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SELECTED ISSUES IN SINGLE MORTGAGE LOAN PURCHASES FOR THE “LOAN TO OWN” BUYER M. Andrew Kauss and Lynn E. Fowler Kilpatrick Townsend & Stockton LLP Before 1990, and the collapse of several commercial banks and the entire savings and loan industry under the weight of bad real estate loans, it was extremely rare for commercial real estate to be bought and sold without a significant level of representations and warranties from the seller. It was then generally well accepted that a prudent buyer in an arms-length transaction could not accept the risk of acquiring property on an “as-is” basis, nor would a seller reasonably expect a buyer to do so. In the aftermath of the financial debacle of that era, first the banks and savings and loans disposing of REO, and then the Resolution Trust Corporation, began to test the appetite of the market for the purchase of properties without any recourse of any kind against the seller. It was during this period that the types of seller disclaimers that are commonplace today first appeared. These provisions were often much more than mere “disclaimers”. Not only did they provide for disclaimer of all seller warranties, but they also required the buyer to affirmatively release all claims against the seller and all manner of persons and entities having any relationship to the seller, and to affirmatively indemnify the seller and such persons and entities against any claims whatsoever related to the property sold. These indemnities extended to all matters, whenever arising, even during the period of the seller’s ownership of the property and even if the result of the acts or omissions of the seller, and even if fully known to the seller and whether or not disclosed. The rationale for the seller position was that the risk was reflected in the price for the property, and justified the harsh terms of the disposition. To the great surprise of many practitioners, the marketplace largely accepted the terms of engagement proffered by these sellers. Whether the purported downward risk adjustment of the price for the property was reality, or merely perceived because the prices represented so much less than the selling lenders had invested in property being sold (not to mention what had been invested in long lost equity), was lost in the fog of the transaction. Responsible buyers (including institutional investors and those who managed their money) came to accept that it could be prudent to buy real estate on this basis, if the due diligence process was sufficiently thorough, and the third party assurances obtained in due diligence (i.e., tenant estoppels, governmental assurances on zoning and entitlements) were sufficiently broad. Once the market made this leap in the purchase and sale of distressed real estate, it was a much shorter leap to the adoption of these transaction terms in non-distressed circumstances, between arms-length buyers and sellers. Of course, this approach to acquisitions of ownership interests in real estate could likely never have evolved absent the ability to obtain title insurance to backstop the fundamental risk, that of title to the real estate itself. A rational buyer could take the view that, if assurance (i.e., insurance) was available to guarantee that title had been obtained and was free of unknown encumbrances, the balance of the risks in the transaction could be effectively evaluated on a business level. Not surprisingly, in the current environment, financial institutions disposing of distressed debt generally seek to apply this same disposition philosophy to those sales as well. Because this debt is being sold at a discount to its face value and/or a discount to the value of the underlying collateral property, selling lenders often take the view that it is justifiable to shift to the buyer all manner of risk existing at the time of sale, as to both the integrity and enforceability of the debt, and the possibility of borrower claims and defenses based on prior actions of the selling lender. Loan purchases, however, involve additional layers of greater risk than those present in the direct purchase of real estate. Certainly, all of the same risks related to the underlying collateral real estate are present and must be assessed. However, overlaying this risk is the risk of the integrity of the loan asset, including, most critically, the mortgage lien itself. Separating the risks into title and priority of lien, on the one hand, and the enforceability of the loan documents, on the other: As to title and lien priority, it is relatively straightforward to obtain title insurance covering the transfer of the mortgage itself. While on the face of it, it would also appear to be relatively straightforward to obtain title insurance offering continuing title insurance as to the priority of the mortgage lien, it is much less straightforward to obtain this insurance without exposure for the acts or omissions of the assigning lender/seller that may have impaired the lien of the mortgage. As in the case of a sale of real estate, if the seller is unwilling to provide assurances as to the title issue described above, or the continuing integrity of the loan documents generally, the alternative