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Proceed with caution.

In the current real estate and financing cycle, lenders across the country often issue notices of non-acceptance when faced with borrowers' attempts to hand over title to property in deeds in lieu of foreclosure. [paragraph] A deed in lieu has historically been thought by lenders to increase the risk of affecting their ability to "wipe out" junior lien holders through the normal process of foreclosure.

This remains true for most states where, whether known or unknown, the general rule is that a deed in lieu does not always wipe out any subordinate liens. [paragraph] However, the June 30,2014, California appellate court decision of Decon Group Inc. u. Prudential Mortgage Capital Co. LLC (California 4th District Court of Appeals, 2014) provides lenders with a strong legal basis for accepting such deeds in lieu of foreclosure in California--even when junior liens are attached to the property in question. [paragraph] As a result of this ruling, well-drafted agreements for deeds in lieu of foreclosure may substantially benefit lenders and senior lienholders in California. However, lenders in other states should remain cautious and approach a deed-in-lieu transaction in the same manner as if it were a real estate purchase outside of a loan context.

Deeds in lieu of foreclosure: A short overview

A deed in lieu of foreclosure is a transfer of title in real property from the property owner to the lender, in order to avoid foreclosure or to cease the process. A deed in lieu of foreclosure is consensual between the borrower and lender, negotiated after the potential for a foreclosure arises.

The principal advantage to borrowers is that they are immediately released from any personal indebtedness associated with the defaulted loan (in the amount of the value of the deeded property). Additionally, borrowers avoid any public fallout of a foreclosure and may receive more generous terms than they would through formal foreclosure proceedings.

Generally, lenders across the country have been wary to accept deeds in lieu where junior liens existed on the title, such as a mechanic's lien or a second mortgage. Lenders typically prefer instead to foreclose in order to ensure the extinguishment all junior liens, removing the title of all debt.

Case law supports the ability of a lender to foreclose its mortgage after acceptance of a deed in lieu of foreclosure, so long as the deed contains an anti-merger provision. Without such an explicit provision, the doctrine of merger may prevent the senior lienholder from exercising his or her lien. In some cases, even where a deed in lieu contains an anti-merger provision, courts have held that a lender will take the property subject to subordinate debt.

Uncertainty for lenders in states other than California

In the vast majority of states, deeds in lieu of foreclosure containing sufficient anti-merger provisions will allow senior lenders to foreclose their mortgage without being subject to any form of junior lien--see, for example, Olney Trust Bank v. Pitts (Third Appellate Court of Illinois, 1990) and Union Bank & Trust Co. u. Farmwald Development Corporation (Michigan Court of Appeals, 1989).

In contrast to this general rule, however, a section of the American Law Institute's Restatement of the Law Third, Property (Mortgage) reads that "the mortgagee [lender] who takes a deed in lieu with actual knowledge of a junior lien will lose the right to foreclose irrespective of whether there is merger intent.

Further, while courts have held that the doctrine of merger is in fact disfavored, lenders remain wary to accept deeds in lieu with any form of junior lien. This is not without good reason; the consequences of a finding of merger by a court can be quite severe for lenders.

The "merger doctrine" holds that a contract for the conveyance of property merges into the deed of conveyance; therefore, any guarantees made in the contract that are not reflected in the deed are extinguished when the deed is conveyed to the buyer of the property. However, lenders often wish to keep a mortgage lien alive, in the event that a deed is later set aside for legal or equitable reasons, and to avoid an argument that the mortgage was discharged when the underlying debt was canceled.

Because a deed in lieu of foreclosure does not extinguish subordinate liens, and a grantee takes the deed subject to existing liens, a lender accepting a deed in lieu wants to be in a position where it can still foreclose its mortgage to eliminate existing encumbrances.

Anti-merger provisions are generally a good way of protecting the lender's interests, but are not always silver bullets in eliminating junior liens.

One reason that deeds in lieu can be dangerous for lenders is that courts generally will not enforce an anti-merger provision in a deed in lieu of foreclosure where the rights of innocent third parties may be affected because of fraud or inequitable conduct by the parties to the transaction--see United States Leather Inc. u. Mitchell Manufacturing Group Inc. (U.S. Court of Appeals for the 6th Circuit, 2002). The U.S. Court of Appeals for the Sixth Circuit has employed the "balancing of the equities" doctrine to thwart what appeared to be an attempted preferential transfer or fraudulent conveyance of mortgaged property by a deed in lieu of foreclosure.

