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 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 - Deeds In Lieu Of Foreclosure 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.