is to obtain third party assurances. In this case, the only third party’s assurances that are at all useful are those that come directly from the borrower. In many circumstances, the mortgage loans offered for sale in recent years by commercial banks and similar lenders have appeared on their face to be relatively low risk. They are not loans secured by properties worth significantly less than the amount of the debt. Rather, they are often matured construction loans or construction/mini-permanent loans, secured by successful projects (often, multi-family rental residential), with sufficient cash flow to service the debt and perhaps more (particularly in this low-interest rate environment), and with appraised values equal to or exceeding the outstanding debt; BUT, refinancing is not available because the appraised value will not sufficiently exceed the outstanding debt to satisfy loan-to-value criteria; and the borrower has no sources of additional capital in order pay down the debt in connection with a refinancing. The relationship of the amount of the debt to the internal economics of the collateral property creates a perception of high quality and low risk in these loans. Certainly, their sellers believe they are high quality and low risk, because they are regularly offered for sale in auction environments under harsh proposed sale terms and under expectations of a purchase price at a minimal discount from the face amount of the debt (which is often the case). However, in light of the nature of the loan as an asset, the economically more sound loan is often the more risky loan in terms of the likelihood of encountering borrower intransigence and opposition. A borrower who is far “under water” has little or no incentive to oppose a lender’s efforts to foreclose the property, particularly if the loan is non-recourse and there is no threat of “carve-out” liability. However, the borrower who has developed a successful project that is servicing its debt but cannot be refinanced is much more likely to view the loss of its equity as a temporary aberration of the market cycle, and much more likely to be incentivized to fight for the time that might allow the market cycle to resurrect that equity. The “loan to own” buyer’s strategic approach to these perceptibly “high quality/low risk” loans will vary. The ultimate goal in purchasing the loan and, hopefully, acquiring the property, is to recapture not only the borrower’s lost equity but also any upside beyond that. At one extreme, the “loan to own” buyer could be the identified source of the new equity that is required to allow the asset to be recapitalized and refinanced, under an arrangement with the borrower that allows the borrower to retain an opportunity to salvage some of its equity once the new equity has been retired with an agreed-upon return. At the other extreme, the borrower could be girded for battle, in which the “loan to own” buyer confronts a variety of possibilities. It may be paid off at face value, which means the quality of the investment return will be determined by the depth of the purchase discount, the interest rate on the loan (and whether any default interest can be collected) and the length of time that the loan is held. On the other hand, the buyer may face a protracted battle with the borrower either inside or outside of bankruptcy, including all manner of claims by the borrower as to why the loan is not enforceable as written, usually due to the alleged actions of the selling lender. It is in this context that the “loan to own” buyer must assess, and attempt to ensure, the quality of the asset it is purchasing. TITLE INSURANCE FOR THE MORTGAGE ASSIGNMENT Under the 2006 ALTA title insurance forms, the assignee of an insured mortgage is entitled, without more, to the rights and benefits of the original lender under the policy. Under Section 1(e) of the Conditions of the policy, successor owners of the loan are “insureds”, but with caveats: (e) “Insured”: The Insured named in Schedule A. (i) The term “Insured” also includes (A) the owner of the Indebtedness and each successor in ownership of the Indebtedness, whether the owner or successor owns the Indebtedness for its own account or as a trustee or other fiduciary…. * * * (ii) ... reserving, however, all rights and defenses as to any successor that the Company would have had against any predecessor Insured, unless the successor acquired the Indebtedness as a purchaser for value without Knowledge of the asserted defect, lien, encumbrance, or other matter insured against by this policy. * * * There are two forms of endorsement to the original lender’s policy available to insure the assignment: ALTA Endorsement 10-06 (Attachment 1) does not “date down” the policy or bring forward any coverages of the policy or any endorsements that are a part of the policy. It merely insures the effectiveness of the assignment and that no release or reconveyance has been placed of record. It does not cover matters recorded after the effective date of the original policy, except to insure that no release or reconveyance has been recorded. The coverage provided by this endorsement is generally conditioned upon the proper endorsement and delivery of the underlying