This is the final episode in our new video series covering Risk Management principles. The prior episode covers escrow period and post-closing disputes.

This episode focuses on the risks inherent in an equity purchase transaction when the owner-occupant of a one-to-four unit residential property in foreclosure conveys the property to an equity purchase investor for rental, investment or dealer purposes. 

The equity purchase investor scheme

An equity purchase (EP) transaction takes place when the owner-occupant of a one-to-four unit residential property in foreclosure conveys the property to a buyer who acquires it for rental, investment or dealer purposes. The non-occupying buyer taking title to the residence of a seller-in-foreclosure is called an EP investor. Unique statutory rules apply to all equity purchase transactions.

Editor’s note – Alternatively, an EP transaction does not occur and the EP rules do not apply when the buyer acquires the property for use as their personal residence. 

Equity purchase statutes apply to all buyers who are EP investors, regardless of the number of EP transactions the investor completes. The investor does not need to be in the business of buying homes in foreclosure for the statutes to apply. [Segura v. McBride (1992) 5 CA4th 1028]

Both the EP investor and their agent are to comply with EP law or be subject to penalties.

The EP regulations extend to control the type of form used to document the EP sale. The EP agreement signed by an EP investor will be printed in bold type, ranging from at least 10-point to 14-point font size, and be in the same language used during negotiations with the seller-in-foreclosure. [See RPI Form 156; Calif. Civil Code §§1695.2, 1695.3, 1695.5]

The written EP agreement is to also contain the required statutory EP notices. Failure to use the correct forms subjects the EP investor and the agents to liability for all losses incurred by the seller-in-foreclosure, plus further penalties. [Segura, supra]

Editor’s note — RPI’s Equity Purchase Agreement, Form 156, complies with all statutory requirements and properly sets forth the right of the seller-in-foreclosure to cancel. [See RPI Form 156] 

Cancellation within five business days

Upon entering into an agreement to sell their principal residence and after proper notice of their rights, a seller-in-foreclosure has a statutory five-business-day right to cancel the EP agreement. Thus, the seller may avoid closing the sale, with or without cause.

The statutory right to cancel within five-business-days is contained in the mandated boilerplate language contained in an equity purchase agreement. When the seller cancels before the period expires, the sale under the purchase agreement may not be closed.  As the EP agreement automatically incorporates the seller’s five-business-day right to cancel before a closing may take place, compliance is assured.

The seller’s cancellation period ends:

  • midnight (12:00 a.m.) of the fifth business day following the day the seller enters into an equity purchase agreement with an EP investor; or
  • 8:00 a.m. of the day scheduled for the trustee’s sale, when it is to occur first. [CC §1695.4(a)]

The seller-in-foreclosure’s five-business-day right to cancel does not begin to run until proper notice of the cancellation period is given to the seller. [CC §1695.4(b)]

Failure to use a purchase agreement containing the mandatory notice of right to cancel allows the seller to cancel the sales agreement and escrow until proper notice and the time for cancellation has run. Further, the seller may even rescind the sale after closing when the notice of right to cancel was not delivered more than five business days before closing.  The right to rescind the closed sales transaction and recover ownership of the property remains until the running of five business days after notice is ultimately given.

A business day is any day except Sunday and the following business holidays:

  • New Year’s Day;
  • Washington’s Birthday;
  • Memorial Day, Independence Day;
  • Labor Day;
  • Columbus Day;
  • Veterans’ Day;
  • Thanksgiving Day; and
  • Christmas Day.

Saturday is considered a business day under EP law, unless it falls on an enumerated holiday. Many state holidays are not included as holidays. [CC §1695.1(d)]

Prohibited activities until expiration of right to cancel

Until expiration of the right of the seller-in-foreclosure to cancel the transaction, the EP investor may not:

  • accept or induce a conveyance of any interest in the property from the seller;
  • record any document regarding the residence signed by the seller with the county recorder;
  • transfer an interest in the property to a third party;
  • encumber any interest in the residence; or
  • hand the seller a “good-faith” deposit or other consideration. [CC §1695.6(b)]

However, escrow may be opened on acceptance and deeds and funds deposited with escrow. This does not violate the right to cancel since the seller-in-foreclosure does not convey the property to the buyer and will not receive funds until the close of escrow.

Cancellation of the purchase agreement by the seller-in-foreclosure is effective on delivery of the signed written notice of cancellation to the EP investor’s address in the purchase agreement. [CC §1695.4(b)]

When the EP investor receives the seller-in-foreclosure’s written notice of cancellation, the EP investor is to return all original contract documents within ten days following receipt of the notice. This includes the original EP agreement bearing the seller’s signature to the seller. [CC §1695.6(c)]

When the cancellation period expires for lack of a cancellation, the purchase agreement becomes enforceable and escrow may be closed, unless other contingencies exist.

