Nontraditional Mortgage Products -- The Slippery Slope Became an Avalanche

On December 28, 2006, in my second post on this Blog, I wrote about the foreseeable and serious problems that would result from the boom in "creative" financing (sub prime loans, loans made with no down payment, ARM loans with low teaser rates that would reset in 2007 & 2008). I called the post, "'Creative'" Financing -- The Slippery Slope in 2007." This became the biggest economic and real estate story of 2007, as the slide turned into an avalanche.

But this blog is not about economics or predicting the future. So what really changed in the area of real estate law as a result of the creative financing fiasco?

As discussed in my last post, borrowers who negotiate a loan reduction or lose their homes to foreclosure will not be required to pay federal income taxes on phantom income.

The California Legislature has enacted a new law to warn borrowers about "nontraditional mortgage products." After January 1, 2008, Senate Bill 385 will require additional written disclosures for nontraditional mortgage products (e.g., loans that negatively amortize or bear interest only). The additional disclosures must be made in both disclosure statements and advertising. A violation of the new law may be a crime. Unfortunately, a mortgage broker cannot determine the content of the additional disclosures by reading SB 385 itself. Rather, the mortgage broker is referred to various guidelines and regulations to learn what he must disclose. SB 385 also broadens the definition of a real estate broker for lenders. This is significant because it is a crime in California to act as a real estate broker without a license. To read the highlights of SB 385, see Business & Professions Code section 10240.3 and Financial Code sections 215.5 and 22171.

In an apparent attempt to curb mortgage fraud, in California effective January 1, 2008, a notary public who acknowledges a document must certify under penalty of perjury under the laws of the State of California that the facts acknowledged by the notary are true and correct, including that the signer has presented documentary proof that he is who he says he is. (It is no longer good enough for a notary to state that they personally know the signer.) Civil Code section 1189.

That's about it. The other laws regulating brokers, lenders and borrowers are pretty much the same. And there are no new laws against financial institutions, lenders and borrowers from "creatively" finding new ways to lose money.

U.S. Mortgage Relief Act

Until yesterday, debt that was forgiven in a foreclosure or as part of a loan workout was classed as income. For example, a homeowner who negotiated a short sale with her lender was required to recognize as income the amount of the loan that was forgiven.
That changed when President George W. Bush signed the Mortgage Forgiveness Debt Relief Act into law.

The measure will eliminate income taxes for many homeowners who must restructure their mortgages as they face foreclosure. The new law relieves a homeowner of the burden of paying additional income taxes if his lender has reduced the original loan amount to make it easier to continue making the mortgage payments. The law is a response to the rising waive of foreclosures and the re-setting of interest rates in 2008 on as many as 1.8 million mortgages.

DISCLOSURES IN THE SALE OF RESIDENTIAL REAL ESTATE -- No Fairytale Endings

Let's imagine that you were interested in purchasing house in Beverly Hills -- just for fun, let's call it the Hansel and Gretel house. Let's also imagine that you found a local broker to represent you in the negotiations with the seller. In our fairytale, the broker had competed unsuccessfully for the listing on the house and in the process learned that it required significant structural repairs. After the house was put on the market, your broker fails to tell you about all of the problems with the house he previously learned about. You do not learn of the structural problems until after the close of escrow. Can this story have a happy ending for the non-disclosing broker?

The Court of Appeal recently answered "no" in Michel v. Moore & Associates, Inc. (2007) 156 Cal. App. 4th 756. In that case a real estate agent, Larry Kirkpatrick of Moore & Associates, conducted a walk through of a house in the hopes of getting a listing. In the process, the agent Kirkpatrick took notes about problems with the house that would have to be disclosed by a listing broker to a buyer, including symptoms of structural problems (cracks in the pool, sliding doors that don't close properly, hardwood floors that are separating and damaged stucco). After another broker got the listing, Kirkpatrick showed the house to the eventual buyer. The buyer learned from the Transfer Disclosure Statement that there were interior cracks, but did not learn the other information contained in Kirkpatrick's notes.