notes. ALTA Endorsement 10.1-06 (Attachment 2), as is the case with ALTA 10, the ALTA 10.1 insures the effectiveness of the assignment and insures that no release or reconveyance has been placed of record (other than as may be noted in the endorsement). Like ALTA Endorsement 10-06, the coverage provided by this endorsement is conditioned upon the proper endorsement and delivery of the underlying notes. However, unlike ALTA Endorsement 10-06, in addition, this endorsement does “date down” the policy and provide coverage over certain enumerated matters occurring after the effective date of the policy and before the date of endorsement. By its express terms, this endorsement does not “date down” the policy for purposes other than as stated, that is, the endorsement does not bring forward coverages of any other endorsements that are a part of the policy. In most circumstances involving commercial properties, the underwriting guidelines for the title company to issue an ALTA 10.1 endorsement will require an estoppel statement from the owner of the collateral property as a condition to the issuance of either of the above endorsements. The title company’s requirement would generally provide: A written sworn statement by the record owner of the land, stating that the lien of the mortgage(s) is (are) still good and valid and, in all respects, free from all defenses, both in law and in equity, should be furnished to the Company. Attachment 3 is a sample of such an estoppel. In some circumstances, the title company will accept an indemnity from the assignor if the borrower estoppel is not available. If neither a borrower estoppel or assignor indemnity is available, any endorsement would be subject to an exception such as the following: Consequences, if any, arising out of any inability to foreclose or delay in foreclosing the Insured Mortgage(s) based upon the expiration of any statute of limitations, or challenges raised to the priority or enforceability of the Insured Mortgage based upon the acts or conduct of the original or subsequent lender. Even if an estoppel or indemnity has been obtained, for insurance of assignments of a loan known to be non-performing, the title company will include the element of the above exception related to statutes of limitation to address the possibility that the loan is so far past due as to be unenforceable. While the underwriting procedures followed by the title companies (i.e. borrower estoppel and/or assignor indemnity) suggest their belief that the issuance of an ALTA 10.1 endorsement insures the assignee against the most fundamental risk in the transaction – the risk of a borrower claim of invalidity or unenforceability of the mortgage based on the actions of the prior lender since the date of the policy – a close reading of these endorsements and the ALTA 2006 Loan Policy form leaves some significant doubt about this. The ALTA 10.1 extends the date of the policy as to the specific enumerated matters that it insures; by its express terms, it does not otherwise extend the date of the policy or any of its coverages. Most notably, it does not extend the date of policy for the purpose of insuring clause 9 of the ALTA 2006 Loan Policy form: 9. The invalidity or unenforceability of the lien of the Insured Mortgage upon the Title. … Without an extension of the date of policy for the coverage of clause 9, it is difficult conclude that the ALTA 10.1 provides the desired coverage. While clause 2.c. of the ALTA 10.1 does provide insurance of priority over “defects, liens, or encumbrances” arising since the date of the policy, it is hard, in light of the failure to extend the coverage of clause 9 of the ALTA 2006 Loan Policy form, to read this as including coverage for the types of borrower claims that are of the greatest concern. Since the substance of the estoppel in Attachment 3 would appear to go directly to the issue of “validity or enforceability of the lien”, it is puzzling that the ALTA 10.1 does not expressly include that coverage. Moreover, there remains some question as to whether the ALTA 10.1 leaves open issues of the imputation of the acts of the assigning lender to undermine or invalidate even the limited scope of coverage provided. Is the endorsement’s merely changing the “Insured” under the policy from the assignor to the assignee as of the date of endorsement sufficient? The assignor was the “Insured” under the same policy prior to the date of endorsement. Better practice would suggest the inclusion of some affirmative statement of non-imputation. Even better practice, were the title insurer willing, would be the issuance of a completely new policy in favor of the assignee. THE “LOAN TO OWN” BUYER AND BANKRUPTCY On the face of it, the buyer of a loan should fare no better or worse in a borrower bankruptcy than the original holder of the loan. However, in light of the uncertain, and sometimes seemingly capricious, nature of results in bankruptcy court, depending on whether a particular court or judge is pro-lender or pro-debtor, are there particular risks for the “loan to own” buyer in this environment? The “loan to own” buyer has purchased a loan with no intent of being a lender. This reality may be evidenced by the very fact that the buyer has