Anti-Deficiency Senate Bill Regarding Short Sales

Homeowners who are “upside-down” on their loans and want to avoid foreclosure recently received a tremendous benefit from California Governor Jerry Brown. On July 15, 2011, Senate Bill 458 was signed into law extending the anti-deficiency protections of Senate Bill 931. Senate Bill 458 prohibits any deficiency judgment to be requested or rendered for senior or junior liens after a Short Sale of one-to-four residential units.

The previous Senate Bill 931 allowed a homeowner to sell their home at a value less than the existing mortgage, requiring the senior lienholder to accept the sale as a full payment of the existing obligation. The difficulty with Senate Bill 931 was that if the junior lienholders did not forgive the debt, the secondary loan on the property turned into personal debt after the Short Sale was completed. Many junior lienholders sold the lien to debt collectors who proceeded to seek the deficiency from the seller after the Short Sale was completed. This practice is now illegal. Pursuant to Senate Bill 458, all the lenders that agree to a Short Sale must accept the agreed upon Short Sale payment as full payment of the outstanding balance of all loans.

It is important to note that SB 458 does not apply to: (1) Properties that are residential rentals, commercials, vacant, and retail; and (2) Trustors that are corporations, limited liability companies, limited partnerships, or political subdivisions of the state. The lenders are permitted to seek damages if there is fraud, or if there are other properties intertwined with the loan. In addition, this does not change the process of a Short Sale. The homeowner must still apply and obtain approval from all the lenders. Depending on the homeowner, applying for a Short Sale may have drawbacks. For instance, the seller must disclose their entire financial status honestly and accurately, risking the chance that the lenders may deny the request for a Short Sale and proceed with the foreclosure. Moreover, this law does not prevent the lenders from negotiating with the borrowers’ agents and family.

With regards to credit score, unless the bank has specifically agreed not to report delinquent payments or the shortage of the sale, the homeowner’s credit score will reflect delinquencies and collections. Real estate agents should not give legal advice to clients facing foreclosure, nor assure sellers involved in the Short Sale process that their credit rating will not suffer adverse effects. Sellers of Short Sales must also seek tax advice before entering into a Short Sale contract. There could be tax ramifications due to debt forgiveness.

It is unclear how new laws will affect the lenders’ business practice, and what impact it will have on an already declining market. Under new law, lenders are entitled to negotiate sale price with agents, other lenders, and borrowers’ relatives. In addition, financial obstacles affecting title must be disclosed to buyers involved in Short Sale process. (See Kring & Chung’s November 2010 Newsletter discussing notices under Holmes v. Summers)

Sellers, buyers, and agents should seek legal advice prior to proceeding with a Short Sale. In order to protect both parties in a purchase agreement, addendums should be drafted extending time frames to accept and/or decline a Short Sale pending lender approval, time to obtain legal evaluation, and time to speak with a qualified CPA.

Short Sale Disclosure

The duty of a listing broker and agent to a buyer has changed in light of the onslaught of short sales. On October 6, 2010, the California Appellate Court in the case of Holmes v. Summer, 4th Appellate Dist., 3rd Div. 2010, extended the listing agents’ duty to a buyer, requiring disclosure of financial obstacles effecting title. Specifically, if the listing agent or broker is aware that monetary liens and encumbrances exceed the sale price of a residential property, requiring the seller to either undergo a short sale or deposit a substantial amount of cash into the escrow to obtain a release from the lender, there is a duty to disclose this state of affairs to the buyer.

In the case of Holmes v. Summers, a buyer of a residential property sued the sellers’ Broker, asserting misrepresentation, failure to disclose, and negligence, when escrow was cancelled as result of the seller being unable to effectuate a short sale and/or come up with cash to obtain the release of a monetary lien. The Court applied a strict standard of care to the seller’s agent, scrutinizing everything she did. For example, the Court found fault with the fact that the Multiple Listing Service (“MLS”) advertised the sale of property for approximately $750,000, stating only that the “seller was motivated and that the [listing agent] would get a 3 percent commission.” The buyers were never advised that the property was subject to three deeds of trust, with a total debt of $1,141,000, or that the seller’s lenders would need to either approve a short sale or the seller would have to deposit $392,000 in cash to escrow to cover the shortfall. The buyers never did a title search, and in reliance on the purchase agreement, sold their home to fund the purchase of what they thought would be their new residence. When the deal fell through, the buyers sued the listing agent and broker, not the seller.

