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January 2013 /$4
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28th Annual Real Estate Law Issue
ExclusiveDeals
HOAs as Quasi-
GovernmentalEntities
page 30EB-5 Visas
ForeignInvestmentin CaliforniaReal Estate
Los Angeles lawyerNadav Ravid evaluates the application and enforcementrights for retailers in leasespage 18
The NationalMortgage Settlement
The NationalMortgage Settlementpage 24
EB-5 Visaspage 8
ForeignInvestmentin CaliforniaReal Estatepage 13
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F EATU RE S
Los Angeles Lawyer
the magazine of
the Los Angeles County
Bar Association
January 2013
Volume 35, No. 10
COVER PHOTOGRAPH:TOM KELLER
01.13
7 Barristers TipsHow to prepare for the unexpected duringoral argumentBY SHAWTINA FERGUSON
8 Practice TipsSatisfying the requirements of EB-5 visareal estate investmentsBY GORDON K. ENG
13 Tax TipsTax planning for foreign investment inCalifornia real estateBY JACOB STEIN
36 Closing ArgumentExamining San Bernardino’s mortgagecondemnation programBY BRUCE TEPPER
35 Index to Advertisers
DE PARTM E NTS
LOS ANGELES LAWYER (ISSN 0162-2900) is published monthly,except for a combined issue in July/August, by the Los AngelesCounty Bar Association, 1055 West 7th Street, Suite 2700,Los Angeles, CA 90017 (213) 896-6503. Periodicals postage paidat Los Angeles, CA and additional mailing offices. Annual sub-scription price of $14 included in the Association membershipdues. Nonmember subscriptions: $28 annually; single copyprice: $4 plus handling. Address changes must be submittedsix weeks in advance of next issue date. POSTMASTER: AddressService Requested. Send address changes to Los AngelesLawyer, P. O. Box 55020, Los Angeles CA 90055.
4 Los Angeles Lawyer January 2013
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law, or the May issue devoted to entertainment law, or the one last November onveterans law—and the regular issues, our mission has been to present well-thought-out, well-written articles that keep members abreast of current legal developmentsand help them manage their law firms.
While certainly not a social sheet describing the comings and goings of local lawyersor their personal achievements, Los Angeles Lawyer was also not intended to be anacademic law review. Instead, it fills a void among legal publications by having ajournalistic mandate and the resources to present articles that meet continuinglegal education requirements or provide practical tips. A lawyer can rely on LosAngeles Lawyer and its Web page for research assistance. The lawyer will find arti-cles to answer a client’s inquiry, support a brief, analyze the opposition’s arguments,or help structure a contract. Each article examines the issue at hand and includesreferences to legal precedents for use in conducting further research. Los AngelesLawyer also helps attorneys manage their practices. Last October, for example, anarticle was published on helping lawyers avoid becoming victims of Internet scams.
The publication is a labor of love by committed professionals; otherwise (apartfrom being on the cover, which is like being on the cover of Rolling Stone) almostno explanation exists for why a person would voluntarily spend countless hours onresearching, writing, and rewriting an article. For Editorial Board members who alsoauthor articles, no rational reason can explain such devotion, because EditorialBoard members are precluded from being on the cover. Board members spend an equalif not greater amount of their time developing topics, presenting them at monthly boardmeetings, pursuing and cajoling prospective authors, and editing their drafts.
The sweat and toil expended by authors, board members, the publisher, and staffhave not gone unnoticed. Appellate courts periodically cite Los Angeles Lawyer arti-cles in decisions. Equally important, LACBA members acknowledge Los AngelesLawyer in surveys and elsewhere as a key reason why they joined the associationin the first place and remain as members.
Los Angeles Lawyer, however, cannot rest on its laurels. The Editorial Board,publisher, and staff will continue to honor the publication’s mission, but we mustalso be prepared to stay relevant and accessible in an environment in which lawyersface an informational overload that has reached a point at which they, like others,expect messages to be presented in 140-word tweets. For 2013 and beyond, this willbe a difficult but not insurmountable task to meet. Your input is welcome, and ifyou know a board member or two (the names of the board members appear on themasthead), contact them and express your thoughts.
Our sincere thanks go out to the authors who have given their sweat to these arti-cles and made an invaluable contribution to this special issue. We hope that real estateattorneys and others will find these topics of value in their practices. n
Just the law, please. Members of LACBA have asked thisof Los Angeles Lawyer, and for nearly 30 years, theEditorial Board, publisher, and staff have committed to
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Los Angeles Lawyer January 2013 7
AS MANY LAWYERS CAN ATTEST, oral advocacy is a critical andoften dispositive component in litigation. Experienced attorneys andsuccessful advocates teach that oral argument is least effective whenapproached as an exercise in recitation. Rather, advocates should main-tain flexibility and have a sufficient command of the record andapplicable law to discern and adapt to the court’s inquiries. What doesall this wisdom mean, and how do these idioms translate into tan-gible best practices to implement during preparation and ultimatelywhen presenting your client’s case before the court?
One of the first steps to undertake when preparing for oral argu-ment is to have a clear command of the applic-able law and facts. Advocates should be ableto explain, without pause, the relevance ofany case cited in his or her papers and, in turn,be able to distinguish the cases cited in theopposing party’s papers. It is also critical to con-firm a few days before the hearing that thelaw cited in the papers is still good law. So, too,should the advocate have a clear understand-ing of the factual record, not just those facts cited in the papers. Theability to discuss, with reference to the factual record, those issues thatthe court deems important is vital to the process. “When you are argu-ing about issue ‘A,’ and the court interrupts and asks about issue ‘B’,you would be wise to direct your attention to issue ‘B,’ because thatis what the court is concerned about,” suggests Patti Jo McKay, thepresiding judge of the Appellate Division of the Los Angeles SuperiorCourt. To sharpen your command of the factual record, review valu-able sources of information, including but not limited to depositiontestimony, discovery responses, affidavits, and other important doc-uments obtained during discovery. Needless to say, on the morningof the hearing, an advocate’s redweld should not contain any docu-ment that he or she cannot comfortably summarize or discuss uponreference by an opponent or the court.
Most will agree that practice is a necessary component in the prepa-ration process. However, it is important to practice in an organizedand focused manner. After a succinct outline has been prepared,practice making the argument aloud without interruption. This ini-tial exercise is designed to build confidence as well as reveal what areasof the argument need fine tuning. Next, put on the opposing coun-sel’s figurative hat to determine which areas of the argument are mostvulnerable. Consider making a list of the vulnerabilities and listingunder each topic two or three reasons why your opponent is mistaken,or, if not mistaken, reasons why that issue has no bearing on the out-come. Practice distinguishing these issues as succinctly but as per-suasively as possible. Once you feel comfortable presenting anddefending your argument, consider asking a colleague and a nonlawyerto listen to the argument. The feedback they give will likely be diver-gent, but both points of view will be helpful.
Researching the judge who will hear the argument can also provevaluable. For instance, if the court issues a tentative ruling in advance
of the hearing, review it. However, attorneys should understandhow to use a tentative ruling during argument. As Judge McKayexplains, “Generally, tentatives tell you which way the court is lean-ing and why. The worst thing an attorney can do is come in and statethat they disagree with the tentative; rather, the attorney shouldspend their time emphasizing additional facts or points of law thatthe court should consider.” If the tentative is favorable, considerstanding quietly and listening to opposing counsel’s argument. Ifopposing counsel does not present a coherent and persuasive argu-ment, succinctly emphasize those points that support the court’s ten-
tative ruling, and conclude.Active listening is also key to presenting your best argument.
The perceptive ear may find that the court has a misunderstandingof a significant fact or would like more guidance as to an issue of law.The practice of being an engaged listener during argument will helpto discern when corrective or additional information is necessary. KurtRasmussen, a California and Missouri trial lawyer who has tried wellover 50 cases throughout the country, agrees. “A presentation out-line is critical, but if you sense confusion from the court, back up andtry it again—going on will not make it better; believe me, I’ve triedand failed and kicked myself afterwards.” Similarly, answer questionsposed by the court and then smoothly transition to the strongest pointsof your argument. This technique will help to foster a conversa-tional tone to your argument that may ease the court’s initial concerns.
Further, always be mindful and adhere to all professional and eth-ical obligations in all stages of advocacy. Do not misstate the law orfacts in your papers or during argument. If the great weight of the caselaw or the factual record is not favorable, you may lose. Do not riskan ethics violation by misstating or exaggerating the underlying factsor controlling law to reach a favorable outcome. “Be honest with thecourt, if there is contrary precedent, say so—then say how your caseis different,” advises Rasmussen.
Admittedly, every attorney has his or her own eccentric methodof preparing and presenting oral argument. While the idiosyncrasiesmay be particular to the advocate, most will agree that the funda-mentals are shared. After argument, if you are confident that the courthas a clear understanding of the applicable law and the most impor-tant facts governing the case, you have done your job. n
barristers tips BY SHAWTINA FERGUSON
How to Prepare for the Unexpected during Oral Argument
The perceptive ear may find that the court has a misunderstanding
of a significant fact or would like guidance.
Shawtina Ferguson specializes in products liability defense and complexcivil litigation at The Rasmussen Law Firm, LLP, in Los Angeles.
8 Los Angeles Lawyer January 2013
LOCATION, LOCATION, AND LOCATION may be important for a suc-cessful real estate investment, but without money, money, and moremoney, the project will not be built. The current real estate marketcrisis has severely disrupted traditional capital and financing sourcesfor real estate projects. One nontraditional source of capital, how-ever, is gaining momentum for projects that can demonstrate that theygenerate new jobs. Under a federal visa program initiated by the U.S.government around the time of a previous recession,1 foreign investorsmay make a capital investment in a U.S. business that meets a rela-tively short list of requirements. In return, the investor can obtain apermanent residence visa (also known as a green card)2 under the EB-5 program, which is administered by the U.S. Citizenship andImmigration Service (USCIS).
A number of green card rights are very appealing to foreigninvestors, including the right to 1) enter and exit the U.S. any num-ber of times and without obtaining additional visas (delays from weeksto months in obtaining business visas to enter the United States arebecoming common), 2) stay in the United States indefinitely, 3) spon-sor the investor’s spouse and unmarried minor children under 21 toobtain permanent status (the investor may relocate his or her familyto the United States), 4) work in the U.S. as an employee or owner(other, labor-based visas require the foreigner to have a U.S. employersponsor the foreigner’s entry, require the employee to have special-ized skills, and limit the duration of the foreigner’s stay), 5) qualifyfor various federal and state benefits, such as social security and in-state tuition rates for higher education, and 6) practice in certain reg-ulated professions (some states limit the ability to obtain profes-sional licenses to citizens or permanent residents).3
The EB-5 visa requires the investor to 1) invest $1 million (reducedto $500,000 in high unemployment and rural areas) from lawfulsources, 2) in a new business, a substantially restructured business,or in a business in which the foreign investment will result in a mate-rial change in the capital of the company, 3) create at least 10 full-time jobs within two years, 4) take on a management role in the busi-ness, and 5) operate the business for at least two years.4 If theapplication is approved, the investor is issued a provisional green cardpending the passage of the two-year period and review of compliancewith the requirements for the visa including the job creation require-ment. If all is in order, at the end of the two-year period the condi-tions on the green card are removed.5 An area of high unemployment,referred to as a Targeted Employment Area, includes a rural area6 oran urban area that has experienced an unemployment rate of atleast 150 percent of the national average rate.7
In 1992, a change was made to the EB-5 visa program to add flex-ibility to how the employment requirements were satisfied. A busi-ness may be qualified as a “regional center” if expected to have anemployment and business effect in a specified geographic area. If theUSCIS accepts a business as a regional center, the investor may be cred-ited for jobs that the business creates indirectly in addition to thosethat it creates directly. For example, if a multitenant shopping cen-
ter is designated as a regional center, the full-time jobs created by theownership and management of the shopping center are directly cre-ated jobs. The jobs created by the tenants of the shopping center areindirect jobs. There may be 5 or 10 full-time positions created by oper-ating a property management office, but the jobs created by the ten-ants of the shopping center could be over 100, and those jobs wouldall be counted to satisfy the job creation requirement. For these rea-sons, in a regional center, it is much easier for the investor to meetthe employment requirements. Further, if more jobs are counted inthe business, more EB-5 investors can participate in the project,resulting in more funding for the developer.
In June 2012, there were approximately 50 approved regional cen-
practice tips BY GORDON K. ENG
Satisfying the Requirements of EB-5 Visa Real Estate Investments
Gordon K. Eng is a business transactional lawyer whose practice includes rep-resentation of lenders, developers, and investors in real estate and businessprojects.RI
CHA
RD E
WIN
G
ters in California and approximately 200 inthe country.8 A range of different real estateprojects have qualified for regional centerstatus, including shopping malls, hotels, mixeduse developments, warehouse distributioncenters, manufacturing facilities, and businessincubators. Because the key thrust of theregional centers is to create jobs, manyregional centers are sponsored by or workextensively with local governments in a formof public-private partnership.
EB-5 Visa Investment Pitfalls
A number of recent lawsuits, USCIS admin-istrative actions, and disputes have erupted,pitting the critical parties involved in EB-5 andregional center investments against oneanother. For example, in 2010, the USCIS ter-minated the status of the Victorville regionalcenter, which was sponsored by the city ofVictorville, for insufficient job creation. Thiswas the first time this action was taken.Victorville had collected about $7.5 millionfrom 15 investors for the construction andoperation of a waste treatment plant.9 Thecity and its regional center filed suit to pre-vent termination of its status10 but withdrewthe suit after an administrative appeal of theUSCIS termination decision was affirmed. Itis reported that the city is refunding some ofthe investor funds,11 but, given the termina-tion of the regional center status, it is unlikelythat any of the EB-5 investors will obtaintheir final green cards.12
A similar fate was suffered by the ElMonte Transit Village project. This regionalcenter was created to develop a 65-acremixed-use development at the city of ElMonte’s bus station. The project has not beencompleted and is entangled in litigation. TheUSCIS has determined that the project is “nolonger promoting job creation or the kind oflocal economic development for which it wasinitially certified to do.” The USCIS termi-nated the regional center status of the project.To further complicate the situation, two of theprincipals of the LLC formed to develop theproject were arrested by the FBI. El Montedesignated a new developer for the project,and the old developer sued, claiming that itstill had the right to proceed.13
California is not the only state to experi-ence woes with the EB-5 program. The NewOrleans mayor’s office of economic devel-opment sponsored a regional center that wasoperated by NobleReach-NOLA, LLC. Theprivate placement issued in connection withthe regional center investment claimed that afund was being formed to invest in a portfo-lio of business ventures in Louisiana andassist in the reconstruction of New Orleansand the surrounding coastal areas that weredevastated by Hurricanes Katrina and Rita.14
A perusal of the investor suit filed against the
general partners of the investment fund showsthe diversity of the investors involved in theinvestor visa program. Partners included cit-izens from China, Jamaica, New Zealand,Saudi Arabia, Singapore, Turkey, and theUnited Kingdom.15 The complaint includesclaims of fraud and violation of fiduciaryduties, including diversion of funds to payallegedly exorbitant consulting fees to thegeneral partners.16 The lesson from thesecases is that counsel for investors and devel-opers must be vigilant to abide by the fullrange of applicable laws and regulations, notjust immigration laws.
