As foreclosures have become increasingly common, the interest of buyers in purchasing foreclosure properties has grown. Most buyers are willing to purchase such properties only after foreclosure sales² have occurred, as, by then, most of the risk has been eliminated: the foreclosing lenders have acquired clear title³ and potential buyers can gain access to the properties and conduct inspections. However, the prices paid for such properties reflect their relative safety and their broad market exposure.

Buyers also can purchase foreclosure properties by bidding at foreclosure sales. However, since bidders cannot get access to houses, much less conduct inspections, before the sale, and since such properties are at risk of being trashed when the owners or tenants have been evicted after a foreclosure sale, these purchases involve significant risk. Furthermore, bidding wars can erupt at foreclosure sales, often resulting in the winners paying inflated prices rather than buying on the cheap.

Increasingly, therefore, buyers seek to purchase properties ("pre-foreclosure properties") after the foreclosure process has commenced but before the foreclosure sale has occurred (the "pre-foreclosure period"). Not only can buyers conduct inspections, they can negotiate "short sales" with the current lenders. California's recent extension of the pre-foreclosure period by 90 days⁴ can only heighten interest in pre-foreclosure sales.

The big problem is that most purchases of pre-foreclosure properties are governed by the Home Equity Sales Contract Act (the "Act")⁵, little known California legislation which can create major headaches for buyers.

The Home Equity Sales Contract Act

The purpose of the Act is to protect the owners of pre-foreclosure properties from predatory purchasers⁶. However, its scope is not limited to purchases by unscrupulous buyers⁷ and there are heavy penalties for even inadvertent violations of its provisions. Furthermore, the Act is convoluted, its requirements are difficult, in certain circumstances, to comply with and it ignores the realities of the current market.

The Act does several separate things, each of which will be discussed separately:

1. It defines the types of covered transactions;
2. For those transactions, it gives sellers a right to cancel their contracts for a designated period (the "cancellation period");
3. It proscribes certain conduct during the cancellation period;
4. It mandates that the contract between the parties contain certain provisions and meet certain formal requirements;
5. It forbids the purchaser from taking "unconscionable advantage" of the seller; and
6. It provides remedies to the seller and sanctions against the purchaser for violations of its provisions.

Application and Exemptions

The Act applies only to a "residence in foreclosure," that is, as an owner occupied one-four unit residential property against which a notice of default has been recorded and remains outstanding⁸. The seller of a "residence in foreclosure"⁹ is defined as an "equity seller."¹⁰

Even if a property qualifies as a residence in foreclosure and the seller as an equity seller, the Act does not apply unless the purchaser is an "equity purchaser," defined as a person acquiring title to a residence in foreclosure unless s/he (1) intends to use the property as a personal residence; (2) is acquiring the property at a trustees sale or by a deed in lieu of foreclosure; (3) is acquiring the property by a sale authorized by statute or by court order;¹¹ or (4) is the spouse or a blood relative of the equity seller.¹²

Put another way, all purchases of non-residential property, non-owner-occupied residential property and residential property containing more than four units are exempt from the Act.¹³ Similarly, purchases of properties in which the buyers intend to reside are free from compliance with its requirements.¹⁴

The Cancellation Right

The centerpiece of the Act is its requirement that the equity seller have an absolute right to cancel the contract (the "cancellation right") for any reason during the period ending (1) at midnight of the fifth business day after the seller signs a contract which complies with the Act; or (2) at 8 a.m., on the morning of the foreclosure sale, whichever comes first (the "cancellation period").¹⁵ This cancellation right is in addition to any right of rescission that the equity seller may otherwise have.¹⁶

During the cancellation period, certain restrictions (the "cancellation period restrictions") are placed on the equity purchaser: s/he may not take title to the property, transfer any interest in the property, encumber the property, record any document signed by the equity seller or pay any consideration to the equity seller.¹⁷ The cancellation period restrictions are straightforward with one exception: The equity purchaser must take care to make the initial deposit with the escrow holder and to give clear instructions that under no circumstances may the deposit be released to the equity seller until after the end of the cancellation period.

The Contract

Before title is transferred, the parties must sign a contract containing the entire agreement of the parties.¹⁸ To insure compliance with this requirement, any agreement between the parties which, under other circumstances, might be contained in a separate document (such as a leaseback agreement or an option to repurchase) must be included in the contract.

