United States: Deed In Lieu: Sometimes It Works, And Sometimes It Doesn’t (Round 1)

Last Updated: March 15 2013
Article by Vicki R. Harding

In West Grand the debtor attempted to have a deed in lieu of foreclosure set aside as a fraudulent conveyance. The pivotal question for the court was whether the debtor received reasonably equivalent value in exchange for the deed in lieu.

Section 548 of the Bankruptcy Code gives a chapter 11 debtor the power to avoid fraudulent transfers. If the West Grand debtor was able to establish that (1) there was a transfer of its property, (2) for which it received less than reasonably equivalent value in exchange and (3) it was insolvent or became insolvent as the result of a transfer, then the transfer could be avoided as a fraudulent transfer.

In this case, the parties agreed that the only issue was whether the debtor received reasonably equivalent value. The facts were as follows:

  • Charter One Bank made a $2.1 million loan to the debtor secured by commercial real estate.
  • After the debtor defaulted, TY Grand purchased the loan for $515,000. The debtor contributed $110,000, and TY Grand paid the remaining $405,000.
  • At the time of purchase, the debtor owed $2.5 million on the loan.
  • Under a forbearance agreement, TY Grand agreed to reduce the $2.1 million original loan balance to $865,000 if certain conditions were met.
  • If the lender received certain payments, including an initial $110,000 payment and then monthly payments of $15,000, it would accept $710,000 by a specified date as full satisfaction of the debt.
  • When the debtor failed to make the final $710,000 by the deadline, it obtained an extension by (i) paying 3 extension payments of $100,000 each (with $50,000 considered a non-refundable fee and the rest applied to the loan), and (ii) making monthly payments (which were reduced from $15,000 to $10,000), resulting in a payoff of $460,000.
  • The debtor provided a deed in lieu of foreclosure in connection with the forbearance agreement.
  • If the only default was the failure to make monthly payments or the final payoff, the lender was required to record the deed in lieu and give a covenant not to sue releasing the deficiency.
  • If there was default other than the monetary defaults, the lender had a right to record the deed in lieu, but also retained the right to pursue a deficiency based on the property being valued at $865,000.

The debtor made payments, but was not able to make the final $460,000 payment, and the lender recorded the deed in lieu. Shortly after the deed was recorded, the debtor filed for relief under chapter 11 of the Bankruptcy Code and brought an adversary proceeding to avoid the deed in lieu and recover the property as a fraudulent transfer.

At the time the deed was recorded, the lender was not aware of any defaults other than monetary defaults. At some point after litigation began, the lender learned that the debtor had breached non-monetary warranties and representations (involving several building code violations and failure to pay real estate taxes), which would permit it to seek to recover a deficiency.

The lender filed a series of proofs of claim that included alternate claims depending upon the outcome of the litigation. The final proof of claim asserted a secured claim of ~$2.7 million if the lender did not prevail, and no claim if it prevailed and the deed in lieu transfer was not avoided.

The court characterized the reasonably equivalent value issue as a two¬¬ step inquiry: (1) did the debtor receive value, and (2) if so was it reasonably equivalent to what the debtor gave up? The court relied on a Seventh Circuit case holding that reasonably equivalent value depends on the facts of each case. The factors to consider are: (i) whether the value transferred was equal to the value received, (ii) the market value of what was transferred and received, (iii) whether this was an arm's length transaction, and (iv) the good faith of the transferee.

Here, the court found that release of over $2 million in debt was value. At the time of the transfer, the lender was not aware of the misrepresentation defaults, so did not intend to pursue any claims it might have. The debtor argued that it received only $460,000 (i.e. the amount of the discounted payoff) in exchange for property that was worth ~$1.1 million. However, the court noted that it also received a release of a deficiency claim that was more than $2 million.

The debtor also argued that the lender purchased the loan for $515,000, received $485,000 in payments from the debtor (and had been collecting rent from the property), so that the transaction did not have reasonably equivalent value since the note cost the lender only $30,000. The court rejected this line of argument, commenting that the transfer between the original lender and TY Grand was not relevant because it did not involve a transfer of the debtor's property.

The court noted that TY Grand received property worth ~$1.1 million and payments of $485,000, while the debtor was released from a $2.5 million debt. So, the debtor received more than it transferred.

Even if the possibility of a deficiency was considered, TY Grand's recovery for a deficiency claim was limited to $710,000. So TY Grand would receive ~$2.3 million (property + payments + deficiency claim), while the debtor was released from a $2.5 million debt.

The debtor also made a similar claim under the Illinois Fraudulent Transfer Act (which could be asserted using the strong arm powers under Section 544 that allow a chapter 11 debtor to avoid transfers of real estate that could be avoided by a bona fide purchaser). However, that claim failed for the same reasons that the claim under Section 548 of the Bankruptcy Code failed.

The viability of a deed in lieu of foreclosure depends on its treatment under state law. For example, it may be important that the interests acquired under the deed in lieu do not merge into the mortgagee's interests, so that the mortgage may be foreclosed if required to extinguish junior liens.

However, even if a deed in lieu works under state law, the question of value to the borrower remains a significant one – particularly in the context of a non-recourse loan. Vulnerability to a fraudulent transfer claim must be a consideration in any deed in lieu transaction.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Vicki R. Harding
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