Following the close of escrow and significant rains, further cracking appeared in the interior walls of the house. The buyer conducted an investigation and discovered the floor was out of level and there was a major soil instability problem. The buyer sued Moore & Associates.

At trial the jury returned a verdict in favor of Moore & Associates on the grounds that Kirkpatrick did not fail in his duty under Civil Code section 2079 to conduct reasonably competent inspection and did not fraudulently conceal any facts.

The Court of Appeal reversed, holding that Moore & Associates owed a fiduciary duty to the buyer that is broader than the more limited, non-fiduciary duty under Civil Code section 2079. Under the broker's fiduciary duty, he must inform the buyer of all information in his possession that is material to the buyer's interests, regardless of how the information is obtained. The failure to make such disclosure is actionable as "constructive fraud," which is easier to prove than actual fraud because the latter requires proof of intent to defraud.

The moral to our fairytale -- when in doubt, disclose. Non-disclosure cases are quite common in residential real estate transactions. I have handled a number of them in my law practice, including a six week trial of a case involving a crack in a closet. It is up to the seller to tell the broker everything that it is material about the house, but the buyer's broker also has a duty disclose all material, adverse information about the property.

The '07 Wildfires -- A Helping Handbook

The recent wildfires have wreaked havoc on the lives of many families in Southern California. As a public service to those families, the Los Angeles County Bar Association and Morrison & Forester have published a "Helping Handbook" available on line. This handbook contains a compendium of California and Federal real estate and insurance law that will assist wildfire victims in the recovery process.

To read the Helping Handbook, click here.

Trade Secrets and Commercial Real Estate

Real estate and business litigation are first cousins. This fact is illustrated by the recent Court of Appeal opinion in San Jose Construction v. S.B.C.C., Inc. -- an action by one commercial construction company against another for misappropriation of trade secrets.

Plaintiff's former employee, a project manager, took confidential documents with him to his new job with a competitor. The documents were a compilation of information about the "design build" of more than a dozen projects that plaintiff used to emerge as the successful bidder on the projects. Using the confidential information, the former project manager sought to have the developers shift to his new employer.

The case contains a helpful summary of the law of trade secrets and unfair competition in CA. As in many trade secret cases, the defendant tried to "slice and dice" the information by claiming each bit of information by itself was not confidential. The plaintiff argued that it was the compilation of information (much like a secret recipe) that made it a trade secret. The Court of Appeal agreed by holding that plaintiff raised a triable issue of fact in opposition to defendant's motion for summary adjudication.

Trade secret cases are not uncommon in the real estate industry. Over the years, I have litigated cases involving proprietary building techniques used for factory built housing, customer lists in the mortgage business, and processes for originating specialized loans for multi-family housing.

GOLF TIPS FROM THE CAL. SUPREME COURT

In a recent case arising from an errant tee shot at Rancho Park Golf Course, Shin v. Ahn, the California Supreme Court opined about the benefits and risks of golf. One obvious lesson can be gleaned from the case: don't stand if front of a recreational golfer who is teeing off!

You may wonder how this case found its way into a blog about California real estate law. The case turns on the Court's extension of the legal doctrine of primary assumption of the risk. Where this doctrine is applied, the defendant must be guilty of conduct more serious than negligence -- recklessness. The doctrine is a branch of the law of premises liability and has bearing upon the liability of property owners/landlords to third persons/ tenants on their property. For example, primary assumption of the risk may apply if a worker at an apartment building is injured while he is engaged in work that is considered dangerous.

IS YOUR OPTION CONTRACT WORTH THE PAPER IT IS WRITTEN ON?

When I was a child, the Quaker Oats Company promoted the sale of its Puffed Wheat breakfast cereal by including a Deed for a square inch of land in the Klondike in each box. As a proud land owner at the age of 6, I thought about building a house on the top of a pole firmly planted in my inch of land in the Yukon Territory. However, I recently learned that all of us kids lost their land in the Klondike in 1965 for the non-payment of $37.20 in property taxes by Quaker Oats.

