CSI Blogs about Insurance in Real Estate

Why “Outside of Escrow” Generally Means “Outside the Law”

By Eric R. Ginder, Esq.

Short sales are a large part of the current market, and therefore a large part of most brokerages’ business.  In last month’s article, attorney Michael Spilger addressed many of the challenges associated with the modern short sale.  In this month’s article, I want to focus in on one of those challenges that nearly every broker, salesperson, seller or buyer in a short sale has faced:  payments outside of escrow, and therefore off the HUD-1 statement.

Today’s lenders are seeking revenue from any and all sources.  Senior lienholders are not eager to share the sale’s proceeds with the junior lienholders; the juniors are not eager to take what the senior offers them and release liability, especially for recourse loans.

The Sold-Out Junior

The junior lienholder’s reluctance to cooperate during a short sale often stems from the fact that many juniors hold “recourse” promissory notes, meaning that they can seek a deficiency judgment against the borrower/seller.  Since their loans are secured by junior trust deeds recorded against real property, California law states that they must generally look first to the security (i.e., the real property) to satisfy the debt.  This means that they must foreclose their lien against the property before they can seek the borrower’s unpledged assets to satisfy a deficiency.  Foreclosing, however, means that the junior takes the property subject to the senior lien.

If the senior lienholder forecloses, the foreclosure sale generally “wipes out” the junior liens.  Before you shed too many tears for junior, realize that this means the “sold-out junior” can now sue the seller/borrower for standard breach of contract and seek a judgment against the seller/borrower’s assets (e.g., personal property, wages, etc.).  In a real estate market where 1) most properties are encumbered by at least two liens; 2) many of the liens secure recourse debt; and 3) most properties lack equity sufficient to satisfy even the first lien (i.e, are “upside-down”), being a sold-out junior has its advantages. 

Thus, it comes as no surprise when a junior lienholder declines the few thousand dollars that most senior lienholders offer.  Unfortunately, it is also no surprise when some juniors consent to the short sale only if the seller agrees to pay the junior an additional sum (or sign a new promissory note), outside of escrow and off the HUD-1 statement, so the senior doesn’t know about it.  Sometimes the buyer is asked to make the payment.  What the senior lienholder doesn’t know won’t hurt it, right?  Wrong.

Remember, borrowers/sellers need the senior lienholders to consent to the short sale, and this consent must be obtained legally and with full disclosure.  Sellers approach their senior lienholders with purchase offers in one hand and hardship letters in the other.  When the senior lienholders make their decision and offer their terms, they do so with the understanding that the offer is the highest the buyer is willing to pay and that the seller is incapable of contributing anything else towards the outstanding loan balance; this understanding is based upon the representations that the borrower/seller makes to them. 

If these representations are false, because the seller is capable of paying more money to the junior lienholder (or willing to sign a new promissory note with them), this fact must be disclosed to the senior lienholder in writing and the senior must consent to it, again in writing.  Similarly, if the buyer is willing to pay more for the property, by paying an additional amount to the junior, this too should be disclosed to the senior lienholder, in writing, and their written consent to it must be obtained.  Both facts may affect 1) the senior’s decision to consent to the short sale, and 2) the terms the senior is willing to offer the borrower/seller. 

Failure to disclose to the senior means that the senior’s consent was not legally obtained; this could be construed as fraud against a federally insured lending institution.  If you don’t believe me, read the California Department of Real Estate’s recent article wherein they described such payments as “a sure sign of fraud, “and “likely illegal.”[1]

Finally, if a senior lienholder agrees to a short sale, premised upon the junior lienholders receiving a certain amount and the transaction closes with the senior believing those terms were honored, there can be serious consequences when the senior finds out that money was paid to the junior outside of escrow.  Some senior lienholders are reinstating their security interests and taking the position that any release of personal deficiency liability was invalidated because of the fraud.

A related twist on this issue are those that do add the payment to the HUD-1 form and then leave it up to the senior lienholder to discover the payment and object.  This practice is really no better than what I have described above.  In order to obtain meaningful legal consent, the senior lienholder must be made aware of the payment and must consent to it, in writing.

Closing a short sale isn’t worth losing your real estate license and certainly isn’t worth a criminal conviction.  If the junior lienholders won’t play ball without undisclosed payments made to them without the senior’s knowledge and written consent, let the deal go; it wasn’t meant to happen. 

Eric R. Ginder is an experienced civil litigator and transactional attorney with more than nine years of trial experience specializing in the area of real estate broker defense, construction defect and insurance coverage litigation. He sits on the San Diego Association of REALTORS^® Risk Management Committee as well the California Association of REALTORS^® Legal Affairs Forum.

Reprinted from the San Diego REALTOR® May 2010 with permission of the San Diego Association of REALTORS^®. Copyright© 2010. All rights reserved.