual impairment of its security as a result of foreclosure have occurred as a result of the defect before it will be entitled to recover under the Loan Policy).
Section 2 (Continuation of Insurance) of the 1992 ALTA Loan Policy contains a provision (sec. 2.a.) that provides for continuation of coverage only if the insured acquires the land by “conveyance in lieu of foreclosure, or other legal manner which discharges the lien of the insured mortgage,” but this specific requirement has been eliminated in the new 2006 Loan Policy, which policy is discussed below. See Janice E. Carpi, Title Insurance Following Foreclosure, Beyond the Workout: Risks for Lenders Taking Back and Owning Real Estate, Third Annual Spring CLE and Committee Meeting, Real Property Law Programs, American Bar Association, Section of Real Property, Probate and Trust Law, New York, NY (May 7-9, 1992) at A-3. The lender may, in addition to obtaining a new Owner’s Policy in connection with a deed-in-lieu transaction, request certain endorsements to the existing Loan Policy such as a non-merger endorsement (discussed above) and an endorsement insuring the continuing validity, enforceability and priority of the mortgage lien upon consummation of the deed-in-lieu transaction.
Creditors’ Rights Issues
Title insurers have often been requested to provide affirmative insurance against creditors’ rights’ claims in deed-in-lieu transactions. Lenders considering such transactions outside of bankruptcy sought to obtain affirmative creditors’ rights coverage from title insurers because of the risk of a fraudulent-conveyance or preferential-transfer claim in a subsequent bankruptcy proceeding by or against the debtor. But such coverage has never been the “standard” or the “norm” (especially in the current economic environment) and title insurers generally are no longer willing to delete the creditors’ rights exclusion or issue the ALTA Form 21 or 21-06 Creditors’ Rights Endorsement. This is as a result of: 1) recent negative court rulings in bankruptcy and non-bankruptcy cases involving creditors’ rights’ issues; 2) the continued downturn in the residential and commercial real-estate markets; 3) significant increases in personal and business bankruptcy filings, and; 4) other reasons related to the nature of and challenges associated with underwriting creditors’ rights risk arising out of the insured transaction. The ALTA Form 21 or 21-06 Creditors’ Rights Endorsement (which, when it was available, and subject to significant underwriting due diligence that ultimately proved to be beyond the core competency of title insurance underwriters generally) insured against loss because of the occurrence, on or before the date of the policy, of a fraudulent transfer or preference under federal bankruptcy law or state insolvency or creditors’ rights laws.
The applicable regulatory agencies or Departments of Insurance in several states have withdrawn approval of the Creditors’ Rights Endorsement and other states are considering similar actions. (Note: ALTA and CLTA decertified the Creditors’ Rights Endorsement in February 2010. Creditors’ rights coverage pertaining to the insured transaction itself has never been permitted as a regulatory matter by the title insurance regulators in Florida, New York, Texas or New Mexico. At various points during 2010, the states of New Jersey, Pennsylvania, Delaware, Ohio and Oregon decertified/withdrew the ALTA Form 21/21-06 or any other form of endorsement affording creditors’ rights coverage.) It is also difficult to obtain reinsurance for potential creditors’ rights issues.
In light of the foregoing, it would be prudent for a purchaser or lender to increase the scope and thoroughness of its own due diligence prior to purchasing a property or making a mortgage loan. Also, a mortgage lender would be well advised to obtain a current appraisal from an independent reputable appraiser at or near the time of the foreclosure sale to support the lender’s position -- assuming that such is the case -- that it did not receive more than it would have as the result of a Chapter 7 liquidation.
But it is important to note that the basic title insurance forms still cover fraudulent and preferential transfer risk that may exist in the past chain of title, i.e., arising from transfers in the title chain prior to the present transaction being insured. Therefore, title insurance underwriters will be alert to these issues, particularly where title is derived from a foreclosure or deed-in-lieu or other transfer as to which the applicable statute of limitations has not yet run, and are likely to impose underwriting requirements as part of their underwriting due diligence in order to determine whether title can safely be insured free of exception for the risk of a challenge of this nature arising out of a prior transfer.
Recharacterization Risk – Equitable Mortgage
Generally, no continuing, contingent, or residual rights (including an option to purchase, right-of-first refusal, continued possession, or even a long-term lease) should be given to the mortgagor-grantor in connection with a deed-in-lieu, as a court may construe the proposed transaction as an equitable mortgage and the title insurer may refuse to provide coverage against any such recharacterization. The parties’ intention to actually create an equitable mortgage instead of a deed of conveyance may be shown by:
- The statements of the parties.
- The existence of a substantial disparity between the value received by the grantor and the actual value of the real property at the time of conveyance.
- The fact that the grantor retained possession of the real property.
- The fact that the grantor continued to pay real estate taxes and other property expenses.
- The fact that the grantor made improvements to the real estate subsequent to the conveyance.
- The nature of the parties to the transaction and their relationship both prior to and after the conveyance.
- The fact that a contingency exists or a subsequent event could occur that would “unwind” the transaction or cause the mortgagor (or guarantors) to again become liable for all or a portion of the debt.
If the conveyance of the deed-in-lieu is not to the lender, but instead to a subsidiary of the lender or a special purpose entity created by the lender, the title insurer will probably have no problem insuring the transaction, as long as the lender owns 100% of the entity actually taking title and the deed contains typical non-merger language to keep the mortgage alive.
If the deed-in-lieu documentation (including a covenant not to sue, as described earlier in this article) contains a “reinstatement” or “unwind” provision that could place the respective parties back in their original positions if there is a subsequent successful challenge to the validity of the deed-in-lieu transaction, such a provision may (depending on the facts) cause the title insurer to raise an exception to the provision because of the risk of a total failure of title under the Owner’s Policy issued to the lender.
A deed in lieu of foreclosure is a complex legal transaction. Attorneys for both the lender and the borrower should carefully consider the practical, legal, title, and tax aspects of a deed in lieu of foreclosure. A voluntary conveyance may benefit either or both parties. Both sides of the transaction should carefully draft and document all phases of the conveyance to avoid unintended and undesirable legal and economic consequences. Also, it is important that the title insurer be consulted at the commencement of the transaction in order to make certain that all applicable underwriting requirements are understood and complied with and that proper title coverages and endorsements (where applicable and available, and excepting creditors’ rights coverage) are obtained.
* Nothing contained in this Article is to be considered as the rendering of legal advice for specific cases, and readers are responsible for obtaining such advice from their own legal counsel. This Article is intended for educational and informational purposes only. The views and opinions expressed in this Article are solely those of the Author, and do not necessarily reflect the views, opinions, or policies of the Author’s employer, First American Title Insurance Company.