SELLER WARRANTIES AND DUE DILIGENCE IN THE PURCHASE OF COMMERCIAL REAL ESTATE. ALAN WAYTE Dewey Ballantine LLP Los Angeles

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1 SELLER WARRANTIES AND DUE DILIGENCE IN THE PURCHASE OF COMMERCIAL REAL ESTATE ALAN WAYTE Dewey Ballantine LLP Los Angeles I. The attempt to learn everything possible about real estate prior to the time of Closing imposes a responsibility on the Buyer's attorney to obtain as much information from the Seller as possible and to carefully supervise the diligence process. A. Warranties not only allocate the risk of certain unexpected post-closing events but assist the Buyer in its search for all relevant information concerning the property. B. Some Sellers will be willing to indemnify but not give warranties, based upon a reluctance to warrant that certain facts do not exist when they have no knowledge of the situation. II. Sellers must be aware of the fact that they cannot refuse to give warranties and yet fail to disclose material information in their possession without risk of liability. A. An "as is" clause may not protect the Seller from failure to disclose material facts known to the Seller which would affect the Buyer's decision to purchase, at least when those facts are not readily discoverable. See Loughrin v. Superior Court, 15 Cal. App. 4th 1188 (1993). B. The addition of "release" language is thought to enhance the "as is" language. III. The extent to which representations and warranties can be obtained from a Seller depends upon both the nature of the warranty requested and the relative bargaining strength of the parties. A. REO properties are traditionally sold without any warranties, even in bad markets B. Large institutions are usually reluctant to warrant since they have difficulty policing what they "know." C. Many Sellers are extremely concerned with the problem of hang-over liabilities. 1

2 1. This particular concern can sometimes be resolved with a very short expiration period for the warranties. (See Exhibit A, 1.2.) 2. It is also sometimes helpful to provide that warranty liability will not exceed a specified amount in the absence of intentional fraud and/or will not be allowed unless the alleged damages exceed a minimum amount. D. Warranties that the Seller is duly organized, has authority to execute the documents and has obtained all necessary consents to the sale should be given by a Seller without resistance. (See Exhibit A, 1.1(a).) Unfortunately, a warranty that one is duly authorized to sign a document may not be of much value because the person giving the warranty would also be not authorized to give it. E. Warranties with respect to title matters are not customary in California and Sellers usually argue that title insurance is intended to protect the Seller. 1. 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. (See Exhibit A, 1.1(p).) 2. A Seller should be willing to warrant that an attached rent roll identifies all leases affecting the property. (See Exhibit A, 1.1(c).) F. 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. (See Exhibit A, (g), (n) and (q).) 1. The use of "to the best of Seller's knowledge" may create problems since it may imply some level of diligence which is not defined. 2. More common is the use of a warranty limited to the "actual" knowledge of a specified person who is knowledgeable about the Property. (See Exhibit A, 1.1(g) and (q).) 3. A further common limitation is to warrant only that a specified person has no actual knowledge of having received written notice from a government agency about a claim. G. Warranties with respect to the accuracy of financial information regarding the Property can be a major source of negotiation. (See Exhibit A, 1.1(f).) 2

3 1. If the information is incorrect, who should bear the loss? This is a different issue than determining whether the Seller has "knowledge." 2. If a warranty is given it should cover the accuracy of all expenses included in pass-throughs to the tenants of the property. H. Warranties regarding lists of tenants, rent rolls, lists of service contracts and true copies of documents should be provided by the Seller. (See Exhibit A, 1.1(c) and (d).) However, Tenant estoppel certificates are the customary method for Buyers to confirm the accuracy of information regarding leases. (See Exhibit A, 1.3). 1. A form of the estoppel certificate should be attached to the Purchase Agreement. 2. A major issue is the percentage of estoppel certificates that must be returned to satisfy the condition, it usually being agreed that certificates must be received from tenants under certain major leases and a specified percentage of other leases. Seller should give a warranty to cover the estoppel certificates that are not received. 3. The Purchase Agreement should specify that the estoppel certificates should confirm all information given by the Seller with no material comments or corrections. I. 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 has been received from a governmental agency that the property is not in compliance. (See Exhibit A, 1.1 (h) and (n).) J. Environmental warranties usually present serious negotiation problems. 1. Sellers should be willing to warrant that they, and their tenants, have not created any environmental problems. (See Exhibit A, 1.1(i)(ii)(A).) 2. If Sellers warrant they have no "knowledge" of a problem, is that worth anything to the Buyer other than providing some confidence that fraud is not being committed. 3. If the Buyer is seeking to transfer some risk to the Seller, it may be preferable to use the indemnity clause rather than negotiate the meaning of "knowledge." 3