Applicability of Securities Laws
One critical concern is that the investmentmay be considered a security subject to stateand federal securities laws. Developers, pro-moters, and counsel must be aware of thecompliance issues, and investors should beadvised of their rights and protections underthe applicable securities laws.
In a traditional EB-5 investment, a singleinvestor forms or buys a business, creates the necessary jobs, and actively runs thebusiness. Securities laws may not be applic-able in this scenario, but it has becomeincreasingly common for multiple parties toinvest in a regional center, and these investorsmay not exercise much control over the oper-ation of the business.17 When investors takea passive role, and the developer takes the pri-mary management responsibility for the pro-ject, the investment becomes a security, thecompany becomes an issuer of a security,and the salespersons and other promoters ofthe investment may also become regulatedpersons.18 If the project is subject to securi-ties laws, the developer and counsel mustconform with the public offering require-ments or an applicable exemption. Larger for-eign investor projects will be more suited tocompliance with one of the private placementexemptions under SEC Regulation D19 orRegulation S, so that the cost of compliancecan be spread across a larger pool of investorsand capital.20
Foreign investors in securities should beaware that the U.S. Supreme Court recentlyreduced the ability of foreign investors toexercise the antifraud provisions of theSecurities Exchange Act of 1934 Section 10(b)and SEC Rule 10b-5.21 In Morrison v.National Australia Bank Ltd., concerningthe sale of securities on a foreign stockexchange, the court rejected the prior conductand effects test that would have allowed forthe foreign investors’ claims to proceed. Thecourt held that Section 10(b) and SEC Rule10b-5 do not have extraterritorial effect, andthe antifraud protections only come into playfor private actions involving a purchase or saleof securities in the United States.22 For
investor visa transactions, Morrison maylimit investor rights if the sale of the capitalinterests occurs overseas. However, it appearsthat as a practical matter, while investor visatransactions are marketed overseas, the trans-actions are typically closed in the UnitedStates, because most developers and theUSCIS require evidence of the investmentfunds. One way to provide the evidence is toestablish an escrow account in the UnitedStates. When the visa application is approved,the funds are released from escrow, and theinvestment is made in the domestic company.The purchase of the interest is then realizedin the United States.
Even if the investor visa transaction wereclosed overseas, the SEC and state regulatorsmay have antifraud enforcement rights.During oral argument for Morrison, the solic-itor general noted that the issue of whetherthe SEC or state securities regulators couldpursue antifraud claims if the fraud had aneffect in the United States was not being lit-igated, so that issue remains unresolved.
EB-5 Due Diligence
Another area of concern for investors anddevelopers are the respective rights of theparties under the operative organizationaldocuments. It is an urban myth that investorsin visa projects are more concerned withobtaining their green cards than with a returnon their investment. While the value that aninvestor places on obtaining a green cardmay be part of the analysis, the litigationthat has arisen regarding failed regional cen-ters indicates that the goals of investors vary.
In any case, no investor seeks to invest ina project in which he or she will lose both theinvestment and the green card. Investorsshould therefore review the organizationaldocuments for a proposed investment to con-firm that critical concerns are addressed. Formost investors concerns will include whether1) the project is designed to satisfy such EB-5 visa requirements as creating sufficientemployment, 2) the investment is protectedfrom loss to the extent possible under applic-able laws and developer willingness, 3) anadequate return on the investment may berealized, and 4) the exit strategy satisfies theinvestor’s needs. The terms and conditionsthat the investor should examine in the orga-nizational documents include investor votingrights or approvals on material decisions ofthe company; provisions that impose fiduciaryobligations on the managers; provisions thatrequire the investor’s funds to be used for jobcreation; rights to remove and replace themanagers for mismanagement or other con-ditions; liquidation preferences; rights torequire dividends, distributions, or preferredreturns; rights to receive reports and account-ing information; disclosures of all fees and
10 Los Angeles Lawyer January 2013
expenses to be charged to the business and theinvestors; requirements that restrict or requirethe company to generate the required jobs inthe targeted market; rights to inspect the pro-ject and its books and records; rights to with-draw from the company; buy-sell rights; andclear and efficient dispute resolution proce-dures.
Some of the rights and protections that aninvestor may desire must be tempered by therequirements for the investor visa. For exam-ple, an investor cannot be guaranteed a returnof invested capital. The USCIS holds that ifthe investment is not at risk, it does not sat-isfy the visa requirements.23 While an investormay reserve the right to withdraw, the investorwho does so also withdraws from the visaapplication process. This could mean waitinganother two years and investing in a differ-ent regional center, because for each visaapplication, a business plan must be pre-pared. The developer and investor shouldtherefor agree on all the specifics in the busi-ness plan.
Developers often use go-betweens to mar-ket investor visa opportunities, especially forregional centers. Investors should confirmthat the statements of the promoters areshared by the developer. A number of reportshave arisen of go-betweens overselling theinvestment, including by stating that thereturn of the invested funds was guaranteed.Some have reportedly asserted that becausethe visa is issued by the U.S. government,the program is guaranteed by the U.S. gov-ernment. Developers also have an interest inassuring that salespersons are not misleadinginvestors. State actions for fraud, breaches offiduciary duties, and unfair business prac-tices may otherwise ensue.
EB-5 Visa Responsibilities
The issuance of a green card includes a num-ber of valuable rights but also includes sig-nificant responsibilities that the investorsshould be prepared to accept. One obligationthat investors often miss is that as a green cardholder, the investor is subject to federalincome and estate taxes, regardless of theamount of time he or she spends in the UnitedStates. State income taxes may also apply.24
Some investors are surprised to learn thatthe United States taxes its taxpayers based ontheir worldwide income.25 The degree of dis-closure required for filing U.S. tax returns isdaunting for some investors. However, com-pliance is critical, as the failure to file taxreturns and pay income taxes can be a basisto revoke a green card.26
As with any business investment, theinvestor should carefully study the viabilityof the business. The requisite number of jobsto be created by the enterprise must, in gen-eral, survive for two years after the issuance
Los Angeles Lawyer January 2013 11
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of the provisional green card. Given the cur-rent economy, one should expect the sur-vival rate of the current regional centers tobe no higher than any other new business. In particular, one should expect that many ofthe regional centers that were started andapproved prior to the economic downturnmay have a lower survival rate than newlyformed businesses. Investors should engagein the same due diligence they would usefor any other investment, including checkingthe backgrounds, experience, and trackrecords of the managers and any related par-ties; confirming the ownership, condition,and status of any critical assets of the busi-
ness; verifying the issuance of critical licensesand permits; and testing the financial assump-tions contained in the business plan andbudgets.
An EB-5 investor should understand thatwhile a visa may be a valuable addition to theinvestment, satisfying the immigration require-ments should not be the end of the analysis.The business must succeed in order to keepthe benefits of the provisional green card, sothe investor should approach the investmentas he or she would any other investment in aforeign county with people with whom theinvestor may not have previously done busi-ness. Developers should also understand that
the applicable laws that must be satisfied gowell beyond the immigration laws. n
1 Immigration Act of 1990, PUB. L. NO. 101-649 (1990).2 Officially known as a Permanent Resident Card orForm I-551, the green card is no longer green but pink.3 See Rights and Responsibilities of a Green CardHolder (Permanent Resident), available at http://www.uscis.gov.4 8 C.F.R. §204.6.5 Holders of green cards can stay in the United Statesindefinitely. They may also proceed with the natural-ization process and become U.S. citizens.6 A “rural area” means any area that is both outside ofa metropolitan statistical area (MSA) and outside of acity or town having a population of 20,000 or morebased on the most recent decennial census. See 8 C.F.R.§204.6(j)(6)(i).7 8 C.F.R. §204.6.8 See www.uscis.gov/eb-5centers.9 Brooke Edwards, Victorville Files Suits against Feds,HIGH DESERT DAILY PRESS, July 15, 2011, available athttp://www.vvdailypress.com/articles/victorville-28901-feds-files.html.10 City of Victorville v. United States Dep’t of HomelandSec., No. 1:2011cv01287 (D. D.C. July 15, 2011),available at http://archive.vvdailypress.com/files/2011/VVCompliant.PDF.11 Brooke Edwards, Victorville Refunds $500K to EB-5 Investor, HIGH DESERT DAILY PRESS, Feb. 12, 2011,available at http://www.vvdailypress.com/sections/article/gallery/?pic=1&id=25930.12 USCIS regulations provide that the investors cannottransfer their investment to another project. Instead,they are required to reapply for a new EB-5 visa andinvest in a new project. See, e.g., Decision of USCIS Ad-ministrative Appeals Office, file RCW 1031910138(July 23, 2012) (on file with author).13 See Notice of Final Termination, re Victorville Re-gional Center, from Rosemary Langley Melville, direc-tor, California Service Center, USCIS, to Keith C. Meltzer (Oct. 20, 2010) (on file with author); see also Rebecca Kimitch, Federal officials shut down for-eign investment program in El Monte, PASADENA STAR-NEWS (Oct. 5, 2011).14 NobleRealEstateFund, LP, Limited Partnership Agree-ment, Dec. 2007, §1.2, attached as an exhibit to the com-plaint in Sumpter v. Hungerford, Jr., No. 2.12-cv-00717-LMA-ALC (E.D. La., filed Mar. 15, 2012). 15 Complaint, Sumpter v. Hungerford, Jr., No. 2.12-cv-00717-LMA-ALC (E.D. La. Mar. 15, 2012).16 Id. at 1-2.17 See 8 C.F.R. §204.6(j)(5)(iii) (setting the standard formanagement participation).18 SEC v. W. J. Howey Co., 328 U.S. 293 (1946).19 See 17 C.F.R. §§230.501-230.508 (exemptions forsecurities sold in private placements).20 See 17 C.F.R. §§230.901-230.905 (exemptions forsecurities that are sold outside the United States).21 Morrison v. National Australia Bank Ltd., ____ U.S.____, 130 S. Ct. 2869 (2010).22 Id. at 2883-84. The USCIS does not make the infor-mation filed for EB-5 applications publicly available,but documentation becomes available when litigationis filed or when administrative guidance is issued.23 See 8 C.F.R. §204.6(j)(5); USCIS Adjudicator’s FieldManual §22.4, Employment Creation EntrepreneurCases.24 See FTB PUBLICATION 1031, GUIDELINES FOR DE-TERMINING RESIDENT STATUS—2011. California taxesresidents based on worldwide income and nonresi-dents based on California-connected income.25 See IRS PUBLICATION 519, U.S. TAX GUIDE FOR ALIENS
(tax responsibilities of immigrants).26 8 C.F.R. §316.5(c)(2).
12 Los Angeles Lawyer January 2013
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Los Angeles Lawyer January 2013 13
THE RECENT CONFLUENCE of falling U.S. real estate prices and aweaker dollar, together with the flight of capital from Russia andChina, has produced a significant demand for real estate in California,Florida, and Manhattan among foreign investors. This demand isfueled by the global perception that the United States is politically andeconomically stable (or at least more stable than the alternatives), hasa transparent legal system that makes it easy for foreigners to invest inreal estate,1 and imposes no currency controls, making it easy to divest.
A foreigner desiring to invest in U.S. real estate typically has manygoals. First, the foreigner may seek privacy. For example, a memberof the Vietnamese Politburo who may be concerned about politicalexposure, a South African who may have violated local currencycontrols may seek to hide his or her identity, and a Mexican nationalwho may be concerned for his or her physical safety were his or herwealth to become known may all feel a need to keep their real estateinvestments secret. Second, to the same extent as U.S. nationals, for-eigners usually desire to shield their U.S. holdings from creditorclaims. Third, unlike U.S. investors who invest in U.S. properties, for-eign investors need to minimize their worldwide tax liability. Additionalimportant considerations include whether the real estate is income-pro-ducing, and if so, whether the income is passive income or income froma trade or business. Another concern, especially for older investors, iswhether the investor is a U.S. resident for estate tax purposes.
Privacy and Liability
Most foreign investors are concerned about privacy. To safeguard it,the real estate should be acquired either by a trust or a legal entity,preferably an LLC. LLCs are generally preferred over corporationsbecause they offer greater structuring flexibility and better creditorprotection than corporations, and, unlike a limited partnership,LLCs do not require the formation of a second entity that will act asthe general partner. If using a trust, the name of the trustee and thename of the trust must appear on the recorded deed. The investorshould not be the trustee, and the trust should not include theinvestor’s name.
A generic name should be used for an entity. However, if the entitywill own California real estate, it will have to register with theCalifornia secretary of state, unless the real estate is vacant land orpersonal use property.2 Either the initial articles of incorporation orthe statement of information will reveal to the world the identity ofthe corporate officers or the LLC manager. A possible alternative isto use a two-tier structure—a California LLC to own the real estate,and a Delaware LLC to act as the manager of the California LLC. InDelaware, the name of the LLC manager is not required to be dis-closed, and all that will appear on California form is the name of theDelaware LLC as the manager. Care should be exercised so that theDelaware LLC is not deemed to be doing business in California, oth-erwise it will also have to register.3
If the real estate is encumbered by debt, the borrower’s name willappear on the recorded deed of trust, even if title is taken in the name
of a trust or an LLC. The borrower’s name may be kept private byhaving the trust entity act as the borrower, with the investor personallyguaranteeing the loan. This ensures that the investor’s name does notappear on any recorded documents.
Corporations, limited partnerships, and LLCs will afford ownersa shield for any liability arising from the assets or the business of theentity.4 However, limited partnerships and LLCs are not required tomaintain certain corporate formalities (like holding annual meetingsof shareholders and maintaining annual minutes), affording creditorsfewer bases for piercing the corporate veil. Interests in limited part-nerships and LLCs are not attachable by creditors, making them amore effective asset protection vehicle than corporations.5 Thus, forexample, when a creditor obtains a judgment against an individualwho owns an apartment building through a corporation, the credi-tor can force the debtor to turn over the stock of the corporation,resulting in the loss of corporate assets.6 If the debtor owns theapartment building through an LLC or a limited partnership, the cred-itor’s remedy is limited to a charging order, which places a lien on dis-tributions from the LLC or limited partnership.7
Income Taxation of Real Estate
A person colloquially referred to as a foreigner is known as a non-resident alien (NRA) for federal income tax purposes. An NRA isdefined as a either a foreign corporation or a person who is 1) phys-ically present in the United States for less than 183 days in any givenyear, 2) less than 31 days in the current year, 3) physically present forless than 183 total days for a three-year period (using a weighing for-mula), and 4) does not hold a green card.8
Income tax rules applicable to NRAs can be quite complex. As ageneral rule, an NRA pays a flat 30 percent tax on U.S.-source “fixedor determinable, annual or periodical” (FDAP) income that is not effec-tively connected to a U.S. trade or business9 and that is subject to with-holding.10 The rate of tax may be reduced by an applicable treaty. Theincome is taxed on a gross basis, with almost no offsetting deductions.