The Act requires that the contract be written in the language used by the parties to negotiate the sale,¹⁹ that it utilize certain minimum font sizes,²⁰ that certain provisions be in boldface lettering²¹ and that it contain certain specified provisions.²² In light of these requirements, buyers should utilize (or at least start with) form contracts specifically tailored to the purchase of pre-foreclosure property, such as those prepared by Professional Publishing²³ or by the California Association of Realtors.²⁴

However, even these forms require modification. For example, neither form provides for inclusion of a rental agreement in the contract, thereby violating the requirement that the contract include the terms of a written occupancy agreement.²⁵ To the contrary, each form refers to a separate rental agreement to be entered into by the parties.²⁶ Furthermore, neither form explicitly states that the deposit, like other consideration, may not be delivered to the equity seller during the cancellation period.²⁷ Finally, neither form includes a "notice to release," which, if not made part of the contract, may not be signed by the equity seller until after the end of the cancellation period.²⁸

One drawback particular to the Professional Publishing form is that the Notice of Cancellation, attached to the contract, merely provides for the "Buyer's Address" to be inserted, whereas the Act requires that the Notice of Cancellation set forth the street address of purchaser's place of business.²⁹

A similar shortcoming of the California Association of Realtors form is that under the signature block for the buyer, there is a space for the buyer's address but the form does not specify that the buyer's business address must be inserted.³⁰ In addition, on page 11, in the "Notice Required by California Law," the word, "cannot" is not in boldface, as the Act requires.³¹

Although these defects may seem inconsequential, they should not be ignored as the language of the Act appears to give remedies to equity sellers even for trivial defects in the contract.³²

Does the Equity Purchaser have a "Representative"?

An equity purchaser must determine whether s/he will be deemed to have a "representative" in the transaction, defined as, "a person who in any manner solicits, induces or causes any property owner to transfer title."³³ Clearly, a real estate agent engaged by the equity purchaser in a transaction will be deemed to be her representative. However, the term "representative" is far broader than one might expect, for if the equity purchaser is an entity, the principal of that entity is deemed to be its "representative."³⁴

This presents a trap for the unwary as the representative must provide to the equity seller, prior to transfer of the property, written proof and a written statement that the representative has a current valid California Real Estate Sales License.³⁵ If the agent-representative fails to do so, that failure, in itself, provides grounds for the equity seller to rescind the transaction.³⁶

Therefore, an unlicensed individual negotiating the purchase of a pre-foreclosure property on behalf of a wholly owned entity may well find that the equity seller not only has the cancellation right discussed above but, in addition, has the right to rescind the transaction!

Short Sales

Since most pre-foreclosure property is "under water," (i.e., encumbered by a loan with a balance exceeding its fair market value) the property can only be sold if the lender is willing to agree to a "short sale," in which the lender accepts a reduced payoff of its loan. However, the Act, as enacted in 1979, is tone-deaf to this current economic reality and presents obstacles to the negotiation of short sales.³⁷

For example, the contract must include a notice that, during the cancellation period, the equity purchaser cannot ask the equity seller to sign a deed or any other document."³⁸ Since "any other document" may well be deemed to include a "notice to release," which is required by lenders in order to deal with third parties concerning the equity seller's loan, an equity purchaser wishing to negotiate a short sale with the lender during the cancellation period should incorporate the "notice to release" into the contract.

However, even if the contract includes a "notice to release," a significant problem lurks, for in a typical short sale negotiation, the buyer presents the contract to the lender, specifying the amount by which the loan is to be discounted. If the lender does not agree to the discount, the parties sign another contract specifying a smaller discount, frequently on the same day. The lender may reject several contracts within a few days before finally accepting one. The problem, in the pre-foreclosure sale context, is that each contract signed within five days of the prior contract may be deemed to fall afoul of the "any other document" provision.

