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Listing or Selling an Overencumbered Property? Disclose, Disclose, Disclose

Civil Litigation Defense, Mortgage & Lending Law, and Real Estate Law

Throughout the San Francisco Bay Area the real estate community has seen a drop in residential property values. This drop was particularly noticeable in portions of Santa Clara County, Alameda County and Contra Costa County. As a result of this drop, many properties in these areas became worth less than the amounts owed on them. These properties are referred to as being “underwater” or “upside down.”

In an attempt to get out from under the without suffering a foreclosure, owners will try to sell the underwater property and reach agreements with lenders for a short sale. A short sale requires the lender(s) to accept less money than is owing to the lender(s) in satisfaction of the debt. The idea behind the short sale is that the owners/borrowers will better protect their credit rating and avoid having a lender pursue them for a deficiency judgment. (See article on anti-deficiency laws)

This is the exact scenario that occurred in a recent case decided by the California Court of Appeal. In the appellate case, the owners of a Huntington Beach property had three loans secured against their property. The loans totaled $1,141,000.00. Unfortunately, the property was only worth about $750,000.00. The total loan amounts were known by both the owners and their listing broker.

The property was listed for sale on the multiple listing service by the owners’ broker. The broker showed the property to the eventual buyers and made no mention of any liens or encumbrances on the property that might affect the ability of the sellers to sell the property free and clear of liens and encumbrances.

The buyers, based on the representation that the property could be delivered free and clear, sold their home in order to enable them to purchase the Huntington Beach property. However, the lenders refused to discount their loans, thereby scuttling the purchase of the property. Because it was not disclosed to the buyers that it was highly speculative whether the property could be delivered free and clear of all liens and encumbrances, the buyers sued the owners’ broker for negligence, negligent misrepresentation, and deceit.

The California Appellate Court was thus presented with the question of whether the owners/sellers’ broker had a duty to disclose the potential inability of the seller to deliver the property free of liens.

The sellers’ brokers argued that revealing the amounts owed to the lenders would require them to disclose the sellers’ confidential financial information, provide information to the buyer that was already “within the diligent attention and observation of the buyer” (California Civil Code §2079.5), and guarantee the performance of the seller.  The sellers’ brokers also argued that the potential financing issues did not affect the value and desirability of the property.

The California Appellate Court did not accept any of the listing broker’s arguments. Rather, the Court ruled that “when a real estate agent or broker is aware that the amount of existing monetary liens and encumbrances exceeds the sales price of a residential property, so as to require either the cooperation of the lender in a short sale or the ability of the seller to put a substantial amount of cash into the escrow in order to obtain the release of the monetary liens and encumbrances affecting title, the agent or broker has a duty to disclose this state of affairs to the buyer.”

What does one take away from this California real property transaction? If you are selling a property or listing a property for sale, err on the side of disclosure. Additionally, even if the property is located in an area where the real estate values did not plummet, such as San Francisco, Marin, or Atherton, be certain that the property can actually be delivered as promised. This especially true if the property is listed in the Multiple Listing Service (see California Civil Code §1088).

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