The buyers did not sue the seller because he was said to be “judgment proof.” This meant that since the seller could not afford to keep his home, he could not, in all likelihood, afford to compensate the buyer for his damages. Under different circumstances, even if a buyer sues the broker, agent and the seller and they are all found at fault, the legal theory of Joint and Several Liability would apply. This means that if two or more defendants are found responsible for an indivisible injury, each defendant is liable for the entire award regardless of the individual degree of fault. A so-called “deep pocket” defendant may be held liable for an entire damage award even if such a defendant is only fractionally liable. In the end, the same result would occur; the broker could end up responsible for all of the buyer’s damages, if in fact the seller is “judgment proof.”

Licensed real estate brokers and salesman should consider the following to limit their liability exposure. First, the agent should have an understanding of the client’s financial obstacles and advise their client from the start that they may be required to disclose such information to the buyers. This type of communication should be solidified with a signed written consent to use confidential information. Second, if applicable, the MLS should include notice of a potential need for Short Sale. Pursuant to Civil Code § 1088, an agent is responsible for the truth of all representations and information listed in the MLS. Constructive notice is not a viable defense. Assuming a title search would reveal the existence of deeds of trusts on the property, the agent cannot rely on a buyer doing such a search.

Balancing factors used by the Court to determine liability on the part of a broker and agent include: 1) the extent to which the transaction was intended to affect the plaintiff; 2) the foreseeability of harm; 3) the degree of certainty of injury; 4) the closeness of the connection between the defendant’s conduct and the injury suffered; 5) the moral blame attached to the defendant’s conduct; and 6) the policy of preventing future harm. By googling Holmes v. Summers, you can read Justice Moore’s analysis of these five factors. The factors arise out of equitable principals, requiring the broker and agent to apply a higher degree of care and consciousness to the Short Sale transaction. The real estate attorneys at Kring & Chung, LLP, some of whom also maintain a real estate broker’s license, are knowledgeable and ready to assist both the Seller and the Agent through the Short Sale transaction, and any other real estate related legal matters.

The Purchase Agreement Arbitration Provision

The standard form residential purchase agreement published by the California Association of Realtors (“CAR”), was updated in October 2002. The Purchase Agreement adopted The Federal Arbitration Act (“FAA”) procedural provisions. Until recently, parties have interpreted this provision to mean that the trial court has no authority to stay or deny arbitration under the California Arbitration Act because the Agreement adopted the Federal rules.

On the contrary, on June 1, 2010, the California Supreme Court held that (“FAA”), incorporated into the newer CAR Forms, does not limit the trial Court’s authority to deny arbitration, arising out of a dispute between a “Buyer and Seller” involved in a Residential Purchase Agreement.  In the case of Valencia v. Smyth, 2010 DJDAR 8103, the owner of a residential property compelled the Buyers to arbitration after they filed a lawsuit. The Seller argued that pursuant to the California Association of Realtors Residential Purchase Agreement, by initiating under the FAA arbitration provision, the buyers were giving up their right to trial, and limited their rights to an arbitration proceeding, only. 

Arbitration proceedings are generally informal and, under California law, the arbitrator may base the decision on business custom and practice, technical insight, and/or broad principles of equity and justice, rather then the strict letter of the law. There are many benefits and disadvantages to arbitration. The Buyers in the Valencia v. Smyth matter did not want to proceed with arbitration and opposed the Seller’s petition to arbitrate. The Buyers argued that the Seller waived his right to arbitration by delaying the motion to compel and engaging in discovery.  

The California Supreme Court disagreed with the Seller, and upheld the trial court’s decision to deny the arbitration petition, in favor of the Buyers.  The Supreme Court held that, “there is no federal policy favoring arbitration under a certain set of procedural rules; the federal policy is simply to ensure the enforceability of private agreements to arbitrate.” (Volt Info. Sciences v. Leland Stanford Jr. U. (1989) 489 U.S. 468).  Essentially, determination of whether a dispute arising out of Residential Purchase Agreement must be arbitrated is a decision left for the reviewing Judge.

Under California law, a contractual arbitration provision does not make arbitration a mandatory alternative to trial. In order for a party to enforce a contractual arbitration provision, they must first file a petition to compel arbitration with the proper Court. A Judge may make factual findings based on affidavits, oral testimony, and declarations submitted by the parties. However, evidentiary support is required before the Court can grant a petition to compel arbitration, or deny the petition, based upon a defense such as fraud. The party seeking arbitration has the burden of proving the existence of an enforceable arbitration agreement, and the party opposing the motion has the burden of proving any defense, by a preponderance of the evidence. If the court finds there is a valid contract binding the parties to arbitrate, it cannot refuse to compel arbitration unless there is a valid defense under Code Civ. Proc., § 1281.2.

Some of the attorneys at Kring & Chung, LLP are also on the Orange County Panel of Arbitrators, and are available to answer any questions you may have. Our litigation attorneys are experienced and ready to assist both the Seller and the Buyer in either petitioning the proper Court to enforce contractual arbitration provisions, and/or oppose petitions to arbitrate. Please contact Anna Greenstin directly if you have any question regarding alternative dispute resolutions, including arbitration proceedings and/or mediation.

