This article discusses a broker’s use of a Conflict of Interest Disclosure to avoid breaching the fiduciary duty he owes to his client when he has a bias relating to the opposing party in a transaction, or another, whose interests are in conflict with his client’s.
Professional relationships compromised
A conflict of interest arises when a broker or his agent, acting on behalf of a client, has a competing professional or personal bias which hinders his ability to unreservedly fulfill the fiduciary duties he has undertaken to advise and act on behalf of the client.
In a professional relationship, a broker’s financial objective of compensation for services rendered by the broker is not a conflict of interest. However, fees and benefits derived from professional courtesies, familial favors, and preferential treatment by others toward the broker or his agents is compensation which must be disclosed to the client. [See first tuesday Form 119]
Further, the referral of a client to a financially controlled business owned or co-owned by the broker, disclosed by use of an affiliated business arrangement (ABA) form, is also not a conflict of interest. [See first tuesday Form 519]
A conflict of interest addresses the broker’s personal situations potentially at odds with the agency duty of care and protection owed the client.
Thus, a conflict of interest creates a fundamental agency dilemma for brokers, not a compensation or business referral issue. A conflict of interest exists when:
- a broker has a positive or negative bias toward the opposing party in a transaction or a person not directly involved in the client’s transaction; and
- that bias in favor of or against the other person might compromise the broker’s ability to freely recommend action or provide guidance to the buyer or seller, landlord or tenant, or lender or broker he agreed to represent.
This bias regarding an opposing person or a party not directly involved, to whom the broker may or may not also owe an agency duty, must be disclosed if the bias might disrupt the broker’s ability to make impartial decisions about the care and protection he owes his client. Unless disclosed and the client consents, the conflict is a breach of the broker’s fiduciary duty of good faith, fair dealing, and trust owed to his client should the broker continue to act on the client’s behalf. [See first tuesday Form 527]
Situations involving a conflict
A conflict of interest, whether patent or potential, is disclosed by the broker at the time or as soon as possible after the conflict arises. Typically, the conflict arises prior to providing a buyer with property information or taking a listing from a seller.
The disclosure creates transparency in the transaction, revealing to the client the bias held by the broker which, when disclosed, allows the client to take the bias into consideration in negotiations. Though the disclosure and consent does not neutralize the inherent bias itself, it does neutralize the element of deceit which would breach the broker’s fiduciary duty if left undisclosed.
Potential overlaps of allegiance or prejudice which cause a conflict that a broker or his agent must disclose include:
- the broker or his agent holds a direct or indirect ownership interest in the real estate, or are directly or indirectly a buyer of the property in the transaction, including a partial ownership interest in a limited liability company (LLC) or other entity which owns or is buying, leasing, or lending on the property;
- an individual related to the broker or one of his agents by blood or marriage holds a direct or indirect ownership interest in the property or is the buyer;
- an individual with whom the broker or a family member has a special pre-existing relationship, such as prior employment, significant past or present business dealings, or deep-rooted social ties, holds a direct or indirect ownership, leasehold, or security interest in the property or is the buyer;
- the broker’s or his agent’s concurrent representation of the opposing party, a dual agency situation; or
- an unwillingness of the broker or his agent to work with the opposing party, or others, or their brokers or agents in a transaction.
Simply, a conflict of interest should be disclosed to the client by the broker when he has a pre-existing relationship with a person other than the client based on any form of kinship, employment, partnership, common membership, religious affiliation, civic ties, or any other socio-economic context which might hinder his ability to fully represent the needs of his client.
Unfortunately, comprehensive rules do not yet exist which establish those instances where a conflict of interest arises and needs to be disclosed. Thus, brokers are left to draw their own conclusions when situations regarding a property or a transaction with or involving third parties arise. In practice, brokers, and especially agents, all too often err on the side of nondisclosure, putting their brokerage fee, if not their license itself, at risk.
Generally, if a broker even questions whether it is appropriate to disclose a potential conflict of interest to a client, he should disclose it. The existence of any concern is reason enough for a prudent broker to be prompt in seeking his client’s consent to the potential conflict. By timely disclosing a conflict of interest and obtaining consent, the broker immediately creates an honest working relationship with his client.
The client’s tardy discovery of the conflict and their complaint to the Department of Real Estate (DRE) for failure to make the disclosure and obtain consent before continuing to advise or act on behalf of the client can result in the suspension or revocation of the broker’s license by the DRE. [Calif. Business and Professions Code §10177(o)]
Fundamentally, a broker who becomes aware he has a conflict of interest but is reluctant to disclose it and seek the client’s consent should consider rejecting or terminating the employment with that individual.
