Why this matters: Learn how to recognize the types of business arrangements and personal relationships which give rise to conflicts of interest for agents in real estate transactions, how to identify conflicts of interests, and disclose and obtain consent to the relationships presenting a conflict of interest.
Fiduciary agency relationships compromised by bias
A conflict of interest arises when a broker or their agent has a competing professional or personal bias which in some manner might debilitate fulfillment of their fiduciary duties owed to their client.
In professional services, negotiations setting a broker’s financial expectation of a fee earned for representing a client are not a conflict of interest.
However, all fees and benefits derived from any source arising out of a transaction entered into by a client are promptly disclosed to the client. Benefits include compensation in the form of:
- professional courtesies such as referral fee kickbacks (though illegal), including discounted services, providing space or assets, or payment of expenses of the broker or agent;
- familial favors — nepotism, such as relatives, close friends and interrelated business associates of the broker or their agents who stand to benefit financially from a broker representation of a client;
- preferential treatment given the broker or their agents by anyone connected to the client’s transaction. [See RPI Form 119]
Similarly, the act of referring a client to a service provider such as an escrow office or mortgage company financially controlled — owned or co-owned — by the broker requires disclosure. The method of disclosure is the use of an affiliated business arrangement (ABA) form to review with the client for their consent before the broker or their agent proceeds to continue to work on behalf of the client. [See RPI Form 519 and Form 205]
A conflict of interest disclosure addresses the broker’s personal and business relationships 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; it is different from conflicts arising out of negotiations for broker fees or disclosure of the broker’s beneficial interest in a referred service provider.
Until the conflict is disclosed and the client consents, any continuation of services for the client is a breach of the broker’s fiduciary duty of good faith, fair dealing and trust owed to the client. When the broker continues to act on the client’s behalf without first making a written disclosure and obtaining the client’s signed consent, the breach of duties owed intensifies.
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Situations involving a conflict
A conflict of interest, whether patent or potential, is disclosed by the broker as soon as possible (ASAP) when the conflict first arises. Typically, the conflict is known to the broker prior to providing a buyer-client with property information or entering into a seller representation agreement with an owner of property available for sale.
The purpose of a disclosure is to create transparency of an asymmetry otherwise known only to the broker in the transaction, not the client. As in all disclosures, the conflict revealed to the client, such as a bias held by the broker toward other participants or service providers in a transaction, allows the client to consider the bias as the broker continues with negotiations and advice to the client.
However, disclosure and consent do not neutralize the inherent bias itself. What takes place is the neutralization of the element of deceit which, when left undisclosed, is a breach of the broker’s fiduciary duty owed the client.
Potential overlaps of allegiance or prejudice presenting a conflict with a client requiring disclosure and consent include:
- ownership or acquisition, direct or indirect, of an ownership interest by the broker or their agent in real estate which is the subject of a client transaction, such as a percentage ownership interest in an entity which owns or is acquiring, leasing or lending on the property;
- an individual related directly or remotely to the broker or one of their agents holds an ownership interest in the property or is the buyer, directly or indirectly;
- an individual with a special pre-existing relationship with the broker, their agent or family members holds an ownership, leasehold or security interest in the property or is the buyer, directly or indirectly, such as a prior employment, significant past or present business dealings, or deep-rooted long-lived social ties;
- the broker currently also represents as their agent an opposing party in the client’s transaction, a dual agency situation; or
- an unwillingness of the broker or their agent to work with a party, their brokers or agents, or with a service provider in the client’s transaction.
Simply, a conflict of interest arises and is disclosed to the client when the broker:
- has a deep-rooted long-lived relationship with another person involved in the client’s transaction, due to kinship, employment, partnership, membership, religious affiliation, civic ties or any other socio-economic context; and
- the relationship might hinder their ability to fully represent the needs of their client in the transaction.
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To disclose or not to disclose?
Comprehensive rules do not exist by code or regulation which establish those instances where a conflict of interest arises and needs to be disclosed. Thus, a broker makes a judgment call as to whether a conflict exists, and when that conflict might influence their judgment working on behalf of a client.
In practice, brokers draw their own conclusions in situations regarding a property, a transaction, or a relationship with or involving others when the broker represents their client. In practice, brokers, and especially agents, all too often erroneously go for nondisclosure, putting their broker fee, and their license itself, at risk. [Calif. Business and Professions Code §10177(o)]
Typically, when a broker even questions whether it is appropriate to disclose a potential conflict of interest to a client, they need to disclose it, get consent and move on. The existence of any concern is reason enough for a prudent broker to be prompt in seeking their client’s consent to the potential conflict.