FDAP includes interest, dividends, royalties, and rents. For exam-ple, NRAs that receive interest income from U.S. sources are subjectto a 30 percent tax. Other miscellaneous categories of income includedwithin FDAP are certain insurance premiums, annuity payments,gambling winnings, and alimony. NRAs, however, are generally nottaxable on their capital gains from U.S. sources unless 1) the NRAis present in the United States for more than 183 days, 2) the gainsare effectively connected to a U.S. trade or business, or 3) gains arefrom the sale of certain timber, coal, or domestic iron ore assets. Whenthese exceptions apply, the NRA is taxed on U.S. source capitalgains at the rate of 30 percent.11
An NRA is taxed on income effectively connected to a U.S. trade
tax tips BY JACOB STEIN
Tax Planning for Foreign Investment in California Real Estate
Jacob Stein is a partner with Klueger & Stein, LLP, a Los Angeles law firm thatpractices international taxation, cross-border transactions, and asset pro-tection.
14 Los Angeles Lawyer January 2013
or business under the same rules as all otherU.S. taxpayers. Income may be reduced byappropriate deductions (connected to theU.S. trade or business) and standard tax ratesapply.12 Because traditional tax rules apply,this is necessarily limited to what constitutesa U.S. trade or business and to what “effec-tively connected” means.
There is no code definition for the term“U.S. trade or business.” However, it has beenheld to include providing personal services inthe United States, selling products in the UnitedStates directly or through an agent, solicitingorders from the United States and then export-ing merchandise outside the United States,manufacturing, maintaining a retail store, andmaintaining corporate offices in the UnitedStates. The meaning of “effectively connected”is highly specific and complex and involves the“force of attraction” rule and “asset-use” and“business-activities” tests.13
In general, however, an NRA will beengaged in a U.S. trade or business if theNRA is a general or limited partner in a U.S.partnership engaged in a trade or business.14
Similarly, a beneficiary of a U.S. estate ortrust will be engaged in trade or business ifthe estate or trust is so engaged.15
For real estate, the critical inquiry concernsthe nature of the rental income. It is passiveif it is generated by a triple-net lease or fromlease of unimproved land. If rental income ispassive, it is taxed on a gross basis, with nodeductions, at a flat rate of 30 percent, withthe applicable withholding.16
The loss of deductions is often tax-pro-hibitive, and investors should consider elect-ing to treat their passive real property incomeas income from a U.S. trade or business.17
However, the election can only be made if the property is generating income.18 Conse-quently, if an NRA owns unimproved landthat will be developed in the future, he or sheshould consider leasing the land for somepurpose in an attempt to generate income.This will give the NRA the ability to claimdeductions from the property and possiblygenerate a loss carry-forward that will offsetincome in future years.
A popular planning tool to avoid taxationof real estate income is portfolio interest,which is payable on a debt instrument and isnot subject to taxation or withholding.19
NRAs often try to fit into the portfolio inter-est rules by lending through equity partici-pation loans or loans with equity kickers.An equity kicker is an addition to a fixed-income security (like a loan) that allows thelender to participate in equity appreciation.This may be accomplished in the form of aconversion option, allowing the lender toconvert debt into equity. These provisionsusually increase interest rates on a contingentbasis to mimic equity participation. NRAs
should be aware, however, that in two casesthe IRS has successfully argued that portfo-lio interest “loan” structures were in realityequity investments that produced incomesubject to taxation and withholding.20
If a foreign individual or a foreign cor-poration owns a U.S. corporation, there aretwo levels of tax. The U.S. corporation willbe subject to the regular income tax on itsprofits, and there will be a tax on dividendspaid to the foreign shareholders, subject to 30percent withholding.
The so-called branch profits tax replicatesthis double tax when the U.S. business isowned by a foreign corporation, whetherdirectly, through a disregarded entity, orthrough a pass-through entity. Under thebranch profits tax, the foreign corporation istaxed on its effectively connected income andon any deemed dividends, which are anyprofits not reinvested in the United States.21
The branch profits tax applies at the rate of30 percent but may be reduced by an applic-able treaty.22 The U.S. has treaties covering thebranch profits tax with most of the Europeannations, reducing the tax to between 5 and 10percent.
The 30 percent tax is onerous, as it appliesto a “dividend equivalent amount,” which isthe corporation’s effectively connected earn-ings and profits for the year, less investmentsthe corporation makes in its U.S. assets(money and adjusted bases of property con-nected with the conduct of a U.S. trade orbusiness). The tax is imposed even if there isno distribution.
The rules applicable to the tax on the dis-position of real estate are found in a separateregime known as the Foreign Investment inReal Property Tax Act of 1980 (FIRPTA).23
Generally, FIRTPA taxes the disposition of aU.S. real property interest (USRPI)24 as if theNRA were engaged in a U.S. trade or busi-ness.25 This means that the traditional incometax rules that apply to U.S. taxpayers will alsoapply to the NRA. Purchasers who acquire aUSRPI from a NRA are obligated to withhold10 percent of the amount realized on the dis-position.
An interest in real property includes anyownership of land, buildings, mineraldeposits, crops, fixtures, personal propertyused to 1) exploit natural resources, 2) con-struct improvements, 3) operate a lodgingfacility, or 4) provide a furnished office to atenant (including movable walls or furnish-ings), improvements, leaseholds, or optionsto acquire any of the above.26 Ownershipinterests include fee ownership, co-owner-ship, leasehold, timeshare, a life estate, aremainder, a reversion or a right to participatein the appreciation of real property or in theprofits from real property.27
A partnership interest is treated as a USRPI
if 1) 50 percent or more of the value of part-nership gross assets consists of USRPIs, and2) 90 percent or more of the value of part-nership gross assets consist of USRPIs pluscash and cash equivalents.28 The dispositionof partnership interest will be subject toFIRPTA to the extent such partnership ownsUSRPIs and will be subject to withholding.
A domestic corporation will be treatedas a U.S. real property holding corporation(USRPHC) if USRPIs equal or exceed 50 per-cent of the sum of the corporation’s assets.29
Disposition of an interest in a USRPHC is sub-ject to the FIRPTA tax and withholding butis not subject to state income tax.30 This maybe compared with the disposition of a USRPIowned directly, which is subject to the lowerfederal capital gains rate but is also subject tothe state income tax.
The disposition of an interest in a domes-tic corporation will not be subject to theserules if on the date of the disposition the cor-poration had no USRPIs and all of the gainwas fully recognized (no installment sales orexchanges) on the sale of any USRPIs soldwithin the past five years.31
Any NRA (individual or corporation) sell-ing a USRPI is subject to withholding of 10percent of the amount realized. Withholdingapplies even if the property is sold at a loss.32
The withholding obligation is imposed onthe purchaser, who must report the with-holding and pay over the tax, using Form8288 within 20 days of the purchase. If thepurchaser fails to collect the withholding taxfrom the foreigner, the purchaser will beliable for the tax plus any applicable penal-ties and interest. The withheld taxes are latercredited against the total tax liability of theforeigner.
Withholding is not required if 1) the sellerprovides a certificate of non-foreign status, 2)property acquired by the purchaser is not aUSRPI, 3) the transferred property is stock ofa domestic corporation and the corporationprovides a certificate that it is not a USRPHC,4) the USRPI acquired will be used by the pur-chaser as a residence and the amount realizedby the foreigner on the disposition is$300,000 or less, 5) the disposition is not sub-ject to tax, or 6) the amount realized by theforeigner on the disposition is zero.33
Estate and Gift Tax
For estate tax purposes, the test is completelydifferent in determining who is an NRA—theinquiry centers around the decedent’s domi-cile.34 This is a subjective test that looks pri-marily at intent. The test considers factorssuch as the length of stay in the United States;frequency of travel, size, and cost of home inthe United States; location of family; partic-ipation in community activities; participa-tion in U.S. business and ownership of assets
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in the United States; and voting.A foreigner can be a U.S. resident for
income tax purposes but not be domiciled forestate tax purposes. An NRA, whether a non-resident alien or nondomicilary, is subject to adifferent transfer tax (estate and gift taxes)regime than a U.S. taxpayer. The estate tax isimposed only on the part of the gross NRA’sestate that at the time of death is situated in theUnited States.35 The rate of NRA’s estate taxis the same as that imposed on U.S. citizens andresident aliens, but the unified credit is only$13,000 (equivalent to about $60,000 of prop-erty value).36 These harsh rules may be ame-liorated by an estate tax treaty. The U.S. doesnot maintain as many estate tax treaties asincome tax treaties, but there are estate taxtreaties in place with many of the majorEuropean countries, Australia, and Japan.37
The following assets are specificallyincluded by the IRC in the definition of prop-erty situated in the United States: 1) shares ofstock of a U.S. corporation, 2) revocabletransfers or transfers within three years ofdeath of U.S. property or transfers with aretained interest (described in IRC Sections2035 to 2038), and 3) debt issued by a U.S.person or a governmental entity within theUnited States (e.g., municipal bonds).38
U.S. property also includes real estate inthe United States (if debt is recourse it isignored—gross value is included, not justequity) and tangible personal property suchas works of art, furniture, cars, and cur-rency.39 A beneficial interest in a trust hold-ing U.S. property is also U.S.-situs property.40
U.S.-situs property does not include life insur-ance proceeds paid on the life of the NRA,bank accounts (unless connected with a U.S.business), portfolio interest loans,41 and sharesof stock in a foreign corporation.42
The gross estate is reduced by variousdeductions relating to the U.S.-situs prop-erty. The estate tax returns must disclose allof the NRA’s worldwide assets, in order todetermine the ratio that the U.S. assets bearto non-U.S. assets. This ratio determines thepercentage of allowable deductions that maybe claimed against the gross estate.43 Whenreal estate is subject to a recourse mortgage,the gross value of the real estate is included,offset by the mortgage debt.44 This distinctionis irrelevant for U.S. taxpayers filing estate taxreturns but is very relevant for NRAs forwhom debts are subject to apportionmentbetween U.S. and non-U.S. assets and there-fore not fully deductible.45
Advance planning can eliminate or reducethe U.S. estate tax obligations of NRAs. Forexample, U.S. real estate owned by the NRAthrough a foreign corporation is not includedin an NRA’s estate. This effectively convertsU.S. real property into a non-U.S. intangibleasset. Even if the real estate were not ini-
tially acquired through a foreign corpora-tion, it may be beneficial to pay an income taxtoday on the transfer of the real estate to a for-eign corporation (usually treated as a sale) toavoid the estate tax in the future.
Gift taxes are imposed on the donor. ANRA donor is not subject to U.S. gift taxeson any gifts of non-U.S. situs property giftedto any person, including U.S. citizens andresidents. Citizens and residents, however,must report on Form 3520 gifts from a NRAthat are in excess of $100,000.46 Gifts ofU.S.-situs assets are subject to gift taxes, withthe exception of intangibles, which are nottaxable.47 Tangible personal property andreal property is sited within the United Statesif it is physically located in the United States.48
NRA donors are allowed the same annual gifttax exclusion as other taxpayers and are sub-ject to the same rate schedule for gift taxes.However, the lifetime unified credit is notavailable to NRA donors.49
The primary thrust of estate tax planningfor NRAs is through the use of 1) foreign cor-porations to own U.S. assets, or 2) the gift taxexemption for intangibles to remove assetsfrom the United States. If the NRA dies own-ing shares of stock in a foreign corporation,the shares are not included in the NRA’sestate, regardless of the situs of the corpora-tion’s assets. It is important that the corpo-ration have a business purpose and activity,lest it be deemed a sham designed to avoidU.S. estate taxes.50
The gift of an intangible, wherever situ-ated, by an NRA is not subject to gift tax.Shares in U.S. corporations and interests inpartnerships or LLCs are intangibles.51
Consequently, real estate owned by the NRAthrough a U.S. corporation, partnership, orLLC may be removed from the NRA’s U.S.estate by gifting entity interests to foreignrelatives.
Ownership Structures
An NRA can acquire U.S. real estate usingseveral alternative ownership structures. TheNRA’s goals and priorities dictate the type ofstructure that is used. Each alternative has itsown advantages and disadvantages. For exam-ple, direct investment (real estate owned by theNRA) is simple and is subject to only onelevel of tax on the disposition. If the real estateis held for one year, the sale is taxed at a 15 per-cent rate.52 The disadvantages of the directinvestment are: no privacy, no liability pro-tection, the obligation to file U.S. income taxreturns, and if the NRA dies while owning theproperty, it is subject to U.S. estate taxes.
Under an LLC or a limited partnershipstructure, the NRA acquires the real estatethrough an LLC or an LP. The LLC may bea disregarded entity or a tax partnership forU.S. income tax purposes. This is an improve-
Los Angeles Lawyer January 2013 15
ment over the direct ownership alternative,because this structure provides the NRA withprivacy and liability protection and allows forlifetime transfers that escape the gift tax. Theobligation to file U.S. income tax returns andthe possibility for U.S. estate tax on deathremain, however.
Ownership of real estate through a domes-tic corporation (a C corporation, since a for-eign shareholder precludes an S corpora-tion)53 will afford privacy and liabilityprotection, allow lifetime gift tax-free trans-fers, and obviate the foreigner’s need to fileU.S. income tax returns. Engaging in a U.S.trade or business requires a U.S. tax return;ownership of stock will not trigger a returnfiling obligation.
There are three disadvantages to the own-ership of real estate through a domestic cor-poration. One is that federal and state cor-porate income tax at the corporate level willadd a second layer of tax. The second is thatdividends from the domestic corporation toits foreign shareholder will be subject to 30percent withholding. The third is that theshares of the domestic corporation will beincluded in the U.S. estate of the foreignshareholder. Further, on the disposition ofthe stock in the corporation, the foreignshareholder will be subject to FIRPTA,because the corporation will be treated as aUSRPHC. This will require the filing of aU.S. income tax return and 10 percent taxwithholding by the purchaser of the shares.
Ownership of the real estate may be bythe U.S. corporation directly, or through aU.S. partnership or disregarded entity ownedby the corporation. The corporation mayeven be an LLC that chooses to be taxed asa corporation. In turn, the ownership of theU.S. corporation by the NRA may be direct,or through a foreign partnership or disre-garded entity.
Foreign corporation ownership offers thefollowing advantages: 1) liability protection,2) no U.S. income tax or filing requirementfor the foreign shareholder, 3) shares in theforeign corporation are non-U.S. assets notincluded in the U.S. estate, 4) dividends arenot subject to U.S. withholding, 5) no tax orfiling requirement on the disposition of thestock, and 6) no gift tax on the transfer ofshares of stock.
The disadvantages of using the foreigncorporation are 1) corporate level taxes (justlike with the domestic corporation), becausethe foreign corporation will be deemedengaged in a U.S. trade or business, and 2) theforeign corporation will be subject to thebranch profits tax, the largest disadvantage ofownership of U.S. real estate through a for-eign corporation.
Because the branch profits tax is notalways reduced or eliminated by a treaty, the
16 Los Angeles Lawyer January 2013
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most advantageous structure for ownershipof U.S. real estate by NRAs is a hybrid for-eign and U.S. corporation. The NRA owns aforeign corporation that in turn owns a U.S.LLC taxed as a corporation. This structureaffords privacy and liability protection,escapes U.S. income tax filing requirements,avoids U.S. estate taxes, allows for gift tax-free lifetime transfers, and avoids the branchprofits tax. Distributions from the U.S. sub-sidiary to the foreign parent are subject to the30 percent FDAP withholding, but the tim-ing and the amount of this dividend is withinthe NRA’s control.