As the California Court of Appeal has just reminded us, sometimes a real estate contract is not worth the paper that it is written on. In Patel v. Liebermensch, the Court of Appeal held that an option contract to purchase real estate is unenforceable unless it contains all of the essential terms of a contract to purchase real property. In Patel, the buyer was not entitled to specific performance of the option contract because the parties had not agreed to the length of the escrow. The Court of Appeal concluded that the trial court had no basis for supplying additional terms that the parties had not agreed to. [Note, the Court of Appeal was reversed by the CA Supreme Court on 12/22/2008; see, January 2, 2009 post.]

The Patel case is a reminder that an option contract must be drafted with the same level of specificity as a purchase contract itself, and all of the essential terms must be included. If you are interested in finding a Los Angeles area real estate lawyer to help you with an option contract or another type of real estate contract, feel free to contact the author of this Blog. If you are interested in buying land in the Klondike, I suggest you consult with a real estate broker in Dawson City or Whitehorse.

BETWEEN A ROCK & A HARD PLACE -- Using A Short Sale to Avoid Foreclosure

In my December 28, 2006 post, I discussed some of the anticipated problems from the "boom" in subprime mortgages and other creative lending practices during recent years. I entitled the post, "'Creative' Financing -- The Slippery Slope in 2007."

It didn't take a crystal ball last December to predict the fall-out from adjustable rate home loans that facilitated the purchase of homes for unprecedented prices with lax underwriting and no money down. It was also apparent this would problem would create weighty issues in California real estate law during 2007 and beyond.

With the prices of homes declining in many areas, some borrowers are between a rock and a hard place. How does the owner of a home with no equity get out from under the loan without suffering a foreclosure and the resulting damage to his or her credit rating?

One strategy is a "short sale." A short sale requires the seller to first negotiate with the lender to reduce the balance of the loan subject to the sale of the property to a third party. For example, let's say the seller bought the house for $550,000 with a non-recourse loan of $500,000; the house is now worth $450,000; the seller persuades the lender to reduce the balance of the loan to $450,000 and sells the house for $454,000, with $450,000 going to the lender and the $4,000 used to pay a portion of the closing costs. The lender doesn't have to deal with the house as an "REO" (real estate owned by the lender); and the seller avoids the negative impact of a foreclosure and is no longer obligated to the lender after the sale is completed.

But there may be negative tax consequences to a short sale. Under the current tax law, the seller may have to recognize "phantom income" from the "cancellation of debt" in the amount of the loan reduction ($50,000). Any reader who wants to employ this strategy should consult with an accountant about the tax consequences of a short sale and to determine if an exemption from the payment of income tax on the cancellation of debt is available.

P.S. On August 31, 2007, President Bush proposed legislation to temporarily eliminate the recognition of income when the lender forgives a portion of the debt. Stay tuned! The Congress may move the boulder that is one of the impediments to short sale.

ILLEGAL REAL ESTATE CONTRACTS

Several years ago I tried an unlawful detainer case that the commercial tenants defended on the basis that their lease was void because it had been negotiated and signed by a unlicensed property manager. The court agreed that the Lease was void, but the tenants lost the case because they had no right to possession without a lease.

Illegality issues can arise in a number of other real estate cases: an unlicensed broker cannot recover a real estate commission; an unlicensed contractor may not be entitled to payment; and a contract for the sale of unsubdivided parcels of the land may be unenforceable.

This last issue was the subject of Black Hill Investments, Inc. v. Albertson's, Inc. (2007) 146 Cal.App.4th 883. In that case, a buyer was able to cancel a purchase agreement because the seller, Albertson's, Inc., failed to include the proper language in the contract. While it is generally illegal to sell parcels that have not been subdivided, there is an exception under Government Code section 66499.30(e) which permits the sale of an unsubdivided parcel when the contract is expressly conditioned on the recordation of a subdivision map. The contract in question allowed Albertson's Inc. to cancel the sale if the subdivision map was not recorded, but did not make the obligation of the buyer to purchase the parcel conditional upon the recordation of the map. Even though the subdivision map was recorded before the buyer canceled, the Court of Appeal determined the contract was void from its inception and could not be revived by the recordation of the map.

