Distressed Real Estate During COVID-19: Deeds in Lieu of Foreclosure Involving Commercial Real Estate

Where the financing is “non-recourse,” that might seem like the end of it because, with one major caveat, the basic understanding between the parties to a non-recourse mortgage loan (indeed, the very premise of a non-recourse mortgage loan) is that the lender only has recourse to the mortgaged property if a default occurs. But the caveat is not small. The typical so-called “non-recourse” loan is backstopped by guarantees against certain bad acts. If those acts are triggered, the guarantor would be liable for damages incurred by the lender resulting from acts such as misappropriation of funds, failure to comply with special purpose entity covenants, waste or willful misconduct. More significantly, beyond liability for damages, the guaranty could also have a provision for “springing” full recourse to the guarantor if the borrower, for example, transfers the property in contravention of loan covenants, makes a voluntary bankruptcy filing, or short of that even admits its inability to pay liabilities as they come due. In some states, including New York, triggering one of these springing recourse guaranties without a negotiated work-out agreement can mean that the lender could seek a deficiency judgment (for the excess of the amount of the loan over the value of the property) even if the lender accepts a deed in lieu.

Note that our discussion regarding guaranties to this point assumes that there is a single guaranty in place—historically called a “bad boy” guaranty—and therefore that the loan is likely a permanent loan (without future funding for construction or renovations) as opposed to a construction loan, which would typically involve delivery of additional guaranties such as a completion guaranty and a carry guaranty. Considering a deed in lieu in the context of a construction loan with a completion guaranty and a carry guaranty presents distinctly different considerations (although a deed in lieu may certainly be an option in this context as well (with many more issues for the parties to address)). We also note that the carry guaranty might contemplate delivery of a deed in lieu—in fact, many carry guaranties are negotiated to address such a situation.

Reasons to Consider a Deed in lieu

• A deed in lieu avoids the expenses of a foreclosure proceeding—in a situation in which foreclosure is a very likely “other” outcome.
• Unlike a foreclosure proceeding, a deed in lieu provides certainty that the transfer will occur—thereby avoiding all manner of delay tactics - and, depending on the jurisdiction, it can also significantly “save” on time when compared to the time what would been expended conducting a foreclosure action. Note that in jurisdictions in which foreclosure actions can take many months or even years, the property may be deteriorating during that time. In this regard, a deed in lieu may be less disruptive to the property and the tenants as it allows the lender to quickly take control of (and stabilize or maximize operations at, or the resale value of) the property.
• A deed in lieu may allow a borrower to avoid the negative publicity associated with a foreclosure proceeding and maintain its reputation with its lender and within the “community”.
• The borrower and guarantor may obtain, in exchange for agreement to cooperate and transfer the property, a release of all surviving obligations and liabilities under the loan documents, including limiting liability under a non-recourse carveout guaranty.

Some Countervailing Considerations

• A deed in lieu is subject to certain liens and claims that would have been extinguished in a foreclosure, even though they arise after the mortgage. As noted, title insurance can provide protection but lenders in some circumstances may well choose—rather than accept a deed in lieu—to pursue foreclosure so as to obtain clean title and not take subject to such intervening liabilities. Foreclosure may be judicial or, in states where allowed, by nonjudicial power of sale.
• The U.S. Supreme Court has ruled that the prevailing bid at a properly advertised and otherwise legally compliant foreclosure sale presumptively constitutes reasonably equivalent value or fair consideration, and therefore is not presumptively avoidable as a fraudulent conveyance on this ground. 

Early Steps by Borrower and Lender

If a borrower is considering a deed in lieu transaction, the borrower should review the loan documents to determine the defaults that could be claimed and the scope of surviving liabilities that likewise could be claimed. The borrower and guarantor should also carefully review the “bad boy” carveouts—to ensure that borrower is strictly complying with the provisions of that document. Then the borrower should gather (and prepare to provide to the lender) all manner of diligence materials—expecting the lender to “re-diligence” every aspect of the property and its operations should the lender be willing to entertain a discussion regarding a deed in lieu. It is important for the borrower to be prepared to actively cooperate in terms of diligence and providing easy and open access to the property, third party reports, title, survey, management and other service agreements, tenants etc.—as the lender will be asked to step in and take over ownership.

Then, generally, the borrower will advise the lender that the property is not performing as expected - being careful not to trigger the “bad boy” guaranty by “admitting its inability to pay its debts as they come due” (if the guaranty includes such a liability prong).

If the lender is willing to consider accepting a deed in lieu, the lender is likely to require the borrower to enter into a pre-negotiation letter which will allow for free and open discussions and exchanges of information between the parties.

A lender considering accepting a deed in lieu will want to perform extensive diligence as it is about to step into ownership—and likely will want to assume an active role and/or market the property for sale as soon as possible. Also, as noted above, the lender who accepts a deed in lieu will take title subject to all liens and claims affecting the property—so each of these will need to be diligenced, evaluated, quantified and addressed (if possible).

Terms of a Deed in Lieu Agreement

A deed in lieu agreement will obligate the borrower to deliver a deed in lieu (along with an assignment of leases and contracts, rents and security deposits, a bill of sale, customary organizational documents and legal opinions)—most often in exchange for a release of liability (of borrower and any guarantor or indemnitor) unless the parties otherwise agree. Ideally, for the borrower, the lender will also agree to execute and deliver at closing a covenant not to sue (i.e., a covenant that it will not sue the borrower or any guarantors in connection with the loan, provided the borrower and any guarantors comply with the deed in lieu agreement).