4 K. Sellers should include a provision that if a Buyer finds a warranty to be inaccurate prior to the Closing, the Buyer cannot close in reliance on the false warranty. (See Exhibit A, 1.1(r).). The Seller must prevent the Buyer from closing with the knowledge of a false warranty and then later bringing suit for damages. See Jeu v. Smiser, 23 Cal App. 4th 312 (1994). IV. Even if warranties are given, the buyer's lawyer must advise the client to undertake a thorough study of the potential risks and liabilities associated with the acquisition. A. While the client might focus on economic issues, such as the viability of the leasing market and comparable land values, the attorney should properly advise the client regarding the possible risks and liabilities which could be imposed upon the Buyer of the property. B. Of particular importance is the need to communicate with the client regarding the client's expectations of what the lawyer intends to do and what the client will do itself or through its staff. It is particularly important to discuss the entire due diligence program with the client and the probable cost of the legal work involved. C. Many lawyers don't perform diligence work that might be expected by the client because they believe the work will be time-consuming and the client will be unwilling to pay. V. The matters which are typically reviewed by the lawyer are summarized as follows: A. Preliminary Title Report. A preliminary title report should be ordered from a title insurance company in preparation for the issuance of an ALTA title insurance policy. 1. Does the contract give sufficient time to review title? 2. The lawyer (or skilled paralegal) must also review copies of all documents of record and have a recent ALTA survey to review. 3. The legal description must be reviewed against the survey and for possible title issues. (a) Does the legal description provide for any exceptions to title because of reserved easements or other interests such as oil and gas interests? Are there any rights of entry 500 feet from the surface which would interfere with your client's use of the property? 4

5 (b) (c) (d) Does the legal description suggest that the property has been subdivided in a manner which violated any applicable subdivision law? Are there discrepancies between the legal description and the survey? Are necessary easements over other property included in the legal description? 4. Do any of the covenants, conditions and restrictions affecting the property impose restrictions which would be unacceptable for the intended use of the property? Are there any restrictions on liquor use? Are there restrictions on business use which would interfere with the proposed use of the property? 5. Have the plans and specifications for the building been approved by all appropriate architectural review committees? It may be necessary to obtain estoppel certificates from architectural committees or others. 6. Do any of the recorded easements interfere with existing or proposed buildings? 7. Is the square footage of the property consistent with the Buyer's expectations? 8. Are the parking spaces shown on the survey? Is the number consistent with zoning requirements and/or Buyer's intentions? 9. Does the survey give requisite information on the flood zones? 10. Are there any major encroachments either on the property or on adjacent property? 11. Are any improvements constructed on or over revocable government licenses? 12. If your client intends to purchase the property subject to an existing mortgage, is it clear that the mortgage is assumable? 13. Prepare a list of appropriate indorsements that should be added to the title insurance policy. Some examples are: 5

6 (a) (b) (c) (d) (e) (f) (g) (h) survey indorsement insuring that the land in Schedule A to the policy is the same as the land depicted on the survey (116.1); contiguity indorsement insuring that certain parcels of land are contiguous with one another (116.4); zoning indorsement regarding current zoning of property (123.2); non-imputation indorsement protecting against imputed knowledge from a partner if purchasing property with a partner of selling partnership (non-imputation); "fairway" indorsement protecting buyer against loss of coverage in the event of a change in partnership interests; indorsement insuring that improvements do not interfere with easements (may be difficult to obtain for owners); indorsement that there is no current violation of covenants, conditions and restrictions (100.5 or ); and indorsement that there is no violation of the Subdivision Map Act (116.7). B. Survey. Order an ALTA survey showing all improvements presently located on the property and their relationship to the property lines. 1. Also confirm that there are no encroachments onto adjoining property or from improvements on adjoining property on the property to be purchased. 2. If any of the improvements are located in a street or sidewalk easement which is the subject of a revocable license from a city or other governmental agency, confirm the unlikelihood of revocation of the license and the possible effect on the owner if the license is revoked. 3. Any setback requirements of city ordinances or recorded covenants should be set forth on the survey and confirmed. 4. The survey should also reflect whether the property is in a flood zone. If it is in a flood zone, be prepared for the added cost of the flood insurance required by federal law when banks lend against certain property in flood zones. 6

