When I first got started in the real estate investing business in 2006, the avalanche of foreclosures was just beginning. Before attempting my first short sale here in Southern California, I discovered I needed to comply with Civil Code Section 1695 by using a very particular type of purchase and sale contract, called a "California Equity Purchase Agreement," with my seller. Although I found several sources where I could find a good version of the California Equity Purchase Contract to download and use in my business, the process of filling out the contract in the context of a short sale negotiation stumped me.
Generally in a short sale context, an investor signs an initial purchase and sales contract with the seller of the home. That initial contract lists the investor's opening offer to the lender as the purchase price for the transaction. After the lender has refused the initial offer, the investor and seller then sign a second purchase and sale contract which lists the investor's next offer to the lender as the purchase price . . . and so on until the negotiation yields the true purchase price upon which the lender and the investor have agreed. The last purchase and sales contract the investor and seller signed (the one that contained the final negotiated purchase price) then becomes the contract used at closing to consummate the transaction. Not so in California!
I will attempt to outline some of the major hurtles an investor faces before purchasing a home from a seller who is in foreclosure. I strongly recommend that you consult competent legal counsel prior to signing an Equity Purchase Contract with a seller in foreclosure to ensure that you fully comply with the law. Since certain sections of Civil Code Section 1695 et seq are currently undergoing legislative review and revision (due to recent court rulings), please consult legal counsel for the most current version of the law.
The Legislature's intent in enacting California Civil Code Section 1695 et seq. was to protect homeowners, whose homes are in foreclosure, from unscrupulous investors who might otherwise coerce them into selling their homes at massive discounts just to avoid a foreclosure. The Legislature recognized that while in foreclosure, these homeowners are in a vulnerable position and their homes are generally their greatest asset. In enacting the law, it appears the Legislature assumed that all homeowners have large amounts of equity in their homes which would be lost in a "fire sale" to an investor to avoid foreclosure. Civil Code Section 1695 was designed to protect the equity these homeowners might lose by giving them a five-day "cooling off" period after signing a purchase and sale contract and by requiring that all equity purchasers use a very particular type of written contract when purchasing a home in foreclosure.
Setting aside the Legislature's assumption that "equity purchasers" (a.k.a. "real estate investors") are piranhas looking to steal houses away from poor, unsophisticated homeowners in distress, the far more troubling assumptions made in enacting this law are the ones involving equity and market value. It is very apparent in today's real estate market that many California homeowners in foreclosure owe more for their homes than their homes are worth. During the mortgage boom, many of these homeowners financed their home purchases with adjustable rate mortgages with "cool" options like paying only a portion of their mortgage interest each month, and a good number financed with zero percent down mortgages. No money down and low monthly mortgage payments may have seemed like a good idea at the time, but we all know different now. As home values have fallen, these homeowners are unable to sell their homes because they have NO equity. Today the assumptions made by California's Legislature regarding the "recent rapid escalation of home values" and "a significant increase in home equities" no longer hold true.
Unfortunately, during the drafting of Civil Code Section 1695, the legislature did not distinguish between "equity" and "non-equity" homes. As a result, Civil Code Section 1695 applies to both types of homes. This presents a problem today when an investor offers to buy a distressed property from an owner who owes what the house is worth or more than the house is worth. In order to make the purchase worthwhile, the investor needs to negotiate a short sale with the seller's lender. Here is where the language of Civil Code Section 1695 creates a number of headaches for the investor. Civil Code Section 1695 requires that each purchaser of a home in foreclosure use a written contract that complies with a very strict set of instructions. Failure to use a written contract that strictly complies with the statute could void the real estate transaction up to two years after close of escrow, and could expose the purchaser to severe civil penalties and even jail time. The following will address the major issues these contract requirements create in a short sale situation.
As I set out to begin my first short sale deal, I got my hands on a good working draft of the California Equity Purchase Contract. Armed with a legal background, I carefully read Civil Code Section 1695, compared the requirements to the contract I had obtained and revised the working draft to comply with the exact specifications of the code section. With my newly revised contract, I set a meeting with my first short sale seller and read through the contract once again, this time from the perspective of filling in the blanks with the specifics of the deal. It was then that I hit my first hurtle. What purchase price should I fill in?
Like I mentioned earlier, during a short sale negotiation, the purchase price listed in the first purchase and sale contract signed between the investor and seller usually contains the investor's initial offer to the lender. Subsequent purchase and sale contracts are used as the negotiations progress to reflect revised offers from the investor to the lender. When the lender finally agrees to accept the investor's "final" offer, the purchase and sale agreement that reflects the "final" offer then becomes the actual contract the parties use to close the transaction.
Unfortunately, the bright minds in the California legislature did not take a short sale negotiation into account when drafting Civil Code Section 1695. Civil Code Section 1695.3(c) requires the total consideration (purchase price) be stated in the Equity Purchase Agreement. Next, Civil Code Section 1695.3 (h) prohibits the equity purchaser from asking the seller to sign any other document prior to the expiration of seller's 5-day right to cancel the contract. So the initial purchase price listed in the Equity Purchase Contract must equal the "total consideration" (the exact purchase price) the equity purchaser intends to pay the seller for the purchase of the home.
