A challenging financial climate calls for creative solutions for borrowers and lenders when a loan appears to be headed to a monetary default or even after a monetary default has occurred.  A solution to this situation that is becoming more common is a deed in lieu of foreclosure transaction.  Re-financing debt is difficult right now for a variety of reasons:  many lenders are not in a position to make loans or re-finance troubled properties; and many borrowers are in poor financial condition and their principals are in no position to guaranty the debt.  As a result, borrowers and lenders are looking to the underlying collateral to satisfy all or part of the debt.

Here is how a "deed in lieu" transaction works:

1. Lender and borrower enter into a written agreement memorializing the terms and conditions of the deed in lieu transaction.
2. Borrower executes a deed transferring the real estate to lender. 
3. Lender returns borrower's promissory note and borrower's obligation to make mortgage loan payments terminates, but borrower may still be liable for any deficiencies.
4. Lender records the deed.

Benefits of a deed in lieu transaction for a lender and a borrower:  

• avoiding foreclosure and the resulting time, court costs and attorneys' fees
• few details of the transaction become public
• the rights/obligations of lender and borrower are established by settling claims regarding the default, the debt, guaranties and any deficiencies

While there are benefits to borrower and lender with a deed in lieu, they have competing interests that must be considered as part of any deed in lieu transaction.

Under what circumstances should a lender accept or offer a deed in lieu transaction?    If the loan is non-recourse, a deed in lieu may be a lender's best alternative in the event of a monetary default because there is no one else who is obligated to cure the default.  The lender should also be comfortable with the quality of the real estate that is being acquired.  The lender should also insist on a non-merger clause in the deed so that it will not be liable for junior liens, mechanics liens and judgments on the real estate.  If the Borrower will not agree to a non-merger clause, a foreclosure action may be a better course of action because lender will receive title free of junior liens, mechanics liens and judgments.  

Special concerns for lenders regarding deed in lieu transactions:

• As noted above, the deed for the real estate should not merge with or extinguish the mortgage.  As a result, the mortgage will still be in place, giving the lender the ability to foreclose and wipe out junior liens.
• The same due diligence must be conducted as if lender were purchasing the property, e.g. update title and survey, do a lien and judgment search, order a new Phase I, etc. to make sure that lender knows the quality of the title lender is receiving.
• If it is recourse debt, try to keep guaranties in place.  Theoretically, this will give lender more resources to satisfy any deficiencies if the property ultimately sells for less than the outstanding loan amount.
• Review the borrower’s and the guarantors' financial statements/tax returns.  If there is a deficiency after the property is ultimately sold, lender needs to know if there is a chance of recovering it.
• Have the property appraised.  The lender should know going in whether the property will likely sell for more or less than the loan amount.  If the property is worth less than the loan amount, the lender will have to pursue the borrower and/or guarantors for any deficiency.  If the property sells for more than the loan amount, the lender might have to write a check to borrower for the surplus.  This concern about whether the lender will face a deficiency or a surplus assumes that the loan has recourse and that the lender has preserved the right to a deficiency and the borrower has preserved its right to be paid the surplus.

Under what circumstances should a borrower accept or offer a deed in lieu transaction?    If the loan is non-recourse, a deed in lieu may be a borrower's best alternative in the event of a monetary default because there is no one else who is obligated to cure the default and the borrower saves the time and expense of fighting a foreclosure.

Special concerns for borrowers regarding deed in lieu transactions:

• Ideally, a borrower would like to have title to the real estate merge with the deed in lieu and have the lender step into its shoes; however, it is unlikely that a lender will agree to those terms.  As a result, the borrower will remain liable for junior liens, mechanics liens and judgments on the real estate.
• Terminating personal and corporate guaranties to avoid liability for deficiencies and obtaining a covenant "not to sue" in the foreclosure agreement should be explored by borrowers.
• A borrower should consider the impact the deed in lieu may have on its  other properties (but a deed in lieu usually is still  better than a foreclosure).
• Borrowers should consult with their tax advisors concerning the ramifications of any debt that is forgiven by a lender.
• If the property value exceeds the loan proceeds and the lenders costs related to the default and foreclosure, the borrower should require a lender to pay borrower the difference.

Taft attorneys have a great deal of experience advising lenders and borrowers about the alternatives available in a monetary default situation.  Please contact us for further details.