Duty Of Disclosure Depends On Knowledge Of Defects

Many buyers have become aware of defects in their purchase after the close of escrow, and wonder if they can sue the seller for failure to disclose material defects.  In California, the duty of disclosure of a seller depends on the extent of  knowledge regarding the alleged defects.

The elements of a cause of action for fraud based on concealment are: (1) the defendant must have concealed or suppressed a material fact, (2) the defendant must have been under a duty to disclose the fact to the plaintiff, (3) the defendant must have intentionally concealed or suppressed the fact with the intent to defraud the plaintiff, (4) the plaintiff must have been unaware of the fact, and (5) as a result of the concealment or suppression of the fact, the plaintiff must have sustained damage.

A real estate seller has both a common law and statutory duty of disclosure.  In the context of a real estate transaction, it is now settled in California that where the seller knows of facts materially affecting the value or desirability of the property, and also knows that such facts are not know to, or within the reach of the diligent attention and observation of the buyer, the seller is under a duty to disclose them to the buyer. 

Undisclosed facts are material if they would have a significant and measurable effect on market value.  Where a seller fails to disclose a material fact, he may be subject to liability for mere nondisclosure since his conduct in the transaction amounts to a representation of the nonexistence of the facts which he has failed to disclose.

However, the obligation to disclose only arises if the defendant had actual or constructive knowledge of the deficiencies.

It is not unusual that there is a lack of direct evidence of a defendant's knowledge, as issues of mind can seldom be proved by direct evidence.  Actual knowledge can, and often is, shown by inference from circumstantial evidence.  Actual knowledge can be inferred from the circumstances only if, in the light of the evidence, such inference is not based on speculation or conjecture.  Only where the circumstances are such that the defendant "must have known", and not "should have known", will an inference of actual knowledge be permitted.

Sometimes deficiencies in a structure are only discovered during the process of demolition.  In the recent case of RSB Vineyards, LLC v. Bernard A. Orsi, the appellate court affirmed summary judgment in favor of the seller because the defects in the house would have been apparent only to a professional who was familiar with structural engineering and commercial building code requirements.  In order to create an inference of actual knowledge, circumstantial evidence must suggest that the defendant "must have known" of the matter to be disclosed.  In the absence of some evidence that defendants had reason to know of the defects, their sheer numerosity does not allow an inference of knowledge.

In California, case law and statutes place important and significant limitations concerning the circumstances under with the principal is chargeable with and bound by the knowledge of his agent.  Not all contractual relationships in which one person provides services to another satisfy the definition of agency. 

An agent is one who represents another in dealings with third persons.  If a service provider, such as a contractor, simply furnishes advice and does not interact with third parties as the representative of the recipient of the advice, the service provider is not acting as an agent.

Any knowledge acquired by the defendant's construction professionals about the renovated residence is not necessarily imputed to the defendant unless there is evidence to suggest those professionals were acting in the role of agent when they acquired that knowledge. For example, an architect preparing plans and specifications acts as an independent contractor, and ordinarily only acts as an agent and representative of the defendant when he is performing supervisory functions with respect to a building under construction.

In RSB Vineyards, the court held that any knowledge acquired by the seller's construction professionals about the renovated residence is not imputed to the seller because there is no evidence to suggest those professionals were acting in the role of agent when they acquired that knowledge.  Because the seller offered evidence that he had no knowledge of the various deficiencies in the building, the seller could not be held liable for nondisclosure in the absence of evidence that he had actual knowledge of the facts to be disclosed.

Lessons:

1.         Buyers need to be very proactive in investigating a residence before purchasing it.

2.         Buyers should not assume that sellers will be held liable for any defects the buyer learns about after the escrow closes because it may be difficult to prove the sellers, or their agents, had actual knowledge of the defects.

Notice of Pendency of Action aka Lis Pendens

Many misunderstand the effect of recording a notice of pendency of action, which is also known as a lis pendens, and a typical inquiry is whether the claimant can record a lis pendens to "stop a sale".  Although recording a lis pendens often has the effect of preventing the closing of a sale, it is because of its practical effect on title companies and buyers, and it is not a legal prohibition on a sale.  It is simply a notice that a legal action is pending, and of course, a legal action must be filed before a lis pendens based upon the action can be recorded.