The lender may also require borrowers and guarantors to execute a release of claims wherein borrower and guarantors agree to refrain from suing the lender and release the lender from any claims, causes of action, and damages under the loan.

The agreement should address conditions to closing (also known as the “tender conditions”) such as (i) the removal of mechanic’s or other liens or judgments, (ii) delivery of the deed, transfer tax (including recordation tax) forms (and possibly payment of the transfer tax), clean insurable title and title commitments, a bill of sale, an assignment of contracts, leases and rents, security deposits and rents, organizational documents etc., (iii) representations and warranties and (iv) covenants—indeed, it will resemble a purchase and sale agreement in many respects. Much of the discussion may entail whether borrower or guarantor is willing to pay outstanding bills and address liens, whether borrower is willing to pay transfer taxes in connection with the conveyance (in this regard, the borrower may point out that, in a foreclosure scenario, it might not be paying transfer tax), the scope of the borrower’s representations and whether the borrower remains liable for continuing obligations to pay bills and address liens or for breaches of representations (or for anything at all).

Lenders should be careful to make clear (both in the agreement and in the deed) that no merger has occurred by virtue of the lender taking title—i.e., that the deed in lieu does not “extinguish” the mortgage—so that the senior lender can foreclose junior liens as needed after the closing.

Often, the lender will retain the reserves and deposits maintained with lender—and the agreement should address this issue.

Questions, Issues and Considerations

1. Intercreditor Agreement and Mezzanine Financing. Is there a mezzanine loan in place? If so, the parties will need to carefully review the provisions of the intercreditor agreement and determine the rights of the mezzanine lender (which itself will often be given certain rights under the intercreditor agreement if the senior lender receives notice that the borrower intends to “hand back” the keys—such as the mezzanine lender purchasing the mortgage loan from the mortgage lender).
2. Transfer Taxes and Other Costs. In jurisdictions in which transfer tax is imposed (often on the transferor), transfer tax will be due in connection with the recordation of the deed in lieu. (Indeed, in NYC, the transfer tax burden may be rather significant, representing up to 3.275% of the total outstanding debt (in most cases) as (i) the New York State transfer tax rate is 0.65% (for commercial property valued at over $2mm) of the amount of the outstanding mortgage debt including accrued interest (unless the lender seeks a deficiency judgment in which case the transfer tax is determined based on the fair market value of the property) and (ii) the New York City transfer tax rate is 2.625% (for commercial properties valued over five hundred thousand dollars) of the amount of the outstanding mortgage debt.) If the borrower is unable to pay the transfer tax, will the lender pay the transfer tax? There will also be other costs to be incurred of course, such as legal fees to be paid.
3. Income Tax Considerations: Giving back property and debt forgiveness—if the borrower’s basis in the property is low—will trigger “gain” that is taxable. While structures can be put in place to address this particular issue, this concern needs to be addressed (and quantified) early on in the process. The deed in lieu agreement also needs to be clear on this point and should allocate responsibility for this tax obligation.
4. Bankruptcy Considerations. A deed in lieu may trigger bankruptcy concerns should the borrower file for bankruptcy protection after the property is conveyed. Risks include the bankruptcy court being asked to potentially set aside the deed in lieu on the grounds that the transfer constituted either a preferential transfer or a fraudulent conveyance.
   
   a. Generally, a preferential transfer is the transfer of property to a creditor on account of a prior debt made when the debtor is insolvent and further made within 90 days of the bankruptcy filings (or within one year of the filing if the transferee is an insider). To be a preferential transfer, the transfer must have resulted in the creditor receiving “more” than it would have, had a chapter 7 bankruptcy liquidation occurred instead of the deed in lieu transaction. However, assuming that (a) the lender has a properly perfected mortgage and (b) the property has no equity, giving the duly perfected lender a deed in lieu should not constitute an avoidable preference, because instead of receiving more, it will have received precisely that which it would have been entitled to in a hypothetical chapter 7 liquidation.
   
   b. Generally, a constructive fraudulent conveyance requires a showing that the borrower received less than reasonably equivalent value for the property If a bankruptcy court were to set aside a deed in lieu, the likely result would be litigation for the difference in value between what the debtor received and what the property was actually worth, but that litigation would probably not undo the transfer of the property. Regardless, the delay and costs associated with fraudulent transfer litigation could be significant. However, a deed in lieu should not constitute a fraudulent conveyance where, for example, the lender loaned $100 million and received property worth $90 million. This is because the borrower received reasonably equivalent value for the $90 million real estate project (i.e, the $100 million in cash loaned to the borrower).
   
   c. In short, if all that happens is that lender gets back its collateral in exchange for deeming the loan satisfied, the only real risk along these lines (absent intentional fraudulent conveyance such as a collusive transfer for the purpose of defeating other creditors) is that someone comes up with an after-the-fact argument that the property was really worth a lot more at the time of transfer.
5. Speed. We view it as advisable to have a short (perhaps even no) time between the date on which the deed in lieu agreement is signed and the closing occurs—so as to minimize the risk of additional liens being filed or payments being made prior to closing—and to avoid new “other” issues from arising.
6. Deal Specifics. Of course, the nature of each underlying property (Is the property a hotel? Is the loan a construction loan?) will bring its own particular set of challenges and issues—and preparation and diligence (including careful review of all loan documents and up-front tax planning) on the part of both parties is critical.

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