Relative’s participation in a transaction
A seller’s broker must disclose the existence of any direct or indirect interest the broker expects to acquire in the seller’s property, or whether a family member, a business owned by the broker, or any other person holding a special relationship with the broker (such as his agents) will acquire an interest in the seller’s property. [See first tuesday Form 527 §3.6]
For example, a broker’s brother-in-law makes an offer to buy property the broker has listed. The purchase agreement states the broker is to receive a fee and that he represents the seller exclusively.
The broker does not disclose to the seller that the buyer is his brother-in-law.
The broker opens two escrows to handle the transaction. The first escrow facilitates the sale and transfers the property from the seller to the broker’s brother-in-law.
The second escrow is for the sole purpose of transferring title to the property from the brother-in-law to a limited liability company (LLC) in which the broker holds an ownership interest, a syndicated acquisition. Both escrows close and the broker receives his fee.
The seller discovers the buyer to whom he deeded the property was his broker’s brother-in-law and that the true buyer was an entity partially owned by the broker. The seller demands a return of the brokerage fee claiming the broker had a conflict of interest which breached the fiduciary duty he owed to the seller since it was not disclosed and the seller did not consent.
Here, the broker is not entitled to retain the brokerage fee he received from the seller. Further, the seller is entitled to recover any property value at the time of the sale in excess of the price he received, or he can set the sale aside, due to the failure of the broker’s agency with the seller.
A broker cannot act for more than one party in a transaction, including himself, without disclosing his dual role and obtaining the client’s consent at the time the conflict arises. [Bus & P C §10176(d); see first tuesday Form 527]
Also, a seller’s broker has an affirmative duty to disclose to the seller his agency or other conflicting relationship he might have with the buyer, even if the seller fails to inquire into whether the broker has a relationship with the buyer.
Further, failure to disclose a broker’s personal interest as a buyer in a transaction when he is also acting as a broker on behalf of the seller constitutes grounds for discipline by the Real Estate Commissioner. [Whitehead v. Gordon (1970) 2 CA3d 659]
In another example, a seller, acting on a broker’s advice as to the estimated value of his real estate, retains the broker to find a buyer for the property. [See first tuesday Form 318]
The broker and seller enter into a net listing agreement.
Under the net listing, the seller agrees to take a fixed sum of money as the net proceeds for his equity should the property sell. Also, the net listing provides for the broker to receive all further sums paid on the price as his brokerage fee.
The broker arranges a sale of the property to his daughter and son-in-law. The seller is not informed of the broker’s relationship with the buyer. On the close of the transaction, the broker receives his fully disclosed brokerage fee as the net proceeds remaining from the sale in excess ofthe net listing price.
On discovery of the broker’s relationship with the buyer, the seller demands a return of the brokerage fee claiming the broker’s kinship with the buyer is a conflict of interest which was not disclosed, violating the fiduciary duty he owed to the seller. The broker claims the seller cannot recover the brokerage fee no matter who the buyer was since the seller only bargained to receive a fixed amount on the sale of his property under the net listing agreement.
Here, and whenever a broker is employed under any type of listing, he has an obligation to voluntarily disclose to his seller, and do so at the earliest opportunity, any special relationship he may have with the buyer and obtain the seller’s consent before proceeding. The seller, unaware of the family relationship between his broker and the buyer, can recover the brokerage fee he paid to the broker. [Sierra Pacific Industries v. Carter (1980) 104 CA3d 579]
A relative’s ownership of the property sold
A selling broker employed to act on behalf of a buyer will disclose to his buyer the nature and extent of any direct or indirect interest he or his agents hold in any property presented to the buyer.
For example, a licensed broker acting as an agent on behalf of a buyer shows the buyer several properties, one of which is owned by the broker and others, vested in the name of an LLC. The broker promptly informs the buyer he has a listing on the property, but does not inform the buyer of his indirect ownership interest in the property.
The buyer later decides to purchase the LLC property. An offer is prepared on a purchase agreement form with an agency confirmation stating the broker is the agent for both the buyer and seller. The offer is submitted to the LLC. [See first tuesday Form 159]
The broker, aware the buyer will pay a higher price for the property than the initial price offered by the buyer, presents the buyer with a counteroffer from the LLC at a higher selling price. The buyer accepts the counteroffer.