There are multiple considerations andstructures available to foreign investors inU.S. real estate, and no structure is perfect.Each structure presents its own advantagesand disadvantages that require analysis inlight of the objectives and priorities of eachclient. n
1 With the exception of a few states that restrict foreignownership of mineral rights, no restrictions are imposedon foreign ownership of U.S. real estate.2 CORP. CODE §17451(a).3 See Jacob Stein, California Registration Requirementsfor Foreign LLCs, CAL. TAX LAWYER 41 (Summer2008).4 Erkenbrecher v. Grant, 187 Cal. 7, 9, 200 P. 641(1921); Hollywood Cleaning & Pressing Co. v.Hollywood Laundry Serv., 217 C. 124, 129 (1932);CORP. CODE §§17101(a), 15632(a).
5 CORP. CODE §§15673, 17302. See Jacob Stein, APractical Take on Charging Orders, 8 BUS. ENT. MAG.28 (Sept. 2006).6 U.C.C. §8112.7 CORP. CODE §17302.8 I.R.C. §7701(b).9 I.R.C. §§871(a), 881. Rental income is sourced towhere the property is located. I.R.C. §861(a)(4).10 I.R.C. §1441(a).11 I.R.C. §871(a)(2).12 I.R.C. §§871(b), 882.13 See I.R.C. §§864(c)(2), (3).14 I.R.C. §875(1).15 I.R.C. §875(2).16 I.R.C. §871(a)(1); Treas. Reg. §1.871-7(a)(3).17 I.R.C. §871(d); Rev. Rul. 92-74, 1992-2 CB 156.18 Rev. Rul. 91-7, 1991-1 CB 110.19 I.R.C. §§871(h), 881(c)(1).20 See, e.g., Farley Realty Corp. v. Commissioner, 279F. 2d 701 (2d Cir. 1960), Portage Plastics Co. v. UnitedStates, 470 F. 2d 308 (7th Cir. 1972).21 I.R.C. §884(a).22 Id.23 Foreign Investment in Real Property Tax Act of1980, codified at I.R.C. §§897, 1445, 6039C.24 A USRPI is defined as any interest in 1) real prop-erty located in the United States or 2) a domestic cor-poration that is a “United States real property holdingcorporation.” I.R.C. §897(c)(1).25 I.R.C. §897.26 I.R.C. §897(c); Treas. Reg. §1.897-1(b).27 Treas. Reg. §1.897-1(d)(2)(i).28 Temp. Reg. §1.897-7T.29 I.R.C. §897(c)(2).30 I.R.C. §897(a)(1). There are no state law equivalentsto FIRPTA, and under state law a sale of an interest ina domestic corporation (even if it is a USRPHC for fed-
eral income tax purposes) by a foreigner is not taxable,following the general rule of I.R.C. §892.31 I.R.C. §897(c)(1)(B); Treas. Reg. §1.897-2(c).32 I.R.C. §1445.33 Id.; Treas. Reg. §1.1445-2(d)(2)(i).34 Treas. Reg. §§20.0-1(b)(1), 25.2501-1(b).35 I.R.C. §2103.36 I.R.C. §2102(b)(1).37 This includes tax treaties with Austria, Belgium,Denmark, Finland, France, Germany, Greece, Ireland,Italy, Netherlands, Norway, Sweden, Switzerland, andthe United Kingdom.38 I.R.C. §2104.39 Treas. Reg. §20.2104-1(a).40 Rev. Rul. 55-163, 1955-1 C.B. 674.41 I.R.C. §2105.42 Treas. Reg. §20.2105-1(f).43 I.R.C. §2105(a)(1), (2).44 Treas. Reg. §20.2053-7. If the mortgage is nonre-course, only the net value of the property is includedin the estate.45 Treas. Reg. §20.2106-2. Apportionment is also pos-sible only if worldwide assets are disclosed on theestate tax return.46 I.R.S. Notice 97-34, 1997-1 C.B. 422.47 I.R.C. §2501(a)(2).48 Treas. Reg. §25.2511-3(b).49 I.R.C. §2505(a).50 See, e.g., Jackson v. Commissioner, 233 F. 2d 289(2d Cir. 1956).51 Interest is an intangible if the partnership is a distinctlegal entity and survives the death of its partners.Sanchez v. Bowers, 70 F. 2d 715 (2d Cir. 1934). Forthe application of this rule to an LLC, see Pierre v.Commissioner, T.C. Memo 2010-106.52 I.R.C. §1(h).53 I.R.C. §1361(b)(1)(C).
Los Angeles Lawyer January 2013 17
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NI
In the aftermath of the Great Recession of thelate 2000s, many retailers shuttered their stores,went out of business, and, in some cases, filedfor bankruptcy. As for the retailers that survived,many imposed an immediate freeze on theirexpansion plans, opting instead to wait and
see how and when the market would recover. Gradually,over the last few years, the expansion freeze has beenthawing, and sanguine retailers have warmed up to thenotion of reentering the market. But their return comes withnew demands. Aside from lower rents, retailers are demand-ing protections in their leases that once only the big anchortenants could obtain. Now, tenants of every size are clam-oring for these anchor protections, and landlords, stillreeling from the recent economic collapse and a paucity ofnew deals, are reluctantly acquiescing.
One significant demand is the exclusive right to sell cer-tain products in a shopping center. This concept, while easyto understand, is relatively difficult to draft in a way thatis enforceable and that addresses each party’s concerns.From a tenant’s perspective, the provision should prohibitthe landlord from allowing another tenant to compete
with its business. On the other hand, landlords want theflexibility to lease space in their centers to a diversified ten-ant mix without unduly excessive or unintended restrictions.
Defining the Exclusive
With that in mind, the first and primary issue to consideris how to define the scope of the exclusive. Some exclusivesfocus on restricting a type of business, such as a “drugstore,” while others focus on restricting certain types ofproducts, such as “groceries.” In either case, problemscan arise. For example, an exclusive right to operate a “drugstore” has been held to prevent other tenants from sellingprescription drugs, but not health and beauty products,1
which many people likely expect to find in a drug store. Theexclusive right to operate a furniture store has been heldto preclude a competitor from selling carpets, rugs, andlinoleum,2 products that many people do not consider tobe furniture. An exclusive for a martial arts studio has been
More retailers are demanding exclusive rights, but theyremain challenging to define and enforce
by NADAV R AVID
The founding member of Ravid Law Group, Nadav Ravid representsREIT landlords and national retailers throughout the UnitedStates.
EXCLUSIVEDEALS
held to preclude a fitness facility featuringboxing and kick-boxing.3 An exclusive rightto sell groceries has been held to prevent thesale of food and beverage items, but not alco-holic beverages, paper products, or householdcleaners.4
In one recent case, Winn-Dixie Stores,Inc. v. Big Lots Stores, Inc., the court analyzedover 100 of Winn-Dixie’s leases spanning thestates of Florida, Alabama, Georgia, Missis-sippi, and Louisiana, and determined thatan exclusive on “groceries” was ambiguous.5
Winn-Dixie sued the family of companiesoperating under the trade names Dollar Tree,Dollar General, and Big Lots. The defendantargued that “groceries” should include onlyfood items but not any beverages, snacks, orcandy, while Winn-Dixie argued that “gro-ceries” should include all food items and allbeverage products, as well as nonfood itemssuch as paper products and household clean-ers. In rejecting each side’s interpretation,the court arrived at its own definition toinclude only food items and beverages but notalcoholic beverages. Interestingly, the federalcourt in Winn-Dixie declined to follow aFlorida state court’s interpretation of theidentical exclusive provision prohibiting thesale of groceries.6 The state court concludedthe term “groceries” should be interpreted toinclude more than just food.7 In distinguish-ing the two cases, the federal Winn-Dixiecourt explained that the leases it analyzeddated back to 1957, while the single lease ana-lyzed by the state court was from 1986. Thisled the court to determine that while “gro-ceries” may have been intended by the par-ties to cover nonfood items in the 1986 lease,the term “groceries” in the 1957 leases wasnot intended to cover nonfood items. Thecourt based its decision on its determinationthat the offerings of groceries have evolvedover time. Although the court’s analysis mayappear to be making a distinction without adifference, the lesson learned is that it isimperative to define the restricted productswith as much specificity as possible, or ajudge may decide on the definition instead.
Exclusive Carve-Outs
Second, most exclusives that focus on thetype of products sold (as opposed to focus-ing on the type of business operated) includecarve-outs allowing other tenants to sell a cer-tain percentage of the excluded productswithout such sales being deemed a violation.A common distinction is the sale of therestricted products on an incidental basis(which is permitted) versus on a primarybasis (which is prohibited). As the Winn-Dixie court concluded, however, the terms“incidental” and “primary” may be tooambiguous to enforce.8 Does “primary” mean51 percent of the total gross sales, or does it
require more? What if a tenant’s most pop-ular product amounts to 30 percent of itstotal sales—would that product be consideredprimary to that tenant’s business and thus aviolation of another tenant’s exclusivity? Toavoid these types of questions, it is a better,but still problematic, practice to specify anactual percentage of gross sales that would notbe considered a violation. Often, the partiesagree to allow other tenants to sell the exclu-sive product in an amount somewhere in therange of 10–25 percent (depending on theproduct) of such other tenants’ gross saleswithout such sales being deemed a violation.
Tying a carve-out to a percentage of grosssales, however, raises other concerns, such aslandlord audit rights, measuring periods, anddamage claims. First, a landlord should pro-vide itself with the right to audit its tenants’gross sales—a provision that is sometimesomitted from leases that do not require thepayment of percentage rent. When auditrights are included in a lease, considerationshould be given to whether the tenant shouldbe specifically required to maintain itsaccounting records by separating out differ-ent product lines. Not all tenants structuretheir accounting in a way that allows easy ver-ification, however, so drafting a lease provi-sion to require it may not work. It is doubt-ful that a tenant will change its company-wideaccounting methods to accommodate a sin-gle lease requirement. If that issue is resolved,however, the next question is what measur-ing period to use. Should the tenant count itssales on a daily, monthly, or annual basis?Most leases are silent on this issue. What ifthere is a restriction on selling 15 percent ofan excluded product but the offending tenant’sgross sales of the restricted product are 12 per-cent in one month and 17 percent in anothermonth? Should the tenant be allowed to aver-age the two months and thus avoid being inviolation of the exclusive? An argument canbe made that the sales should be measured onan annual basis, since that is the typical mea-suring period for percentage rent in leases. Ifthe sales are measured annually, however, iteffectively means that a tenant that bargainedfor an exclusive may have to wait 12 monthsbefore it can demonstrate that another tenantis violating the exclusive.
To avoid these practical issues, some ten-ants prefer to measure a violation by theamount of sales floor area used to sell arestricted product. For example, a lease couldprovide that a tenant will not be consideredto be in violation of the exclusive if it uses lessthan 10 percent of its sales floor area to sellthe restricted product. But measuring floorarea is not always straightforward either. InWinn-Dixie, Big Lots argued that only thefootprint of the display unit should be countedtoward the carve-out, while Winn-Dixie
argued that in addition to the display unit,half the aisle space should also be countedtoward the sales area.9 The court agreed withBig Lots and concluded that aisle space shouldnot be included. To remove these types ofuncertainties and avoid leaving it up to thecourt to decide, parties should expressly spec-ify whether the calculation of the offendingfloor area should include aisle space in addi-tion to the floor area taken up by the displayunit itself.
Remedies
Once all of the issues with respect to defin-ing what constitutes a violation of an exclu-sive use are addressed, next up is determin-ing the remedies for the tenant in the event ofsuch a violation. Many landlords are willingto protect a tenant when the landlord isdirectly to blame for a violation by, for exam-ple, knowingly signing a lease with a com-petitor. If the violation, however, is caused bywhat is referred to as a rogue tenant (one thatdoes not have the right to sell the exclusiveproducts under its lease but does so any-way), landlords are reluctant to provide atenant with remedies. A landlord does notwant to be considered to be in breach of itslease if it has not directly done anythingwrong. Most tenants recognize this and arewilling to make a distinction between thesetwo types of violations by negotiating dif-ferent remedies for each type of violation. Forinstance, if the landlord is directly to blame,the tenant’s remedy applies right away. If theviolation is caused by a rogue tenant, on theother hand, the landlord may require noticealong with an opportunity to cure the viola-tion by pursuing an injunction against therogue tenant to force it to stop the violation.In the case of a rogue tenant violation, ten-ants are usually willing to give the landlorda reasonable period of time to cure the vio-lation, after which the tenant will expect toget some sort of relief.10
If a violation is established, it is possiblethat a tenant could terminate its lease and berelieved of all of its future obligations, asshown in Medico-Dental Building Companyv. Horton & Converse, in which the courtheld that a landlord violated a tenant’s exclu-sive right to sell drugs when it leased otherspace in the building to a pharmacist.11 Thecourt held that the tenant’s exclusive was amaterial part of the consideration that inducedthe tenant to enter into the lease, so thecovenant to pay rent and the restrictivecovenant were interdependent.12 Consequent-ly, the landlord’s breach of the restrictivecovenant allowed the tenant to vacate thepremises without further liability for rent.Under some circumstances, a tenant may alsorecover lost profits,13 although many land-lords require tenants to waive rights to recover
20 Los Angeles Lawyer January 2013
lost profits for a landlord’s breach. Provingdamages, however, may be a difficult andcumbersome task, and in some cases, toospeculative for a court to determine.14
Liquidated Damages
To provide certainty, many landlords andtenants insert liquidated damages provisionsproviding the tenant with a fixed amount of damages following a violation of the ten-ant’s exclusive. Under California law, there isa presumption of validity for liquidated dam-ages clauses in commercial leases, unless theparty seeking to invalidate the provisionshows that the provision was unreasonableunder the circumstances existing at the timethe contract was made.15 The reasonable-ness of the provision must be judged “at thetime the contract was made and not as itappears in retrospect.”16 Thus, the validity ofa liquidated damages provision is not depen-dent on the amount of the damages actuallysuffered; rather, all of the circumstances exist-ing at the time the contract was entered intomust be considered to determine whether theliquidated damages provision is reasonableand therefore enforceable. “The amount setas liquidated damages ‘must represent theresult of a reasonable endeavor by the partiesto estimate a fair average compensation forany loss that may be sustained.’”17
With this in mind, it is common fornational retailers to request liquidated dam-ages in the form of a 50 percent rent dropupon a violation of the exclusive.18 Tenantsshould be careful, however, in negotiatingthis remedy too aggressively, because in somejurisdictions a full abatement of rent has beenruled an unenforceable penalty.19 Some land-lords seek to include a sales test so that thetenant’s rent is reduced only if the tenant canprove that its sales have dropped as a resultof the violation of its exclusive. Sales tests(which are also used in other areas of retailleasing), however, raise many complicationsthat, some tenants argue, make using themunfair. Other variables not connected to acompetitor’s presence may contribute to anincrease or decrease in a tenant’s yearly grosssales.
