A borrower defaults in payment of a commercial mortgage loan. A lender starts foreclosure. This is a rare occurrence, isn’t it? Well, not really. Foreclosures have been around since the start of mortgage lending and will continue to be with us as long as lenders make loans.
To begin, some general background is needed so that you know the lay of the land. When lenders underwrite commercial loans, they evaluate risk and return and approve or decline accordingly, based on certain factors. These factors include the borrower’s credit, the borrower’s ability to develop or operate the property in a profitable manner, the cash flows (actual or projected) from tenant leases of the property, the tenants’ credit, and the borrower’s cash equity in the property.
The last item, sufficient borrower equity, ensures the lender a remedy in the event of a default. Equity is measured by a ratio that compares the loan amount to the property value (the loan-to-value, or LTV, ratio). In the past, most commercial lenders set the LTV ratio under 80 percent, thinking the lower the LTV ratio, the more borrower equity in the project and the less risk. Things changed during the pre-2007 bubble. Lenders threw out the old playbook and allowed more debt, either through higher LTV ratios or secondary financings such as junior mortgages or “mezzanine” loans (secured by a collateral pledge of the ownership entity, not the property). But any way you cut it, more debt means less equity, and less equity means more risk. When the market collapsed, lenders were caught holding overvalued collateral with no equity, which made full recovery impossible.
While loan underwriting has tightened, loans still fail. Mortgage defaults continue, as do foreclosures. The recent past, however, provides a good study of what works and what doesn’t, and it illustrates different options lenders and borrowers might take following loan default.
Goals of Lenders and Borrowers
What are the goals for borrowers and lenders that the general practitioner should keep in mind? The borrower seeks a release of liability from the loan and forgiveness of debt. This includes avoidance of a deficiency judgment if the sale price obtained at foreclosure or other disposition is less than the debt secured by the mortgage.
The lender seeks full repayment of the loan. This usually requires foreclosure or other realization against the collateral. Sometimes the lender seeks to collect a deficiency judgment against the borrower or an affiliated guarantor. Today, most real property assets are held in single-purpose ownership entities (SPEs) usually formed as limited partnerships or limited liability companies. The real property is typically the largest asset of the SPE. Upon a loan default, the SPE itself is likely insolvent and financially unable to pay a deficiency judgment. Thus, if a lender expects to collect on a deficiency judgment, the only real avenue is through a personal guaranty.
Ownership and control of the mortgaged property or proceeds from its sale provide the common form of relief to the lender. Speed and efficiency in a lender gaining ownership and control are critical to preserving the value of the collateral.
Following a loan default, what can a lender do? In most states, full judicial foreclosure is available, allowing the lender to retake the property and obtain a deficiency judgment. If the lender pursues this option, there is relatively little the borrower or its counsel can do to stay or affect the proceeding. Most of the action is dictated by the lender, subject to the rules of court.
To begin, the lender files a complaint and serves a copy on the borrower and all other necessary parties (such as guarantors, junior mortgage lenders, and intervening lien claimants). Typically, lender’s counsel obtains a foreclosure guaranty from a title company that discloses parties holding an interest in the property necessary for proper joinder and service. Like any court action, judicial foreclosure takes time to move through the courts. From the lender’s perspective, the delay from the date of filing to date of sale often results in reduced value in the collateral. On top of this, there is no assurance that a deficiency judgment will be imposed or collected. Therefore, most commercial lenders undertake judicial foreclosure only in limited circumstances.
Some states allow non-judicial foreclosure of the property, usually by way of a public or private trustee’s sale. As the name implies, no formal court action is required. Although the process varies by state, the trustee typically starts the process by serving a notice of default on the borrower and any other party, such as a guarantor, who may have liability under the loan. The notice itemizes the outstanding debt and provides the borrower some opportunity to cure the default (by bringing all loan payments current, for example) and reinstate the loan. Next, if the default remains uncured, the trustee serves notice of sale on the borrower and all interested parties. If the default continues, the trustee sells the property at auction to the highest bidder, usually the lender. Again, the action is controlled by the trustee and the lender. If the borrower and its counsel want to stay the proceeding, they need to act, usually by filing suit seeking an injunction, prior to the sale.
Before commencing the sale process, the trustee typically obtains a trustee’s sale guaranty from a title company to identify all parties who hold an interest in the property and must be given notice of the sale. Many states require a lender to waive any claim for a deficiency judgment to pursue a trustee’s sale. Nevertheless, non-judicial foreclosure is typically a faster and cheaper method for the lender to take title to the property.
Most states permit a lender to take control over mortgaged property following a loan default through the appointment of a receiver. Like a foreclosure action, the lender files a petition and serves a copy on the borrower and all other necessary parties. Typically, lender’s counsel obtains a litigation guaranty from a title company that identifies parties holding an interest in the property for proper joinder and service. If appointed, the receiver takes control and manages the mortgaged property. The receiver collects rents, executes leases, makes repairs, pays debt service and operating expenses, and may even sell the property. Continuing operation of a commercial business can preserve the property’s value, so many lenders pursue receivership prior to foreclosure.
In most jurisdictions, the receiver may also sell the property upon order of the court following due notice and a hearing. Again, as in foreclosure, the lender dictates the action, but the borrower and its counsel may contest the receivership sale. Absent another offer at a higher price, however, the borrower lacks the necessary tools to stay or set aside the receivership sale.