In California, recording a lis pendens simply gives constructive notice that a legal action has been filed affecting title or right to possession of the real property described in the notice.  Any taker (i.e., buyer or lender) of a subsequently created interest in that property takes his interest subject to the outcome of the litigation.  It is this uncertainty that has the practical effect of discouraging any purchase or loan after it is filed.

In order to record a lis pendens, the legal action must assert a real property claim, such as a quiet title or partition action.  Other legal actions such as a divorce or partnership dispute involving real property can support a lis pendens.

A "court shall order" expungement of a lis pendens if the pleading on which the lis pendens is based does not state a real property claim, if the claimant fails to establish the probable validity of the claim on which the lis pendens is based, or if the giving of an undertaking (i.e., bond) would secure adequate relief to the claimant. 

If a party alleges that a lis pendens is "void and invalid" (under Code of

Civil Procedure § 405.23) because of defective service, the party may move the court to expunge it.  Any notice of pendency of action shall be void and invalid as to any adverse party or owner of record unless the requirements of Code of Civil Procedure § 405.22 are met for that party or owner, and a proof of service in the form and content specified in Code of Civil Procedure § 1013a has been recorded with the lis pendens.  I have reviewed lis pendens recorded by licensed attorneys that do not include a proof of survive, or the proof of service is defective.

Section 405.22 requires the claimant filing a lis pendens to serve the parties to whom the real property claim is adverse and to all owners of record of the real property affected by the real property claim as shown by the latest county assessment roll by registered or certified mail, return receipt requested, at all known addresses.

If the county assessor lacks a known address for a party or owner, the claimant may file a declaration to that effect in lieu of the mailing that would otherwise be required.   Service shall also be made immediately and in the same manner upon each adverse party later joined in the action.

In the recent decision of Rey Sanchez Investments v. Superior Court (PCH Enterprises, Inc.), the appellate court held the subject lis pendens was void and invalid because (1) no proof of service was recorded with the lis pendens, and (2) noncompliance with section 405.22 occurred  because after the petitioner  became a party to the action, service of the lis pendens was not made in the same manner as required by 405.22, and it was not made immediately upon the petitioner.

A lis pendens that is void and invalid under section 405.23 does not need to be expunged in order for it to be void and invalid, as that status exists ab initio, in those cases where no proof of service is recorded or the service is defective.

In my experience, the typical defect in the service is service by regular mail, and not by registered or certified mail, return receipt requested, at all known addresses, before the lis pendens is recorded.

Lessons:

1.         A lis pendens can be very effective at clouding title, and discouraging a purchase or loan

2.         A lis pendens requires a filed legal action that asserts a real property claim

3.         Service of the lis pendens is very important to prevent it from being void and             invalid

Statute of Frauds and Caveat Sectorem (Broker Beware)

In the recent case of Westside Estate Agency, Inc. v. Randall, the court of appeal recognized that caveat sectorem (broker beware) is a less renowned cousin of the phrase "caveat emptor" (buyer beware).  California's statute of frauds declares invalid any "agreement authorizing or employing an agent, broker, or any other person to purchase or sell real estate" unless that agreement is in writing and signed by the broker's client. (Civil Code § 1624(a)(4).

In that case, the broker lost a commission of $925,000 because he agreed to help a friend buy a $5 million Bel Air estate, but the deal was closed by another broker on different terms.  When the first broker sued his friend for the commission, the trial court dismissed the lawsuit for noncompliance with the statute of frauds because he did not have an agreement in writing, and the court of appeal affirmed.

The statute of frauds emphasizes the important of written agreements by declaring several types of agreements "invalid" unless "they, or some note or memorandum thereof, are in writing and subscribed [i.e., executed] by the party to be charged or by the party's agent."

In these types of situations, the court is presented with two issues:

1.         Does the statute apply to the contract at issue; and if so,

2.         Are the statute's requirements of a properly subscribed writing met

The statute of frauds applicable to this situation can apply to licensed brokers and anyone else who aids and assists them, or who otherwise engages in acts covered by the statute.   However, the statute only reaches agreements for "compensation or a commission" owing because of the "purchase or [sale of] real estate" or "procur[ing], introduc[ing], or find[ing] a purchaser or seller of real estate."