By timely disclosing a conflict of interest and obtaining consent, the broker immediately improves their working relationship with their client — now replete with fairness, a broker whose advice is to be trusted. Fundamentally, a broker who becomes aware they have a conflict of interest but is reluctant to disclose it and seek the client’s consent needs to consider rejecting or terminating the employment with that client.
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Brokerage Reminder: Disclosing a conflict of interest – the counterpoint mitigating a bias
Relative’s participation in a transaction
A seller broker discloses their acquisition of any direct or indirect interest in their seller-client’s property. The broker also discloses family members, family business entities and any others holding a special relationship with the broker. For example, an agent of the broker or their family members who are acquiring an interest in the seller-client’s property are disclosed to the seller-client. [See RPI Form 527 §3.6]
Consider this set of facts. A broker’s brother-in-law makes an offer to buy property owned by a seller-client the broker represents. The purchase agreement states the fee amount the broker is to receive as the exclusive representative of the seller-client.
The broker does not disclose to the seller that the buyer is their brother-in-law. The seller accepts the offer.
The broker opens two escrows to handle the transaction. The first escrow facilitates the purchase agreement sale. On closing, the title is conveyed to the buyer, the broker’s brother-in-law.
The second escrow concurrently transfers title to the property from the brother-in-law to a limited liability company (LLC) partially owned or managed by the broker. Both escrows close and the broker receives their fee from the seller-client.
The seller discovers the buyer was their broker’s brother-in-law, a strawman sandwiched into the transaction. The true buyer was an entity partially owned or controlled by the broker.
The seller demands a return of the broker fee (and lost value due to below-market sales price). The seller claims the broker had an undisclosed conflict of interest which breached the fiduciary duty owed to the seller.
In this instance, the broker may not retain the broker fee they received from the seller-client. Further, the seller-client is entitled to recover any property value at the time of the sale in excess of the price they received. Alternatively, the seller-client may set the sale aside and recover ownership due to the failure to disclose the broker’s conflict of interest with the buyer and obtain the seller-client’s consent.
A broker is limited to negotiating on behalf of their client until they disclose their dual agency and obtain each client’s consent. [Bus & P C §10176(d); See RPI Form 527]
Also, a seller broker has an affirmative duty to disclose to the seller-client the broker’s representation or other conflicting relationship they might have with the buyer. The affirmative duty to voluntarily disclose exists without the prior need for the seller-client to inquire into whether the broker has a relationship with the buyer.
Further, failure to disclose a seller broker’s personal involvement as a buyer when they are the seller broker constitutes grounds for discipline by the Real Estate Commissioner. [Whitehead v. Gordon (1970) 2 CA3d 659]
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DRE Hot Seat: Broker fails to supervise or disclose an overt conflict of interest
A relative owns the property sold
A buyer broker discloses to their buyer-client any direct or indirect interest the broker or the broker’s agents hold in any property presented to the buyer. The disclosure occurs at the point the buyer requests more information about the property other than introductory promotional material distributed about the property.
For example, a buyer broker shows the buyer several properties, one of which is vested in the name of an LLC owned by the broker and others. The broker does not inform the buyer of their indirect ownership interest in the property.
The buyer later decides to purchase the property owned by the LLC. An offer is prepared on a purchase agreement with an agency confirmation provision stating the broker is the agent for both the buyer and seller. The offer is submitted to the LLC. [See RPI Form 151]
The broker is aware the buyer will pay a higher price for the property than the initial price offered by the buyer. The broker prepares and 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 — apart from disclosing they are a dual agent in the transaction — to promptly disclose their ownership interest in the property to the buyer the moment the conflict arises — at the point the buyer asks for more information on the property. The conflict of interest in the broker’s ownership is a material fact and requires disclosure. The conflict is material since the buyer’s decision concerning acquisition of the property might be affected by knowledge of the broker’s indirect ownership.
As a result of the nondisclosure, the buyer may recover both 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, the buyer might decide differently about the price set and terms for payment. Alternatively, the buyer may have retained a different broker who was not compromised by a conflict of interest.
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A broker fee when acting as a principal
A broker acting solely as a principal in a real estate transaction — sale, leasing or mortgage origination — regarding property they own is not restricted in their conduct by compliance with agency obligations, as they owe none. A broker selling or buying property for their own account is not acting as the agent for any participants, and they cannot be an agent for themselves. [Robinson v. Murphy (1979) 96 CA3d 763]
As a buyer, a DRE licensee has no conflict with others due to the fact they are licensed. Further, a buyer does not declare they are a licensee, as that fact, while not involved in the transaction, might confuse other participants about their role in the transaction — simply because the fact was volunteered.