7 5. See generally Shannon J. Skinner, A Practical Guide to Survey Review (The Practical Real Estate Layer, January 1993). C. Inventory of Personal Property and UCC-3 Search. Will any personal property which is used in the operation and/or maintenance of the improvements be transferred in the sale? If so, obtain an inventory of the property if one is available. (See Exhibit A, 1.1(o).) 1. Order a UCC-3 search from the Secretary of State to confirm there are no financing statements affecting the property 2. Consider the impact of any sales tax which might be payable in connection with the sale. 3. Are there any motor vehicles or trademarks which are used in the operation of the property and which should be included in the purchase? D. Environmental Review. Existing laws which impose strict liability on landowners for the presence of toxic wastes, such as CERCLA, make it imperative that a Buyer make "all appropriate inquiry into the previous ownership and use of the property consistent with good commercial or customary practice." 1. This review is necessary if a Buyer is to take advantage of the innocent purchaser defense provided in 42 U.S.C. 9601(35) (B). 2. At a minimum, the Buyer should engage an independent engineer to make a Phase I investigation for the presence of toxic wastes. In addition, the building should be thoroughly inspected for the presence of asbestos. E. Leases. All existing leases and subleases relating to the property must be reviewed in detail. 1. Are there any unusual landlord obligations? Rights of tenants to terminate? Conflicting rights to expand or renew? Unacceptable modifications to the form? 2. Estoppel certificates should be obtained from the tenants confirming that the leases are in full force and effect and that no defaults are claimed, setting forth any security deposits and confirming that the landlord has no obligations to the tenant except as are expressly set forth in the written instruments delivered to the Buyer. The estoppel certificate should also expressly confirm that there are no disputes with respect to the payment of operating costs. 7

8 3. The Seller should confirm in a separate warranty that there are no leasing commissions due and unpaid with respect to the leases, especially with respect to any leases which contain options to renew or options for expansion. 4. Read the correspondence file maintained by the building manager to review the history of tenant complaints. 5. The methods for passing through operating expenses should be reviewed as well as the history of tenant issues in connection therewith. F. Service Contracts. All service contracts relating to the property should be reviewed. 1. They should all be terminable on short notice. 2. Typically such service contracts will include contracts for gardening services, elevator maintenance, landscaping and parking services. 3. If the Buyer is to assume any of the service contracts, then an estoppel certificate should be obtained from the service provider confirming the obligations and the right to terminate the contract VI. Many aspects of the diligence procedure are often performed by the client. The lawyer must confirm that he or she has no responsibility in this area. A. Permits and Licenses. Obtain copies of any permits and licenses in effect with respect to the operation of the property and confirm that they are valid and in good standing. (See Exhibit 1.1(m).) Are they transferable with the property or may they be easily obtained by a new purchaser without unusual fees or conditions or delays? Some of the common governmental licenses and permits to be considered are: 1. Elevator permits; 2. Cabaret permits (permitting entertainment in hotels and restaurants); 3. Liquor licenses; and 4. Certificates of occupancy. B. Soils Report. If the client anticipates the possibility of constructing additional improvements, a soils report should be obtained to determine the nature of foundation support which will be necessary. C. Building Inspection. An independent engineer should be retained to inspect the building for structural and mechanical defects. 8

