When a borrower defaults on its mortgage, a lender has a number of remedies available to it. In recent years, lenders as well as borrowers have increasingly chosen to pursue alternatives to the adversarial foreclosure process. Chief among these is the deed in lieu of foreclosure (referred to as a "deed in lieu" for short) in which the lender forgives all or most of the borrower's obligations in return for the borrower voluntarily handing over the deed to the property.

During these difficult economic times, deeds in lieu offer lenders and borrowers numerous advantages over a traditional foreclosure. Lenders can diminish the uncertainties inherent in the foreclosure process, reduce the time and expense it takes to recover possession, and increase the likelihood of receiving the property in better condition and in a more seamless manner together with a proper accounting. Borrowers can avoid expensive and protracted foreclosure fights (which are usually unsuccessful in the long run), manage continuing liabilities and tax implications, and put a more positive spin on their credit and reputation. Even so, deeds in lieu can also pose substantial risks to the parties if the issues attendant to the process are not thoroughly considered and the documents are not properly drafted.

A deed in lieu should not be considered unless a professional appraisal values the property at less than the remaining mortgage obligation. Otherwise, there is the threat of another creditor (or trustee in bankruptcy) claiming that the transfer is a fraudulent conveyance and, in any case, the borrower would obviously be reluctant to relinquish a property in which it might stand to recover some value following a foreclosure sale. Also, a deed in lieu transaction should not be forced upon a borrower; rather, it must be a free and voluntary act, and a representation and warranty reflecting this should be memorialized in the agreement. Otherwise, there is a risk that the transaction could be vitiated by a court in a subsequent proceeding on the basis of undue influence or similar theories. If a borrower is resistant to completing a deed in lieu transfer, then a lender intent on recovering the property should instead commence a traditional foreclosure.

Ensuring that there are no other adverse liens on the property, and that there will be no such liens pending the delivery and recordation of the deed in lieu of foreclosure, is perhaps the biggest pitfall a lender must avoid in structuring the transaction. Subordinate liens on the property can only be discharged through a foreclosure process or by agreement of the adverse creditor. Therefore, before initiating, and again before consummating, the deed in lieu transaction, the lender must do a sufficient title check; after receiving the report, whether a lender will move forward will usually be a case-by-case decision based on the existence and amount of any discovered liens. Often it will be prudent to attempt to negotiate for the purchase or satisfaction of relatively minor third party liens. If the lender does decide to proceed with the transaction, it should evaluate the benefits of obtaining a new title insurance policy for the property and to have a non-merger endorsement included in it.1

For protection against known or unknown subordinate liens, the lender will also want to include anti-merger language in the agreement with the borrower, or structure the transaction so that the deed is given to a lender affiliate, to enable the lender to foreclose (or use leverage by reason of the ability to foreclose) such other liens after the delivery of the deed in lieu. Reliance on anti-merger provisions, however, can be risky. Cancelling the original note can endanger the lender's security interest, so the lender should instead provide the borrower with a covenant not to sue. This also affords the lender flexibility to retain any "bad boy" carve-outs or any other continuing liabilities that are agreed to by the parties, including environmental matters. Depending on the jurisdiction or particular factual circumstances, however, another creditor might successfully attack the validity of the attempt to preclude merger. Moreover, a non-merger structure may, in some jurisdictions, have a transfer tax consequence. The bottom line is that if there is not a high degree of confidence in the property and the borrower, the lender needs to be especially vigilant in structuring the transaction and setting up the appropriate contingencies.

One significant benefit of a carefully structured deed-in-lieu process is that there will be a detailed agreement setting forth the conditions, representations and provisions that are contractually binding and which can survive the delivery of the deed and related releases. Thus, in addition to the normal pre-foreclosure due diligence that would be conducted by a lender, the agreement will provide a roadmap to the transition process as well as critical information and representations regarding operating accounts, accounting, turnover of leasing and contract documents, liability and casualty insurance, and the like. Indeed, once the lender takes possession of the property through a voluntary deed process as opposed to foreclosure, it will likely (both as a legal and practical matter) have greater exposure to claims of tenants, contractors and other third parties, so a well-crafted deed-in-lieu agreement will go a long way toward enhancing the lender's comfort with the overall process while at the same time providing order and certainty to the borrower.

Another substantial concern for the lender is to make certain that the transfer of the property from the borrower to the lender fully and unequivocally extinguishes the borrower's interest in the property. Any remaining interest that the borrower maintains in the property may later give rise to a claim that the transfer was not an absolute conveyance and was instead an equitable mortgage. Therefore, a lender should strongly resist any offer from the borrower to lease, manage, or reserve an option to purchase any part of the property following the transaction.

These are just a few of the most important issues in a deed in lieu transfer. Other significant issues must also be considered in order to protect the parties in this relatively complex process. Indeed, every transaction is unique and can raise different issues, and each state has its own rules and customs relating to these arrangements, ranging from transfer tax issues to the fact that, for example, in New Jersey, deed in lieu transactions likely fall under the state's Bulk Sales Act and its requirements. However, these issues should not dissuade—and certainly have not dissuaded—lenders and borrowers from increasingly using deeds in lieu and thereby reaping the substantial benefits of structuring a transaction in this way.