Deeds in Lieu

When a borrower is not  paying, but is willing to give the property back to its lender, sometimes it makes sense to settle the matter by giving the property back instead of having the lender foreclose on it.  But some lenders won’t agree to take a deed in lieu of foreclosure from the borrower.  

Taking a deed in lieu involves more risks than foreclosing on a property.  Some of these risks are: 

• the borrower could later sue to set aside the deed in lieu;
• a court might find that the deed in lieu was not a complete conveyance of all the borrower’s rights in the property, but was instead an “equitable mortgage”;
• a bankruptcy court could find the deed to be a fraudulent conveyance and/or a voidable preference; or
• encumbrances subordinate to the lender’s interest, such as junior liens or mechanics’ liens, may have or achieve priority over the deed given by the borrower, so the lender taking back the property would have to pay them off or risk being foreclosed on in turn.

While these risks cannot be completely eliminated, many of them can be minimized.  Sometimes the risks can be minimized enough so that the lender and borrower are willing to settle the matter, complete a deed in lieu, and thereby avoid the costs of a foreclosure. 

Usually even if the borrower gives a deed in lieu of foreclosure to the lender, the lender’s existing deed of trust remains in place and is not released for some time, in case other claimants come forward or the borrower files for bankruptcy protection.  For that reason, the rights and obligations of the lender and borrower need to be carefully set out in a written settlement agreement (as in any settlement of any dispute).

Here are some strategies we use to minimize the risks of deeds in lieu listed above:

First, to avoid the risk of a later lawsuit against the lender by a borrower who gives a deed in lieu, we usually require the borrower to execute and deliver a general release designed to provide the lender with defenses against any claims by the borrower.  To induce the borrower to sign such a release, we usually encourage the lender to sign a covenant not to sue the borrower, in which the lender agrees not to seek a deficiency judgment against the borrower after receiving the deed in lieu.  Both parties usually think this is fair.

We also always recommend encouraging any borrower to have its lawyers review any deeds in lieu and any related documents that we prepare, and include representations that the borrower has done so in the settlement documents.  Such a review helps ensure that the borrower is entering into the deed in lieu transaction with full knowledge of its rights and makes it harder for a borrower to challenge the transaction later.

The second risk is that a court might find that the deed in lieu was not a complete conveyance, but was instead an “equitable mortgage”.  This means that the deed in lieu was not actually intended as a valid conveyance of all of the borrower’s interests in the property, but instead was intended as a security device (like a mortgage or deed of trust) pursuant to which the borrower was forced to waive its “equity of redemption”— its right to receive any surplus from a foreclosure sale.  That’s not allowed in California and certain other states. 

To minimize this risk, we recommend obtaining an appraisal of the property to determine whether the value of the property, less the value of the existing encumbrances on the property, is less than the amount owed by the borrower.  If the borrower would not receive any surplus from a foreclosure sale, a court is less likely to find that a deed in lieu was actually an equitable mortgage. 

Just as important, a lender taking a deed in lieu must insist that the borrower vacate the property immediately upon delivery and recording of the deed in lieu.  The borrower leaving the property is good evidence that the borrower really did intend to give the property back to the lender in exchange for elimination or reduction of the borrower’s (and/or guarantor’s) debt.

The third major risk is that a bankruptcy court could find the deed to be a fraudulent conveyance and or a voidable preference if the borrower were to file bankruptcy.  Because borrowers seeking to settle their debts by giving back their properties are almost never in great shape financially, not much can be done to avoid this risk except to have the borrower make written covenants and representations (usually in the settlement documents) that it is not insolvent and that it does not plan to file for bankruptcy protection.  Just in case the borrower seeks bankruptcy protection, however, it is advisable for the lender to obtain an appraisal showing that the value of the property is below the amount owed, and therefore the borrower has no equity in the property.    

Finally, when we are settling a debt for a lender client, we always specify that we must review and approve the condition of title as a condition to settlement.  We do diligence  to confirm that if one of our lender clients takes the title to a property through a deed in lieu, the title it will receive as a result of accepting and recording the deed in lieu will have priority over any junior liens.  We also counsel our lender clients to obtain title insurance to insure their title.  If clean title cannot be provided, it usually makes sense to foreclose instead.

In addition, we usually state in the deed in lieu that it is subordinate to the lender’s existing deed of trust (which, as noted above, is typically not released for some time).  This preserves the lender’s ability to argue that any junior liens recorded before the deed in lieu and missed by the title insurance company’s search were subordinate in priority to the lender’s existing deed of trust, and that the lender’s interest as beneficiary under its deed of trust was not merged into its interest as grantee under the deed in lieu.  (Without such a statement, lienors junior to the lender’s deed of trust would probably obtain priority over the lender’s deed in lieu.)

Are you seeing many deeds in lieu in the current downturn?  We've seen some, but not a lot.  Please let me know what you're seeing.