Deeds in Lieu of Foreclosure

Insights

Nov 7

Plenty of collateral? Suppose John Smith and Peter Clark want to start a mini-warehouse company. They start a limited liability company called Smith & Clark, LLC, and go to First National Bank to borrow the $1,000,000 they need to buy the land they’ve picked out and build their buildings. The LLC signs a promissory note that is interest only for the first 18 months, and John and Peter personally guarantee the LLC’s debt. They give the bank a mortgage on the entire property. They believe the value of their property, the collateral, will be $1.5 million when completed, so even if things did not go right, there would be plenty of collateral for the bank to satisfy the debt ... or so they thought.

John and Peter don't know it, but UHaul is planning a modern, multi-story, climate controlled storage facility across town, which will compete directly with theirs. When UHaul’s facility opens a few months after John and Peter’s, they can't attract tenants. Six months later, they are out of cash and options. John and Peter start falling behind on their payments to the bank. Although they're disappointed, they plan to simply give the collateral back to the bank and call it even. They go and talk to their banker and raise the possibility of a “deed in lieu.” The banker says he'll run it up the ladder and get back with them. The bank appraises the property. It isn't worth $1.5 million; it's worth only $750,000.

What is a deed in lieu? In these economic times, the “deed in lieu” has taken on almost mythical proportion. Everybody has a friend of a friend who “just gave the collateral back to the bank and walked away.” In reality, deed in lieu transactions are much more complicated.

When a Georgia borrower takes out a loan secured by real estate, he owns his property so long as he pays the debt to the bank in a timely fashion. However, if the debt is not paid off, then the bank can foreclose against the property. From the bank's perspective, foreclosure can be expensive and complicated; from the borrower's, having public notice of the loan default in the local newspaper (a requirement of any non-judicial foreclosure) is embarrassing. So both borrower and bank sometimes have a mutual interest in avoiding public foreclosure. To avoid, they agree that the borrower will sign a deed, a "deed in lieu," transferring his interest in the collateral to the bank. What happens to the debt, though? The deed in lieu, standing alone, doesn't answer the question.

There can actually be situations where deeds in lieu are unfavorable to the borrower. Although Peter and John missed the mark on their valuation of the collateral, if they had been right and the property had been worth $1.5 million, then their simply giving the property back to the bank would have resulted in a $500,000 loss to them. If the bank could find a buyer at $1.5 million two weeks after the deed in lieu is signed, then it would recognize a $500,000 windfall at John and Peter’s expense. John and Peter would prefer to put the property on the market, sell it for $1.5 million, and make the $500,000. Sometimes that may not be possible because of the time it takes them to sell and the unwillingness of the bank to wait on a loan that is in default, but the point is that any borrower considering a deed in lieu must know what the collateral is worth.

Collateral worth more than the debt it secures is a luxury, however, that most commercial property buyers do not have. This is where John and Peter find themselves. As soon as First National Bank gets the $750,000 appraisal back, the first question that the bank will ask is, "What are you guys going to do about the $250,000 deficiency?” In other words, how will John and Peter pay the $250,000 difference between the $1 million loan and the collateral value?

If John and Peter are smart, they will demand that the bank release them from the remainder of the debt before signing a deed in lieu. The bank will, of course, resist that request. Generally speaking, the bank will waive its right to collect the deficiency only in the rare case in which it has no chance of collection. In our hypothetical, the bank will likely look to John and Peter to write checks to satisfy the balance.

Complicated issues arise even in a seemingly simple "deed in lieu" deal. Legal representation is critical. A lawyer can help negotiate with the bank and then properly paper the deal.

Johnson Marlowe LLP is an Athens, GA based law firm focusing on business disputes and litigation, partnership divorces, construction litigation, and other complex, high-stakes civil cases. The firm also serves as outsourced in-house counsel to businesses throughout Georgia.