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 owner’s 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 owner’s 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 borrower’s

statutory cure rights, a debtor can, for valuable post-default consideration, validly convey

the debtor’s interest in the mortgaged property to the mortgagee or the mortgagee’s

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 grantee’s 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 party’s 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 party’s 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 lender’s 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 lender’s 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 mortgagee’s 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 borrower’s 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 borrower’s 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 borrower’s 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 borrower’s 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 Grantor’s warranty of title].

[The interest conveyed by this deed includes, without limitation, all of Grantor’s 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

Appendix A, Page 2

real property records of                                                             County, Colorado, before the execution and delivery of this deed.]

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 , 200          .

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

By Secretary Name:

Title:

STATE OF COLORADO )CITY AND ) ss.

COUNTY OF DENVER )

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.

Appendix A, Page 3

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 Borrower’s right, title and interest in and to the Project. By this Assignment, Borrower wishes and intends to transfer to Assignee all Special Declarant Rights provided for

Appendix B, Page 2

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 Declarant’s 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 Assignee’s 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:

Appendix B, Page 4

STATE OF COLORADO )) ss.

COUNTY OF )

The foregoing instrument was acknowledged before me this       day of                                               , 200            , by as of Ritzy Club, LLC, a Colorado limited liability company.

My commission expires .

Witness my hand and official seal.

Notary Public

ACCEPTED:

DESIGNEE, INC., a Washington corporation

By

Name: Title:

Appendix B, Page 5

STATE OF                 )) ss.

COUNTY OF )

The foregoing instrument was acknowledged before me this       day of                                               , 200            , by as of Designee, Inc., a Washington corporation.

My commission expires .

Witness my hand and official seal.

Notary Public