In entering into contracts for the sale of unsubdivided land, as well as other real estate contracts, the parties should take care to include the proper language and to confirm that the status of the parties will not render the contract void from its inception.

A TALE OF TWO MARKETS--THE LEGAL IMPACT

Two stories in the March 10, 2007 edition of the Los Angeles Times highlight the divergence between the residential and commercial real estate markets in Southern California.

As we discussed in our post on December 28, 2006, the residential market is on slippery footing because of the subprime and adjustable rate, 100% loans made when rising prices lifted all boats. The increase in foreclosures and mortgage delinquencies has rocked the financial markets. But the real casualties the people who hoped the rising market would protect them and now find they own homes with little equity and monthly loan payments they cannot afford.

The legal fall-out of the "creative financing" mania will trigger: a wave of non-judicial foreclosures and damaged credit ratings; and an increase in lawsuits by buyers who claim they were misled by brokers or lenders when they "creatively" financed home purchases beyond their means.

The commercial real estate market in So Cal is a different story. Some commercial tenants are being priced out of the market. The recent sale of Equity Office Properties to Blackstone for a record $39 billion is a sign of the times.

One lesson to be learned from the increase in commercial rents is the importance of negotiating lease options to extend the term when entering into a commercial lease. From the tenant's perspective, the option rent should be based on something other than an appraisal of fair market rental value before the option term begins. From the landlord's perspective, the option rent should be fixed by an arbitration that determines the fair market rental value with no right for the tenant to "rescind" if it disagrees with the arbitrator's determination.

BUYERS (AND AGENTS) BEWARE IF THE SELLER IS UPSIDE DOWN

In the January 30th post, I discussed the California statutes that regulate "foreclosure consultants" who seek to "assist" buyers who are in danger of losing their homes to foreclosure. There is an another group of California statutes that may be a trap for the unwary buyer of a house in foreclosure.

When mortgage defaults and foreclosures increase, investors may actively seek out homes owned by a buyer is in default before foreclosure sale takes place. California Civil Code sections 1695-1695.17 were enacted to protect homeowners in that vulnerable situation. In brief, if an owner resides in the home (or up to 4 residential units) and has equity in the property, the owner is in a protected class as an "equity seller." Subject to specific exclusions, if an investor tries to acquire title from an equity seller and does not intend to reside in the property, the investor is an "equity buyer."

When an equity buyer tries to enter into a deal directly or through an agent with an equity seller, there are a number of special requirements. For example, the equity seller has five (5) days to cancel and the equity buyer cannot pay any money to the seller during that time period. Violations of Civil Code sections 1695, et seq. can result in criminal penalties and fines.

There is another interesting protection for equity sellers. If an equity buyer is represented by an agent, the agent must have a bond from an admitted insurer in an amount equal to twice the fair market value of the property. But no insurer admitted in California offers such a bond, so agents should avoid representing equity buyers.

FORECLOSURE CONSULTANTS --The Risks in Bottom Feeding

The Sacramento Delta is known for its fishing... and for tides that can rise and fall as much as six feet. The residential real estate market goes through similar cycles. A rising market can lift all boats, and a declining market can cause some property owners to run aground.
Some people view this as a business opportunity and look for homeowners facing foreclosure who have equity in their homes but lack the ability to refinance. They may offer to rescue the homeowner from foreclosure and salvage their credit in exchange for title to the house. The distressed homeowner may also be granted an option for a fixed time period to re-purchase their home if they have a reversal of fortune.
But dealing with homeowners in foreclosure may be a trap for the unwary if they are ignorant of the Cal statutes that protect homeowners facing foreclosure. This is not a case where ignorance is bliss -- the violation of the statutes carry both civil and criminal penalties. (Civil Code 2945.6 & 2945.7)
The legislative findings in Civil Code 2945 explain why property owners of 1-4 residential units facing foreclosure need special protection. Civil Code 2945.1 broadly defines the term "foreclosure consultant" to include a variety of dealings with distressed property owners. Although the statutes contain specific exemptions, a 1997 California case holds that a licensed broker can be regulated as a foreclosure consultant.
A foreclosure consultant is required to prepare and enter into a written contract with the owner which discloses the nature of the services to be performed, the total amount of compensation and the terms of compensation. (Civil Code 2943) Foreclosure consultants must provide a statutory notice concerning the homeowner's legal rights under Civil Code 2943.5, including the right to terminate the contract within 3 days. An additional notice is required if the foreclosure consultant will assist the property owner in obtaining the release of any surplus funds after a completed foreclosure sale under Civil Code 2945.3(h).
Following the laws to the letter can protect both the foreclosure consultant and the property owner in California.