Once the parties have agreed upon a liq-uidated damages amount, the next matter todetermine is the length of time the tenantwill be entitled to such damages. It is commonfor national retailers to pay reduced rent foranywhere from 6 to 12 months after a vio-lation, followed by what is commonly referredto as a fish-or-cut-bait provision under whichthe tenant either reverts to paying full rent inspite of the violation or terminates the lease.
Monetary Damages
Aside from recovering damages from thelandlord, a tenant may also want damages
from the offending tenant as well as specificenforcement of its exclusive. Whether a ten-ant has a right to sue another tenant for vio-lation of an exclusive will vary dependingon the jurisdiction. For example, Florida,Georgia, and Alabama allow tenants to sueother tenants directly, but Mississippi does notunless there is privity of estate between thetwo tenants.20
In California, there is no case law that
addresses this issue directly on point; however,in several cases a tenant has successfully pur-sued the offending tenant, at least indirectly.In Hildebrand v. Stonecrest Corporation, thelandlord agreed that it would not permit thesale of drugs, medicines, or cosmetics in thesupermarket located in the shopping cen-ter.21 When the supermarket began sellingthese items, the tenant sued the landlord andthe supermarket. The court awarded the ten-ant a judgment against the landlord but alsoentered a judgment in favor of the landlordagainst the supermarket in the same amountas the tenant’s judgment against the land-lord.22 In Lewis v. Alpha Beta Company, aliquor operator sued its cotenant and thelandlord for a breach of the exclusive right tosell alcoholic beverages.23 The landlord thenfiled a cross-complaint against the cotenant.The court issued a permanent injunctionagainst the cotenant based on the landlord’scross-complaint, which rendered the liquoroperator’s suit against its cotenant moot.Nonetheless, the court determined thatalthough formally the judgment was in favorof the landlord alone, in reality the liquoroperator was also a prevailing party, and theoperator was therefore entitled to attorney’sfees.24
There can be many difficulties in enforc-ing damage claims by one tenant directlyagainst another. These difficulties were high-lighted in Winn-Dixie when the court heard
expert testimony from several economistswho provided different economic models andregression analyses on all of the leases. Oneexpert testified that whenever Big Lots openedup a store next to Winn-Dixie, Winn-Dixiesuffered, on average, a 6.5 percent loss of salesat that store. Using a different approachcalled the “gravity model,” another expert tes-tified that the lost sales could exceed 30 per-cent per store. Another expert testified that “if
a loaf of bread is bought in a Dollar Generalstore, that loaf of bread will not be bought ata Winn-Dixie store.”25 The court rejectedthese models and arguments on the basisthat, among other reasons, they were toospeculative and failed to take into account BigLot’s carve-out allowing it to sell some gro-ceries.26 The court determined that the expertsfailed to provide evidence that the loss inWinn-Dixie’s sales came from sales by BigLots of products placed outside of its per-mitted floor area carve-out. This raises thequestion of whether damages can ever beproven if an exclusive is subject to a carve-out.
A tenant that seeks to specifically enforceits exclusive may require the landlord toagree in the lease to pursue a remedy againstthe offending tenant on behalf of the tenantwith the exclusive. Alternatively, a tenantmay simply choose to pursue specific enforce-ment directly against the offending tenant, aswas the case in Winn-Dixie. In some cases,specific enforcement of an exclusive may bea powerful tool against the offending ten-ant, because the offending tenant will havelikely spent considerable amounts of moneyin constructing its store and will not want tobe in the position of having to shut down itsbusiness. But that will not always be the case.In circumstances in which a tenant is allowedto sell some of the exclusive products on acarve-out basis, and monetary damages aretoo speculative, the offending tenant may
Los Angeles Lawyer January 2013 21
not have enough of an incentive to stop vio-lating the exclusive. After all, once an injunc-tion is issued, the tenant is merely required tostop violating the exclusive; there is no otherpenalty. Obtaining an injunction in these cir-cumstances would amount to a pyrrhic vic-tory for the tenant that bargained for anexclusive. For example, among the leasesunder which Winn-Dixie “won” an injunc-tion, Big Lots was merely ordered to complywith the exclusive by reducing the size of thefootprint of its grocery sales. After years oflitigation, during which time Big Lots con-tinued to violate Winn-Dixie’s exclusive,Winn-Dixie was merely restored to the posi-tion it was in before Big Lots violated theexclusive, after presumably having lost salesand having incurred substantial legal fees.
Notice
In those jurisdictions in which a tenant has theright to sue another tenant for the violationof an exclusive, notice is typically required.To satisfy the notice requirement, a tenantshould record a memorandum of the leasethat specifically refers to its exclusive rights.By doing this, the tenant provides construc-tive notice of its exclusive use to all incom-ing tenants of the center. Practically, however,except for some big-box tenants, it is notcommon for potential tenants to search thechain of title before entering into leases todetermine whether an intended use will berestricted by another tenant’s exclusive. Itwill be interesting to see if a court refuses toimpose constructive knowledge on an unso-phisticated tenant, if not a big-box tenant. TheWinn-Dixie court noted that the noticerequirement was satisfied in that case becauseBig Lots was an experienced commercial ten-ant with over 7,800 stores in 32 states andbecause Big Lots was aware that Winn-Dixietypically secured exclusives. The court deemedthat these facts imposed an obligation on BigLots to inquire about the existence of anexclusive.27
To remove any doubt of whether a tenanthas notice of another tenant’s exclusive rights,some landlords insert provisions in the leaseto provide actual notice by informing thetenant that it is subject to existing exclusivesaffecting the center, and listing the exclusiveson an exhibit. While this may solve the prob-lem of notice, it may also result in the unin-tended consequence of alerting the tenantsthat the landlord is willing to grant exclusivesto its tenants.
Successor Liability
It should be noted that not only will the orig-inal landlord be subject to the exclusive rightsit grants to its tenants but also the landlord’ssuccessors will be responsible for upholdinga tenant’s exclusive use after the successor
22 Los Angeles Lawyer January 2013
Anita Rae ShapiroSUPERIOR COURT COMMISSIONER, RET.
PRIVATE DISPUTE RESOLUTIONPROBATE, CIVIL, FAMILY LAW
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landlord takes over the property. For exam-ple, in Carter v. Adler, the tenants had exclu-sive rights for “Grocery, Delicatessen, Meats,Produce, Fish and Poultry” within a shoppingcenter.28 The land was later purchased by anew landlord who also acquired an adjacentparcel for the purpose of combining the twoparcels and developing the combined areainto one supermarket. The court ultimatelyfound that the successor landlord was pre-vented from operating a supermarket on theadjacent parcel because of the tenant’s exclu-sive.29 Although the Carter court did notdirectly address any notice requirement,Section 1468 of the California Civil Codeappears to require that a restrictive covenantbe recorded in the public records to be bind-ing on a successor owner.
Antitrust Considerations
As a final note, exclusive use clauses have beenheld to not violate the federal Sherman Anti-trust Act. Courts have applied the “rule of rea-son” contained in the act and have consis-tently upheld restrictive covenants when therestrictions do not have a substantial adverseeffect on competition.30
Exclusivity provisions are rising in popu-larity with tenants of all sizes in the retailindustry. Drafting these provisions requirescareful thought and consideration of a myr-iad of issues. Without specificity, such pro-visions are ripe for attack and may lead tounpredictable outcomes. In light of the recentWinn-Dixie case, special attention should begiven to defining the scope of the exclusive,establishing carve-outs, and identifying avail-able remedies in different jurisdictions, suchas monetary damages and injunctive relief. n
1 Rite Aid of Ohio, Inc. v Marc’s Variety Store, Inc. 93Ohio App. 3d 407, 416 (1994).2 Kulawitz v. Pacific Woodenware & Paper Co., 25 Cal.2d 664, 673 (1944).3 Freestyle Martial Arts Corp. v. Soco, LLC, 2007 Cal.App. Unpub. LEXIS 8925, at *6-7.4 Winn-Dixie Stores, Inc. v. Big Lots Stores, Inc., 2012WL 3292001, at *6–7 (S.D. Fla.).5 Id. at *6.6 See Winn-Dixie Stores, Inc. v. 99 Cent Stuff-TrialPlaza, LLC, 811 So. 2d 719 (Fla. 3d DCA 2002).7 Winn-Dixie, 2012 WL 3292001, at *6.8 Id. at *9 and *16.9 Id. at *7. The Florida state court in the prior caseadopted Winn-Dixie’s position.10 See Kulawitz v. Pacific Woodenware & Paper Co.,25 Cal. 2d 664, 673 (1944) (distinguishing between alandlord violation and a rogue tenant violation).11 Medico-Dental Bldg. Co. v. Horton & Converse, 21Cal. 2d 411 (1942).12 See id. at 420.13 Freestyle Martial Arts Corp. v. Soco, LLC, 2007 Cal.App. Unpub. LEXIS 8925 (2007). The lease withFreestyle contained an exclusive for the operation of amartial arts studio, but a second lease provided for theoperation of a boxing and kickboxing fitness facility. 14 See Winn-Dixie 2012 WL 3292001, at *10-12.15 CIV. CODE §1671(b).
16 El Centro Mall, LLC v. Payless ShoeSource, Inc., 174Cal. App. 4th 58, 63 (2009) (citations omitted) (uphold-ing liquidated damages for tenant’s failure to contin-uously operate).17 Id. (citations omitted).18 See, e.g., Red Sage Ltd. P’ship v. Despa DeutchSparkassen Immobilien-Anlage-Saellschaft MBH, 254F. 3d 1120, 1130 (2001). See also Valentine’s, Inc. v.Ngo, 251 S.W. 3d 352, 355 (Mo. Ct. App. 2008), inwhich the court upheld a liquidated damages provisionin the amount of $100,000, even though that amountwas not directly related to any actual loss of profits thatthe tenant would have suffered due to the violation.19 See, e.g., Barr & Sons Inc. of Cherry Hill, N.J. v.Cherry Hill Ctr., Inc., 90 N.J. Super. 358, 377 (1966);Mark-It Place Foods, Inc. v. New Plan Excel RealtyTrust, Inc., 156 Ohio App. 3d 65, 97 (2004).20 See, e.g., Winn-Dixie, 2012 WL 3292001, at *2; Rothv. Connor, 510 S.E. 2d 550, 556 (Ga. App. 1998);
Willow Lake Residential Ass’n, Inc. v. Juliano, 80 So.3d 226, 237 (Ala. Civ. App. 2010). See also Winn-Dixie, 2012 WL 3292001, at *4.21 Hildebrand v. Stonecrest Corp., 174 Cal. App. 2d158, 161 (1959).22 Id. at 163-64.23 Lewis v. Alpha Beta Co., 141 Cal. App. 3d 29, 32(1983).24 Id. at 33.25 Winn-Dixie, 2012 WL 3292001, at *11.26 Id.27 See id. at *16.28 Carter v. Adler, 138 Cal. App. 2d 63, 65 (1955).29 Id.30 See, e.g., Dunafon v. Del. McDonald’s Corp., 691 F.Supp. 1232, 1241–42 (W.D. Mo. 1988). But see In reTyson’s Corner Reg’l Shopping Ctr., 83 F.T.C. 1598(1974) (The FTC acted against approval rights fordepartment stores.).
Los Angeles Lawyer January 2013 23
24 Los Angeles Lawyer January 2013
With foreclosures in the United States rising toover 3.9 million since 2008, the residential mort-gage industry has come under public scrutiny.1
New legislative and regulatory enactments havefollowed, and mortgage servicing practices areundergoing significant changes. Under the
National Mortgage Settlement (NMS) negotiated by acoalition of state attorneys general and federal agencies,five major mortgage servicers agreed to abide by new ser-vicing standards of conduct and allocate significant finan-cial resources to loan modifications.
Building on the settlement, California enacted theHomeowner’s Bill of Rights (HOBR), which imposes manyof the same servicing standards on other residential mort-gage servicers.2 At the federal level, the Consumer FinancialProtection Bureau, an agency created by the Dodd–FrankWall Street Reform and Consumer Protection Act, recentlyproposed new regulations that would require compliancewith many of the same standards. Collectively, the resultwill be a host of changes in mortgage servicing and fore-closure practices in California, which will have a signifi-
cant effect on homeowners and those in the residentialmortgage industry.
In 2010, a joint federal and state investigation was ini-tiated after major mortgage servicers were alleged to havefiled false affidavits in judicial foreclosure proceedings, apractice dubbed robo-signing.3 As later articulated in thecomplaint that resulted from the investigation, bankemployees were accused of repeatedly “preparing, exe-cuting, or filing affidavits in foreclosure proceedings with-out personal knowledge of the assertions in the affidavitsand without review of any information or documentationto verify the assertions in such affidavits.”4
Although robo-signing was the initial focus, the inves-tigation quickly expanded into other servicing practices.5
In 2012, the United States, the state attorneys general ofevery state except Oklahoma, and the District of Columbiafiled a complaint in the U.S. District Court for the District
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RIGHTS INFORECLOSURE
To protect homeowners facing foreclosure, the NationalMortgage Settlement and Homeowner’s Bill of Rightsimpose new standards on mortgage servicers
by LOI S M. JACOBS and HEATHER E. STERN
Lois M. Jacobs and Heather E. Stern are partners in the law firmof Kralik & Jacobs LLP, where they represent banks and otherfinancial institutions in lender liability and other disputes.
Los Angeles Lawyer January 2013 25
of Columbia against five major mortgageservicers: Citibank, JP Morgan Chase/Wash-ington Mutual, Bank of America/Country-wide, Wells Fargo/Wachovia, and Ally Fin-ancial/GMAC Mortgage, LLC.6 In additionto robo-signing, the complaint included alle-gations of dual-tracking, which is the processof continuing to pursue foreclosure whileconcurrently communicating with the bor-rower about loan modification options.7 Tosettle the complaint, the five major servicersagreed to enter into consent judgments, col-lectively referred to as the NMS.
