This article series analyzes the use of an installment sale as a flexible financing arrangement to encourage prospective buyers to purchase the seller’s property in a recessionary market.
Part II of this series comments on the listing agent’s and carryback seller’s need to investigate and analyze a buyer’s creditworthiness and capacity to pay.
For an introduction to the concept of seller carryback financing and a discussion of the tax benefits of carrying paper for the seller, and the flexible sale terms available to the buyer, see Part I of this article series.
The need for credit checks
All carryback sellers face the risk a buyer will default, no matter how wealthy, conscientious and qualified they might initially appear to be. On any default in payments on a trust deed note, the seller’s sole source of recovery is to resort to the property secured by the trust deed (unless the note is subordinated to a construction loan or additionally secured by property other than the property sold).
Thus, a carryback seller and his listing agent must determine the creditworthiness of the buyer for the same reason a landlord must obtain reliable credit information on prospective tenants — are they willing and able to pay as agreed. Prudent mortgage lenders also abide by these same fundamentals when making a loan; propensity to pay and source of funds for payments.
Further, the seller must assure himself the buyer will maintain the property unimpaired under the carryback trust deed. As for credibility to manage the ownership of property, if the buyer is discovered to be unqualified to own and care for property, the seller may justifiably cancel the carryback transaction since the buyer presents an unreasonable risk to the security for the carryback note.
The buyer must have the financial ability and credit history to pay both the first trust deed loan and the second trust deed note carried back by the seller before the seller approves and closes the sale. Any default by the buyer on the first trust deed jeopardizes the seller’s security interest in the property under his second trust deed lien.
The listing agent checks the buyer’s creditworthiness and ability to pay his debts by:
- analyzing an application for credit, along with credit reports, telecredit checks and criminal background reports obtained on the buyer under authority granted in the application [See first tuesday Form 203 and 302];
- reviewing financial statements, both an operating statement (profit and loss report) and a balance sheet (net worth statement) and confirming bank balances [See first tuesday Forms 207 and 207-1];
- contacting the buyer’s creditors (vendors, landlords, lenders) for their experiences with the buyer’s payment history; and
- inspecting properties owned by the buyer to determine the level of care and maintenance the properties have received from the buyer.
The listing agent orders out the buyer’s credit report. On receipt, the agent reviews it and presents it to his seller. In turn, the seller independently decides to either proceed with the transaction or cancel it under a further-approval contingency in the purchase agreement. [See first tuesday Form 158 §8.5]
Written disclosures itemizing the buyer’s credit information are mandated on all sales involving one-to-four unit residential properties when the seller carries back a portion of the sales price. [Calif. Civil Code §§2956 et seq.]
All disclosures are to be made in good faith by the buyers, brokers and agents to meet the objective of the credit investigation. [CC §2961; see first tuesday Forms 302, 207 and 207-1]
Even the existing trust deed lender has the right to obtain credit information from the buyer on a change of ownership. The lender, like a carryback seller, needs to make an informed decision as to whether the risk of default in the payments or care and management of the property will increase under the new ownership, called impairment of the security. [Santa Clara Savings and Loan Association v. Pereira (1985) 164 CA3d 1089]
The right to obtain credit information also applies to private parties such as carryback sellers.
For example, private lenders rely on their agents to obtain information on a buyer’s ability to comply with the terms of both the note (payments) and the trust deed (care and maintenance) sufficient to make a decision about the buyer’s creditworthiness.
A private lender does not typically have the resources of institutional lenders to personally investigate and assess a buyer’s creditworthiness and management capabilities prior to making a loan. Thus, a broker or an agent who assists private lenders and carryback sellers is obligated to help them, or advise that someone else needs to help them, determine the buyer’s ability to operate the property and his propensity and resources to make payments on a promissory note. [Dawn Investment Co., Inc. v. Superior Court of Los Angeles (1982) 30 C3d 695]
The creditworthiness contingency
A listing agent has the duty in a carryback transaction to obtain credit information on the buyer and disclose any facts known or readily available to him about the buyer’s creditworthiness which might affect the seller’s decisions in the transaction.
Initially, a carryback disclosure statement should be attached to any purchase agreement containing provisions for a carryback note. The carryback disclosure statement is mandated on the sale of four-or-less residential units. However, a prudent listing agent will also require a disclosure statement in carryback transactions on all types of property be part of the offer/counteroffer negotiations. [CC §§2956 et seq.; see first tuesday Form 300]
Both the carryback disclosure statement and the purchase agreement includes a credit approval contingency. The further-approval contingency provision calls for the buyer to hand the seller a completed credit application. [See first tuesday Form 302]
The selling agent preparing a carryback offer should consider having the buyer fill out the credit application on commencement of negotiations and attach it to the buyer’s purchase agreement as an addendum. Early disclosure helps the seller determine the buyer’s sincerity and good-faith willingness to cooperate in a fully transparent credit analysis process.
A review of the buyer’s financial statements and the agent’s verification of earnings and funds are completed during the contingency period. Clarifications by the buyer may be needed by the seller to finish the credit analysis process. [See first tuesday Forms 208 through 213]
The credit contingency allows the carryback seller to terminate the purchase agreement by a written Notice of Cancellation should he disapprove of the buyer’s creditworthiness. [See first tuesday Form 150 §10.5]
However, the credit contingency does not give the carryback seller the unrestricted right to withdraw from a binding and otherwise enforceable purchase agreement.
For example, a carryback seller enters into a purchase agreement containing a credit approval provision giving him the right to cancel the transaction based on his disapproval of the buyer’s creditworthiness.
During the contingency period and before the seller investigates the buyer’s credit, the seller changes his mind about selling the property. He then cancels the transaction by using the credit contingency as a “weasel clause,” or “back door provision,” in an attempt to escape enforcement of the purchase agreement. The seller has no grounds for disapproving the buyer’s credit since he has received no derogatory information about the buyer’s creditworthiness or ability to perform on the purchase agreement or the carryback note.
However, the seller must have good reason to disapprove the buyer’s credit in order to cancel the transaction. A reason to cancel the transaction must relate to the creditworthiness sought to be determined under the contingency provision. Without good reason, the seller who cancels by wrongfully using the credit contingency breaches the purchase agreement in bad faith. [Lyon v. Giannoni (1959) 168 CA2d 336]