MORTGAGE FRAUD--Playing with Dynamite

There is an epidemic causing harm in the billions to the real estate industry -- mortgage fraud. This fraud is often a violation of both civil and criminal laws. That is why the FBI is actively involved in the investigation and apprehension of the perpetrators.

Mortgage fraud can take many forms: a homebuyer inflates his assets or income on a loan application or conceals liabilities; an investor falsely represents that she will live in a condominium to obtain a better loan rate; a con artist uses someone else's good credit to borrow money to buy a residence at an inflated price; or an organized crime ring hatches a complex scheme to defraud a lender using a dishonest appraiser and an insider employed by the lender.

Each of these transactions is governed by Federal Law. Form 1003, the Uniform Residential Loan Application that every buyer signs when he or she applies for a loan, references Title 18, United States Code section 1001. Under that code section, buyers, appraisers, agents, loan officers and other parties are prohibited from lying on a loan application or any other document related to the transaction.

The "straw buyer" is the most pathetic character in the annals of mortgage fraud--the pig in the cartoon. For example, a con artist persuades a straw buyer to take title to a residence that is being leased, using their good credit to obtain a loan. The straw buyer is promised by the con artist that he will make all the mortgage payments, sell the residence in one year and split the profit 50-50. The deal is "too good to be true." The con artist may, in cahoots with the seller, inflate the price of the house with a false appraisal and get cash back at the closing for repairs that are never made. The con artist then disappears with the kickback and the straw buyer finds herself saddled with an inflated mortgage and a house with no equity in a declining market. The straw buyer stands to suffer a foreclosure and ruin her credit, unless she sells the house short for a loss and compensates the lender for the loan deficiency. Perhaps worst of all, the straw buyer has unwittingly engaged in violations of Federal Law that carry criminal penalties.

To read more about mortgage fraud and the types of schemes used by the culprits, click here.

EMINENT DOMAIN -- "The Times They Are A Changing"

The Supreme Court's decision in Kelo v. City of New London set off shock waves among property owners. In Kelo, the Court upheld the City's taking of Ms. Kelo's well maintained home City so that a Fortune 100 corporation could build a new office complex. In response, legislation has been passed across the country that makes it more difficult for private property to be taken by eminent domain for private, not public, use.

On January 1, 2007, several new laws went into effect in California which will impede a redevelopment agency from taking private property for development for a private use. Under Health & Safety Code 33031, a city or county can declare urban property to be "blighted" as the first step in the process of eminent domain. The primary purpose of such a taking is the generation of increased property tax revenues through redevelopment. But what if a parcel of property in the project area is already improved with a building that is in fine condition and is being put to a productive private or public use. Why should a government agency be able to force the sale of that property so it can be transferred to a private developer for a private use (for example, the development of a new shopping center)?

These questions have been addressed in part by Health & Safety Code 33320.1(b)(2). That code section prohibits the inclusion of nonblighted parcels in a redevelopment project area for the purpose of obtaining property tax revenue without "substantial justification." In other words, the taking of private property by a city for private use is no longer justifiable on the basis that the city will generate more property tax revenue after the shopping mall opens for business.

So let's say a city wants to take a medical clinic to be part of a parking lot or retail store for a new shopping mall. If the medical clinic is not blighted, there must be a substantial justification for its taking. Increased property tax revenues for the city is no longer a relevant factor, and it is unlikely that a court will find substantial justification from the opportunity for shoppers to purchase a pair of designer jeans or a caffe latte in a new mall.