purchased a distressed loan; and, it is very likely to be strongly evidenced by the buyer’s dealings with the borrower, or lack thereof, after the purchase. Will the “loan to own” buyer’s behavior as the holder of the loan impact its treatment in bankruptcy? In Radlax Gateway Hotel, LLV v. Amalgamated Bank, 132 S.Ct. 2065 (2012), the Supreme Court recently ruled on the ability of a debtor to confirm, over the objection of a secured lender, a “cramdown” plan that called for the auction of a secured lender’s collateral property under auction rules that prohibited the secured lender from credit bidding in the auction. At issue was the secured lender’s right to credit bid, under Section 363(k) of the Bankruptcy Code, which provides: Unless the court for cause orders otherwise the holder of such claim may bid at such sale, and, if the holder of such claim purchases such property, such holder may offset such claim against the purchase price of such property. (Emphasis added) The Bankruptcy Court had found that there was no “cause” to deny credit bidding, and the debtor did not appeal this finding. The debtor sought to confirm that plan under the “cramdown” provisions of Section 1129(b)(2)(A), on the basis that the plan provided the secured lender the “indubitable equivalent” of its secured claim. Referring to the matter before it as an “easy case”, the Court had little difficulty rejecting the debtor’s arguments (which, as described by the Supreme Court, appeared to be little more than sophistry) rather summarily. However, there are two interesting things about the case that are relevant to this discussion. First, the very fact that a matter such as this reached the Supreme Court demonstrates just how dangerous an environment bankruptcy court can be for lenders. Second, and more substantively, because the debtor had not appealed on this basis, the opinion in Radlax does not address at all the issue of what would constitute “cause” to deny a lender the right to credit bid. There are, of course, more general risks, such as seemingly innocuous discrepancies in loan documents in the hands of a bankruptcy judge. In In re Head Grading, Co., the United States Bankruptcy Court for the Eastern District of North Carolina held a deed of trust invalid and declared an $180,000 debt unsecured where the promissory note was misdated by a single day and thus, the court ruled that there was no “note of even date” as described in the trust. In re Head Grading, Co., 353 B.R. 122 (Bankr. E.D.N.C. 2006). The court found that “North Carolina law requires deeds of trust to specifically identify the debt referenced therein,” Id. at 123 (citing In re Foreclosure of Deed of Trust of Enderle, 431 S.E.2d 549 (N.C. Ct. App. 1993), and Putnam v. Ferguson, 502 S.E.2d 385 (N.C. Ct. App. 1998)), and reasoned that because the date in the deed of trust and the note differed, “it did not properly and specifically identify the obligation secured.” Id. at 124. The court stated that the “clarity and certainty in lien perfection requirements would be lost” if the rule were not strictly adhered to. Id. A prospective buyer of this loan could reasonably conclude that, under state law, this would be a scrivener’s error that is resolved by reference to the other evidence on the face of the documents themselves, or, if a defect, one that is readily subject to reformation of the instrument. Thus, a prospective buyer of this loan could reasonably conclude that there was no material risk. It is worth noting that the decision in Head Grading was contrary to an earlier state court decision apparently precisely on point. In In re Foreclosure of Hooper, the North Carolina Court of Appeals affirmed a trial court ruling that upheld the validity of the foreclosure of a deed of trust that was dated November 10, 1995, and purported to secure a $150,000 debt obligation “as evidenced by Promissory Note of even date herewith, the terms of which are incorporated by reference”, even though there was no promissory note dated November 10, 1995. It did so based on extrinsic evidence offered by the lender and the lack of any contrary evidence offered by the buyer. See, John C. Murray, Defective Real Estate Documents: What are the Consequences?, 42 Real Prop. Prob. & Tr. J. 367, 404 (2007). (Summarizing In re Foreclosure of Hooper, 541 S.E.2d 524 (2000) (unpublished decision)). Herein lies a potential serious risk for the “loan to own” buyer. Assume that the debtor in bankruptcy can demonstrate from discovered evidence the lender’s acquisition of the loan with a clear intent to acquire the property through foreclosure, and a post-acquisition course of conduct by a loan buyer which, while clearly within the lender’s rights, is perceived to be unreasonable and contrary to customary practice of lenders desiring only to be paid in full. Could the debtor successfully argue that such a course of conduct constitutes “cause” to deny the right to credit bid under Section 363(k)? As noted above, the Supreme Court provides no insight on this issue in the Radlax case; and there is little other case authority on the issue, certainly none that is particularly helpful to this analysis. See, John T. Gregg, A Review of Credit Bidding Under 11 U.S.C.A. §363(k), Norton