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April 2011

Expansion of Broker/Seller Disclosure Obligations

Appellate Court Requires "Short Sale" Status to be Disclosed Prior to Contract Execution

In an extension of seller and broker disclosure obligations, the Fourth District Court of Appeal has held in Holmes v. Summer (2010), 188 Cal.App.4th 1510, that when a seller's agent knows that a proposed transaction would require a "short sale" in order to convey title free of monetary liens, that agent must disclose such information, not during escrow, but before a purchase agreement is executed by the parties. 

The general rule in California is that when a seller has knowledge of facts materially affecting the value or desirability of property, and such facts are not known to or likely to be discovered by the buyer, the seller has a duty to disclose those facts.  The same duty of disclosure is also owed by the seller's agent to the buyer. 

The typical real estate sale agreement includes a due diligence or "free look" period.  After the agreement is executed, the seller is required to deliver information and to make disclosures to the buyer regarding the condition of the property, including encumbrances, both physical and financial.  In most instances, the agreement requires the buyer to make a deposit, to indemnify the seller in connection with its investigation, to maintain general liability insurance and to maintain the confidentiality of the information being disclosed by the seller.  The buyer's goals are (i) to develop an acceptable comfort level relative to the desirability of the property and the feasibility of the proposed use, and (ii) to avoid uncertainty. 

In Holmes, the buyers negotiated to purchase a home from the sellers. However,  the sellers' debt against the property exceeded the purchase price by $392,000, and the three mortgage holders would be required to forgive a portion of their respective debts for the sale to proceed – thus a short sale.  Such information was known by the sellers' broker and not disclosed to the buyers prior to their entering into the purchase agreement.  The buyers, in reliance on the apparent ability of the sellers to convey title, sold their home and suffered damages when the sellers' lenders refused to permit the short sale. 

The trial court concluded that the broker owed no duty to disclose the excess debt to the buyers and dismissed the case.  On appeal, the buyers argued that the broker had a duty to disclose the excess debt because it created a substantial risk of the transaction's failure beyond that generally present in residential sales.  The broker argued that she was prevented from disclosing such information because of her duty to protect her clients' confidential financial information and negotiating strategy; that the excess debt was not related to the value or desirability of the property; and that the liens were a matter of public record that would have been disclosed during escrow.

The Court of Appeal ruled in favor of the buyers and reversed the trial court.  In doing so, the Court held that the desirability of property may be impacted by its financial condition if the buyer may be harmed by the inability to pass title, as the buyers alleged.  The Court further determined that the broker's duties to act honestly and treat all parties to the transaction fairly required disclosing all information pertinent to the transaction and superseded the broker's obligation to keep her clients' financial information confidential. 

Finally, the Court noted that although the buyers could have conducted a title search before making an offer or entering into the purchase agreement, because the sellers had promised to deliver clear title and because the standard form purchase agreement they signed required delivery of a title report within seven days of execution, they had no reason to obtain a title report (and pay the associated expense) before entering into the purchase agreement. 
As a result, the case was remanded to the Orange County superior court for further consideration.

The decision is notable in that it shifts certain disclosures from the due diligence period – where the parties have a contractual relationship and corresponding obligations to each other – into the contract negotiating period.  Following this decision, a seller may no longer rely solely on the escrow process and the buyer's examination of a title report for the disclosure of information regarding monetary encumbrances.  Instead, a seller and its agent will be required (certainly in the residential sale context) to carefully consider whether to disclose any potential financial impediments to the sale in anticipation that a buyer may be harmed by the sale not proceeding. 

It is not clear whether the decision is applicable to commercial purchase and sale transactions.  In commercial transactions, there is a greater likelihood that the buyer is sophisticated and a corresponding likelihood that the courts will not be as protective of a buyer as was the case in Holmes.   Regardless, prudence suggests that a seller and its agents in a commercial sale should make the same disclosures as required in a residential sale. 

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