Here, the broker has a duty to promptly disclose his ownership interest in the property to his client the moment the conflict arises – the exposure of the buyer to the property. The conflict of interest in the broker’s ownership is a material fact requiring disclosure since the client’s decisions concerning acquisition of the property might be affected.
As a result of the lack of disclosure of the conflicting position of the buyer’s broker, the buyer can recover the fee received by the broker and the increase in price under the counteroffer.
Had the buyer known the broker held an ownership interest in the property when it was first presented, he might have negotiated differently when setting the price and terms for payment, or retained a different broker to represent his interests who was not compromised by a conflict of interest.
However, a broker acting solely as a principal in the sale of his own property is not restricted in his conduct by compliance with agency obligations. The broker selling or buying property for his own account should act solely as the seller or buyer, rather than pay himself a taxable fee for also acting as a broker in the transaction which then exposes him to claims of agency violations. [Robinson v. Murphy (1979) 96 CA3d 763]
When a broker-seller receives a brokerage fee on the sale of his own property or on the purchase of property for his own account, he subjects himself to real estate agency requirements.
For example, a broker sells a residence he owns which exists in violation of safety requirements for occupancy due to defects in the foundation known to the broker. The broker does not tell the buyer about the foundation defects.
Out of the proceeds the broker receives on closing the sale of his property, the broker-seller pays himself a brokerage fee, claiming to exclusively represent himself (which is not an agency and does not require a license).
The buyer later discovers he must demolish the residence and rebuild it with an adequate foundation. The buyer obtains a money judgment against the broker for breach of his general agency duty owed to all parties in a real estate transaction to disclose known property defects that cause the buyer to take a loss.
The broker is unable to pay the money judgment. The buyer seeks payment from the DRE Recovery Fund.
Recovery is received from the DRE Recovery Fund since the broker held himself out as acting as a real estate broker in the transaction – he received a fee. The broker’s license is then suspended. Before the broker can reactivate his license, he must reimburse the DRE Recovery Fund. [Prichard v. Reitz (1986) 170 CA3d 465]
A DRE licensee acting solely as a principal on his own behalf when buying (or selling) property need not disclose the existence of his real estate license. The licensee has no conflict due to the existence of his license since he is not holding himself out as a broker or agent acting on behalf of anyone in the transaction.
Consider a broker who is employed by an owner to arrange a real estate loan. The lender making the loan is the broker’s sister.
The broker, however, funds the loan himself by depositing his personal funds into his sister’s account. In essence, the broker is the lender.
Here, the broker has a duty owed to the buyer to disclose his dual capacity in the loan transaction. He was acting both as a broker arranging the loan on behalf of the owner and as the lender making the loan, a conflict of interest. The broker’s actions constitute grounds for discipline by the Real Estate Commissioner. [Tushner v. Savage (1963) 219 CA2d 71]
Conflicts in real estate syndication
A potential conflict of interest also exists when a broker manages multiple LLCs which own like-type properties in the same market area, the result of his syndicating the acquisition of several properties.
For example, consider a broker entrusted with managing two investment groups which own similar apartment projects located within the same market and compete for the same prospective tenants. The broker is paid a management fee by each investment group based on a percentage of the rents received.
When contacted by a prospective tenant, the broker is initially faced with the dilemma of which apartment building to refer the tenant to and thus which investment group will benefit from the tenant’s occupancy.
A similar conflict of interest results from parallel transactions in which multiple LLCs managed by the same broker are actively competing to sell or buy property within the same marketplace.
A conflict of interest of this nature must be disclosed to the investors before they agree to participate as members in an LLC the broker manages. This disclosure is contained in first tuesday Form 371, Investment Circular provision 6d, which states:
The Manager has numerous other business responsibilities and ownership interest which will demand some or most of his time during the LLC’s ownership of the property. The Manager’s other interests include ownership of projects comparable to the property purchased in this transaction. To the extent his time is required on other business and ownership management decisions, he will not be involved in monitoring or marketing of the LLC’s property. [See first tuesday Form 371]
With this disclosure, the broker’s allegiance to multiple projects and investment groups is transparent and can be taken into consideration by all investors at the time they receive the Investment Circular from the Broker – before investing and consenting to the risk.
Preparing the Conflict of Interest Disclosure
A broker and his agents acting on behalf of a client may not act in a manner which might cause the client to conclude that other individuals, or a position held by the broker or his agents, can improperly influence or cause the broker or his agents to fail to properly act in their fiduciary capacity as the client’s agent without first disclosing to the client the facts which might lead to that conclusion.