The nonmonetary terms of the NMS arebroad, imposing numerous new mortgageservicing requirements on the settling ser-vicers. In order to prevent robo-signing, theNMS mandates that a servicer take appro-priate actions to verify its right to foreclose.For example, a servicer must review “com-petent and reliable evidence” to substantiatethe borrower’s default and the right to fore-close before a loan is referred to nonjudicialforeclosure.8 Further, in all states, a servicerhas to send the borrower a “statement settingforth facts supporting Servicer’s or holder’sright to foreclose” no later than 14 daysbefore the loan is referred to a foreclosureattorney or trustee. The statement must alsoinclude such additional information as an“itemized plain language account summary”and a “statement to the borrower outliningloss mitigation efforts undertaken with respectto the borrower prior to foreclosure referral.”9
The NMS imposes specific obligations oneach servicer in handling a borrower’s loanmodification request. Potentially eligible bor-rowers must be notified of “currently avail-able loss mitigation options prior to foreclo-sure referral” and upon timely receipt of acompleted application, a servicer has to eval-uate the borrower’s qualification for “allavailable loan modification options.…”10
All “initial denials of an eligible borrow-er’s request for first lien loan modification”are required to be evaluated by an indepen-dent entity or an employee who was notinvolved with the particular loan modifica-tion.11 When a first mortgage loan modifi-cation is denied after independent review,the servicer is required to send a written non-approval notice to the borrower explainingthe reasons for denial and what factual infor-mation was considered.12 The borrower hasa right to appeal and obtain an independentreview of the denial.13 If the servicer deniesthe borrower’s appeal, the servicer’s appealdenial letter “shall include a description ofother available loss mitigation, includingshort sales and deeds in lieu of foreclosure.”14
The NMS also restricts dual-tracking byprohibiting a servicer from referring a loan toforeclosure while a completed loan modifi-cation application is pending. A servicer must
obey time limits before foreclosing if the bor-rower, for example, filed an incomplete appli-cation, accepted a loan modification but failedto perform, appealed a loan modificationrequest that was denied, or submitted anapplication after the loan was referred forforeclosure.15
To improve communication between ser-vicers and homeowners, a servicer is requiredunder the NMS to establish an “easily acces-sible and reliable single point of contact(SPOC) for each potentially-eligible first lienmortgage borrower.”16 Servicers must also ini-tiate “outreach efforts to communicate lossmitigation options for first lien mortgageloans to all potentially eligible delinquentborrowers.”17 However, the use of “nothingmore than prerecorded automatic mes-sages…shall not be sufficient” if the mes-sages fail to result in contact between theborrower and the servicer.18
The nonmonetary provisions extend toimposing measures to deter community blightcaused by neglected real-estate-owned prop-erties; requiring regular quality assurancereviews of documents submitted in judicialand nonjudicial foreclosure proceedings toensure accuracy and compliance with applic-able law and the NMS; establishing over-sight and management of third-party pro-viders such as foreclosure firms, law firms,foreclosure trustees, and subservicers; address-ing second lien loan modifications, shortsales, and bankruptcy; and protecting militarypersonnel.
The NMS
The official NMS Web site states that from amonetary standpoint, the settlement is “thelargest consumer financial protection settle-ment in US history.”19 The settling servicersagreed to collectively dedicate $20 billion infinancial relief for borrowers. The agreementearmarks at least $10 billion to reducingprincipal balances for borrowers who owemore than the current value of their homes;at least $3 billion to a refinancing program forborrowers who are current on their mortgagesbut under water; and up to $7 billion forother forms of relief, including forbearance ofprincipal payments by unemployed borrow-ers, antiblight programs, short sales and tran-sitional assistance, and benefits for militaryservice members.20
Servicers agreed under the NMS to pay atotal of $5 billion to the federal governmentand various states, including California.21
Of this amount, approximately $1.5 billionwill be used to establish a Borrower PaymentFund to provide cash payments to borrowerswhose homes were foreclosed between andincluding January 1, 2008, and December31, 2011. Borrowers will have to file a claimonline or by mail by no later than January 18,
2013. They must show that they were notoffered loss mitigation or were otherwiseimproperly foreclosed on and that they meetother criteria.22
The NMS has significant enforcementprovisions. For example, it has created amonitor whose duty is to oversee the ser-vicers and ensure compliance with the consentjudgments.23 Each participating servicer mustfile regular reports with the monitor, detail-ing compliance. Based on these reports andindependent oversight, the monitor mustcommunicate its findings to the servicers, theU.S. District Court, and a monitoring com-mittee of state attorneys general and federalofficials. According to the monitor’s first sta-tus report, which covers March 1, 2012,through June 30, 2012, the settling servicersprovided nearly 140,000 homeowners witha total of $10.6 billion in relief.24 If a servicerfails to comply with the NMS, a party to theapplicable consent judgment or the moni-toring committee can file an enforcementaction and seek injunctive relief and/or civilpenalties.25
While the NMS contains broad provi-sions releasing each servicer from any claimbrought by any state attorney general orbanking regulator based on past misconductinvolving mortgage loan servicing, foreclosurepreparation, and mortgage loan originationservices, many other potential claims are notaddressed.26 Notably, the releases cover onlythe named servicers. They do not extend tothird parties that may have provided defaultor foreclosure services for the settling par-ties—for example, Mortgage Electronic Re-gistration Systems, Inc.27 In addition, secu-ritization claims are not addressed, includingany claims of state and local pension fundsrelated to the formation, marketing or offer-ing of mortgage-backed securities.28 Otherclaims that are not released include viola-tions of state fair lending laws, criminal lawenforcement, claims of state agencies havingindependent regulatory jurisdiction, claims ofcounty recorders for fees, and actions to quiettitle to foreclosed properties.29 The releasesalso do not preclude individuals or businessentities from pursuing their own claims.30
Lastly, the NMS contains a sunset provi-sion. The consent judgments and the servic-ing standards incorporated within them “shallretain full force and effect” for only three anda half years from the date of entry of thejudgments.31
California Homeowner’s Bill of Rights
Recognizing that the NMS applies to only fiveservicers and has a limited existence, Califor-nia became the first state to take the settle-ment’s servicing standards and other provi-sions and use them to create new statutoryprovisions. Between July and September 2012,
several bills were enacted that are collectivelycalled the HOBR.32 The HOBR explicitlystates that its provisions do not obviate orsupersede the obligations of the signatories tothe federal NMS.33 Beginning on January 1,2013, the HOBR provides that a mortgage ser-vicer,34 mortgagee, trustee, beneficiary, orauthorized agent “may not record a notice ofdefault” (NOD) under certain deeds of trust,which is a legal prerequisite to a nonjudicialforeclosure sale,35 until several new require-ments are met.36
For banks and other institutions that,during the immediately preceding annualreporting period, as established with theirprimary regulator, foreclosed on 175 or fewerCalifornia residential real properties, theHOBR prohibits a mortgage servicer, mort-gagee, trustee, beneficiary or authorized agentfrom recording a notice of default until twoprerequisites have been met.37 First, at least30 days must pass after either 1) the mortgageservicer made initial contact with the bor-rower, by telephone or in person, to “assessthe borrower’s financial situation and exploreoptions for the borrower to avoid foreclo-sure,” or 2) the servicer satisfied certain spec-ified due diligence requirements in attempt-ing to reach the borrower.38 This is similar tothose provisions of Civil Code Section 2923.5that were enacted in 2008 and had been setto expire on January 1, 2013. Second, if theborrower has submitted a “complete appli-cation”39 for a first mortgage loan modifica-tion, the mortgage servicer must issue a “writ-ten determination” regarding the borrower’seligibility for the loan modification that theborrower has requested.40
The HOBR defines a “borrower” as anynatural person who is a mortgagor or trustorand who is potentially eligible for any federal,state, or proprietary first lien loan modifica-tion or other available loss mitigation optionoffered by, or through, his or her mortgageservicer. However, some individuals are
excluded, such as those who have filed forbankruptcy.41 In addition, the provisions onlyapply to first lien mortgages or deeds of trustthat are secured by owner-occupied residen-tial real property containing no more thanfour dwelling units.42
For banks and other institutions who fore-closed on more than 175 residential realproperties in California during the immedi-ately preceding annual reporting period, addi-tional requirements must be met before aNOD can be recorded.43 In addition to meet-
ing the requirements imposed on those fore-closing on 175 or fewer residential proper-ties,44 a mortgage servicer with more than 175foreclosures must also provide each borrowerwith written information on the rights ofborrowers who serve in the military or are amilitary dependent.45 The mortgage servicermust also advise each borrower about his orher right to request information, including acopy of the promissory note, a copy of thedeed of trust, a copy of any assignment of thedeed of trust, and a copy of the borrower’spayment history since the borrower was lastless than 60 days past due.46 Dual-tracking isbanned for all mortgage servicers. Under theHOBR, mortgage servicers can no longerrecord a NOD while a borrower has an appli-cation pending for a loan modification.47
Instead, the mortgage servicer must first makea written determination that the borrower isineligible.48
For banks and other institutions thatexceed the threshold of 175 residential prop-erty foreclosures, the written notice denyingthe loan modification must identify the rea-sons for the denial and provide instructionson how to appeal the denial.49 The serviceris prohibited from recording a NOD until atleast 31 days have passed after the borrowerhas been notified in writing of the denial andno appeal has been received.50 If the bor-rower appeals the denial, the servicer is pro-hibited from recording a NOD until the later
of 15 days after the denial of the appeal or 14days after a first lien loan modification isoffered after appeal but declined by the bor-rower, or, if a first lien loan modification isoffered and accepted after appeal, the date onwhich the borrower fails to timely submitthe first payment or otherwise breaches theterms of the offer.51 The mortgage servicer isalso required to acknowledge receipt in writ-ing of any document related to a first lien loanmodification application.52 Once a NOD isrecorded, the mortgage servicer must pro-
vide the borrower with additional informa-tion in writing, including foreclosure pre-vention alternatives (unless the borrower haspreviously exhausted the loan modificationprocess).53
As with previous law, once the applicablerequirements have been met for recording aNOD, the NOD that is recorded must con-tain a declaration attesting to the servicer’scompliance with the requirements.54 Addres-sing the issue of robo-signing, the HOBRfurther states that the declaration must “beaccurate and complete and supported bycompetent and reliable evidence.”55 In addi-tion, the servicer must “ensure that it hasreviewed competent and reliable evidence tosubstantiate the borrower’s default and theright to foreclose, including the borrower’sloan status and loan information.”56 Anyservicer who “engages in multiple andrepeated uncorrected violations” of this pro-vision is liable for a civil penalty of up to$7,500 per mortgage or deed of trust in anaction brought by a governmental entity.57
The HOBR also directs mortgage ser-vicers who exceed the 175 residential prop-erty foreclosure threshold to have a SPOC.58
If a borrower requests a foreclosure preven-tion alternative, the servicer “shall promptlyestablish a single point of contact and provideto the borrower one or more direct means ofcommunication with the single point of con-tact.”59 This SPOC is defined as “an indi-
26 Los Angeles Lawyer January 2013
The California Attorney General’s office is authorizedto impanel a special statewide grand jury “to investi-gate, consider, or issue indictments in any matters in which there are two or more activities, in whichfraud or theft is a material element, that haveoccurred in more than one county and were conducted either by a single defendant or multipledefendants acting in concert.”
Los Angeles Lawyer January 2013 27
MCLE Test No. 221The Los Angeles County Bar Association certifies that this activity has been approved for MinimumContinuing Legal Education credit by the State Bar of California in the amount of 1 hour.
MCLE Answer Sheet #221RIGHTS IN FORECLOSURE
Name
Law Firm/Organization
Address
City
State/Zip
Phone
State Bar #
INSTRUCTIONS FOR OBTAINING MCLE CREDITS
1. Study the MCLE article in this issue.
2. Answer the test questions opposite by markingthe appropriate boxes below. Each questionhas only one answer. Photocopies of thisanswer sheet may be submitted; however, thisform should not be enlarged or reduced.
3. Mail the answer sheet and the $20 testing fee($25 for non-LACBA members) to:
Los Angeles LawyerMCLE TestP.O. Box 55020Los Angeles, CA 90055
Make checks payable to Los Angeles Lawyer.
4. Within six weeks, Los Angeles Lawyer willreturn your test with the correct answers, arationale for the correct answers, and acertificate verifying the MCLE credit you earnedthrough this self-assessment activity.
5. For future reference, please retain the MCLEtest materials returned to you.
ANSWERS
Mark your answers to the test by checking theappropriate boxes below. Each question has onlyone answer.
1. nn A nn B nn C nn D
2. nn A nn B nn C nn D
3. nn True nn False
4. nn True nn False
5. nn True nn False
6. nn A nn B nn C nn D
7. nn True nn False
8. nn True nn False
9. nn True nn False
10. nn True nn False
11. nn True nn False
12. nn True nn False
13. nn True nn False
14. nn True nn False
15. nn True nn False
16. nn A nn B nn C nn D
17. nn True nn False
18. nn True nn False
19. nn True nn False
20. nn A nn B nn C nn D
1. Which of the following was not a party to the NationalMortgage Settlement (NMS)?
A. Ally Financial, Inc.B. Oklahoma.C. Citibank, N.A.D. California.
2. “Robo-signing” is:A. Filing false affidavits in foreclosure proceedings.B. Addressed by the NMS.C. Addressed by the California Homeowners Bill ofRights (HBOR).D. All of the above.
3. “Dual-tracking” is a process in which a mortgage ser-vicer first reviews and considers a borrower’s loan mod-ification application before taking any steps to begin anonjudicial foreclosure.
True.False.
4. Under the terms of the NMS, when a first mortgage loanmodification is denied by a settling servicer after anindependent evaluation, the borrower does not haveany right to appeal the denial.
True.False.
5. The NMS requires the settling servicers to establish asingle point of contact for each potentially eligible first lienmortgage borrower.
True.False.
6. The terms of the NMS include funds allocated to:A. Reductions of principal balances for underwaterborrowers.B. Forbearance of principal payments byunemployed borrowers.C. Payments to the federal government and certainstates, including California.D. All of the above.
7. The NMS created a monitor whose duty is to overseethe servicers and ensure compliance with the consentjudgments.
True.False.
8. The deadline for a borrower whose home was fore-closed upon between and including January 1, 2008,and December 31, 2011, to file a claim seeking monetaryrelief under the NMS is January 18, 2014.
True.False.
9. The NMS terms require the settling servicers to com-ply with the servicing standards set forth therein untilDecember 31, 2020.
True.False.
10. The California HBOR states that its terms supersedethe terms of the NMS.
True.False.
11. Under the California HBOR, a “borrower” is any nat-ural person who is a mortgagor or trustor and who ispotentially eligible for any federal, state, or proprietaryfirst lien loan modification.
True.False.
12. Some requirements that the California HBOR imposeson a bank depend on the number of foreclosures con-ducted by a bank in all 50 states in the immediately pre-ceding annual reporting period as established by thebank’s primary regulator.
True.False.
13. Effective January 1, 2013, in California, if a borrowerhas submitted a “complete application” for a first mort-gage loan modification, the mortgage servicer must, ata minimum, issue a “written determination” regarding theborrower’s eligibility for the requested loan modifica-tion before recording a Notice of Default.
True.False.
14. Under the California HBOR, mortgage servicers thatforeclosed on 175 or fewer California residential realproperties in the immediately preceding annual report-ing period are not required to have a single point of con-tact for borrowers.
True.False.
15. In 2013, whenever a trustee’s sale in California is post-poned for a period of at least 10 business days pursuantto Civil Code Section 2924g, a mortgagee, beneficiary, orauthorized agent shall provide written notice to a borrowerregarding the new sale date and time within five businessdays.
True.False.
16. The California HBOR states that the following reme-dies are available for violation of certain of its terms,assuming certain conditions are satisfied:
A. Injunctive relief.B. Recovery of actual economic damages.C. Reasonable attorney’s fees and costs to aprevailing borrower.D. All of the above.
17. Under the California HBOR, a tenant or subtenantunder a month-to-month or periodic tenancy leasing arental property that is sold in foreclosure is entitled toreceive 60 days’ written notice to quit.
True.False.
18. If a tenant is in possession under a fixed-term resi-dential lease entered into before transfer of title at the fore-closure sale, the California HBOR states that the tenantshall have the right to possession until the end of the leaseterm.
True.False.
19. The California HBOR does not contain any law enforce-ment provisions.
True.False.