Miscellaneous

The Act contains other dubious provisions, as well. For example, it provides that the equity purchaser may not take "unconscionable advantage" of the equity seller.³⁹ The effect of this provision is unclear as California courts already have the authority to refuse to enforce unconscionable contract provisions or entire contracts which are unconscionable.⁴⁰

The Act also discourages the inclusion in the contract of a repurchase option in favor of the equity seller. For one thing, inclusion of such a repurchase option creates a presumption that the transaction is actually a loan transaction.⁴¹ If a repurchase option is included, the contract should clearly and unequivocally state that the parties intend a sale and not a loan transaction. However, even this language may not be sufficient to overcome the presumption. A second issue is that if the equity seller is given a repurchase option, the equity purchaser may not encumber or transfer the property without the prior written consent of the equity seller.⁴²

Remedies and Sanctions

The Act provides harsh remedies and sanctions. First, the equity seller may obtain actual damages plus reasonable attorneys' fees.⁴³ Exemplary damages also may be awarded to the equity seller "if the court deems such an award proper."⁴⁴ In fact, exemplary damages in an amount not less than three times the equity seller's actual damages must be awarded if the equity purchaser has sold or encumbered the property during the cancellation period or has taken unconscionable advantage of the equity seller.⁴⁵

Even worse, the equity seller may rescind the transaction within two years of recordation of the deed and recover reasonable attorneys' fees if the court determines that the equity purchaser took unconscionable advantage of the equity seller.⁴⁶

Most drastic of all are the criminal sanctions imposed by the Act: an equity purchaser who engages in fraud or deceit or violates the cancellation period restrictions can be fined up to $25,000, imprisoned by up to one year or both!⁴⁷ Should the possibility of criminal sanctions seem far fetched, in a published appellate court case, the equity purchaser was convicted of violating the cancellation period provisions and his conviction was overturned on a mere technicality!⁴⁸

Conclusion

Anyone considering the purchase of pre-foreclosure property should be thoroughly familiar with the Act and be extremely cautious in following its requirements and prohibitions.

1. Richard A. Goodman is a partner in the Oakland, California, law firm of Goodman & Levine LLP. He is the author of Real Property Exchanges (California Continuing Education of the Bar 1982) as well as many articles on real estate and taxation, some of which are posted on his web page: www.the1031attorney.com. This article is Copyright © 2009. All rights reserved. [Back]

2. All references to "foreclosure sales" in this article are to trustees' sales, since such sales constitute the vast majority of foreclosure sales in California. Judicial foreclosure sales, which are subject to different rules, make up only a tiny fraction of foreclosure sales in California. [Back]

3. One exception to this rule is when the foreclosing lender holds a second or other subordinate deed of trust. In that case, the foreclosing lender acquires title subject to the senior lien or liens.[Back]

4. California Foreclosure Prevention Act (ABX2 7) was signed by Governor Schwarzenegger on February 20, 2009.[Back]

5. Civ. Code §§ 1695-1695.17. Related legislation regulating the conduct of "foreclosure consultants" (i.e., persons who, for a fee, assist homeowners in dealing with their foreclosure problems) is beyond the scope of this article. See Civ. Code § 2945 et seq. [Back]

6. See Civ. Code § 1695(a): "The Legislature finds and declares that homeowners whose residences are in foreclosure have been subjected to fraud, deception, and unfair dealing by home equity purchasers."[Back]

7. See Segura v. McBride, 5 Cal. App. 4th 1028, 1037.[Back]

8. Civ. Code § 1695.1(b). Presumably, the Act does not apply if a notice of default is recorded after a purchase agreement has been signed. However, it is unclear if the Act would apply should such a purchase agreement be amended after a notice of default has been recorded.[Back]

9. In this article, I use the term "pre-foreclosure property" interchangeably with "residence in foreclosure." [Back]

10. Civ. Code § 1695.1(c).[Back]

11. The approval by a bankruptcy court of a plan of reorganization which provided for the debtor's sale of her house, did not exempt the transaction from the Act. Spencer v. Marshall (2008) 168 Cal. App. 4th 783.[Back]

12. Civ. Code § 1695.1(a).[Back]

13. If a notice of default has been filed against a 1-4 unit residential property, and the purchaser wishes to utilize a standard purchase agreement, it is prudent to include in the contract a representation by the seller that the property is not owner occupied. [Back]

14. Note that this exemption may apply even though the equity purchaser never actually resides in the property![Back]

15. The courts have not yet ruled on a number of issues concerning the cancellation period, including whether an immaterial mistake in the contract extends the cancellation period; whether the cancellation right can be exercised after close of escrow; and whether an amendment to the contract triggers the start of a new cancellation period. [Back]