9 1. Included in the inspection should be the condition of the roof, the elevators, the major mechanical systems (such as HVAC, electrical and plumbing) and the presence of asbestos. 2. If possible, a set of "as built" plans and specifications should be obtained from the Seller to assist in the review. 3. This review must be coordinated with the study of applicable building codes to ascertain the level of current compliance with ADA, earthquake retrofit and sprinkler ordinances, etc. D. Parking Requirements. Parking requirements for the property need to be reviewed independently. 1. The number of parking stalls should be determined. 2. Zoning requirements should be reviewed. 3. The REA and all leases should be reviewed to ascertain that there are no conflicts. E. Financial Information. The recent income and loss statements for the property should be reviewed with particular reference to the calculation of operating costs which are paid by the tenants. 1. Have the operating costs been calculated in a fair and consistent manner? 2. Property tax assessments relating to the property should be reviewed to see if they are fair and appropriate, and the property tax scheme applicable in the local jurisdiction should be reviewed and understood. 3. Are there any unusually low or high expenses included in the operating costs? F. Insurance Policy Review. It may be appropriate to review the existing insurance policies of the property owner to determine the nature of past coverage and to review any claims that the owner has filed with respect to the property in the past five years. G. Employees. Determine whether any employees associated with the maintenance or operation of the property will be employed by the Buyer and, if so, under what terms. 9

10 1. Will the employees be willing to transfer to the new Buyer? Are there any accrued vacation or other benefits which would be payable by the Buyer? 2. Consider any possible union and/or ERISA or benefit plan issues connected with the transfer. (See Exhibit A, 1.1(j).) 3. Will the Federal Plant Closing Law apply? VII. Some matters involving diligence often performed by lawyers may not be performed unless the client requests it after discussion with the lawyer. A. Litigation Search. Search the local litigation records to determine whether the property is subject to any existing litigation and whether the owner of the property is a party to any litigation. 1. Even if the new owner will not necessarily be a party to the litigation upon acquiring the property, it is often helpful to ascertain whether the present owner is involved in any litigation and the nature of any such litigation. 2. An examination of federal and state records for at least the last five years is appropriate. B. Zoning Laws. Confirm that the property complies with all existing zoning ordinances. 1. It should be determined whether any variances are in effect with respect to zoning ordinances and if the zoning laws have been modified after construction of the building so that if the building were destroyed it could not be rebuilt in its present form. 2. Ascertain that it is not necessary to control other property in order to comply with applicable zoning ordinances. For instance, it is often necessary to maintain parking on adjoining property in order to provide sufficient parking spaces to satisfy zoning ordinances. 3. Review the boundaries of any nearby Redevelopment Areas and possible extensions of the boundaries. (a) It is not always a simple matter to determine compliance with local zoning ordinances. The existence of a certificate of occupancy should be confirmed and this is often regarded as informal prima facie evidence that the property complies with city zoning ordinances. 10

11 (b) (c) (d) (e) (f) (g) If possible, a letter or other written confirmation should be obtained from the local governmental agency regarding compliance with the ordinances. Indorsements to title insurance policies can be obtained but usually at considerable expense and the language of the indorsement may not give adequate protection. An opinion of the Seller's counsel can be requested but many counsel resist giving such opinions because of the difficulty of confirming compliance with the zoning ordinance. An architect's certificate may be obtainable if the building is relatively new. It is also appropriate to determine how the current zoning relates to the general plan. Obviously, if the client anticipates making substantial modifications to existing improvements or constructing any new improvements, zoning issues will be even more material. C. Building Code Compliance. Make inquiry of the local building department to ascertain that the improvements complied with building codes when built and to what extent it fails to comply with current codes. 1. It may be appropriate to engage an independent engineer to make this investigation since the analysis often involves technical issues. 2. Much can be learned by making inquiry of the local building department. (a) Ascertain that there are no local laws in effect which would require retrofitting of the building for special purposes, such as (a) access to lavatories and other facilities for handicapped, (b) fire safety, such as enclosing stairwells, adding sprinkler systems and/or smoke alarms and (c) earthquake safety. It may not be permissible to make modifications to the building unless such retrofitting is accomplished and/or the retrofitting may be required to be accomplished within a specified time period. 11

12 (b) If possible, confirm with a letter from the city building department that there are no present violations of record in their office. D. Special Statutes. Ascertain that the property is not subject to the application of various statutes which affect the use and operation of real estate in the local jurisdiction. 1. For example, historical or cultural designations may limit the right of the owner to modify or demolish the building. 2. Special zoning laws, such as the California Coastal Commission Act, may restrict construction and development in certain specified areas near the coast