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DEEDS IN LIEU OF FORECLOSURE Colorado is a lien theory state, which means that regardless of language of conveyance that may

be contained in a deed of trust, mortgage or other instrument, a purported conveyance that is intended to secure an obligation creates a lien rather than transferring title to the beneficiary, mortgagee or other grantee. See Colo. Rev. Stat. 38-35-117. Title does not pass to the beneficiary, mortgagee or other grantee except by foreclosure, and then only if the beneficiary, mortgagee or other grantee is the successful bidder at the foreclosure sale. Until January 1, 2008, Colorado statutes provided for the right of a property owner to redeem the property for a period of time following foreclosure sale, and court decisions routinely protected this right of redemption against attempted encroachments by mortgagees. Since 2008, the owners right of redemption has been replaced with some exceptions for certain residential mortgages, provided for in Colo. Rev. Stat. 38-39-901, et seq. with an extended pre-foreclosure-sale right to cure. Language in pre-2008 cases, referring to the relative sanctity of the owners right to redeem, no longer applies literally. Still, deeds in lieu of foreclosure reflect a circumvention of the normal foreclosure process, and the spirit of older case law is likely to live on. In any event, structuring a deed in lieu of foreclosure requires attention both to legal/theoretical issues and to practical issues. This article will look at both. Legal/Theoretical Issues Although a deed in lieu of foreclosure is likely to foreshorten a borrowers statutory cure rights, a debtor can, for valuable post-default consideration, validly convey the debtors interest in the mortgaged property to the mortgagee or the mortgagees designee. A waiver of cure rights, or an agreement to shorten the cure period, is unenforceable if made before default see Colo. Rev. Stat. 38-38-703 but such waivers or agreements can be valid if they are made after default and if they are supported by consideration. In its simplest form, a deed in lieu of foreclosure is a deed given by the mortgagor directly to the mortgagee, in satisfaction of the secured debt, and the satisfaction of debt supplies the consideration. For reasons we will discuss, few

transactions are or should be structured in this form, so consideration must be found elsewhere, typically in the form of a complete or partial exculpation of the borrower or others from personal liability for the secured debt. In structuring a deed in lieu of foreclosure transaction, the key legal concerns are (1) to avoid having the transaction treated as an equitable mortgage as opposed to an absolute conveyance of the property, and (2) to avoid permitting the lien of the original security instrument to merge with fee title to the mortgaged property. Equitable Mortgage Concerns The term equitable mortgage is sometimes used to refer to the result of an attempt unsuccessful for some technical reason to create a legal mortgage, which will nonetheless be enforced by a court of equity as though it were in fact a mortgage. For the present purpose, however, the term is used to describe an arrangement which, though having the form of something other than a security device, is nonetheless intended to create a secured transaction. A deed, purportedly absolute on its face, may constitute an equitable mortgage if its execution is accompanied by the grantees agreement to return the deed, or reconvey the property, if a debt owed by the grantor to the grantee is paid within a specified time. Morris v. Cheney, 81 Colo. 393, 255 P. 987 (1927). Similarly, a deed deposited in escrow, to be returned to a debtor if he pays his debt when due or to be delivered to the creditor if the debt is not paid, constituted an equitable mortgage. Larson v. Hinds, 155 Colo. 282, 394 P.2d 129 (1964). A quitclaim deed, accompanied by a contemporaneous agreement that allowed the grantor to retain possession of the property so long as payments were made to the grantee, was likewise an equitable mortgage and could only be foreclosed as such. Ver Straten v. Worth, 79 Colo. 30, 243 P. 1104 (1926). An installment contract for deed, where the purchaser was entitled to possession so long as scheduled payments were made, but where the seller was purportedly entitled to terminate the contract and retake possession on default, was in effect a mortgage and could only be enforced by foreclosure. Pope v. Parker, 84 Colo. 535, 271 P. 1118 (1928). Leases, repurchase options and other devices that are intended to leave an obligor