16. Civ. Code § 1695.4(a). Under California law, all sellers are entitled to rescind the sale for a number of reasons, including fraud in the inducement, material mistake and lack of capacity. In addition, the Act gives the equity seller the right of rescission under certain circumstances. Civ. Code § 1695.14. [Back]

17. Civ. Code § 1695.6(b). However, if the equity purchaser does sell or encumber the property during the cancellation period, a bona fide purchaser or encumbrancer for value is protected. [Back]

18. Civ. Code § 1695.2.[Back]

19. Civ. Code § 1695.2.[Back]

20. Civ. Code §§ 1695.2 and 1695.5.[Back]

21. Civ. Code §§ 1695.2 and 1695.5.[Back]

22. The required provisions are set forth in California Civil Code sections 1695.3 and 1695.5. [Back]

23. Form 101-EP.1 CAL, entitled Residential Purchase Agreement for Owner-occupied Property in Foreclosure by Non-Occupant Buyer.[Back]

24. Form NODPA-11, entitled Notice of Default Purchase Agreement.[Back]

25. Civ. Code § 1695.3(f).[Back]

26. Paragraph 11 in the Professional Publishing form and paragraph 3B in the California Association of Realtors form.[Back]

27. Civ. Code § 1695.6(a) (4).[Back]

28. See discussion of short sales, above.[Back]

29. Civ. Code § 1695.5(b).[Back]

30. Civ. Code § 1695.3(a).[Back]

31. Civ. Code § 1695.3(h).[Back]

32. See Remedies and Sanctions, above.[Back]

33. Civ. Code § 1695.15(b). [Back]

34. Schweitzer v. Westminster Investments (2007) 157 Cal. App. 4th 1195.[Back]

35. Civ. Code § 1695.17(a). A requirement contained in this subsection that an agent-representative be bonded in an amount equal to twice the fair market value of the property has been judicially struck down. Schweitzer v. Westminster Ins., supra, at 1211.[Back]

36. Civ. Code § 1695.17(b). It is unclear whether rescission under this section is subject to the two-year limitation set forth in Civ. Code § 1695.14. Furthermore, whether a bona fide purchaser or encumbrancer is protected in the event of a rescission under this section is uncertain.[Back]

37. See Beerer, California Home Equity Sales Contract Act-A Mine Field for the Unprepared. http://ezinearticles.com/?California-Home-Equity-Sales-Contract-Act---A-Mine-Field-for-the-Unprepared!&id=1095260.[Back]

38. Civ. Code § 1695.3(h). This provision may be inconsistent with Civ. Code § 1695.6(b) (1), which merely precludes the equity purchaser from accepting from or inducing the equity seller to execute an instrument of conveyance during the cancellation period.[Back]

39. Civ. Code § 1695.13.[Back]

40. See Miller & Starr, California Real Estate, 3d Edition, §1:64.[Back]

41. Civ. Code § 1695.12. This presumption can be overcome only by "clear and convincing evidence."[Back]

42. Civ. Code § 1695.6(e). However, a bona fide purchaser or encumbrancer is protected against the application of this provision.[Back]

43. Civ. Code § 1695.7. Attorneys' fees are recoverable by the equity seller even if not provided for in the contract.[Back]

44. Ibid. Apparently, no specific findings are required to justify an award of exemplary damages. For a discussion of possible constitutional challenges to the exemplary damages provisions of the Act, see California Real Property Remedies and Damages (California Continuing Education of the Bar) §4.63.[Back]

45. Ibid. Alternatively the court may award a civil penalty of up to $2,500, but it may not award both the penalty and exemplary damages.[Back]

46. Civ. Code § 1695.14. However, a bona fide purchaser or encumbrancer is protected against the application of this provision. Furthermore, it is unclear whether an equity seller may seek rescission for a violation of the cancellation period restrictions, since Civ. Code § 1695.7 provides that an equity seller may bring an action for the recovery of damages or other equitable relief…" [Back]

47. Civ. Code § 1695.8. The constitutionality of this provision is highly suspect since, theoretically, an equity purchaser could be convicted for even unintentional violations of the cancellation period restrictions![Back]

48. In re Phelps (2001) 93 Cal. App. 4th 451. The Act defines "residence in foreclosure" as property "which the owner occupies as his or her principal place of residence." In this case, the equity seller had moved out of the property before the contract was signed. [Back]