Now we have a problem. In a short sale transaction, how can the equity purchaser determine the exact purchase price until the short sale negotiation with the lender is complete? And how can the equity purchaser even begin a short sale negotiation until the seller signs an Authorization to Release form - which falls under the "any other document" prohibition of Civil Code Section 1695.3(h)? In its desire to protect the public, the brilliant minds in Sacramento effectively forced these types of short sale negotiations in California to proceed in a backward and illogical manner. Instead of negotiating with the lender to get to a final purchase price, the investor must start with a final purchase price and then try to negotiate with the lender. So what purchase price should the investor list in the Equity Purchase Agreement? Should the equity purchaser just guess at what the short sale reduced payoff will be? No, because Civil Code Section 1695.6(d) prohibits the equity purchaser from making any untrue or misleading statements to the seller including any statements regarding "the amount of proceeds the equity seller will receive after the foreclosure sale." If the equity purchaser's "guess" is wrong, the investor has just violated Civil Code Section 1695.6 (d).
Assuming we could ignore the violation of Civil Code Section 1695.6(d), what if the equity purchaser guesses at what the short sale reduced payoff will be, uses that number as the initial purchase price, and then finds out the lender either refuses to discount the loan down to that number, or discounts the loan below that number? Does the seller pay the difference if the lender's number is higher than the total consideration listed in the agreement? Does the seller receive the difference if the lender's number is lower than the total consideration listed in the agreement? Either result would be unacceptable. So a guess is not wise.
Not only does Civil Code Section 1695.3(c) require that the total consideration (the final purchase price) be stated in the Equity Purchase Agreement at the outset when the equity purchaser and seller first sign the contract, Civil Code Section 1695.3 also states that the Equity Purchase Agreement constitutes the "entire agreement" between the parties. This means there will be no other agreements between the investor and seller that reflect terms different than those listed in the initial Equity Purchase Agreement. The effective result of Civil Code Section 1695.3 leaves the investor in a position of trying to "guess" at the precise number to put down for a purchase price even before beginning to negotiate a short sale with the lender. Since this Equity Purchase Agreement constitutes the "entire agreement" between the parties, the investor and seller cannot subsequently alter the purchase price as negotiations proceed forward with the lender.
You see why I was stumped! As I prepared to meet my seller for my first short sale transaction, I struggled with how to fill in the purchase price in my Equity Purchase Agreement. I spoke with several experts in real estate investing and short sale negotiations and several real estate attorneys. No one could give me an answer. They were all stumped too.
If the issue of what purchase price to use in a Equity Purchase Contract can be resolved, then attention to the consequences of the lender either accepting a payoff amount lower than my listed purchase price, or refusing to accept a short-sale reduced payoff. In using a "Standard Equity Purchase Contract". I quickly realized the language of the contract did not provide any contingencies for dealing with the results of a short negotiation with the seller's lender. The standard version of the contract simply states that the investor is purchasing the home from the seller for "X" purchase price. Of course the standard version makes sense if the seller has a good amount of equity in the home and the investor is making a straight purchase instead of pursuing a short sale with the lender. Under those conditions, the Standard Equity Purchase Contract operates just like any other standard purchase and sale agreement. Given the Legislature's original intent and (flawed) assumptions when enacting Civil Code Section 1695, the Standard Equity Purchase Contract works fine for homes with a good amount of equity.
But in a short sale context, there is no equity in the home. Now that the investor is stuck with the original Equity Purchase Contract. What happens when the lender agrees to accept a reduced payoff, leaving a difference between the purchase price and the reduced payoff amount? This is the investor's profit of course, but the Standard Equity Purchase Contract makes no provision for this difference to be applied toward the benefit of the investor. Without the addition of a few contingencies to the standard contract, this money would be paid by the investor to the seller since the investor agreed to pay the mortgage balance for the home. Such a result would defeat the investor's entire exercise of pursing a short sale in the first place.
And what happens if the lender does not agree to a short sale and does not reduce the amount of the mortgage balance? Again, without the addition of special contract contingencies, the investor has agreed to purchase the seller's home for the full outstanding mortgage balance. If the seller has no equity (or owes more than the house is worth), where is the deal for the investor?
Here is where a qualified attorney comes in handy, assuming you find one who understands and foresees the consequences I have just laid out. Your attorney can craft some additional specialized language to insert into your Equity Purchase Contract to deal with the inevitable consequences of the original purchase price being reduced after a lender agrees to a short-sale reduced payoff, or the consequences of the lender refusing to reduce the outstanding mortgage balance.
And so I figured with that hurtle overcome I was home free. But then the next headache arose. Short sale negotiations are a process of offers and counteroffers being traded between the investor and the seller's lender - generally beginning with the lowest offer first and then moving up from there. The lender wants to see the investor's offer in the form of a purchase and sale contract. Now what?
How is the California Equity Purchase Agreement used in the context of a short sale negotiation? I have heard countless investors pose this question to any number of experts across the country. And since the essence of California Civil Code Section 1695 is starting to work its way across the country in the form of corresponding legislation in other states, this question is an important one. As I said earlier, Civil Code Section 1695.3 states that the Equity Purchase Agreement constitutes the "entire agreement" between the parties. This means there will be no other agreements between the investor and seller that reflect terms different than those listed in the initial Equity Purchase Agreement.