with ongoing property rights so long as the obligation is not delinquent, but to deprive the obligor of those rights upon the occurrence of a default, may be held to constitute equitable mortgages. The consequences of a determination that an arrangement amounts to an equitable mortgage are potentially severe. At a minimum, the arrangement will not be enforced in accordance with its purported terms. Instead, the secured partys equitable lien will have to be foreclosed by judicial action, with its attendant delays. The time within which the debtor may attack an ostensibly completed transaction is probably limited only by the doctrine of laches, so the secured party can never be certain as to when enough time has passed to validate the secured partys apparent title. Moreover, if the secured party had other, conventional lien rights (for example, a deed of trust to the Public Trustee), those rights may be determined to have been waived or superseded by the equitable mortgage. The power of sale contained in a pre-existing deed of trust may be unenforceable, as may any of the covenants contained in the deed of trust. Since the existence of a previous debtor/creditor relationship is one of the badges which frequently accompanies a determination that a given transaction was intended as a security arrangement, a lender contemplating workout terms must be especially careful. If a deed in lieu of foreclosure is to be taken, the borrower should have no ongoing rights with respect to the property no right to possession or income, no option to repurchase, no right to object to the lenders sale of the property to a third party and no right to an accounting for any proceeds of sale. Conversely, if a defaulted loan is to be reinstated or the term of the loan is to be extended, it is unwise for the lender to demand possession, or escrowing, of a deed that is to be recorded in the event of a subsequent default or returned to the borrower if no default occurs. Even if the borrower never attacks the arrangement, future title examiners may well notice that the chain of title depends on a deed from mortgagor to mortgagee, dated or acknowledged well before the date of recording, and reject title as unmarketable

in view of the ongoing possibility that the borrower, or someone claiming under him, will attack the lenders title. Lien Merger Concerns The Colorado Supreme Court has held that [i]n law a merger always takes place when a greater estate and less coincide and meet in one and the same person, in one and the same right, without any intermediate estate, unless a contrary intent appears. Goldblatt v. Cannon, 95 Colo. 419, 37 P.2d 524 (Colo. 1934). If a mortgage lien is merged with a greater estate such as fee title, the lien ceases to exist and related covenants are no longer enforceable but liens and interests that were junior to the merged lien are not affected, unless for some reason the holders of those liens and interests also participate in transferring the liens and interests to the owner of the greater estate as well. Thus, if the holder of a mortgage lien acquires fee title, in lieu of foreclosure of a senior lien, and cannot demonstrate that the intention of both parties to the transfer of fee title was to avoid merger of the mortgage lien, the mortgage lien ceases to exist and can no longer operate as a means to extinguish junior liens and other interests in the property. For an example of how detrimental this can be to a mortgagee, see Colorado National Bank Exchange v. Hammar, 764 P.2d 359 (Colo. App. 1988). Merger is not the inevitable result of a deed in lieu of foreclosure, but whether it is deemed to have occurred depends on what characterization a court chooses to place on facts that have already occurred. In both Goldblatt and Hammar, supra, the court found that merger was intended. In Federal Land Bank of Wichita v. Colorado National Bank of Denver, 786 P.2d 514 (Colo. App. 1989), the senior lienholder was more fortunate, and the courts held that merger had not been intended and so had not occurred. To minimize the risk that merger will be held, or even alleged, to have occurred, two devices are typically used, in tandem. First, the documents governing the deed in lieu transaction should state unequivocally that neither party intends a merger to occur. Second, the conveyance should run to an entity other than the lender ideally an entity

