A deed in lieu of foreclosure may be taken by a lender under a workout agreement after its loan goes into default. However, depending upon the terms of the agreement, the lender’s deed may be no better than the mortgage or deed of trust that it was granted in the first place.
In 364 N.B.E. Corp. v. Edge Capital, LLC et al. (In re 364 N.B.E. Corp.), 2015 WL 9581323 (Bankr. E.D.N.Y. December 29, 2015), the debtor asked the court to declare that a deed in lieu of foreclosure that was recorded prior to the debtor’s bankruptcy was no more than a mortgage under New York law. The debtor’s claim was based on Section 320 of the New York Real Property Law, which provides that a deed conveying real property must be considered as a mortgage if it “appears to be intended only as security in the nature of a mortgage . . .”
Under the facts of 364 N.B.E. Corp., the debtor executed the deed in lieu under the terms of a workout agreement which provided that the deed would be held in escrow “as security” for the debtor’s performance of a modified mortgage, and that the deed could be recorded upon a default under the agreement. The debtor defaulted and the deed was recorded shortly before the debtor filed for bankruptcy. Based on its interpretation of the workout agreement, the court held that the deed appeared to be intended as security for a debt and, therefore, “was functionally a mortgage.” As a result, the debtor could redeem the property by payment of the debt before a foreclosure sale or, presumably, under a confirmed Chapter 11 plan.
Although the decision of the New York court may seem counter-intuitive, courts applying Maryland law may well reach the same result because §7-101(a) of the Real Property Article (“RP”) is substantially similar to the New York statute applied by the bankruptcy court. The Maryland Court of Appeals applied RP §7-101(a) in C. Phillip Johnson Full Gospel Ministries, Inc. v. Investors Financial Services, LLC, 418 Md. 86 (2011), where it held that a deed in lieu of foreclosure that was executed at the time the loan was made, before any default occurred, was no more than a mortgage notwithstanding that the borrower agreed the deed could be recorded after default. In its opinion, the Court distinguished its case from the more common situation in which a deed in lieu of foreclosure is executed as part of a workout agreement after default. Under that scenario, the Court stated that the mortgagor “may legitimately contract with the noteholder to execute a conveyance, in exchange for adequate consideration, so long as there is no overreaching.” Id. at 97.
As a consequence of these cases and the statutes that they interpret, “deeds in escrow” may not have the effect that lenders may desire. That is, if a lender takes a deed from a borrower before a default, the lender may not be able to record the deed after a default free and clear of the interest of the borrower. This would violate the rule against clogging the borrower’s equity of redemption.
For questions, please contact Larry Coppel (410) 576-4238.