Short Sales and Deficiency Judgments

As declining residential property values are starting to stabilize, mortgage lenders are approving more Short Sales as an alternative to foreclosure.  A homeowner may elect to pursue a Short Sale when the fair market value of the property is less than the amount of the loan, and the owner cannot cover the mortgage payments.  Some homes are encumbered with two or more loans.  All lien holders must approve before a Short Sale can occur.  If the loans are generated with different lending agencies, then the Real Estate Agent must contend with different business practices when assisting with the Short Sale application.  For example, lenders have different procedures regarding Short Sale applications.  Some lenders require submittals of offers.  Often the Seller must disclose his financial records and explain his financial hardship.  Financial information must be accurate and honest.   Otherwise, the Seller and his Agent could be liable to the lender for fraud.  

If the lenders approve of the Short Sale, a lender “Approval Letter” will follow.  More often than not, the Approval Letter will specifically state that the lender reserves its right to pursue a deficiency judgment against the borrower for the difference between the loan balance and the price received from the Short Sale.  This language is often overlooked by the Agent and the Seller, because they either do not understand the legal ramifications, or they are rushing to complete the sale.  Sometimes the Approval Letter is silent and the lender does not mention it is reserving its rights to recoup the deficiency.  The lender’s silence on this issue usually does not constitute a waiver of its right to do so.  Unless the Seller receives a written release directly from the lender, an unsophisticated Seller will be exposed to a possible deficiency judgment.  This means that, after the property is sold, the Seller may receive a demand letter from the lender to pay the difference between the sale and loan amounts.  

Agents must advise the Seller of government programs that may prevent lenders from going after the Seller for deficiency.  For example, in the last few weeks the Homeowners Affordable Modification Program (“HAMP”), through the Home Affordable Foreclosure Alternatives (“HAFA”), came out with a new law that prevents lenders from going after the Seller for the deficiency.  If the Seller meets the HAFA requirements, and proceeds with the Short Sale through HAMP, then the lenders must release borrowers from the obligation to repay the difference between the sales price and the loan amount.  No deficiency judgments are allowed for a first or second loan.  You can learn more about the HAFA requirements on line. 

Agents usually are not attorneys, nor are they Certified Public Accountants.  When their clients receive a demand letter from the lender, the Agents are sometimes just as bewildered as the Seller.  The Agent should advise the Seller, in writing, of the importance of speaking to an attorney or CPA about whether the borrower will remain liable for the deficiency.  If so, the Seller will want to reserve the right to cancel the Short Sale without penalties or pursue negotiations with the lender to obtain a written waiver of the deficiency and general release of all claims against the borrower.

Agents assisting Sellers with Short Sales use the Short Sale Addendum (C.A.R. Form SSA 11/07). Section F of Form SSA broadly advises the Seller that he can incur credit or legal consequences, or taxable income from a Short Sale.  It states that the Seller should “seek advice from an attorney, CPA or other expert regarding such potential consequences of a Short Sale.”   However, the language is ambiguous, and can create confusion about whether the Seller can cancel the sale after the lender approves of the Short Sale but does not release the deficiency.

In addition to using Form SSA, Agents and Brokers should also prepare a more detailed Addendum to the Purchase Agreement, permitting the Seller to meet with a lawyer or CPA to discuss the lender’s agreement, and thereafter allowing a five day window to cancel the sale, if necessary.  Such an Addendum to the Short Sale Purchase Agreement should include 1) the Seller’s right to terminate the Short Sale (within a limited period of time); 2) notice that the Seller may have negative tax, legal or credit consequences which result when the funds due at the close of escrow are insufficient to fully satisfy a loan secured by the property; 3) notice that the lender may agree to take less than the full amount of the loan without releasing the deficiency; and 4) advise the Seller that there are government programs that may assist the Seller with avoiding a deficiency judgment.

Essentially, the Agent should address Short Sale issues more directly, and bring to light the possibility of the lender “approving” the Short Sale, but not releasing the Seller from any deficiency.  Since proper documentation of the Short Sale process is necessary to maximize the Seller’s legal protection, an attorney should be consulted to guide the Seller through this process.  In addition, Agents should be advising the Seller of new HAFA programs that are being implemented to protect homeowners.

The real estate attorneys at Kring & Chung, LLP, some of whom also maintain a real estate broker’s license, are knowledgeable and ready to assist both the Seller and the Agent through the Short Sale transaction, and any other real estate related legal matters.

Anna Greenstin is an associate with Kring & Chung, LLP’s Irvine office.  She can be contacted at (949) 261-7700, or agreenstin@kringandchung.com.