that existed before the deed in lieu transaction and that has an operating history and other assets, to discourage any claim that the grantee was a mere alter ego of the mortgagee. Assuming it is important to the lender to preserve the existing lien, then the lender should also consider obtaining an update of the original mortgagees title insurance policy concurrently with the recording of the deed in lieu of foreclosure. If the title insurer is willing to update the loan policy without exception for possible consequences of the deed in lieu, the merger issue will not disappear entirely, but the lender will at least be able to look to the title insurer for the defense of any attack on the continuing validity of the lien. As with any title insurance transaction, it is essential that the title company be informed in writing of all off-record circumstances that may affect its risk in issuing or updating insurance coverage. A Note About Equity Clogging Equity-clogging is an arcane concept with real-world implications of significant but largely undefined scope. Early English common law mortgages operated in fact much the way a literal reading of the language of a modern mortgage would suggest as absolute conveyances of title (including the incidents thereof, such as the right of possession and the right to receive income), subject to defeasance upon the occurrence of a condition subsequent, namely the payment of a defined debt by a specified date. If the condition failed to occur, the conveyance became absolute. See generally, 4 American Law of Property 16.5 (1952). Over time it became less customary, and eventually legally forbidden, for the mortgagee to take possession of the mortgaged property prior to default. As it became accepted that the mortgagor retained most of the practical attributes of ownership until default, the English Chancery, or equity, courts developed the practice of permitting mortgagors to redeem their property from strict enforcement of their mortgages by paying the mortgage debt following default hence the term equity of redemption. Creditors being creditors, numerous efforts were made to circumvent debtors equitable redemption rights. The equity courts were adamant, however, that no such scheme would be enforced. As one American court described the doctrine,

The doctrine against clogging the equity of redemption of a mortgage estate is an old English doctrine brought forward in this Country to prevent lenders taking an inequitable advantage of distraught borrowers. The doctrine would prevent the mortgagee from taking through any trick, scheme or contrivance the equity of redemption from the borrower. Out of the doctrine developed the proposition that when the borrower repays his loan he is entitled to a return of that which was mortgaged as security for the loan . . . . MacArthur v. North Palm Beach Utilities, Inc., 202 So.2d 181, 185 (Fla. Sup. Ct., 1967). Perhaps the most widely denounced trick, scheme or contrivance is that by which the mortgagee acquires, simultaneously with its mortgage, an option to purchase the mortgaged property from the mortgagor at any time while the debt remains unpaid. English and American courts have almost uniformly refused to enforce such options. See Humble Oil & Refining Co. v. Doerr, 123 N.J. Super. 530, 303 A.2d 898 (1973), which contains by far the best discussion of cases which have applied or considered the rule, and Barr v. Granahan, 255 Wis. 192, 38 N.W.2d 705 (1949). Cf. 9 Thompson, Real Property 4668 (1958 Repl. Vol.); 4 American Law of Property 16.58-16.61 (1952). But see, MacArthur v. North Palm Beach Utilities, Inc., supra. Equity clogging is unlikely to occur in a deed in lieu of foreclosure transaction where, as recommended, the borrower is divested absolutely of all interest in the mortgaged property. In a workout situation, however, where a lender agrees to accept a substantial reduction in the recoverable amount of interest, principal, or both, the lender may seek to capture some up-side potential benefits by insisting on an option to convert all or part of the loan at some future time to an equity interest in the mortgaged property. At that point, the possibility of an equity-clogging claim may arise, and the mortgagee and its lawyer need to weigh the risks and benefits. Practical Considerations A deed in lieu of foreclosure transaction differs from a transaction involving a purchase of the collateral in one crucial respect the decision to invest has already been made and executed. Nonetheless, a mortgagee should approach a deed in lieu transaction

with substantially all of the questions and concerns that an arms length buyer would have. These include, without limitation: A physical inspection of the property and inquiries of those found to be in possession. As a prospective grantee, the mortgagee or its designee has constructive notice of, and will be bound by, the rights of parties in possession. Obtaining a current environmental assessment with regard to the property. If there are serious contamination issues, the mortgagee may be better off abandoning the collateral instead of taking title and attempting to resell it. Investigating the status of the borrowers obligations to third parties, whether or not they are technically secured by liens on the property, to the extent performance of those obligations would be required to maintain essential services or to establish good relationships with tenants, brokers, homeowners associations or other members of the local community. Accounting for and requiring turnover of tenant security deposits previously collected by the borrower. Identifying and requiring assignment of the borrowers rights as declarant with respect to a planned community or condominium project. Note that if the mortgagee or designee intends to resell the property rather than continuing with development and marketing efforts, the assignment of declarant rights should contain the provisions contemplated by Colo. Rev. Stat. 38-33.3-304(5)(d), in order to minimize the risk of liability as a successor declarant. Relinquishment by the borrower of control of any homeowners or condominium unit owners association, by resignation of declarant appointees from the board of directors, architectural control committees and similar bodies. Relinquishment by the borrower of control of any special district serving the mortgaged property. Identifying and requiring assignment of any rights the borrower may have to receive reimbursements for infrastructure costs from utility companies, water or sanitation districts, metropolitan districts and similar bodies.