20. The Dodd-Frank Wall Street Reform and ConsumerProtection Act established the:
A. Settlement monitor for the NMS.B. Mortgage Fraud Investigation Department.C. Consumer Financial Protection Bureau.D. None of the above.
vidual or team of personnel each of whom hasthe ability and authority to perform theresponsibilities” required by law.60 Further,the servicer has to “ensure that each memberof the team is knowledgeable about the bor-rower’s situation and current status in thealternatives to foreclosure process.”61
In a departure from prior law, entities arebarred from recording or causing to berecorded a NOD, or otherwise initiating theforeclosure process, unless they hold “thebeneficial interest under the mortgage or deedof trust, or [are] the original trustee or the sub-stituted trustee under the deed of trust, or thedesignated agent of the holder of the benefi-cial interest.”62 Further, for trustee’s sales, arequirement is added that whenever a trustee’ssale is postponed for a period of at least 10business days pursuant to Civil Code Section2924g, a mortgagee, beneficiary, or authorizedagent shall provide written notice to the bor-rower within five business days of the post-ponement.63
In addition to civil penalties that a gov-ernmental entity may pursue for violatingthe provisions governing declarations inNODs, the HOBR also contains other sig-nificant enforcement mechanisms. If a trustee’sdeed upon sale has not yet been recorded, aborrower is entitled to bring an action forinjunctive relief to enjoin material violationsof certain aspects of the law.64 On the otherhand, if the trustee’s deed upon sale has beenrecorded, then the borrower can bring anaction for “actual economic damages” result-ing from the violation if it was not correctedor remedied before the trustee’s deed wasrecorded.65 If the court finds that the mater-ial violation was intentional, reckless, orresulted from willful misconduct, the courtmay award the borrower treble the actualdamages or statutory damages of $50,000.66
A prevailing borrower may also be awardedreasonable attorney’s fees and costs.67 Someof the provisions of the HOBR sunset onJanuary 1, 2018, but at that time, other, sim-ilar provisions become effective.
Evictions, Law Enforcement, and Blight
The HOBR also includes several other newCalifornia laws. One addresses evictions ofresidential tenants in possession of foreclosedresidential properties. A tenant or subtenantunder a month-to-month or periodic tenancyleasing a rental property that is sold in fore-closure is entitled to receive 90 days’ writtennotice to quit, rather than the 60 days’ noticeprovided under prior law.68 Tenants in pos-session under a fixed-term residential leaseentered into before transfer of title at theforeclosure sale “shall have the right to pos-session until the end of the lease term, and allrights and obligations under the lease shallsurvive foreclosure.…”69 The foregoing does
not apply if, for example, the purchaser willoccupy the house as a primary residence, thefixed-term lease was entered into with themortgagor or a parent, child, or spouse of themortgagor, or the fixed-term lease was not theresult of an arms-length transaction.70
Various law enforcement provisionsapplicable to mortgage and foreclosure-relatedcrimes are enhanced. The California AttorneyGeneral’s office is authorized to impanel a spe-cial statewide grand jury “to investigate, con-sider, or issue indictments in any matters inwhich there are two or more activities, inwhich fraud or theft is a material element, thathave occurred in more than one county andwere conducted either by a single defendantor multiple defendants acting in concert.”71
This would include the ability to investigateand indict perpetrators of financial crimesinvolving victims in multiple counties. Thetime for prosecuting some misdemeanorsrelating to, for example, engaging in unlaw-ful loan modification activities or providingmortgage loan originator services without alicense, is extended. Specifically, prosecutionof such violations must be commenced within“three years after discovery of the commissionof the offense, or within three years aftercompletion of the offense, whichever islater.”72
Finally, the HOBR makes permanent somelaws relating to real property blight, includ-ing Civil Code Section 2929.3. This statuterequires a legal owner to maintain vacantresidential property purchased by that ownerat a foreclosure sale, or acquired by thatowner through foreclosure under a mortgageor deed of trust, or else face governmentalpenalties.73 However, new homeowners aregiven additional time in which to abate anyviolation for a residential property foreclosedon or after January 1, 2008, and before anenforcement agency could take action.74
New Dodd-Frank Regulations
At the federal level, the Dodd-Frank Act,enacted in 2010 in response to the financialcrisis, established the Consumer FinancialProtection Bureau (CFPB). The CFPB wasdirected to “regulate the offering and provi-sion of consumer financial products or servicesunder the Federal consumer financial laws.”75
Following execution of the NMS, theCFPB issued two Notices of Proposed Rule-making, including draft regulations, that aresimilar to some NMS provisions. One pro-posed regulation would impose requirementsrelating to early intervention with delinquentborrowers and obligate servicers, amongother things, to make a good faith effort tonotify borrowers of loss mitigation options.76
In addition, this draft regulation wouldrequire “continuity of contact” with delin-quent borrowers and regulate the loss miti-
gation procedures applicable to servicers thatoffer such options to borrowers. The otherproposed regulation would impose certainduties on servicers that make loss mitigationoptions available to borrowers in the ordinarycourse of business related to evaluation of bor-rower applications for these options.77 As ofNovember 2012, the draft rules were stillout for public comment, and it was unknownwhen the CFPB would promulgate final rules,if at all. If any rules are adopted, one issuelikely to arise is whether they would pre-empt state statutes like the HOBR.
Regardless of whether a mortgage ser-vicer is a party to the NMS, the provisionsnegotiated by the five major servicers in thatsettlement are likely here to stay in the formof new state laws and proposed federal reg-ulations affecting California foreclosures.The practical effect of the new provisions isyet to be seen, but undoubtedly borrowersand the residential mortgage industry shouldanticipate significant changes in the way thatthey interact and how their business rela-tionships are structured. n
1 Press Release, CoreLogic Reports 57,000 CompletedForeclosures in September (Oct. 31, 2012), availableat http://finance.yahoo.com/news/corelogic-reports-57-000-completed-123000769.html.2 See generally http://oag.ca.gov/hobr.3 David Streitfeld, JPMorgan Suspending Foreclosures, N.Y.TIMES, Sept. 29, 2010, available at http://www.nytimes.com/2010/09/30/business/30mortgage.html?_r=0.4 See Complaint, United States v. Bank of America, No.12-0361(D.C. Dist., Mar. 14, 2012) (on file withauthors).5 See Executive Summary of MultiState/FederalSettlement of Foreclosure Misconduct Claims [here-inafter Executive Summary], available at http://por-tal.hud.gov/hudportal/documents/huddoc?id=natlse-texecsum(2).pdf.6 Id.7 Complaint, Bank of America, No. 12-0361 at ¶64(h).8 See Ally Consent Judgment, exh. A, at §I.A.1, avail-able at http://www.justice.gov/opa/documents/resi-dential-con-sent-judgement.pdf. (Servicers must ensurethat factual assertions in pleadings, declarations, affi-davits, and sworn statements in judicial foreclosures,“and notices of default [and] notices of sale…submit-ted…in non-judicial foreclosures,” are “accurate.”).9 Id. at §§I.A.18, I.B.10, IV.B.13.10 Id. at §IV.A.1.11 Id. at §IV.G.1.12 Id. at §IV.G.2.13 Id. at §IV.G.3.14 Id. at §IV.G.3.d.15 Id. at §IV.B.16 Id. at §IV.C.1.17 Id. at §IV.D.1.18 Id. 19 See http://www.nationalmortgagesettlement.com/about.20 See, e.g., National Mortgage Settlement Fact Sheet:Mortgage Servicing Settlement, available at http://www.nationalmortgagesettlement.com.21 Id.22 See Executive Summary, supra note 5.23 See https://www.mortgageoversight.com.24 Jim Puzzanghera, Banks Have Given $10.6 Billionin Relief in National Settlement, L.A. TIMES, Aug. 29,
28 Los Angeles Lawyer January 2013
2012, available at http://articles.latimes.com/2012/aug/29/business/la-fi-mo-mortgage-settlement-fore-closure-bank-of-america-20120829.25 See, e.g., Ally Consent Judgment, exh. E, at §J.3,available at http://www.justice.gov/opa/documents/residential-consent-judgement.pdf. 26 See, e.g., id., exhs. F, G, H. See also ExecutiveSummary, supra note 5, at 4.27 Id. Mortgage Electronic Registration Systems, Inc.,known as MERS, is a private corporation that admin-isters a national registry of real estate debt interesttransactions. See Fontenot v. Wells Fargo Bank, NA,198 Cal. App. 4th 256, 267 (2011).28 Ally Consent Judgment, exhs. F, G, H.29 Id.30 Id.31 See, e.g., Ally Consent Judgment, exh. E, at §K.32 The California HOBR includes AB 278 and SB 900(servicing and foreclosure requirements), AB 2314(blight and crime prevention), AB 2610 (protections fortenants in foreclosed properties), AB 1950 (fraudissues), and SB 1474 (multijurisdictional fraud andcrimes).33 CIV. CODE §2923.4(b). See also CIV. CODE
§2924.12(g).34 See CIV. CODE §2920.5(a) (definition of “mortgageservicer”).35 CIV. CODE §2924(a)(1).36 CIV. CODE §§2923.5(a), 2923.55(a).37 CIV. CODE §§2923.5, 2924.18(b).38 CIV. CODE §2923.5.39 See CIV. CODE §2924.18(d).40 CIV. CODE §§2923.5(a)(1)(B), 2924.18(a)(1).41 CIV. CODE §2920.5(c).42 CIV. CODE §§2924.15, 2924.18(f).43 CIV. CODE §§2923.55(g), 2923.6(i).44 CIV. CODE §2923.55(a)(2).45 CIV. CODE §2923.55(b).46 Id.47 CIV. CODE §§2923.6(c), 2924.18(a)(1).48 Id.49 CIV. CODE §2923.6(f).50 CIV. CODE §2923.6(e)(1).51 CIV. CODE §2923.6(e)(2).52 CIV. CODE §2924.10.53 CIV. CODE §2924.9.54 CIV. CODE §2924.17(a).55 Id.56 CIV. CODE §2924.17(b).57 CIV. CODE §2924.17(c).58 CIV. CODE §2923.7(g).59 CIV. CODE §2923.7(a).60 CIV. CODE §2923.7(e).61 Id.62 CIV. CODE §2924(a)(6). Previously, CIV. CODE §2924stated that the “trustee, mortgagee or beneficiary, orany of their authorized agents” shall file a NOD.63 CIV. CODE §2924(a)(5).64 CIV. CODE §§2924.12(a)(1), 2924.19(a)(1).65 CIV. CODE §§2924.12(b)-(c), 2924.19(b)-(c).66 CIV. CODE §§2924.12(b), 2924.19(b).67 CIV. CODE §§2924.12(i), 2924.19(h).68 CIV. CODE §2924.8; CODE CIV. PROC. §1161b.69 CODE CIV. PROC. §415.461(b)70 Id.71 PENAL CODE §923(c).72 PENAL CODE §802(e).73 CIV. CODE §2929.3.74 HEALTH & SAFETY CODE §17980.75 12 U.S.C. §5491(a).76 Proposed C.F.R. §1024.40, available at http://www.gpo.gov/fdsys/pkg/FR-2012-09-17/html/2012-19974.htm.77 Proposed C.F.R. §1024.41, available at http://www.gpo.gov/fdsys/pkg/FR-2012-09-17/html/2012-19974.htm.
Los Angeles Lawyer January 2013 29
30 Los Angeles Lawyer January 2013
KEN
CO
RRA
L
A recent Second District opinion, Silk v.Feldman,1 reaffirmed that a homeowners asso-ciation (HOA) is a quasi-governmental entity.The holding essentially reiterates an earlierFourth District opinion holding that associa-
tion board meetings and the publications of HOA boardsinvolve public issues to which anti-SLAPP statutes apply.2
For attorneys representing or suing HOAs, the classifica-tion of a private HOA as a quasi-governmental entity(rather than, for example, a business entity) may supportclaims or defenses that, while arguably warranted underexisting law, could also substantiate arguments for exten-sions or modifications of existing law.
In Silk, the plaintiff, a homeowner within a commoninterest development, sued the defendant, a homeownerand member of the association’s board of directors, fordefamation and libel. These causes of action were premisedupon a letter that the defendant wrote to the associationmembers in which he accused the plaintiff of cutting“secret deals” and “feather[ing] [her] own nest.” The
defendant moved to dismiss the complaint under the anti-SLAPP statute, asserting that his publication was pro-tected under Code of Civil Procedure Section 425.16(e) asa statement made in connection with an issue under con-sideration by a judicial body, as a statement made in a pub-lic forum in connection with an issue of public interest, andas “other conduct in furtherance of the right of freespeech.” The trial court denied the defendant’s motion,finding that the alleged defamation was not an exercise ofthe right of petition or free speech.
The Second District affirmed the trial court’s denial ofthe defendant’s anti-SLAPP motion, but not on the groundthat the alleged defamation or libel was not an exercise ofthe right of petition or free speech. Instead, the appellatecourt held that the plaintiff carried her burden of show-ing a probability of prevailing in the action (the second
Courts have consistently ruled that HOAs are legally similar to municipal governments, but questions remainabout how close that similarity is
by BRIAN T. GR AVDAL
Brian T. Gravdal is an attorney with the law firm of Berman,Berman & Berman LLP who practices common interest devel-opment and homeowners association litigation.