Barring these complicated factual scenarios, other dangers lurk regarding the question of the intent of the parties to the transaction.

Many states rely (at least in part) on the intention of the parties; either express or implied, to determine whether a merger occurred as the result of a deed-in-lieu transaction. Frequently, implied intent not to merge is presumed.

In Tidwell u. Dasher (Michigan Court of Appeals, 1986), the court dealt with the issue of whether a deed in lieu of foreclosure created a merger that would impact the priority of an intervening lien. The court stated that "[t]he question of intention of a mortgagee [lender] or vendor is a question of fact which must be developed from evidence produced to show what the intention was at the time the acts were done."

In Weitzki u. Weitzki (Nebraska Supreme Court, 1989), the Supreme Court of Nebraska noted that the intention of the lender is controlling as to whether the mortgage is kept alive. The Weitzki court held that when the lender becomes the owner of the property and there is no expression of intention as to whether the lender wished to keep the mortgage alive, it will be presumed that the lender intended to do what would prove most advantageous to him or her in the absence of circumstances indicating a contrary purpose.

Yet, still other states have enacted laws that presume the intention of the lender not to allow a merger to occur, allowing lenders to void a deed in lieu of foreclosure in certain circumstances and foreclose the deed of trust.

Thus, while most courts favor the intent of the borrower not to merge (and thus destroy its own interest in the property), many of these courts find that intent "must be discerned from all the circumstances," according to Long Island Lighting Co. u. Commissioner 0/Taxation and Finance (New York Appellate Division, 1997).

A deed in lieu drafted without sufficient evidence of the lender's intent not to merge could be a costly mistake.

Contrary to the current case law in other states, senior lienholders in California should consider the many advantages to deeds in lieu of foreclosure as a result of the appellate court decision in Decon.

Decon and its impact in California

In Decon, a property owned by a borrower (a limited liability company) had a first deed of trust held by the lender, and a junior mechanic's lien held by a third party. The lender on the first deed of trust accepted a deed in lieu from the borrower.

Of significance, the deed in lieu of foreclosure did not extinguish, or eliminate, the mechanic's lien. After the lender became the vested owner under the deed in lieu of foreclosure, it proceeded to file a non-judicial foreclosure to eliminate the mechanic's lien.

The mechanic's lien holder disputed the foreclosure, arguing that the property could not be foreclosed upon after the original borrower met its debt obligations by giving the lender the deed in lieu. Specifically, the mechanic's lien holder argued that a doctrine of "merger" dictated that the deed in lieu "eliminated" the senior loan and deed of trust, precluding the ability for the senior lender to foreclose.

The lender disagreed, and filed a lawsuit to foreclose. The court granted judgment in favor of the mechanic's lien holder, and the lender appealed. The court of appeal reversed, determining that the deed in lieu did not eliminate the senior deed of trust, as its survival was the specific intent of the parties. The court held that the foreclosure was valid, effectively wiping out the mechanic's lien, and the lender owned the property "free" of any encumbrances.

The ruling in Decon is in keeping with a very long line of California cases regarding the issue of merger and intent--see also Sheldon u. La Brea Materials Co. (California Court of Appeals, 1932), holding that no merger had taken place as a matter of equity once a senior lienholder accepted title; and Hines u. Ward (Superior Court of Appeals of California, 1946), holding that presumptively no merger would take place if grantee of property is also the senior lienholder.

The Decon decision continues to carve out a substantial exception to the doctrine of merger. The exception is very clearly based on intent; where the senior lien holder does not intend to merge the lien into the fee, merger does not occur. With the assistance of competent counsel, Decon should motivate California lenders that normally reject deeds in lieu to consider the number of potential benefits they may provide.

Benefits of deeds in lieu

There are substantial advantages for lenders nationwide in accepting deeds in lieu of foreclosure. First, it circumvents or reduces the delay, expense and uncertainty of going through the foreclosure process. In the first quarter of 2014, the national average time to foreclose on a property was 572 days. A carefully drafted and negotiated deed-in-lieu contract where a borrower willingly turns over the keys to a property within 30 to 60 days can save a great amount of time, money and distress for lenders.