Obtaining a transfer of the borrowers rights with respect to contracts, leases, construction warranties, plans and specifications, governmental permits and licenses (including liquor licenses) and other intangible assets.

If the borrower has any available cash, proration of rents, utilities, taxes and other items of income and expense. Obtaining assurances of future cooperation by the borrower with respect to issues and problems relating to the property.

Depending on the borrowers financial and organizational condition, the lender may find it impossible to obtain satisfaction with respect to many of these items. Proceeding with the transaction may still appear more attractive than the alternatives. On the other hand, the lender will not get anything for which it fails to ask.

Appendix A [Sample Deed in Lieu of Foreclosure]

SPECIAL WARRANTY DEED [NAME OF GRANTOR], a [State of Formation] [Type of Entity] whose address is (Grantor), for the consideration of TEN DOLLARS and other good and valuable consideration, in hand paid, hereby sells and conveys to [NAME OF GRANTEE], a [State of Formation] [Type of Entity] whose street address is (Grantee), the following real property in the County of and State of Colorado, to wit: [insert legal description] with all its appurtenances, and warrants the title against all persons claiming by, through, or under Grantor, subject to (1) the lien of general taxes for 200 , payable in the following year, (2) the Deed of Trust from Grantor to the Public Trustee of County for the use and benefit of [Grantee or, if different, name of original lender], dated [date of deed of trust] recorded [date of recording] at Reception No. in the real property records of County, Colorado, (3) [list any other encumbrances created by Grantor or persons claiming by, through or under Grantor that are to be excepted from Grantors warranty of title]. [The interest conveyed by this deed includes, without limitation, all of Grantors right, title and interest as declarant (including but not limited to any special declarant rights) under the Declaration . . . dated as of , and recorded , at Reception No. in the real property records of County, Colorado (referred to, as it may have been amended or supplemented to date, as the Declaration); provided, that by accepting this deed, Grantee shall not be deemed to assume, and shall have no liability for, any act or omission of Grantor or any other declarant under the Declaration that occurred before the execution and delivery of this deed, nor shall Grantee have any liability or responsibility of any kind under any amendment or modification of, or any supplement to, the Declaration that has not been recorded in the real property records of County, Colorado, before the execution and delivery of this deed.]

Appendix A, Page 2

Notwithstanding the fact that Grantor may be indebted to Grantee or an affiliate of Grantee, or that Grantee or an affiliate of Grantee may have or acquire, directly or indirectly, an interest in one or more liens or encumbrances affecting title to the property conveyed herein, (A) this deed is intended as an absolute conveyance rather than as security for any obligation, and Grantor expressly waives any statutory, equitable or other right to redeem any interest in the property conveyed herein, and (B) this deed shall not result in the merger of any such lien or encumbrance with the title conveyed hereby, or in the subordination or extinguishment of any such lien or encumbrance in favor of any other lien or encumbrance. Signed and delivered as of the ____ day of ATTEST: , 200 .

[NAME OF GRANTOR], a [State of Formation] [Type of Entity] By


Name: Title:


) ) ss. )

The foregoing instrument was acknowledged before me this ____ day of , 200 , by as of [Name of Grantor], a [State of Formation] [Type of Entity]. My commission expires:____________________________ Witness my hand and official seal.

Notary Public

Appendix B [Sample Assignment of Special Declarant Rights]

