Workout professionals often ask us whether they should accept a deed in lieu of foreclosure offered by a borrower whose property is now worth less than the debt. What is a deed in lieu of foreclosure? A deed in lieu of foreclosure is where a borrower deeds the real property that is collateral for the loan to the secured creditor instead of going through the foreclosure process. When it works, a deed in lieu of foreclosure has advantages for both the secured creditor and the borrower. The borrower avoids a foreclosure on its record, and gives up responsibility for maintaining the property, paying property taxes and insurance, and providing security. Where there are tenants, the borrower no longer has to assume the responsibilities of being a landlord.
For the secured lender, a deed in lieu of foreclosure terminates a troubled debt more quickly than traditional judicial or non-judicial foreclosure. Instead of waiting at least four months for a traditional non-judicial foreclosure sale to take place, during which time the property can deteriorate, the lender takes title to the property immediately. The secured lender also avoids the cost of foreclosure, the potential cost of a receivership, and the possibility that the borrower will get cold feet at the last minute and file bankruptcy.
So why wouldn’t a secured lender take a deed in lieu of foreclosure anytime a borrower offers one up?
The answer often depends upon whether a deed in lieu of foreclosure will give the lender title free and clear of all other deeds of trust, liens and encumbrances.
For instance, let’s assume that the borrower owns a commercial office building with 50% occupancy. There are first and second deeds of trust against the office building. The senior priority deed of trust (often called the “first deed of trust”) cannot accept a deed in lieu of foreclosure from the borrower without also obtaining subordination agreements from the lender who holds the junior deed of trust (in this case, a “second deed of trust”) and all of the tenants. This is because a deed in lieu of foreclosure does not relate back in time to the date on which the lender’s first deed of trust was recorded. Instead, the deed in lieu of foreclosure will be junior to all other deeds of trust, liens and encumbrances then pending against the property. Depending upon the willingness of the holder of the second deed of trust to subordinate its lien to the deed in lieu of foreclosure, and the desirability of the existing leases and the willingness of the tenants to subordinate and attorn to the lender once it becomes the owner of the property, it may be a challenge to complete the deed in lieu of foreclosure.
Frequently, the process of obtaining subordination agreements from junior secured lenders is difficult because rarely does a borrower in trouble continue debt service payments to a junior loan while defaulting on the senior loan. Similarly, it may be difficult for the lender who becomes the new owner to reach agreement with the tenants, who are often disgruntled at the poor service that their landlord had given them as the building, largely empty, slowly falls into disrepair. Finally, the guarantors of the senior loan will want to be released from their guaranty in exchange for turning over the property by way of a deed in lieu of foreclosure. This is a credit decision that the senior lender must make. If the guarantors have other assets, the secured creditor may wish to bargain with the guarantors to reach an agreement to collateralize the deficiency. The secured creditor may even decide to sue the guarantors to collect the deficiency.
In those cases where a deed in lieu can be obtained, either because title is clear and there are no junior encumbrances or troublesome tenants, it is critical for the lender to know it will have marketable title. Where a deed in lieu of foreclosure is offered and there are no known junior deeds of trust, liens or other encumbrances, the lender must obtain a preliminary title report to be certain that, upon closing, the lender will have clear title to the property. As with any other acquisition of real property, the lender must carefully examine all exceptions shown on the preliminary title report to be certain that, after closing, the lender has clear title. Working with a first-rate title insurer is a must.
In a typical deed in lieu of foreclosure transaction, the lender, the borrower and the guarantors, and perhaps other parties with an interest in the property, enter into an agreement to clearly define the rights and duties of each party. The lender should ask for a general release of claims from the borrower and the guarantors to be certain that all claims against the lender have been extinguished. Nothing could be worse than to take back a property that the lender did not want to own in the first place, only to be faced with defending a lender liability lawsuit.
This article does not cover environmental hazards, another important concern that a lender must carefully consider before accepting a deed in lieu of foreclosure. We’ll address environmental issues in workouts in later posts.
The JMBM Special Assets Team™ has negotiated, documented and closed numerous deed in lieu of foreclosure transactions. When a borrower asks you to accept a deed in lieu of foreclosure on a troubled problem loan, carefully consider the circumstances before moving ahead. We urge you to call the JMBM’s Special Assets Team™ for guidance and, in particular, to you help you properly document the transaction and protect the lender.
This is Dick Rogan, bank lawyer and author of www.SpecialAssetsLawyer.com, signing off for now. Join us again soon to check out what’s new in the World of Workouts.
Year after year, day after day, workout professionals in the know rely on JMBM’s Special Assets Team™ to handle problem commercial and real estate loans. Whatever problem loans you have, chances are, we’ve seen it. Give us a call.
Our Perspective. JMBM represents commercial banks, special servicers, private lenders, asset-based lenders, hard money lenders and factors. We help lender clients throughout the United States craft business and legal solutions to their commercial and real estate troubled loans. For more information, please contact Dick Rogan at RRogan@JMBM.com, or (415) 398-8080.
Richard A. Rogan is Chair of the JMBM Special Assets Team™. He also serves as the co-managing partner of JMBM’s San Francisco office and co-chair of its Bankruptcy Practice Group.
JMBM’s Special Assets Team™ has represented hundreds of lenders in California and throughout the United States. We regularly appear in bankruptcy courts, district courts and superior courts. We are proud to serve as trusted counsel and advisors who look for a business solution and try to help lenders find the best possible resolution for each troubled loan. Whether a loan is being newly documented, restructured or litigated, JMBM’s Special Assets Team™ has the skill, know-how and experience to solve your problem in a practical no-nonsense way.
NOTE TO CONSUMERS: As a matter of Firm policy, JMBM does not represent individual consumers who have disputes with their lenders. Many lenders have specialized consumer workout professionals who have the time to help consumer borrowers. There are many fine attorneys who specialize in representing consumers. Individuals with consumer lending problems should contact a lawyer or law firm who specializes in consumer insolvency and bankruptcy in their local area. When in doubt, we suggest you contact your local bar association’s Lawyer Referral Service. [For example, see Bar Association of SF or LA County Bar Association Lawyer Referral Services]
JMBM does not provide legal advice to consumers, and cannot respond to consumer inquiries.