For a sale, the moving party, usually the receiver, identifies the contract of sale, buyer, sale price, and other terms, and then seeks court approval. The court considers the rights of the borrower and the claims of third-party creditors. If approved, the court enters an order of sale, and the receiver executes a deed, on behalf of the owner, to the buyer. The buyer typically obtains an owner’s title policy. Many title insurers only insure the sale after the appeal period runs without an appeal being filed. If no objections to the sale are filed, a title insurer may insure prior to the expiration of the appeal period. The loan documents must specifically grant the remedy of receivership and a receivership sale. Courts have ruled that in the absence of specific contractual rights to receivership, a receivership sale is not permitted at law.
Foreclosure and receivership sales provide the lender with protection against other creditors of the defaulted borrower. As to junior lien holders, foreclosure extinguishes junior liens from title to the collateral. As to unsecured creditors, foreclosure protects the lender from later attack under state and federal insolvency laws such as § 547 or § 548 of the U.S. Bankruptcy Code or state laws similar to the Uniform Fraudulent Transfer Act (UFTA). In BFP v. Resolution Trust Corp., 511 U.S. 531 (1994), the U.S. Supreme Court considered whether a mortgage foreclosure sale that realized substantially less than the property’s fair market value constituted a fraudulent transfer under § 548. The Court held that the amount obtained from a non-collusive foreclosure sale conducted in accordance with applicable state law was, as a matter of law, “reasonably equivalent value” and thus not a violation of § 548. Similarly, § 3(b) of the UFTA provides that foreclosure of a debtor’s interest by a regularly conducted, non-collusive sale following a mortgage default may not be avoided as a transfer for less than reasonably equivalent value. These are significant protections given to the lender.
Deed in Lieu of Foreclosure
Still, many commercial lenders prefer using a transfer called a deed in lieu of foreclosure (DIL) as a faster, cheaper, and more direct way to reclaim title to the mortgaged property. Many borrowers prefer this transaction as well. Under a DIL, the transfer of the property from borrower to lender is consensual. The rights, obligations, and benefits exchanged are negotiated and then memorialized in a written DIL agreement signed by borrower and lender. Unlike in a foreclosure, here the borrower, lender, and their respective counsel all have a place at the table to negotiate their best deal.
Like an arm’s-length purchase and sale agreement, the DIL agreement should identify the parties, describe the property, and specify the consideration, any due diligence rights, the closing date, conditions to closing, and allocation of closing costs. It is typical for lender/transferee to pay all closing costs, such as transfer taxes, title and escrow charges, and due diligence expenses. Consideration may include forgiveness of debt, waiver of a claim seeking a deficiency judgment, and even a cash payment to the borrower. In negotiating the terms and conditions of transfer, borrower’s counsel should attempt to limit or avoid liability following transfer. This includes limiting deed warranties and representations and warranties under the DIL agreement.
Again, these rights and obligations are not set but are subject to negotiation. This gives both lender’s counsel and borrower’s counsel an opportunity to craft a transaction that optimizes the benefits and reduces the risk to their respective clients.
Unlike a foreclosure, a DIL does not divest junior liens, making the lender’s ownership position subject to pre-existing title matters such as mortgages, judgments, and mechanic’s lien claims. Thus, most lenders obtain a title report or commitment, and if the transfer occurs, an owner’s policy of title insurance. Further, to protect against the assertion of inchoate liens, non-record claims or interests, or junior encumbrances of record, most lenders leave the underlying mortgage lien open. They also include in the deed a “non-merger” clause expressing their intent not to merge the existing mortgage into the deed-in-lieu transfer. Leaving the existing mortgage intact permits later foreclosure if junior lien holders seek to assert their lien rights. Finally, most lenders take title to the property in the name of an SPE to shield the lender from personal liability for matters such as unpaid or delinquent taxes, third-party claims, environmental matters, or other landholder liability.
Although lenders and borrowers may prefer using them, courts and title companies disfavor DILs because they pose significant creditors’ rights risk. A DIL does not enjoy the same presumption of reasonably equivalent value as does a non-collusive foreclosure. Thus, most lenders will only accept a DIL if the fair market value of the property is substantially lower than the balance on the loan. Most lenders obtain a current Member of the Appraisal Institute (MAI) appraisal of the property to evidence value. Further, except for prior transfers in the chain of title, the 2006 American Land Title Association (ALTA) owner’s title policy excludes any coverage against later attack by unsecured creditors of borrower because the DIL constitutes a fraudulent transfer or avoidable preference.
Commercial mortgage default remedies were rigorously tested during the economic crash of the past decade. Consequently, their strengths and weaknesses were exposed; they were reworked and refined accordingly, and now they give lenders a number of effective options for retaking property and collecting debts. Lenders play offense following a default. They choose and initiate the action and drive it to conclusion. Borrowers play defense. They react to the actions taken by lenders. Although borrower options are more limited, some situations, such as deeds in lieu of foreclosure, give borrowers and their counsel more leverage to negotiate a better result. Careful planning, both in the original loan documentation and recovery after a default, are vital considerations for both lender and borrower. Choosing the best option requires lenders to balance such competing factors as speed, efficiency, cost, and risk. For borrowers, the best option usually means finding a way to gain a release from debt, avoid a deficiency judgment, and terminate any continuing liability related to the loan and the property.