It does not reach contracts employing persons, even brokers, merely to provide information about real estate or to search for suitable locations to purchase, except when those functions are "incidental" to one of the purposes otherwise covered by the statute of frauds.

If the statute applies, its bar against relief is absolute, and applies no matter how the unhappy broker styles his claim to recover compensation or a commission, and generally no recovery will be allowed on a theory of quantum meruit, unjust enrichment, or equitable estoppel.

However, the statute does not apply to all actions involving brokers, including:

1.         An action to recover for a broker's performance of services other than and not incidental to the sale or purchase of real estate or procuring, introducing or finding a purchaser or seller of real estate;

2.         An action by a principal against his broker to disgorge a commission already paid on the ground that the broker breached his fiduciary duty and obtained a secret profit; and

3.         An action between brokers to divide a jointly earned commission.

There are three narrow exceptions in which the statute will not be deemed a bar to a broker's action to recover compensation or a commission if there is no written agreement:

First, a broker has a limited right to estop his principal from asserting the statute to "prevent either unconscionable injury or unjust enrichment", and a broker offering to buy or sell real estate may assert estoppel only if the principal has engaged in "actual fraud".

            "Actual fraud" is defined as when (1) the principal has told the agent that their agreement for a commission was in writing when it was not, or (2) the principal has told the agent to cancel an otherwise valid written contract for exchange of the property while concurrently making an oral promise to the agent to still pay the commission, but then reneges on that promise.

Second, the broker's principal and the other party have executed a written and binding agreement for the purchase of real estate, the written agreement specifies that the broker will receive a commission, and the broker's principal cancels the written agreement.  In this case, the broker may sue because either (a) the principal breached an implied promise to complete the transaction so the broker could recover the commission, or (b) the broker is a third party beneficiary of the written agreement between the principal and the third party to the transaction.

Third, the principal subsequently ratifies the agreement, presumably an alleged oral one, in a writing.

Lessons:

1.         If an agreement relates to money, get it in writing, and

2.         If you do not follow Lesson 1, and the principal refuses to pay a commission, consult an attorney to see if you can fashion a winning argument that supports an award of the commission or compensation despite the statute of frauds.

A Good Faith Defense Exists to a Fraudulent Conveyance Action

The Uniform Fraudulent Transfer Act set forth in California Civil Code § 3439, et seq., has been renamed the Uniform Voidable Transactions Act, but it still makes voidable a fraudulent conveyance of real property, which is a transfer by the debtor of property to a third person undertaken with the intent to prevent a creditor from reaching that interest to satisfy its claim.  If a transferee or obligee took in good faith and for a reasonably equivalent value, however, the transfer or obligation is not voidable. (Civil Code § 3439.08(a), the "good faith defense".)

Whether a transfer is made with fraudulent intent and whether a transferee acted in good faith and gave reasonably equivalent value within the meaning of

§ 3439.08(a) is a question of fact.  The transferee, seeking to assert the good faith defense under § 3439.08(a), has the burden of proving that subdivision's applicability by a preponderance of the evidence (i.e., more likely to be true than not true).

A transferee cannot avail itself of the good faith defense if the transferee:

had fraudulent intent,

colluded with a person who was engaged in a fraudulent conveyance,

or actively participated in a fraudulent conveyance,

or had actual knowledge of facts showing knowledge of the transferor's fraudulent intent.

In the recent case of Nautilus v. Yang, the court of appeal reviewed a trial judgment involving a transfer of real property ("Property") from two brothers to their father with no consideration paid by the father, who then obtained a reverse mortgage from Security One Lending, which subsequently sold the mortgage to Urban Financial.  Unknown to both Security One and Urban Financial, Nautilus had obtained a judgment against one of the brothers, and recorded an abstract of judgment against the Property.  A title company provided a preliminary title report to Security One, but the title company failed to realize that the abstract affected the Property.  The proceeds of the reverse mortgage were used to pay-off the existing liens against the Property in the amount of $308,576.72.

