Decon Makes Deeds in Lieu of Foreclosure A More Attractive Option in California for Lenders

Lenders often issue notices of non-acceptance when faced with borrowers’ attempts to hand over title to property in deeds in lieu of foreclosure. 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. However, the recent California appellate court decision in Decon Group., Inc. v. Prudential Mortgage Capital Co., LLC, provides lenders in the state with a strong legal basis for accepting such deeds in lieu of foreclosure—even when junior liens are attached to the property in question. ¹Decon Group., Inc. v. Prudential Mortgage Capital Co., LLC, Cal. App. 4th, 174 Cal. Rptr. 3d 205, review filed 8/11/14, 207 (2014), (“Decon”). As a result of this ruling, well drafted agreements for deeds in lieu of foreclosure may substantially benefit lenders and senior lienholders.

Deeds in Lieu of Foreclosure:
A Short Background for Lenders

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. Usually, a deed in lieu of foreclosure is merely a voluntary agreement between the borrower and lender negotiated after the potential for a foreclosure arises. The principal advantage to the borrower 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, the borrower avoids any public fallout/notoriety of a foreclosure, and may receive more generous terms than they would through formal foreclosure proceedings. Another benefit to the borrower is that a deed in lieu is less detrimental to credit scores. Generally, lenders have been wary to accept deeds in lieu where junior liens existed on the title, preferring instead to foreclose in order to extinguish all junior liens, removing the title of all debt. However, in light of Decon, senior lien holders should now consider the many advantages to deeds in lieu of foreclosure.

Decon and its Potential Impact

In Decon, a property owned by a borrower (an LLC) 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. ²See: Sheldon v. La Brea Materials Co. (1932) 216 Cal. 686 (holding that no merger had taken place as a matter of equity once a senior lienholder accepted title); and Hines v. Ward (1898) 121 Cal. 115 (holding that presumptively no merger would take place if grantee of property is also the senior lienholder). The 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 lenders who normally reject deeds in lieu to consider the number of potential benefits they may provide.

Additional Benefits for Lenders

There are substantial advantages for lenders in accepting deeds in lieu of foreclosure. First, it circumvents or reduces the delay, expense and uncertainty of going through the foreclosure process. In 2013, the national average time to foreclose on a property was 414 days. Investing a relatively small amount of effort by having a deed in lieu contract drafted and negotiated, whereby a borrower willingly turns over the keys to a property within 30 to 60 days, can save a great amount of time, money and headaches for lenders. Second, 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. Third, 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. Fourth, a deficiency judgment against a borrower for any remaining balance would still be available if the lender so chooses. 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. Finally, a well negotiated contract for a deed in lieu of foreclosure from a borrower can potentially grant lenders a windfall in excess proceeds.

Potential Dangers

While there are numerous advantages for lenders in accepting deeds in lieu of foreclosure, there are still very real dangers which must also be taken into consideration.

Lenders will frequently ask borrowers to attempt to sell their property first. Sometimes even a short sale loss on the full value on the property is advantageous to requiring the bank to sell the property itself, thereby retaining all the risk involved 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 burden. Also, leases with existing tenants, especially those for whom there is no subordination agreement in place, may be problematic for lenders who do not wish 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 who 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 on the Rise

The number of deeds in lieu of foreclosure has significantly increased nationally in recent years, with California leading the pack. Recognizing the benefits of deeds in lieu, Fannie Mae has implemented new guidelines which streamline the process, allowing borrowers who are current with their loan to become eligible. Previously, only borrowers who were in arrears by 30 days or more were eligible. Fannie Mae VP Leslie Peeler stated that “[D]eeds-in-lieu are important tools to prevent foreclosures and help struggling borrowers.” As addressed in Decon, the lender must also 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, often complicating the title with junior lienholders.