“Short sales” deserve attention as we continue focusing on opportunities in a down real estate market. As you probably know, a short sale is where the current lender agrees to release property from the lien of the mortgage in exchange for less than the outstanding mortgage debt. Shorts sales gain popularity as owners owe more on their outstanding mortgage than their property is currently worth.
The devil is in the details with commercial and residential short sales. All parties to the transaction (seller/borrower, lender, buyer, guarantor(s)) should consider how to protect themselves with written agreements. This article will examine some of the critical terms that should be reduced to writing when navigating a short sale.
Essential Contract Terms
A short sale comes to life when a contract for sale is executed by the seller/borrower and buyer. At a minimum, the contract should clearly state that the transaction is a short sale and provide
that closing is contingent upon:
- the lender’s approval of the terms and conditions of the contract;
- the lender’s approval of the settlement or closing statement;
- the lender’s agreement to accept a specific payoff amount which is less than the balance due on the loan; and
- the lender’s release and satisfaction of the mortgage upon receipt of the discounted payoff, together with a dismissal of any pending foreclosure or other lawsuit affecting the property
The contract should require the lender to provide the foregoing assurances in a writing signed by an officer who has authority to bind the lender. The contract should also contain a deadline for lender approval, as discussed below.
It is common for a seller/borrower to solicit offers from multiple buyers. The lender may require the seller/borrower to obtain multiple offers so that the lender can select and approve its favorite one. The important distinction between an offer and a contract can be overlooked in this instance. What looks like an offer could be a contract, and the seller/borrower may have inadvertently exposed itself to liability to each buyer. When dealing with multiple offers or contracts, the parties should consider a “back-up contract” provision to acknowledge that the second (or third or fourth) contract is subject to the termination of the primary contract.
The lender is not a party to the short sale contract. However, the lender, the seller/borrower and any loan guarantor should consider entering into a separate agreement amongst themselves to set forth the terms of the short sale as amongst themselves. This separate agreement should reference the short sale contract and include additional terms governing the parties to the loan. Some of these additional terms include:
- a representation from the seller/borrower and any guarantor that the short sale contract is a valid, arm’s length contract, and that the buyer under the short sale contract is not related to or affiliated with the seller/borrower or any guarantor;
- that the purchase price under the short sale contract represents the fair market value of the property;
- that following closing, neither the seller/borrower nor any guarantor will have or acquire any direct or indirect interest in the property; and
- that neither the seller/borrower nor any guarantor will receive any proceeds from the sale of the property now or in the future.
These provisions are designed to protect the lender from fraudulent activity.
Other considerations to be addressed in the separate agreement between the parties to the loan include:
- whether the lender will waive any deficiency balance on the loan;
- whether the lender will file any tax reporting forms required by law to evidence any forgiveness of debt;
- whether the parties waive any claims against each other relating to the loan;
- whether a bankruptcy has been or will be filed by the seller/borrower or any guarantor; and
- whether any pending foreclosure or other lawsuit will be dismissed.
Some of the foregoing provisions benefit the seller/borrower and any guarantor. As a result, all of the parties to the loan can benefit from this separate agreement.
This is Taking Too Long: Can I Walk Away?
The irony with short sales is that, from a timing standpoint, they tend to be anything but short. It is common for the seller/borrower or buyer to walk away if the process is taking too long. But walking away may be a breach of contract. Short sale contracts (including the popular version approved by the Florida Association of Realtors) typically provide as follows:
If Seller does not deliver written notice to Buyer that Lender has approved the purchase price and contract terms with 45 days from the Effective Date, either party may within five (5) days thereafter cancel the Contract by delivering written notice to the other.” (emphasis added).
This seemingly innocuous provision can lead to disputes over escrow deposits and resulting lawsuits. For example, what if loan approval is not obtained and neither party cancels the Contract within the five (5) day window? Has the right to terminate been waived? Does the contract continue in perpetuity until the lender issues its approval, if ever? Or is the contract ineffective until lender approval? It will be interesting to see how a court will respond when a party to a short sale contract challenges the other party’s ability to walk away, particularly when a significant deposit is at stake. Better contract drafting can avoid these issues.
Unique Affect on Deadlines
Short sales can uniquely affect contract deadlines for inspections and other due diligence items. Generally, real estate contracts will allow a party a limited time to obtain a desired approval or inspection. When dealing with a short sale, an important issue is whether the time periods for deadlines commence when the contract is signed by all parties or when lender approval is obtained. Blindly entering into a short sale contract without considering this issue can leave a buyer in an unfortunate position. For example, if the date of contract execution marks the commencement of the critical time periods, then the buyer may end up paying for a loan application, appraisal, inspection or environmental report even though lender approval is never obtained. The buyer will therefore want to designate lender approval as the commencement date for these time periods. This could also save the buyer from wasting time and expense reviewing association documents, restrictive covenants, existing leases to be assumed at closing, permits and other property entitlements.
Short sales can be beneficial because they allow the borrower to sell property that is worth less than the outstanding mortgage and allow the lender to get the loan off of its books without the expense and burden of foreclosing and spending additional funds carrying the property until sale. However, the benefit of a short sale can be undermined if the parties do not appreciate the risks and complexities of a transaction with so many moving parts. Rushing into a short sale contract or agreement without this appreciation is therefore discouraged.