GOVERNINGBOARDS
Los Angeles Lawyer January 2013 31
prong of the two-part anti-SLAPP analysis).The Silk court opined:
Courts have recognized a homeownersassociation functions as a quasi-gov-ernmental entity, paralleling the pow-ers and duties of a municipal govern-ment. Thus a newsletter circulated bysome members of a homeowners asso-ciation [has been] deemed a “publicforum” within the meaning of section425.16(e)(3).…It requires no leap oflogic to conclude that statements madein a letter critical of the actions of ahomeowners association director mayalso qualify as free speech.…Certainly,if an official of a city governmentengaged in the conflict of interestalleged in [the defendant’s] letter, itwould be a matter of public interest.3
As early as 1976, legal commentators rec-ognized the quasi-governmental nature ofthe HOA and its regulatory powers. As thecourt in Cohen v. Kite Hill Community Assoc-iation observed, as a “mini-government,” anHOA “provides to its members, in almostevery case, utility services, road maintenance,street and common area lighting, and refuseremoval. In many cases, it also provides secu-rity services and various forms of communi-cation within the community.” Moreover,the HOA’s functions are “financed throughassessments or taxes levied upon the membersof the community, with powers vested in theboard of directors…or other similar bodyanalogous to the governing body of a munic-ipality.”4
In an extrapolation of this theory, in Dam-on v. Ocean Hills Journalism Club, the FourthDistrict held that the board meeting of anHOA is a “public forum” and a publicationof the association (such as a newsletter) is alsoa public forum for purposes of the anti-SLAPP statute.5 Noting that board meetingsof an association fit within the traditionaldefinition of a “public forum,” the FourthDistrict opined that the meetings were opento the public, provided a place where mem-bers could communicate ideas, and “serveda function similar to that of a governmentbody.”6 Equating the association to a munic-ipal government, the court continued, “Inexchange for the benefits of common own-ership, the residents elect an legislative/exec-utive board and delegate powers to this board.This delegation concerns not only activitiesconducted in the common areas, but alsoextends to life within ‘the confines of thehome itself.’”7 Also important to the Damoncourt was the fact that the legislature hasmandated that association boards hold openmeetings and allow members to speak pub-licly there.8 These provisions “parallelCalifornia’s open meeting laws regulatinggovernmental officials, agencies and boards.”9
The Fourth District also concluded thatthe association’s newsletter was a publicforum and a “vehicle for communicating amessage about public matters to a large andinterested community.”10 Damon also holdsthat although the alleged defamatory state-ments “were made in connection with themanagement of a private homeowners asso-ciation, they concerned issues of criticalimportance to a large segment of our local
population.”11 In this way, HOAs are dif-ferent from, for example, the governing bodyof a not-for-profit corporation, which hasnot been considered a quasi-governmentalentity.12 In further contrast, it has also beenheld that private disputes between a smallnumber of employees and a large, well-knownemployer do not involve a public issue orissue of public interest.13
In Damon, the size of the planned com-munity was 3,000 residents, while in Silk, theassociation comprised a 136-unit residentialdevelopment. It is not clear if the size of adevelopment could have been one of the keyfactors in these decisions. Are the affairs ofan HOA public issues, no matter how smallthe HOA? Possibly, but in another FourthDistrict case, Cabrera v. Alam, the court rea-soned that while the association at issue was“smaller than the homeowners associationdiscussed in Damon” and possibly “techno-
logically less sophisticated,” nevertheless,“the impact the association and its leadershiphad on all the residents…was not any less sig-nificant.”14
State and Federal Court Conflict
In California, the question of whether it isappropriate to call an HOA a quasi-govern-mental entity appears to be adequatelyanswered in Damon and Silk. At least one fed-
eral court, however, disagrees.15 According toSui v. Southside Towing, “California caseshave not been uniform in characterizing ortreating homeowners’ associations as ‘quasi-governmental.’”16 The Sui court found sig-nificant the California Supreme Court’s hold-ing that “a nonprofit California homeowners’association [is] a ‘business establishment’ forpurposes of California’s Unruh Civil RightsAct, which prohibits discrimination by ‘busi-ness establishments of every kind whatso-ever.’”17 The California Supreme Court fur-ther held that an HOA “performs all thecustomary business functions which in the tra-ditional landlord-tenant relationship rest onthe landlords’ shoulders.”18
Curiously, many of the same attributesthat led other courts to conclude that anHOA is quasi governmental led the Sui courtand the California Supreme Court to holdotherwise. As the Sui court noted, the func-
32 Los Angeles Lawyer January 2013
tions of an HOA included “employing a pro-fessional property management firm, obtain-ing insurance for the benefit of all owners,maintaining and repairing common areas,establishing and collecting assessments fromall owners to pay for its undertakings, andadopting and enforcing rules and regula-tions.”19 To buttress its holding, the Sui court,citing “persuasive authority” of the NinthCircuit, concluded that none of the Californiacases cited by the Sui plaintiffs “holds orimplies that a California homeowners’ asso-ciation effectively exhibits ‘all of the attrib-utes of a state-created municipality and theexercise by [the homeowners’ association]of semi-official municipal functions as a del-egate of the State,’ such that the homeown-ers’ association ‘was performing the full spec-trum of municipal powers and stood in theshoes of the State.’”20 As one can see, the dis-tinction between the Silk-Damon analysisand the one employed by the Central Districtand Supreme Court is nebulous.
Potential Legal Implications
Despite the apparent and recent conflictbetween California state courts’ willingnessand the Central District’s hesitancy to endorsethe quasi-governmental nature of home-owners associations, the concept does raiseinteresting questions. To what end can thisclassification be extended, or has that endalready been reached? Damon and Silk cer-tainly support the application of “publicfora” and “public issue” principles to certainactivities of a homeowners association in thecontext of a defamation action, thereby sub-stantiating a special motion to strike underanti-SLAPP law. More broadly speaking,however, the rationale of the Damon andSilk holdings can conceivably be used to sup-port other claims and defenses.
For example, an argument could be madethat any decision of the board of directorswith respect to the amendment, interpretation,or enforcement of governing documents, orto decisions related to the assessment of finesand penalties for violations of the CC&Rs, areimmune from civil liability, regardless of theform of the cause of action. In essence, theboard of directors, in interpreting and enforc-ing the provisions of its governing docu-ments, acts similarly to a local legislature,administrative agency, or judicial body. Ac-cordingly, one may argue that Civil CodeSection 47, which establishes civil immunityfor communications made in the proper dis-charge of an official duty, or in any “legisla-tive proceeding, judicial proceeding, [or] inany other official proceeding authorized bylaw,” applies to HOAs.
In the same vein, decisions made by anHOA’s board of directors in an official pro-ceeding are authorized by Civil Code Sections
1350 et seq., which grant broad powers andduties to an association governing a com-mon interest development. Courts havealready held that the litigation privilegeattaches to the publication of a prelitigationassessment lien,21 and one court has sug-gested that certain actions authorized byCC&Rs are part of “the law” for purposesof the litigation privilege.22
It has long been the rule that the board ofdirectors of an HOA owes a fiduciary duty tothe members of the association. It has alsobeen suggested that in addition to thoseduties, an HOA should also be held to therequirements of “due process, equal protec-tion, and fair dealing.”23 This raises the ques-tion of whether a private HOA can be con-sidered a state actor for purposes of a civilrights action under the Fourteenth Amend-ment or 42 USC Section 1983. Little author-ity on the subject exists in California.24 In Sui,the court rejected the plaintiffs’ argumentthat a private resort owners’ association per-formed “the traditional and exclusive publicfunction of a municipal governance.”25 “Theplaintiffs…failed to show that [the associa-tion] had assumed all of the attributes of astate-created municipality and exercise semi-official municipal functions as a delegate ofthe State.”26 This argument, however, isundermined by the fact that HOAs performmany of the functions of municipal govern-ments. Accordingly, the question of whetheran HOA can be a state actor may still beconsidered unresolved.
Governmental Sovereign Immunity
Perhaps the furthest, but not implausible,extension of the argument that HOAs arequasi governmental is that HOAs shouldenjoy the immunities of a public entity underGovernment Code Sections 815 et seq. Com-munity associations are already protectedfrom liability by judicial deference (theLamden rule).27 Public-entity immunity is anatural extension of this concept, particu-larly when coupled with the quasi-govern-mental nature espoused in Damon and Silk.
Relevant to the determination of whethera private association is entitled to qualifiedimmunity as a quasi-governmental entity arethe association’s activities and its relationshipto government. In cases in which courts haverecognized a private entity’s claim of immu-nity, the entity had performed quasi-govern-mental functions pursuant to a governmen-tal grant of authority. According to Silk andDamon, the board of directors of an HOAperforms public, quasi-governmental func-tions. HOAs are granted statutory powers,duties, and responsibilities by Civil CodeSections 1350 et seq. and by judicial enforce-ment of CC&Rs. If many Californians con-sider their HOAs a “second municipal gov-
ernment, regulating many aspects of theirdaily lives,”28 and if HOAs have heightenedduties paralleling those of municipal gov-ernment entities, should HOAs not also enjoythe same immunities?
As this area of law continues to develop,these and other questions will likely be pre-sented to the courts and the legislature. Thesequestions call for analysis, and novel claimsor defenses should be considered by counselwho defend or prosecute HOAs. n
1 Silk v. Feldman, 208 Cal. App. 4th 547 (Aug. 14,2012).2 Damon v. Ocean Hills Journalism Club, et al., 85 Cal.App. 4th 468 (2000); See also CODE CIV. PROC.§425.16.3 Silk, 208 Cal. App. 4th at 553-54.4 Cohen v. Kite Hill Cmty. Ass’n, 142 Cal. App. 3d 642,651 (1983) (citing Wayne S. Hyatt & James B. Rhoads,Concepts of Liability in the Development and Ad-ministration of Condominium and Home Owners Ass-ociations, 12 WAKE FOREST L. REV. 915, 918 (1976).5 Damon, 85 Cal. App. 4th at 475-46.6 Id. at 475.7 Id. (quoting Nahrstedt v. Lakeside Vill. CondominiumAss’n, 8 Cal. 4th 361, 373 (1994)). 8 See CIV. CODE §§1363.05, 1363, 1350-76.9 Damon, 85 Cal. App. 4th at 475.10 Id. at 476.11 Id. at 479; see also Chantiles v. Lake Forest II MasterHomeowners Ass’n, 37 Cal. App. 4th 914, 922 (1995)(“For many Californians, the homeowners associa-tion functions as a second municipal government, reg-ulating many aspects of their daily lives.”).12 Donovan v. Dan Murphy Found., 204 Cal. App. 4th1500, 1507, n.3 (2012).13 Id. at 1509 (citing Rivero v. American Fed’n ofState, County and Mun. Employees, AFL-CIO, 105 Cal.App. 4th 913, 919, 926 (2003)).14 Cabrera v. Alam, 197 Cal. App. 4th 1077, 1088(2011) (The association’s annual meeting and elec-tion of board of directors constituted a public forumwithin the meaning of §425.16(e)(3).).15 Sui v. Southside Towing, 2012 U.S. Dist. LEXIS91522 (C.D. Cal. June 5, 2012).16 Sui, 2012 U.S. Dist. LEXIS 91522, at *15.17 Id. (citing O’Connor v. Village Green Owners Ass’n,33 Cal. 3d 790, 796 (1983)).18 O’Connor, 33 Cal. 3d at 796.19 Sui, 2012 U.S. Dist. LEXIS 91522, at *15-16 (citingO’Connor, 33 Cal. 3d at 796).20 Id. at *16-17 (emphasis in original) (citing Hudgensv. NLRB, 424 U.S. 507, 519 (1976)).21 See, e.g., Wilton v. Mountain Wood HomeownersAss’n., 18 Cal. App. 4th 565, 570 (1993). 22 California Riviera Homeowners Ass’n v. SuperiorCourt, 48 Cal. App. 4th 1886, 1892 (1996).23 Cohen v. Kite Hill Community Ass’n, 142 Cal. App.3d 642, 651 (1983) (“The…governmental aspects ofthe association…give rise to a special sense of respon-sibility upon the officers and directors.”).24 Sui, 2012 U.S. Dist. LEXIS 91522, at *13.25 Id. at *12 (citing Snowdon v. Preferred RV ResortOwners Ass’n, 379 Fed. Appx 636, 637 (9th Cir.2010).26 Snowdon, 379 Fed. Appx. at 637 (internal citationsand quotations omitted).27 Lamden v. La Jolla Shores ClubdominiumHomeowners Ass’n, 21 Cal. 4th 249 (1999) (Under theLamden rule, a court should defer to the decisions ofan HOA board when it acts in good faith.).28 Chantiles v. Lake Forest II Master HomeownersAss’n, 37 Cal. App. 4th 914, 922 (1995).
Los Angeles Lawyer January 2013 33
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36 Los Angeles Lawyer January 2013
THE SUMMER OF 2012 brought to California not only several munic-ipal bankruptcies but also the highly publicized formation of a JointPowers Authority (JPA) by San Bernardino County and some of itsmunicipalities. The JPA was created to seize and restructure certainmortgages to assist homeowners who were under water (that is,their homes were worth less than their mortgage debt).
With the stated purpose of stimulating San Bernardino’s economy,the Homeownership Protection Program JPA was promoted by aNorthern California venture capital firm. Under the program, localgovernments would take title to the mortgages (but not the realproperties) and pay the mortgage holders “fairmarket value” with money provided by insti-tutional investors. The government andinvestors would then issue new mortgages tothe homeowners, setting the loan amountslightly below the fair market value of thehome, which would enable distressed home-owners to acquire equity and reduce theirmonthly payments. The restructured mort-gages would then be sold to third-partyinvestors (déjà vu), with the government recov-ering administrative costs and the venture cap-ital firm earning a fee on each transaction.
Underwater mortgages are a significant byproduct of the 2008 stockmarket crash, in which packagers of mortgage tranches were amongthe principal bad guys. Since 2008, approximately $7 trillion inhousehold home equity wealth has been lost, and nearly 23 percentof the 52.5 million mortgaged homes in the United States are underwater. Moreover, 14,000 homes in San Bernardino County are eitheralready foreclosed or on the brink of foreclosure. Underwater home-owners who live in the shadow of debt overload do not spend. Thisdrains consumer demand from the economy, worsening unemployment.
In this context it is hardly surprising that San Bernardino Countyis considering a mortgage condemnation program. Among its sellingpoints: 1) only performing loans are included, 2) it is privatelyfunded, requiring no new taxes or funding from public entities, and3) it targets loans ensnared in private securitization trusts. The planhas the blessing of Robert Schiller, one of the economists who cre-ated the Case-Schiller Index.
Although questions have been raised as to the federal constitu-tionality of the JPA program, the 1984 US Supreme Court’s decisionin Hawaii Housing Authority v. Midkiff—allowing the state ofHawaii to condemn properties for the purpose of selling them to indi-viduals who owned housing on them—would appear to authorize thetakings contemplated under the program proposed for San Bernardino.Less sanguine, however, is the analysis under state constitutionaland statutory law, especially after Kelo v. City of New London, thedecision that led to a backlash against takings. Proposition 99 andthe 1982 holding of the California Supreme Court in City of Oaklandv. Oakland Raiders serve as examples of the legal hurdles that the JPA
plan faces. Furthermore, because the mortgages targeted by the pro-gram are likely held by securitization trusts located outside theenforcing public entity, Code of Civil Procedure Section 1240.050would appear to preclude the JPA program, however well inten-tioned it may be.
Practical concerns have also been raised. Reliance on juries to limitcompensation to fair market value in an eminent domain action isproblematic at best. The impact on the housing markets affected bylegislation implementing the program could lead to higher interestrates or a cessation of local real estate lending. If any of the mort-
gages taken are the product of a refinance instead of a purchase-moneyloan, the lender would have recourse against the buyer for shortagesarising out in an eminent domain action. Almost all loan docu-ments require the borrower to defend the lender in any eminentdomain action, typically with the counsel of lender’s choosing. Thiswould result in a homeowner being financially devastated by the oblig-ation to pay the lender’s attorney’s fees. Moreover, the proposed pro-gram could be viewed as a forced write-downs of loans, whichcould drain some bank reserves, providing banks with a reason torefuse to make loans.
On the other hand, the public purpose in the proposed JPA pro-gram is the establishment of incentives for homeowners to remainin their houses while their loans are reconfigured. The specter of aban-doned or vacant foreclosed houses, with the attendant adverseimpacts on neighborhood property values, is grim. The fundamen-tal question is, given 1) the limited resources of the government, 2)the likelihood that constitutional and other challenges to the programwill be raised, and 3) the adverse effect on lender reserves, is the JPAprogram worth the risk? Although the JPA program presumes to berevenue neutral, the public sector is relying on the good faith per-formance of one of the primary bad actors of the 2008 residentialproperty meltdown. In this context, it is better to allow regulated mar-ket forces to correct the previous excesses, even if the short-termeffects are severe. n
closing argument BY BRUCE TEPPER
Examining San Bernardino's Mortgage Condemnation Program
The government and investors would then issue new mortgages
to the homeowners, setting the loan amount slightly below
the fair market value of the home and reducing monthly payments.
Bruce Tepper is a Century City lawyer who specializes in land use, environ-mental, and water litigation and appeals. He represents private and publicsector clients statewide.