ABSOLUTE ASSIGNMENT OF SPECIAL DECLARANT RIGHTS THIS ABSOLUTE ASSIGNMENT OF SPECIAL DECLARANT RIGHTS (this Assignment) is made as of , 200 , by RITZY CLUB, LLC, a Colorado limited liability company (Borrower) whose address is 1099 Ski Time Square Drive, Steamboat Springs, Colorado 80487, to DESIGNEE, INC., a Washington corporation (Assignee) whose address is 123 East Drive, East Haven, Connecticut 06510. RECITALS A. Major Financial Corporation, a Delaware corporation (Lender) is the beneficiary and holder of the Combination Deed of Trust, Security Agreement and Fixture Financing Statement given by Borrower, dated as of , 200 and recorded in the Office of the Clerk and Recorder of Routt County, Colorado (the Land Records), in Book at Page (Reception No. ) (the Deed of Trust). Borrower is the declarant (the Declarant) under the Condominium Declaration for Ritzy Club Condominiums (the Project) as more particularly described on Schedule 1 attached hereto (as amended from time to time in accordance with the terms and provisions thereof and hereof the Declaration). Ritzy Club Association, Inc., a Colorado nonprofit corporation, or any successor thereto as provided in the Declaration, is the unit owners association formed pursuant to the Declaration (the Association). B. Except as otherwise specifically stated herein, capitalized terms used herein without definition have the meaning given such terms in the Declaration, or if not defined therein, the meaning given such terms in the Colorado Common Interest Ownership Act, as such Act exists on the date of this Assignment (CCIOA). C. Concurrently with the execution and delivery of this Assignment, Borrower is conveying to Assignee, absolutely, irrevocably and without any reservation of rights, all of Borrowers right, title and interest in and to the Project. By this Assignment, Borrower wishes and intends to transfer to Assignee

Appendix B, Page 2

all Special Declarant Rights provided for in the Declaration or available to Borrower under the provisions of CCIOA. D. Designee wishes to acquire all such Special Declarant Rights, and intends to hold such rights solely for transfer to another person. ASSIGNMENT NOW, THEREFORE, in consideration of the foregoing and the mutual provisions of this Assignment, Borrower and Designee agree as follows: 1. Assignment; Warranty. Borrower assigns and transfers to Designee, absolutely and without any reservation of rights, all Special Declarant Rights provided for in the Declaration and by CCIOA. Borrower warrants that except for a Collateral Assignment of Declarants Rights in favor of Lender, dated the date of the Deed of Trust, Borrower has done nothing to alienate, transfer or encumber any of such Special Declarant Rights. 2. Statement of Intention. Pursuant to Colo. Rev. Stat. 38-33.3-304(5)(d), Assignee declares Assignees intention not to exercise such Special Declarant Rights itself, but to hold all such Special Declarant Rights solely for transfer to another person. Notwithstanding the foregoing, Assignee may exercise the right to control the executive board of the Association, to the extent permitted by the Declaration and CCIOA, as provided in Colo. Rev. Stat. 38-33.3-303(5). 3. Miscellaneous.

(a) This Assignment, and the covenants, conditions, representations and warranties contained in it, shall bind and benefit the successors and assigns of Borrower and Assignee. (b) Wherever used. the singular number shall include the plural, and the use of any gender shall be applicable to all genders. (c) This Assignment is to be construed and enforced in accordance with the substantive laws of the State of Colorado. (d) If any provision of this Assignment is determined to be invalid or unenforceable under Colorado law, it shall not affect the validity or enforcement of the remaining obligations or portions hereof.

Appendix B, Page 3

(e) No failure or delay by Assignee to exercise or enforce any rights, powers or remedies hereunder shall operate as a waiver of such rights, powers or remedies. All rights, powers and remedies herein provided for are cumulative and none are exclusive. (f) Borrower shall execute upon request such additional documents, and shall take such other actions, as may be requested by Assignee or Lender in order to carry out the purposes of this Assignment. 4. Counterparts. This Assignment may be executed in two or more counterparts, each of which shall, upon execution and delivery of counterparts by each party, constitute a single Assignment. Signed and delivered as of the date first mentioned above. RITZY CLUB, LLC, a Colorado limited liability company

By Name: Title:


) ) )

ss. day of

The foregoing instrument was acknowledged before me this , 200 , by as of Ritzy Club, LLC, a Colorado limited liability company. My commission expires Witness my hand and official seal. .

Notary Public

Appendix B, Page 4

ACCEPTED: DESIGNEE, INC., a Washington corporation

By Name: Title:


) ) )

ss. day of

The foregoing instrument was acknowledged before me this , 200 , by as of Designee, Inc., a Washington corporation. My commission expires Witness my hand and official seal. .

Notary Public