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Future Risks in the Sale of Commercial Real Estate
| | Tuesday, April 04, 2006 @ 08:29 AM EDT
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Contributed by: jdruben
jdruben Properties
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The chess game involved in negotiating the sale of commercial real property involves more than the sale price. Warranties are often heavily negotiated because of the parties' competing objectives: the buyer wants protection from unknown risks, while the seller wants to eliminate warranties or at least limit them.
While the seller may be unwilling to give more than minimal warranties, there are some tools to make the negotiation proceed more smoothly while the seller can still hedge future potential liabilty. The goal is no buyer complaints in the future, with the seller protected by a legal moat and full disclosure.
THE ALLOCATION OF FUTURE RISKS IN THE SALE OF commercial real estate
By Joel D. Ruben, Esq.
The chess game involved in negotiating the sale of commercial real property involves more than the sale price. Warranties are often heavily negotiated because of the parties' competing objectives: the buyer wants protection from unknown risks, while the seller wants to eliminate warranties or at least limit them.
A warranty is an affirmation by the seller of a fact relating to the property. Since the breach of a warranty by the seller generally entitles the buyer to damages, a seller will endeavor to sell the property “as is,” without any representations or warranties. If the sale price has already been discounted or if the buyer has negotiated a substantial time period during which to conduct an extensive investigation of the property while reserving the right to cancel, the seller may be unwilling to give more than minimal warranties.
To Warranty or Not to Warranty, That is the Question
Some types of properties are traditionally sold without any warranties, such as “real estate owned” or “REOs” which have been foreclosed upon by an institutional lender.
There are some warranties that a seller is likely to give. Warranties that the seller is duly organized, has authority to execute the documents and has obtained all necessary consents to the sale will customarily be given by a seller. In addition, a seller will customarily provide warranties regarding a list of tenants, the rent roll, the list of service contracts and that true and correct copies of documents have been provided to the buyer.
Even where an REO is not involved, sellers will seek to limit certain types of warranties to the actual knowledge of those employees who have had “hands on” involvement with the property. Warranties with respect to absence of claims, litigation, condemnation and similar matters are often given by sellers if qualified by the “actual knowledge” of specific persons who are knowledgeable regarding the property. The seller will also want to provide that the employee with actual knowledge will not be personally liable for breach of a warranty. The use of the qualification "to the best of Seller's knowledge" may create problems since it may imply some level of diligence which is not adequately defined. The buyer will argue that such a warranty includes what the seller actually knows, plus what the seller should have learned through a reasonable investigation.
The seller's goal to limit potential future liability can also be achieved by the negotiation of the following contract provisions:
• If the seller provides any warranties, it will seek a very short expiration period for the warranties. This “survival period” is negotiable, but will probably be shorter than the applicable statute of limitations.
• It is also helpful for a seller to negotiate a “floor” (a claim will not be allowed unless the alleged damages exceed a minimum amount) and “ceiling” or upper limit on warranty liability (except where a claim is based on intentional fraud).
• Depending on the nature of the buyer's concerns about the property, the buyer may seek to negotiate “hold back” in escrow of a portion of the purchase price during the survival period. The seller will resist any hold back.
Warranties with respect to title matters are not customary if the buyer can obtain title insurance and special endorsements to address title risks. Also, a seller may provide the buyer with an ALTA survey. The buyer can then specify which title exceptions in a preliminary title report and survey matters should be eliminated or cured before the closing. An exception may occur with respect to unrecorded matters and leases. A seller should be willing to warrant that no unrecorded matters affect title, except as disclosed in an exhibit to the purchase agreement or by the ALTA survey discussed above.
Warranties regarding compliance with zoning laws and building codes are virtually impossible to obtain from sellers in view of the difficulty of knowing whether a building is in compliance. The usual compromise is to obtain a warranty that no written notice from a governmental agency that the property is not in compliance has actually been received.
Environmental warranties may also present serious negotiation problems. Sellers should be willing to warrant that they, and their tenants, have not created any environmental problems. However, if an environmental investigation has been conducted, the warranty should be qualified by the contents of the environmental reports which will be provided to the buyer. Environmental insurance may fill the void of some environmental warranties. It can take weeks to months to negotiate a policy of environmental insurance, so start early if it appears that this insurance may be required to close the deal.
Full Disclosure Is The Seller's Best Protection
In the final analysis, the seller's best protection is to make full and fair disclosure in writing about the property. This can be done by qualifying any warranties with the written disclosure of problems with the property in one or more exhibits to the purchase agreement.
Note: Joel D. Ruben is an experienced and creative attorney who has practiced real estate and business law in Los Angeles, CA since 1977. Mr. Ruben specializes in business and real estate litigation and real estate transactions. Through his years of experience as a trial lawyer and litigator he has gained an appreciation of the art of carefully drafting real estate contracts to significantly reduce the possibility of future litigation. To find out more about Joel Ruben's law practice, call him at (310) 282-9100.
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