However, a broker-seller who structures the transaction to receive a broker fee on the sale of their property they own or acquire subjects themselves to real estate agency requirements. They were a licensee taking a fee as a licensee in the transaction when otherwise no fee was earned.
For example, a broker sells residential property they own. The residence is 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.
The broker as the seller instructs the sale escrow to pay themselves a seller broker fee on the transaction, which they receive as disbursed by escrow. A provision in the buyer’s purchase agreement states the seller exclusively represents themselves (which does not create an agency with anyone as an agent represents another, never themselves).
The buyer later discovers they need to demolish the residence and rebuild it with an adequate foundation. The buyer obtains a money judgment against the broker for breach of their general agency duty owed to all participants. The broker failed to disclose known property defects in a real estate transaction in which they acted as a licensee by collecting a fee.
The broker is unable to pay the money judgment. The buyer seeks payment from the DRE Real Estate Recovery Account.
The buyer’s claim is paid by the DRE Real Estate Recovery Account. The seller licensed as a broker held themselves out as a real estate broker rendering services for a fee in the transaction. The broker’s license is suspended. The condition for the broker to reactivate their license is to reimburse the Recovery Account. [Prichard v. Reitz (1986) 178 CA3d 465]
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Conflicts in a 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.
Consider a broker entrusted with managing two investment groups which own similar apartment projects located within the same market. The two projects compete for the same prospective tenants in the local market. The broker is paid a management fee by each investment group based on a percentage of the rents received. A percentage fee based on services rendered requires a broker license to receive the fee, which existed in compliance.
When contacted by a prospective tenant, the broker is faced with the dilemma of which apartment building to refer the tenant to. In turn, the broker’s decision benefits one investment group at the expense of the other, a conflict of interest.
A similar conflict of interest results from parallel transactions when multiple LLCs managed by the same broker are actively competing to sell or buy property in the same marketplace.
A potential conflict of interest is by its nature foreseeable and is disclosed to the investors before they agree to invest as owner-members of an LLC the broker manages. This disclosure is contained in promotional material handed to prospective investors, such as RPI Form 371, Investment Circular, in provision 6d, which states:
The Manager has numerous other business responsibilities and ownership interests which will demand some or most of their 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 their time is required on other business and ownership management decisions, they will not be involved in monitoring or marketing of the LLC’s property. [See RPI Form 371]
With the conflict disclosed, the broker’s allegiance to multiple projects and investment groups is transparent. On review of the investment opportunity prospectus with the disclosure, the conflict is considered by all investors at the time they receive the Investment Circular from the broker — before investing and consenting to the risks.
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Form-of-the-Week: LLC Investment Circular and Operating Agreement — Forms 371 and 372
Conflict under a net listing
Consider a seller who receives advice volunteered by an agent soliciting employment to represent the seller. The agent advises the seller, giving an estimate on the value of their real estate based on the agent’s Comparative Market Analysis. [See RPI Form 318]
Following negotiations for setting the fee amount, the broker and seller enter into a net proceeds arrangement for the broker fee under a seller representation agreement, sometimes called a net listing.
The seller-client interested in receiving a specific dollar amount of net proceeds on closing a sale agrees to sell only when they receive a fixed sum of money as their net proceeds on closing. The net listing functions to provide the seller broker a fee earned in the amount of all sums remaining after escrow disburses the net proceeds to the seller and all seller closing costs are disbursed.
The broker arranges a sale of the property to their daughter and son-in-law. The seller is not informed of the broker’s relationship with the buyers. On closing, the broker receives their seller broker fee in the amount of the proceeds remaining after the disbursement by escrow of the seller-agreed net proceeds amount and all seller closing costs.
On discovery of the seller broker’s relationship with the buyer, the seller-client demands a return of the broker fee. The seller claims their broker’s kinship with the buyer created a conflict of interest which was undisclosed in violation of fiduciary duties the broker owed the seller.
The broker claims the seller may not recover the broker fee no matter who the buyer is. The seller bargained for a fee in the amount the property’s sales price exceeded the net listing price and closing costs, which the seller received as agreed.
Here, as always, a broker employed to render real estate services is obligated to voluntarily disclose to their client any special relationship they may have with others in the transaction. The seller broker was compelled to obtain the seller-client’s consent before proceeding with a sale to the broker’s family members. Thus, the seller recovers the broker fee they paid to the broker.
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