Annual Survey of Bankruptcy Law (August 2008). Would such a course of conduct move a bankruptcy judge to reach an absurdly harsh result on other issues, as in Head Grading? In any event, a “loan to own” buyer, in its dealings with the borrower, would be prudent to balance its desire to acquire the property against the risk of behaving overly aggressively in its efforts to do so. TAX TRAPS There are a variety of potential tax risks to a buyer of a note at a discount that must be borne in mind in any “loan to own” strategy. These are risks that, generally speaking, are not present for the original holder of the note. These risks emanate from the fact that the buyer of a note at a discount has a tax basis in the note equal to the purchase price for the note, rather than the fact amount of the debt. As long as the buyer holds the note without triggering a taxable event, this fact does not present any particular challenges. However, there are a number of circumstances where the tactical steps that are integral to a “loan to own” strategy could constitute a taxable event, thereby triggering “phantom” income to the note buyer. (For a complete treatment of the tax implications of the acquisition of distressed real estate loans, see Chester W. Grudzinski, Jr., The Consequences Of Acquiring Distressed Real Estate Loans, 37 WGL-RETAX 14 (2009)). 1. Significant Modification of Note – Exchange Triggering Tax If the buyer of a note at a discount subsequently engages in a “significant modification” of the note, the buyer is treated as having exchanged the purchased note for a “new” modified note. This exchange is a taxable event, which triggers a “phantom” gain (or loss) in the amount of the difference between the buyer’s basis in the note (initially, its purchase price) and the value of the “new” modified note (generally, its face amount). This gain (or loss) will either be short term or long term capital gain, depending on whether the modification is deemed to have occurred within one year after acquisition of the note, or thereafter. Under IRC Regulations §1.1001-1(a), the gain or loss realized from the conversion of property into cash, or from the exchange of property for other property “differing materially either in kind or in extent”, is treated as income or as loss sustained. The amount realized from a sale or other disposition of property is the sum of any money received plus the fair market value of any property (other than money) received. Under Regulations §1.1001-3(b), a significant modification of a note, results in an exchange of the original note for a modified note that “differs materially either in kind or in extent” for the purposes of Regulations §1.1001-1(a), resulting in the possibility of a taxable event. A modification that is not a “significant modification” is not an exchange for purposes of §1.1001-1(a). Under Regulations §1.1001-3(c)(1), a modification can occur either by agreement of the parties, or by operation of the terms of the note. The former includes “any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument, whether the alteration is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise”. Regulations §1.1001-3(c)(1)(i). Additionally, while, generally, an alteration of a legal right or obligation that occurs by operation of the terms of a note is not a modification, there are certain alterations which will constitute modifications, even if they occur by operation of the terms of the note: Specifically: An alteration that results in the substitution of a new obligor, the addition or deletion of a co-obligor, or a change (in whole or in part) in the recourse nature of the instrument (from recourse to nonrecourse or from nonrecourse to recourse) is a modification. An alteration that results in the conversion of a note to an instrument or property right that is not debt for Federal income tax purposes is a modification unless the alteration occurs pursuant to a holder's option under the terms of the instrument to convert the instrument into equity. An alteration that results from the exercise of an option provided to an issuer or a holder to change a term of a note is a modification unless: o the option is “unilateral”; and o in the case of an option exercisable by a holder, the exercise of the option does not result in (or, in the case of a variable or contingent payment, is not reasonably expected to result in) a deferral of, or a reduction in, any scheduled payment of interest or principal. An option is “unilateral” only if, under the terms of an instrument or under applicable law: (i) there does not exist at the time the option is exercised, or as a result of the exercise, a right of the other party to alter or terminate the instrument or put the instrument to a person who is related to the issuer; (ii) the exercise of the option does not require the consent or approval of (a) the other party, (b) a person who is related to that party, or (c) a court or arbitrator; and (iii) the exercise of the option does not require consideration (other than incidental costs and expenses relating to the exercise of the option), unless, on the issue date of the instrument, the consideration is a de minimis amount, a specified amount, or an amount that is