False representations prohibited

In negotiations with the seller-in-foreclosure, the EP investor may not make false representations or misleading statements about:

  • the value of the property in foreclosure;
  • the net proceeds the seller will receive on closing escrow [See RPI Form 310];
  • the terms of the purchase agreement or any other document the EP investor uses to induce the seller to sign; or
  • the rights of the seller in the EP transaction. [CC §1695.6(d)]

These rules also apply to the EP investor’s agent.

Brokers limited to listing property

The buyer’s broker representing an EP investor is to deliver to all the parties to an EP transaction a written EP disclosure statement. The EP disclosure statement confirms the agent for the EP investor is a licensed real estate broker.

The broker is to also provide proof of licensure to the seller-in-foreclosure. [CC §1695.17(a)]

When the buyer’s agent fails to deliver either the EP disclosure or the proof of licensure to the relevant parties, the EP agreement is voidable at the discretion of the seller any time before escrow closes.

Also, the EP investor is liable to the seller-in-foreclosure for any losses arising out of the EP investor’s agent’s nondisclosure of licensing requirements. [CC §1695.17(b)]

However, the EP investor is entitled to equitable indemnity from their agent. Equitable indemnity is available to the EP investor who, without active fault, is forced by legal obligation to pay for losses created by their agent’s nondisclosure. [San Francisco Examiner Division, Hearst Publishing Company v. Sweat (1967) 248 CA2d 493]

Broker as principal

The EP legislation does not restrict the ability of an individual, who may be licensed as a broker or sales agent, to act solely for their own account as a principal purchasing property as an investor in an EP transaction.

Thus, a licensed real estate broker or agent may be the EP investor. This eliminates use of the agency law disclosure and avoids licensee disclosure and proof requirements, unless a broker fee is paid in the transaction to the buyer/licensee. The licensed real estate broker or agent, acting solely as an EP investor, is a buyer who coincidently holds a real estate license. As the licensee is not acting as an agent for anyone in the transaction, their licensed status need not be disclosed since it is not relevant.

Conversely, when a real estate broker is employed as the seller-in-foreclosure’s broker, and the broker decides to directly or indirectly buy the property, the broker is to disclose to the seller-client the broker is also acting as a principal in the transaction. [Calif. Business and Professions Code §§10176(d), 10176(g), 10176(h)]

Representing a seller who is insolvent

Prudent brokers and agents are inclined not to solicit or accept an exclusive right-to-sell listing from a seller-in-foreclosure.

Property in foreclosure has to be sold and escrow closed before the date of the trustee’s foreclosure sale when the seller’s goal of selling the property is to be achieved. Unless the delinquent mortgage is brought current prior to five business days before the trustee’s sale, or paid in full before the trustee’s sales is completed, the home will be sold at the trustee’s sale. When sold by foreclosure, the objectives of the listing employment are lost. Thus, the agent is not entitled to a fee. [CC §§2924c(e), 2903]

As a listing complication, the agent for a seller-in-foreclosure usually finds themselves in market conditions which require more time to locate a buyer and close escrow.  In a troubled market, the frequency of foreclosures is inversely related to the frequency (volume) of negotiated sales; more distress sellers than ready buyers.

Time constraints imposed on the seller’s agent by a trustee’s sale date place extra pressure on the broker employed under an exclusive listing agreement to locate a buyer.  As always, the seller’s agent under an exclusive listing is to perform their agency duties by properly marketing the property with care and diligence.

Difficult to close

Further, the seller-in-foreclosure is financially weak, if not completely insolvent, and not particularly forthcoming about closing issues. These cash-poor ownership situations lead to clouds on title, deferred maintenance and lack of upkeep on the listed property. These conditions make it difficult for the agent to market the property or perform and close escrow on a transaction.

Expectations of a seller-in-foreclosure are a further complication. They expect the broker to save what equity they may have (based on the listed price) by negotiating a sale of the property and closing escrow before the property is lost to the foreclosing lender.

When the insolvent seller loses their equity, they may claim a lack of due diligence or unprofessional conduct on the part of the broker. These risks face licensed brokers and agents who list property which is in foreclosure.

Two-year right of rescission

A two-year right of rescission period allows a seller-in-foreclosure to recover their residence when there is evidence the EP investor took unconscionable advantage of them when negotiating the purchase of the property.

Consider a Notice of Default (NOD) recorded on a homeowner’s personal residence after several months of delinquencies.

The homeowner, now in foreclosure on recording the NOD, is willing to sell on almost any terms to salvage their remaining equity in the property. The property is listed and the seller’s agent markets the property primarily to buyers who will occupy the property as their personal residence.

