Deeds in lieu
In the context of personal property security, the secured party may propose after default that it retain collateral in satisfaction, or partial satisfaction, of the obligation (except in some cases where the collateral is consumer goods). See U.C.C. 9-620. We have referred to this as strict foreclosure. See Commentary.Personal property foreclosure.
Deeds in lieu of foreclosure are the modern form of strict foreclosure in the context of real property secured debt. Upon default, the holder of a mortgage or deed of trust may propose that in lieu of foreclosure it take a deed to the real property in satisfaction of the secured obligation. An agreement between the parties to this end will typically be consummated through an escrow to which the secured creditor delivers the debtor's note, marked "paid", and a deed of reconveyance (of the deed of trust) in favor of the debtor, and the debtor delivers a grant deed (the deed in lieu of foreclosure) in favor of the secured creditor. The escrow will be instructed to record the deed of reconveyance and then the grant deed and to deliver the note to the debtor. This procedure is more elaborate than strict foreclosure in the personal property context because the transfer of title to real property, unlike the transfer of title to most personal property, must be reflected in a formal instrument and perfected through recording.
Debtors in default on debt secured by real property may be interested in giving a deed in lieu of foreclosure to avoid the embarassment of foreclosure and eviction, especially if persuaded that the value of the real property does not exceed the amount of the secured debt. But even if the defaulting debtor retains some equity in the property, she may be interested in giving a deed in lieu if the debtor believes the likelihood of realizing equity through a foreclosure sale to be slim and believes that the amount of equity to be realized through a voluntary sale of the property prior to foreclosure will be significantly reduced or eliminated by real estate commissions and closing costs. This will be especially true where the secured creditor is prepared to offer some consideration to compensate the debtor for some of its equity. Secured creditors will often be interested in receiving a deed in lieu if they believe the real property to be worth close to the amount of the secured debt, because the procedure is quicker and considerably less expensive than foreclosure. Or there may be other reasons for the secured creditor to prefer taking a deed in lieu. Tom Wolf suggests in his novel A Man in Full that a bank would prefer a private, quiet transfer of title to the bank in order to save itself the embarassment of a public foreclosure that would reveal its earlier, now obviously overoptimistic, decision to loan $175 million dollars to finance construction of an office tower in the outskirts of Atlanta.
Secured creditors who take a deed in lieu will, of course, take subject to any superior liens on the property. In addition, unlike the creditor who forecloses, the creditor who takes a deed in lieu will take subject to subordinate liens on the property, which, after extinction of the lien previously held by the creditor taking the deed in lieu of foreclosure, will step up one in priority. Only foreclosure extinguishes subordinate liens. Under circumstances where the property is encumbered by other liens, taking a deed in lieu will only make sense if the creditor taking such a deed is willing to service the debt or debts secured by other liens, and servicing such debt will only make sense if the property is worth more than the total of all debts secured by the property, including the debt being extinguished by the creditor who is taking the deed in lieu. Moreover, the default for which the secured creditor takes a deed in lieu will, in most cases, also constitute a default under the terms of the security instruments held by other consensual lienholders, thus possibly triggering foreclosure by other such lienholders. Accordingly, to avoid such foreclosure, a secured creditor considering the deed in lieu should consider seeking agreements from other lienholders that they will refrain from foreclosure upon an assumption of debt repayment obligations by the creditor seeking the deed in lieu. Of course these issues will not arise if there are no liens on the property other than the lien held by the creditor seeking the deed in lieu.
There are other important issues which must be considered by the secured creditor who is considering taking a deed in lieu. Among them is the possibility that the giving of a deed in lieu may constitute a fraudulent conveyance which can be undone by an unsecured creditor of the debtor or, in bankruptcy, either by the bankruptcy trustee or by the debtor-in-possession. If a debtor conveys its property to a third party with an intention to place the property beyond the reach of unsecured creditors who might have a future right to attach or execute against such property in a lawsuit to collect the debt, any unsecured creditor has a right under state law (and a bankruptcy trustee or debtor-in-possession has a right under bankruptcy law) to set aside the conveyance, thus making the property available to the party asserting the fraudulent conveyance. But a conveyance of property by a debtor may be fraudulent as to its unsecured creditors even if made without an intent to place assets beyond the reach of creditors. Even a gift, such as a father's gift of stock to his daughter and son-in-law to help them get started in life following the wedding, will be fraudulent if, at the time of the gift, or as a result of the gift, the father is insolvent. Such transfers, or any other transfers given for less than reasonably equivalent value, made under such circumstances deprive unsecured creditors of assets to which they could otherwise look for satisfaction of a judgment. While not intentionally fraudulent, such transfers are, by statute, constructively fraudulent. The fraudulent conveyance law makes the insolvent debtor's charity start with unsecured creditors.
In BFP v. Resolution Trust Corporation, the United States Supreme Court held that a regularly conducted, non-collusive foreclosure under a power of sale (a non-judicial foreclosure) cannot be attacked in bankruptcy as a fraudulent conveyance. The court there concluded that such a sale, with its attendant protection of public bidding, should be deemed "for reasonably equivalent value." But the grant of a deed in lieu is an animal of different stripe: privately negotiated, absent the protections of public bidding. Thus, a grant of a deed in lieu may be constructive fraud if the debtor, insolvent at the time or as a result of the transfer, gives the deed for less than reasonably equivalent value. This will not be the case if the property is worth no more than the debt being extinguished. But if creditor receives a deed in lieu to a piece of property worth substantially more than the debt being extinguished, the debtor is receiving less than reasonably equivalent value.
The creditor taking the deed in lieu may also find it more difficult or expensive to obtain title insurance. Absent title insurance, the creditor taking the deed in lieu may subsequently find the property to be unmarketable. To insure the grantee's title, the title company will wish assurance that the deed cannot later be construed as an equitable mortgage (a deed absolute in form later construed to be a transfer only for the purpose of security). The title company may therefore require that all appearances of a continuing secured transaction are eliminated: that the deed be free of any conditions such as an option to repurchase; that the grantor give up possession of the property (unless there is a bona fide and perhaps recorded lease); that the note be marked paid and returned to the debtor; that the deed of trust be reconveyed; that the grantor give an estoppel certificate stating that the grantor will not thereafter claim a continuing secured transaction. And, unless it wishes to investigate the solvency of the debtor and the value of the property being conveyed, the title company ought to exclude from coverage protection against a subsequent action to avoid the transfer as a fraudulent conveyance.
The creditor considering taking the deed in lieu should also consult its tax advisor because of potential tax consequences which we do not explore here.
A debtor's agreement in a deed of trust or mortgage to give a deed in lieu in the event of default will be unenforceable (see Cal. Civ. Code 2889). There is simply too much danger that a debtor, flush with optimism at the time of a secured loan or secured credit purchase, will unwittingly or unwisely sacrifice future equity. For the same reason, a deed absolute on its face given by the debtor to the lender at the time of a loan but which is intended only as security for an obligation will be construed as an equitable mortgage requiring foreclosure by sale in the absence of a deed in lieu negotiated after default (see Commentary. Equitable liens). There are, however, at least some circumstances where a court may enforce an agreement made prior to default in which the debtor alienates its right of redemption. See Guam Hakubotan, Inc. v. Furusawa Investment Corp.
In the context of personal property security, we see the same debtor protection: the debtor may not consent to strict foreclosure prior to default. U.C.C. 9620(c) and U.C.C. 9-602(10).