In certain instances, the Bank may choose to take a deed in lieu of foreclosure. In other words, the debtor gives the Bank a general warranty deed, which conveys the property to the Bank and includes certain special provisions. The Bank does not have to resort to foreclosure (nonjudicial or judicial) while the debtor owns and is in possession of the property. The Debtors sometimes prefer this method, because they can avoid what they perceive as the embarrassment of a public sale. The primary advantage to accepting a deed in lieu of foreclosure is that such acceptance allows the Bank to take immediate control of the property, often important in the context of income-producing property. The primary disadvantage to acceptance of a deed is that junior liens and encumbrances will not be extinguished by the conveyance.
A well-drafted deed in lieu of foreclosure will (i) include representations and warranties by the debtor that there are no junior liens affecting the property (ii) include a release in favor of the Bank for any alleged lender liability claims and (iii) contain language which prevents the Bank’s lien from “merging” with the fee estate and extinguishing the lien by operation of law. (Absent non-merger language in the deed, the fact that the Bank both owned the property and held the lien would result in the merger of and disappearance of the lien into the Bank’s ownership of the property.) The representations and warranties of the debtor may not be of any practical value to the Bank, since the customary context of the deed in lieu arrangement is the financial difficulty of the debtor. The Debtor may not have the financial ability to back up its representations and warranties. The non-merger language in a well-drafted deed permits the Bank to foreclose on the property if junior liens are subsequently found.
An advantage to nonjudicial foreclosure over acceptance of a deed in lieu of foreclosure is that it has the effect of extinguishing any liens or encumbrances junior to the Bank’s deed of trust lien, where the foreclosure sale does not result in proceeds in excess of the Bank’s lien. The liens are extinguished by operation of law. (Technically, the junior liens will also be extinguished as an encumbrance on the property, even if excess proceeds are generated from the sale, but the liens will follow the proceeds rather than affect the property.) So, for example, if the property is affected by junior mechanic’s liens on nonremovables or with second, third, or fourth contractual liens and if the property has declined in value (so that the fair market value of the property is less than the indebtedness secured by the property), the Bank will foreclose in order to extinguish these subordinate liens. In Texas, the Bank’s mortgage lien remains intact after the Bank receives a deed in lieu, and the mortgage is not “merged” into the deed. The common law doctrine of merger provides that when a greater estate in land and a lesser estate are combined in a single person, the lesser estate is extinguished and merged into the greater estate. This doctrine is qualified by the intention of the parties, and it is presumed that the mortgage holder intended to keep the lien and title estates separate if needed to protect the mortgage holder’s priority over junior liens. In addition, the Texas Property Code provides that a mortgage holder, such as the Bank, may void a deed in lieu before the fourth anniversary of the date of the deed if the debtor fails to disclose the existence of a lien on the property before the conveyance and the mortgage holder had no knowledge of the undisclosed lien. If the mortgage holder elects to void the deed, the priority of the mortgage is not affected by the execution of the deed. In addition, the mortgage holder may foreclose the mortgage without electing to void the deed.