I sometimes scratch my head and wonder who in their right mind was counseling the California Legislature when it first considered Civil Code Section 1695. When a seller has no equity and is facing foreclosure, Civil Code Section 1695.3 basically prohibits an investor from helping that seller through a short sale transaction. The short sale negotiation is doomed to fail even before the investor begins. If the Equity Purchase Agreement is used as the investor's sole negotiating tool with the lender, why would the lender ever give a discount?
Having sorted out the hurtles posed by the purchase price, the special contractual language required in a short sale context, and how to actually use the Equity Purchase Contract when negotiating a short sale with the seller's lender, there are a few other dangers to look out for when attempting to purchase "distressed" properties in light of Civil Code Section 1695.
First, is an investor required to use a California Equity Purchase Contract to purchase a home before the lender records its Notice of Default? The simple answer is no. Civil Code Section 1695 only applies to a "residence in foreclosure" (§1695.1(a)) "against which there is an outstanding notice of default." (§1695.1(b)). The recording of a notice of default triggers Civil Code Section 1695. However, short sales take time to negotiate and close. If the investor uses a standard purchase and sale contract in a transaction where the seller is behind in payments but is not yet subject to a notice of default, that investor runs the risk of non-compliance with Civil Code Section 1695 should the lender record a notice of default prior to close of escrow.
Second, does Civil Code Section 1695 apply to a seller's non-owner occupied income property? Not necessarily. Civil Code Section 1695 only applies to "residential real property consisting of one-to-four family dwelling units, one of which the owner occupies as his or her personal place of residence." (§1695.1(b)) If the investor is working with a seller's single family rental property, Civil Code Section 1695 does not apply and therefore, the investor would be free to use a standard purchase and sales contract. But what if the seller later claims the property is his/her own personal residence? Or what if, due to unforeseen circumstances, the seller needs to move in to the "investment" house and use it as a personal residence during the short sale negotiation? Technically, that could trigger Civil Code Section 1695 and the investor would have to re-sign the deal under an Equity Purchase Contract.
Additionally, does Civil Code Section 1695 make it difficult to purchase a distressed property in a land trust or other structured entity? This aspect of Civil Code Section 1695 did not even register on my radar as I proceeded with several of my short sale transactions. Until recently, I simply inserted my LLC as the "Buyer" of the distressed property when I filled out my equity purchase contracts. I know many investors use land trusts or corporations or other structured entities as their "buyers" in these situations. It did not even dawn on me that Civil Code Sections 1695.15 and 1695.17 might apply to me as the representative of my LLC.
Civil Code Section 1695.15 addresses the liability of an equity purchaser for the statements or acts committed by its "representative." Civil Code Section 1695.17 addresses the requirement that the "representative" hold a "valid current California Real Estate Sales License." Like other investors I had spoken to, we all assumed these sub-sections applied to equity purchasers who used realtors to help them find distressed homes and work with the owners. Civil Code Section 1695.17 requires a "representative" of the equity purchaser to a) show written proof of a "valid current California Real Estate Sales License" and b) written proof that the representative "is bonded by an admitted surety insurer in an amount equal to twice the fair market value of the real property." I also knew that no surety insurer in the State of California was willing to issue the bond required by Civil Code Section 1695.17. I simply assumed this part of the California Home Equity Sales Contract Act made it virtually impossible for California realtors to aid equity purchasers in buying distressed properties in foreclosure. Since I was not working with a realtor to find distressed homes, or to work with the owners, I disregarded this sub-section. I now know that was an imprudent assumption, especially for an attorney.
In Schweitzer v. Westminster Investments (69 Cal.Rptr.3d 472), a December 2007 case out of Riverside County, the California Fourth District Court of Appeals held that an employee/officer of a corporation is deemed a "representative" under Civil Code Sections 1695.15 and 1695.17. I about fell on the floor when I read this case.
Reading this case has given me a very healthy respect for California Civil Code Section 1695 et seq. and the consequences for non-compliance. It also points out that trial courts and appellate courts are taking a hard look at whether investors are complying with its requirements. Fortunately, it appears the bond mentioned in Civil Code Section 1695.17 is no longer required after being held unconstitutional by the Fourth District Court of Appeals. But beware. The court basically lobbed this ball back to the California Legislature to re-write the bond requirement in a clearer fashion. After the Legislature did such a brilliant job writing the initial California Home Equity Sales Contract Act, I do not hold out much hope they will do any better job re-writing the bond requirement.
Today's real estate market is loaded with opportunity and profit, and there are many desperate homeowners who want and need our help. This is not meant to discourage investors from pursuing short sale transactions. On the contrary, I sincerely hope this clarifies some of the questions investors have regarding Civil Code Section 1695 et seq. And, being an investor myself, I would love to see this keep other investors from making mistakes that could jeopardize a lot more than the profit in their short sale deal. I have found there are solutions to all of these issues but it starts by finding qualified competent legal advice.