The parties agreed that there was no evidence that Security One or Urban Financial had actual fraudulent intent, actually colluded with the debtor brother to defraud Nautilus, or actively participated in the fraudulent scheme.  The appellate court framed the issue on appeal as whether there is evidence showing Security One or Urban Financial had actual knowledge that the transferor had fraudulent intent.

Constructive knowledge or inquiry notice is not sufficient to defeat the good faith defense.   There must be evidence of actual knowledge of facts by the transferee showing the transferor had fraudulent intent.

In the Nautilus case, the appellate court concluded that Security One and Urban Financial, based on the facts known to them, did not have actual knowledge of the transferor's fraudulent intent when making the reverse mortgage loan because:

a.         They did not know of the abstract of judgment before the reverse mortgage was funded or sold to Urban Financial, as that was the fault of the title company alone;

b.         The transfer from the brothers to their father, a family member, that was not made in exchange for financial consideration, was insufficient to defeat the defense because that is common in many reverse mortgage loan situations;

c.          It was insufficient that the reverse mortgage funds were to be used to pay off a preexisting judgment lien against one of the brothers by a creditor other than Nautilus because Security One and Urban Financial did not have a duty to conduct further inquiry merely because of the brother's previous litigation; and

d.           In our litigious society, commerce quickly would grind to a halt if every buyer had an affirmative duty to conduct an independent inquiry prior to purchasing an asset merely because the seller was involved in litigation or otherwise was accused of wrongdoing.

This case illustrates the value of the good faith defense to a fraudulent conveyance claim, if the transferee can prove it did not have actual knowledge of the transferor's fraudulent intent.

Successor in Interest After Foreclosure Can Evict Tenant With 90 Day Notice

The general rule is that foreclosure of a senior encumbrance terminates subordinate (i.e., filed later in time) liens, including leases.  An exception to the general rule is contained in California Code of Civil Procedure section 1161b.

Section 1161b, subsection (b)(1), provides that tenants in possession of a rental premises under a fixed-term residential lease can remain until the end of the lease term, and all of their rights and obligations under the lease survive the foreclosure sale.

However, it also provides that such tenants can be evicted if they are served with a 90 day written notice to quit by the purchaser at the foreclosure sale, or its successor in interest, if the purchaser or successor intend to occupy the premises as a primary residence.

The question is: Who is included in the term "successor in interest"?  That term is not defined by section 1161b.  There can be differing interpretations because "successor in interest" is not qualified by terms like "immediate", "ultimate", or "eventual".

Recognizing that the legislature did not specifically limit the exception under section 1161b to one specific successor in the chain of title, the court in the recent case of Epps v. Lindsey decided that the term "successor in interest" is not limited to the purchaser's immediate successor in interest, but to "the" ultimate or most significant successor in interest who then-owns the property intending to reside there, and who serves the 90 day notice to quit. 

In Epps v. Lindsey,  Bank of America foreclosed on its loan, and the parents of Joshua Epps purchased the property for Epps who lacked the cash to make a bid himself.  A month later, the parents transferred the property to Epps who intended to use it as his primary residence.

After Epps served the tenant in the property with a 90 day notice to quit, the tenant refused to vacate the property, and an unlawful detainer action was filed by Epps.  The tenant contended he was able to remain in the property for the duration of the lease.  Epps contended he was a successor in interest to the foreclosing Bank of America, even if the property was owned by his parents in the interim.

In ruling that Epps was a "successor in interest" under section 1161b, the Court saw no problem with allowing a successor in interest that is two steps removed from the foreclosure sale from exercising the same rights afforded under section 1161b to the "purchaser" or the purchaser's immediate successor. 

The Court determined that section 1161b was enacted in-part to address the concern that unsuspecting tenants were being evicted despite paying their rent.  The statute's exception for a 90 day notice to quit suggests the legislature intended to give the post-foreclosure owner, who doubles as a would-be resident, preference over a non-defaulting tenant whose interest would have otherwise been extinguished by the foreclosure sale.   

Caveat:  To get the benefit of this statute, none of the owners after the foreclosure sale can accept any rent tendered by the tenant because acceptance of the rent would confirm the owner's consent to the written lease that still had time remaining before it expired.