Avoiding the agent, an offer is submitted directly to the seller-in-foreclosure by an EP investor. The EP investor is not represented by a broker. Under the EP offer, the seller-in-foreclosure will receive cash for their equity. Additionally, the EP investor will cure the seller’s mortgage delinquencies and take over the mortgage, a classic equity purchase arrangement.

On review of the offer, the seller-in-foreclosure’s broker recommends the seller accept the EP investor’s offer. The broker further recommends that if an acceptable backup offer is received within the five-business-day cancellation period, the seller is to accept the backup offer and cancel the EP agreement.

The seller-in-foreclosure accepts the EP investor’s offer. The five-day cancellation period expires without receiving a backup offer. The EP transaction is later closed and the property conveyed.

Does the EP investor receive good title when they accept the grant deed?

No! The EP investor’s title remains subject to the seller-in-foreclosure’s right of rescission for two years after closing. When at any time during the two years following the close of escrow and the recording of the grant deed the seller believes the EP investor’s conduct and the price paid gave the EP investor an unconscionable advantage, the seller may attempt to rescind the transaction and recover the home they sold, called restoration. [CC §1695.14]

These rescission conditions are more prevalent during periods of swift upward price movement. The market conditions which favor speculator activity are precisely the same conditions that cause a seller of a home to demand it be returned. A profit has come about within two years which is now sought by both the investor who speculated and gained by a flip, and the seller who believes they were ripped off of the profit taken by the investor.

The unconscionable advantage

The legislature has not clearly defined what exactly constitutes an act of unconscionable advantage by an EP investor. Thus, showing the existence of an unconscionable advantage in the EP investor’s conduct is problematic. It is difficult for the seller-in-foreclosure to prove, and for the EP investor to refute.

What a reasonable sales price might have been under the circumstances at the time the EP transaction was entered into might appear to be unconscionable to the seller in the future. Thus, an EP investor assumes not only the risk that a rising economy may provide a profit on a flip, but that it will provoke the seller into attempting to rescind the sale to capture that profit as part of the original sale.

When real estate values rise rapidly and significantly, the “greed factor” may set in. This dynamic transforms a formerly desperate seller-in-foreclosure into an astute rescinding seller.

However, the test of unconscionable advantage is not based on events occurring after the seller-in-foreclosure enters into the purchase agreement.  Thus, any increase in the value of the property after acceptance of the EP investor’s offer may not be considered. It is the fair market value (FMV) of the property at the time of the EP investor’s acquisition that is critical.

Market circumstances existing at the time of the negotiations, or when the parties entered into the agreement, are the economic considerations which form one of the two elements for testing unconscionable advantage. [Colton v. Stanford (1890) 82 C 351]

Aspects of unconscionability

Unconscionability has two aspects:

  • the lack of a meaningful choice of action for the seller-in-foreclosure when negotiating to sell to the EP investor, legally called procedural unconscionability; and
  • the purchase price or method of payment is unreasonably favorable to the EP investor, legally called substantive unconscionability.

To deprive the seller-in-foreclosure a meaningful choice between the EP investor’s offer and offers from other buyers, a misrepresentation or other fraudulent activity needs to exist to establish the lack of a meaningful choice or alternative to the EP investor’s offer.

The price paid, like any other provision in a purchase agreement, might be considered unconscionable. When determining the unconscionability of the purchase price, justification for the price at the time of the sale and the terms of payment of that price will be examined.

An unconscionable method of payment could include:

  • carryback paper with a below market applicable federal rate interest rate (AFR), long amortization or a due date on the note that bears no relationship to current payment schedules; or
  • an exchange of overpriced land, stock, gems, metals or zero coupon bonds at face value with a 20-year maturity date.

A form of payment which is uncollectible, unredeemable and with no present value is also unconscionable.

However, the existence of unreasonable pricing and payment alone is not enough to show the unconscionable advantage needed to rescind a closed transaction. Both the lack of a meaningful choice and unreasonably favorable terms needs to be present to show unconscionability existed.

Un-American activity coupled with a low price

An unconscionable advantage occurs when the EP investor exploits an element of oppression or surprise and exacts an unreasonably low and favorable purchase price or terms of payment.  These are elements of fraud from threats, undue influence or deceit.

Oppression by the EP investor exists when the inequality in bargaining power results in no real negotiations, a “take it or leave it” environment. The foreclosure environment itself often presents a one-sided bargaining advantage for an aggressive EP investor to exploit.

Surprise occurs due to the post-closing discovery of terms which are hidden in the lengthy provisions of the agreement or escrow instructions.

The greater the marketplace oppression or post-closing surprise discovered in the transaction, the less an unreasonably favorable price paid by an EP investor will be tolerated. [Carboni v. Arrospide (1991) 2 CA4th 76]