based on a formula that uses objective financial information. Regulations §1.1001-3(c)(3). The failure of a party to exercise an option to change the terms of the note is not a modification. Regulations §1.1001-3(c)(5). Generally, the failure of the borrower to perform its obligations under the note is not itself viewed as an alteration of a legal right or obligation and, therefore, is not a modification. Regulations §1.1001-3(c)(4)(i), Similarly, a mere forbearance by the note buyer is not a modification. However, if the forbearance is accompanied by a written or oral agreement to modify other terms of the note, it will constitute a modification, as will a forbearance that extends for a period more than two years, plus any additional period that the parties are engaged in good faith negotiations, plus any period that the borrower is in bankruptcy. Regulations §1.1001-3(c)(4)(ii). As to the time at which a modification is deemed to have occurred: A modification occurs at the time of execution of an unconditional operative agreement, even if not effective until a later date. However, if the agreement is subject to conditions, then the modification occurs upon the satisfaction of the conditions and the agreement’s becoming effective. 3(c)(6)(i) and (ii). Regulations §1.1001- A modification that results from a bankruptcy plan of reorganization occurs at such time as the plan becomes effective. Whether the modification of a debt instrument is a significant modification is determined under Regulations §1.1001-3(e). The general rule is set out in Regulations §1.1001-3(e)(1): “General rule. Except as otherwise provided in paragraphs (e)(2) through (e)(6) of this section, a modification is a significant modification only if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant. In making a determination under this paragraph (e)(1), all modifications to the debt instrument (other than modifications subject to paragraphs (e)(2) through (6) of this section) are considered collectively, so that a series of such modifications may be significant when considered together although each modification, if considered alone, would not be significant.” To supplement this less than helpful general rule, Regulations §1.1001-3(e) specifies the following objective tests and “safe harbors”: 1. Change in Yield: A change in yield that is more than the greater of 25 basis points (0.25%) and 5% of the existing annual yield is deemed significant. Regulations §1.1001-3(e)(2)(ii). 2. Change in Timing of Payments: In general, a modification that changes the timing of payments (including any resulting change in the amount of payments) due is a significant modification if it results in the material deferral of scheduled payments. The deferral may occur either through an extension of the final maturity date or through a deferral of payments due prior to maturity. The materiality of the deferral depends on all the facts and circumstances, including the length of the deferral, the original term of the instrument, the amounts of the payments that are deferred, and the time period between the modification and the actual deferral of payments. Regulations §1.1001-3(e)(3)(i). While this general statement is not very useful, there is a “safe harbor” period which begins on the original due date of the first scheduled payment that is deferred and extends thereafter for a period equal to the lesser of five years and 50% of the original term of the instrument (without reference to borrower options to extend). The deferral of one or more scheduled payments within the safe-harbor period is not a material deferral if the deferred payments are unconditionally payable no later than at the end of the safe-harbor period. If the period during which payments are deferred is less than the full safe-harbor period, the unused portion of the period remains a safe-harbor period for any subsequent deferral of payments on the instrument. Regulations §1.1001-3(e)(3)(ii). 3. Change in Obligor: If the note is a recourse debt instrument, then the substitution of a new obligor is a significant modification. Regulations §1.10013(e)(4)(i). Conversely, if the note is a nonrecourse debt instrument, then the substitution of a new obligor is not a significant modification. Regulations §1.1001-3(e)(4)(ii). The Regulations do not provide any guidance on how “carve out” guaranties or “springing” guaranties bear on the question of whether the note is a “recourse debt instrument”. 4. Addition or Deletion of Co-obligor: The addition or deletion of a co-obligor is a significant modification if the addition or deletion of the co-obligor results in a change in payment expectations. Regulations §1.1001-3(e)(4)(iii). 5. Change in Security or Credit Enhancement: A modification that releases, substitutes, adds or otherwise alters the collateral for, a guarantee on, or other form of credit enhancement for, a recourse debt instrument is a significant modification if the modification results in a change in payment expectations. Regulations §1.1001-3(e)(4)(iv)(A). As to “nonrecourse debt instruments” this issue is addressed in a temporary regulation effective July 6, 2011, which provides that a modification that releases, substitutes, adds or otherwise alters a substantial amount of the collateral for, a guarantee on, or other form of credit enhancement for a nonrecourse debt instrument is a significant modification. The substitution of a similar commercially available credit enhancement contract is not a significant modification; and, an improvement to the property securing a nonrecourse debt instrument does not result in a significant modification. Regulations §1.1001-3T(e)(4)(iv)(B). 