The following instructions are for the preparation and use of the Conflict of Interest Disclosure, first tuesday Form 527. Form 527 is used to disclose any potential biases in favor of the opposing party or others a broker may have which compromises his ability to fully represent and give proper care and protection to the interests of his client.
Each instruction corresponds to the provision in the form bearing the same number.
Editor’s note – Check and enter items throughout the agreement in each provision with boxes and blanks, unless the provision is not intended to be included as part of the final agreement, in which case it is left unchecked or blank.
Enter the date and name of the city where the disclosure is prepared. This date is used when referring to this disclosure.
1. Type of agreement: Check the box to indicate which type of agreement this disclosure is made in connection with.
1.1Check the box to indicate the disclosure is made on the same date as the previously checked agreement or if different, enter the date and city set out on the referenced agreement.
1.2– 1.3 Enter the names of the parties to the agreement and what positions they hold under the agreement.
1.3Enter the address of the real estate involved.
2. Client(s) represented: Enter the name(s) of the client(s) represent by the broker or agent making this disclosure with regard to the above referenced agreement.
Disclosure of conflict of interest:
3. Conflict of interest: States the following information is a disclosure to the broker’s client of relationships or positions held by the broker, his agents, family members, or business associates which present circumstances that might appear to be in conflict with the agency duty owned to the client.
3.1 Real estate: Check the box to indicate the conflict of interest arises out of the ownership of real estate. Enter the property type, address, and interest held by the broker, his agents, their kin, or business associates in the property. Enter the activity creating a possible conflict.
3.2 Government agency: Check the box to indicate a position held in a government agency by the broker, his agents, kin, or business associates which might constitute a conflict of interest. Enter the agency name and the position held by the broker, his agents, their kin, or business associates. Enter the activity creating a possible conflict.
3.3 Business position: Check the box to indicate a business position held by the broker, his agents, their kin, or business associates which might constitute a conflict of interest. Enter the business name, the goods or services provided by the business, and the position held by the broker, his agents, their kin, or business associates. Enter the activity creating a possible conflict.
3.4 Business investment: Check the box to indicate a business investment of the broker, his agents, their kin, or business associates which might constitute a conflict of interest. Enter the company name, type of trade or business, and the interest held by the broker, his agents, their kin, or business associates. Enter the activity creating a possible conflict.
3.5 Representation of others: Check the box to indicate the broker’s or his agent’s representation of others in or servicing the transaction which might constitute a conflict of interest. Enter the name of the person who is also owed an agency duty and the activity creating a possible conflict.
3.6 Kinship and employee relationships: Check the box to indicate an employee of the broker or a relative of the broker or his agents is the conflict of interest. Enter the name of the individual(s), their relationship to the broker or an employee, and the activity constituting the conflict.
4. Other disclosures: States other disclosures of direct or indirect compensation or economic benefits may have previously been made to the broker’s client, such as additional compensation and controlled business arrangements. [See first tuesday Forms 119 and 519]
5. Broker certification: States the information entered into the form is true and correct to the best knowledge of the broker and the agent. Enter the date the disclosure is signed and the name of the broker. Obtain the signature of the broker or his agent who is representing the client in the transaction. Enter the name of the agent representing the client on behalf of the broker in the transaction or leave it blank if no agent is involved.
6. Client certification: States the client has received a copy of this conflict of interest disclosure and consents to continuing the agency relationship. Check the box to indicate a Signature Page Addendum is attached. Enter the name(s) of the client(s) and obtain their signatures. [See first tuesday Form 251]
Compensation and earnings received by the broker
Direct or indirect compensation received by a broker must be disclosed but is not a conflict of interest. The Compensation Disclosure in a Real Estate Transaction form is used to disclose the amount, its form and the source of compensation, and the benefits the broker and his agents anticipate receiving for any other service they provide or from any other individual, company, or provider as a result of a party’s entry into a real estate transaction in which the broker is acting as a broker. [Bus & P C §10176(g); see first tuesday Form 119]
Additionally, a broker listing a property or representing a buyer who refers the owner or buyer to a business or service provider he owns or co-owns uses an Affiliated Business Arrangement Disclosure Statement to inform the party of his ownership interest in that company. The disclosure enables the broker to indirectly benefit from the referral and properly share in any profits from the referrals he makes to businesses he controls. [See first tuesday Form 519]
Similarly, the Affiliated Business Arrangement Disclosure Statement – Loan Broker form is used by a mortgage loan broker arranging financing when referring a borrower to providers of settlement services whose earnings are shared by the loan broker as a co-owner of the provider. [See first tuesday Form 205]