Deeds-In-Lieu of Foreclosure, The Deficiency and Zombie Notes

By Larry R. Rothenberg, Esq.

Until the last few years, when creditors accepted a deed-in-lieu of foreclosure, the transaction almost always provided for a cancellation of the note and a release of any further liability on the part of the borrower.  However, times have changed.  A release of further liability in connection with a deed-in-lieu transaction is no longer automatic. There is now a clear trend for mortgage holders to consider more rigorously whether the circumstances warrant agreeing to accept a deed-in-lieu only if the borrower agrees to remain liable for a deficiency. 

Some mortgage holders calculate the deficiency based on the total debt less the proceeds of the future sale of the REO.  However, using this method may cause some problems.  A court might not enforce an action to collect until the amount of the deficiency is ascertainable.  What if the REO is not sold for an extended period of time?  In addition, once the REO is sold, the mortgage holder may be vulnerable to claims or defenses by the borrower that the deficiency is not enforceable because: 

– The REO was not marketed and sold within a reasonable time
– The REO was not sold in a commercially reasonable manner, and should have been sold for a larger amount
– The mortgage holder failed to use reasonable diligence in maintaining or protecting the property, resulting in unnecessary loss in value

In order to avoid exposure to such problems, it would be preferable to have the amount of the deficiency established with certainty at the time of closing the deed-in-lieu transaction.  For example, the agreement may provide for a credit based on a current appraisal of the market value or a quick sale value of the property.  The deficiency may also be established based on an agreed amount determined by other methods.

In any event, if the borrower is to remain liable for a deficiency, it is important to have the borrower sign an agreement evidencing an understanding of the liability for the deficiency.  In order to avoid misunderstandings and unwanted litigation, as well as to ensure compliance with the Fair Debt Collection Practices Act, the agreement should be written in terms that are understandable to the least sophisticated consumer.

It goes without saying that if the deed-in-lieu transaction calls for a release of further liability, the original note should be canceled and returned to the borrower promptly after the closing of the deed-in-lieu transaction. 

A recent news item reported a lawsuit filed in Florida by a borrower against the investor, the loan servicer, and the servicer’s attorney, alleging that the borrower was lead to believe that the deed-in-lieu transaction was in consideration of a full release of further liability, but the canceled Note had not been delivered.  The report refers to the note as a “Zombie Note”, speculating that the Note might come back to life and haunt the borrower if it is sold to a debt buyer. 

Such lawsuits can be avoided by promptly delivering the canceled note to the borrower in cases where there is to be a release of further liability, or by having a clear, signed agreement providing for liability for a deficiency.

If you have any questions on this matter, please contact Mr. Larry R. Rothenberg, Esq. Larry is the partner-in-charge of the Cleveland real estate and foreclosure department of WWR. He is the author of the Ohio Jurisdictional Section within the treatise, “The Law of Distressed Real Estate”, and was a contributing author to “Ohio Foreclosures, What You Need To Know Now”, published by The West Group. He can be reached at 216.685.1135 or


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