6. Change in Priority of Debt: A change in the priority of a note relative to other debt of the borrower is a significant modification if it results in a change in payment expectations. 7. Change in Nature of Instrument as Debt: A modification that results in an instrument or property right that is not debt for Federal income tax purposes is a significant modification. 8. Change in Recourse Nature of Instrument: A change in the nature of a note from recourse (or substantially all recourse) to nonrecourse (or substantially all nonrecourse) is a significant modification. Similarly, a change in the nature of a note from nonrecourse (or substantially all nonrecourse) to recourse (or substantially all recourse) is a significant modification. 9. Accounting or Financial Covenants. A modification that adds, deletes, or alters customary accounting or financial covenants is not a significant modification. The Regulations provide that a “change in payment expectations” can be either a positive or negative change, and occurs if, as a result of a transaction: a. there is a substantial enhancement of the obligor’s capacity to meet the payment obligations and that capacity was primarily speculative prior to the modification and is adequate after the modification; or b. there is a substantial impairment of the obligor’s capacity to meet the payment obligations and that capacity was adequate prior to the modification and is primarily speculative after the modification. 2 Tax Triggered by Foreclosure If the buyer of a note at a discount subsequently acquires the collateral property through foreclosure or deed in lieu of foreclosure, the buyer will be deemed to have disposed of the note in return for its acquisition of the collateral property. If the value of the collateral property exceeds the buyer’s then basis in the note, the foreclosure or deed in lieu of foreclosure will trigger a “phantom” gain in the amount of the excess. Again, this gain will either be short term or long term capital gain, depending on whether the foreclosure or deed in lieu of foreclosure occurs within one year after acquisition of the note, or thereafter. While the value of the property at the time of foreclosure will always be subjective and open to debate, it goes without saying that the essential goal of the “loan to own” note buyer is to purchase the note for a price substantially below the value of the collateral property. One question that always comes up is whether the amount bid in at a foreclosure sale represents the fair market value of the property. While the results of the foreclosure sale will be relevant evidence of the fair market value, courts have routinely held that the foreclosure sale bid by the lender is not determinative of fair market value and can be rebutted by other evidence. 3. Market Discount Generating Ordinary Income The purchase of a note at a discount creates a “market discount” for tax purposes in an amount equal to the amount of the discount. This “market discount” then accrues over the remaining term of the note and is required to be recognized as ordinary income (rather than capital gain) at the time of payment or disposition of the note. The policy behind the market discount rules reflects Congress’s belief that differences between the purchase price of a note and the remaining principal amount reflect changes in interest rates, and the corresponding gain should be taxed similarly to interest. However, in the case of a mortgage in default, the value of the mortgage is more tied to the value of the collateral than the prevailing interest rates. Accordingly, there may be arguments that these market discount rules do not apply to notes that are in default and accelerated at the time of purchase. For example, legislative history indicates Congress’s intent to exclude from the application of the market discount rules the purchase of a demand loan, under the theory that it is short term by nature and relatively immune from fluctuations in value caused by interest rate swings. A mortgage note in default is arguably analogous to a demand loan and should be similarly excluded from the application of the market discount rules. If the market discount rules do apply to mortgage notes in default, a number of issues remain. Generally, the difference between the principal amount and the purchase price of the note would be the amount of the market discount. However, in a “loan to own” situation, the buyer would rarely expect to get the full principal amount, so it would be nonsensical to treat the remaining principal balance as the appropriate measure of market discount. Similarly, the market discount accrues over the remaining term of the note. Again, in a “loan to own” transaction, the buyer of the note does not expect to hold the note to maturity, so the typical market discount accrual period arguably should not apply. These issues make analyzing the impact of the market discount rules problematic at best. Even though these rules have been enacted in 1984, Treasury has not taken steps to address the applicability of the market discount rules to purchases of notes in default. ATTACHMENT 1 - ALTA 10 Endorsement - 2006 (Assignment) ENDORSEMENT Attached to Policy No. _________ Issued By Title Insurance Company 1. The name of the Insured is amended to read: _________________. 