Next, taking immediate ownership allows lenders to control the operation of the property in question, maximizing the economic value and more swiftly obtaining rents and additional income available to an owner. Immediate ownership also allows for lenders to directly market title to the property and proceed with sale.

Another benefit is that the bankruptcy process is effectively avoided for lenders through deeds in lieu of foreclosure; deeds in lieu will not be set aside by a bankruptcy court if the borrower later files for bankruptcy or attempts to rescind the transaction based on fraud or coercion.

Lastly, if the lender chooses, a deficiency judgment against a borrower for any remaining balance would still be available. If the balance of the property does not satisfy the amount of the loan, a lender is still able to sue for a deficiency judgment after accepting a deed in lieu of foreclosure.

A deed-in-lieu transaction can be particularly helpful to a lender in a jurisdiction that allows only judicial foreclosure, where foreclosure can take up to two years in states like Delaware. Attorneys' fees and enforcement costs can also be avoided by a deed in lieu.

Dangers for lenders

While there are numerous advantages for lenders in accepting deeds in lieu of foreclosure, there are still very real dangers that must also be taken into consideration. Deeds in lieu can be subject to challenge if the borrower files for bankruptcy following transfer of title to the lender.

The deed in lieu can also be attacked as a fraudulent transfer under state or federal bankruptcy law or as a preferential transfer under the Bankruptcy Code. Should such an attack be successful, the transfer will be unwound. The negotiation process for a deed in lieu may also amount to a stall tactic by the borrower rather than a genuine negotiation.

As a result of these complications, lenders will frequently ask borrowers to attempt to sell their property before the transaction. Sometimes even a short-sale loss on the full value of the property is advantageous to requiring the bank to sell the property itself, and retaining the bank's many risks in owning the property prior to sale. For that reason, it may be preferable for lenders to simply negotiate for the short sale with the borrower before a deed in lieu of foreclosure is drafted.

Lenders often face additional issues concerning their ownership of property. Potentially unknown environmental liabilities or property cleanup requirements can be a costly, unforeseen burden. Also, leases with existing tenants, especially those for whom there is no subordination agreement in place, may be problematic for lenders that do not wish to operate as landlords (even for the period of time between accepting title and putting the property up for sale).

Further, there is danger for lenders that accept a partial conveyance of property, unless the entire mortgage debt is released as a result of the partial conveyance. Otherwise, the lender may face valuation, allocation and title problems, and/or issues in connection with subsequent foreclosure of the remainder of the property still subject to the mortgage (with all the additional cost and time involved).

Deeds in lieu are on the rise

With California leading the pack, the number of deeds in lieu of foreclosure has significantly increased nationally in recent years. Most sophisticated lenders have a specific procedure for deeds in lieu, including a settlement agreement, deed with non-merger language, assignments and/or estoppels.

As described earlier, many lenders will not cancel the underlying note, and will instead give the borrower a covenant not to sue. This consensual transfer process is often more successful in resolving a borrower's default than a scorched-earth method of collection. Enforcement expenses are frequently not reimbursed following foreclosure, meaning that attorneys' fees are simply another cost to lenders without a deed in lieu.

As addressed in Decon, the lender must always be cautious and hire experienced legal counsel to ensure that the deed in lieu is structured in a manner that will not result in merging the mortgage lien with title to the property upon consummation of the transaction. Taking this step is crucial to the process and will prevent the lender from foreclosing subordinate liens.

Any mistakes in the drafting and negotiation of deeds in lieu of foreclosure can mean the difference between the quick resolution of an outstanding debt and dragging a lender into a foreclosure or bankruptcy proceeding, with a result of potentially complicating the title with junior lienholders. Outside of California, senior lienholders must be wary of accepting deeds in lieu of foreclosure, in light of recent court decisions allowing for the equitable subordination of senior debts in some instances.

Steven Casselberry is a partner and chair of the Banking and Financial Services Department for Michelman & Robinson LLP in Orange County, California. David J. Williams is an Orange County, California-based attorney specializing in banking, financial services, real estate and business litigation and transactions. They can be reached at and
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Title Annotation:LEGAL
Author:Casselberry, Steven; Williams, David J.
Publication:Mortgage Banking
Geographic Code:1U9CA
Date:Apr 1, 2015
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