2. The company insures against loss or damage sustained by the Insured by reason of: a. The failure of the following assignment to vest title to the Insured Mortgage in the Insured: ________________________________________________________________; b. Any modification, partial or full reconveyance, release, or discharge of the lien of the Insured Mortgage recorded on or prior to Date of Endorsement in the Public Records other than those shown in the policy or a prior endorsement, except: ________________________________________________________________; This endorsement shall be effective provided that the note or notes secured by the lien of the Insured Mortgage have been properly endorsed and delivered to the Insured at Date of Endorsement. This endorsement is issued as part of the policy. Except as it expressly states, it does not (i) modify any of the terms and provisions of the policy, (ii) modify any prior endorsements, (iii) extend the Date of Policy, or (iv) increase the Amount of Insurance. To the extent a provision of the policy or a previous endorsement is inconsistent with an express provision of this endorsement, this endorsement controls. Otherwise, this endorsement is subject to all of the terms and provisions of the policy and of any prior endorsements USADMIN 9792793 3 ATTACHMENT 2 - ALTA 10.1 Endorsement - 2006 (Assignment and Date Down) ENDORSEMENT Attached to Policy No. _________ Issued By Title Insurance Company 1. The name of the Insured is amended to read: _________________. 2. The company insures against loss or damage sustained by the Insured by reason of: a. The failure of the following assignment to vest title to the Insured Mortgage in the Insured: __________________; b. Any liens for taxes or assessments that are due and payable on Date of Endorsement, except: _________; c. Lack of priority of the lien of the Insured Mortgage over defects, liens, or encumbrances other than those shown in the policy or a prior endorsement, except: __________; d. Notices of federal tax liens or notices of pending bankruptcy proceeding affecting the Title and recorded subsequent to Date of Policy in the Public Records and or prior to Date of Endorsement, except: ______________________________ ; e. Any modification, partial or full reconveyance, release, or discharge of the lien of the Insured Mortgage recorded on or prior to Date of Endorsement in the Public Records other than those shown in the policy or a prior endorsement, except: __________________________. This endorsement shall be effective provided that the note or notes secured by the lien of the Insured Mortgage have been properly endorsed and delivered to the Insured at Date of Endorsement. This endorsement is issued as part of the policy. Except as it expressly states, it does not (i) modify any of the terms and provisions of the policy, (ii) modify any prior endorsements, (iii) extend the Date of Policy, or (iv) increase the Amount of Insurance. To the extent a provision of the policy or a previous endorsement is inconsistent with an express provision of this endorsement, this endorsement controls. Otherwise, this endorsement is subject to all of the terms and provisions of the policy and of any prior endorsements USADMIN 9792793 3 AFFIDAVIT AND ESTOPPEL CERTIFICATION State of , County of : The undersigned, being first duly sworn, deposes and says the following: (1) I am: (i) the [title or office:] _________________of [company name:] , OR (ii) [name] _____________, an individual, the Borrower that made, executed, and delivered that certain deed of trust or mortgage (“Mortgage”) in favor of , as the original beneficiary or mortgagee, dated , recorded in __________, in the land records of County, ________. (2) This Affidavit and Estoppel Certification (Certification) is made to the best knowledge of the undersigned Borrower. (3) Based on information and belief, the Mortgage is a good and valid lien upon the property described therein (Property), and the Mortgage and the note or notes, indebtedness and other obligations secured by the Mortgage (Obligations) are in all respects free from all defenses, in law and in equity. (4) This Certification is made for the protection and benefit of the current owner and holder of the Obligations secured by the Mortgage, and all other parties that may acquire an interest in the Property, and particularly for the benefit of any title insurer that insures the title to the Property directly or indirectly in reliance on the facts and representations contained in this Certification (Borrower) By: OR _________________________________ (Borrower, individually) SUBSCRIBED AND SWORN TO before me this ____ day of 20___. Notary Public for My commission expires: USADMIN 9792793 3 ,