The truth about getting around due-on-sale clauses Copyright 1999 by John T. Reed 2 State statutes and common law States also have similar criminal laws which are also violated in the typical mortgage scam. Common laws may also be violated. For example, if the borrower promised to inform the lender if the ownership, occupancy, etc. changed, and fails to do so, they have committed breach of contract. Persuading someone to commit breach of contract could be illegal interference on your part. Violations of common law are civil, not criminal, matters. That means you cannot be imprisoned for committing them, but you could be made to pay damages or forced to take some action. For example, you getting the previous owner to keep the insurance on the property in his name to conceal the change in ownership from the lender is arguably conspiracy (two or more persons), mail fraud (something related to the insurance will go through the mail either from you or to you), concealment of a material fact, and false statement (to the insurance company about who is the current owner). If you do two such deals within a ten-year period, you have arguably violated the racketeering law. If you cannot disclose it, it's probably wrong In general, you should never do anything that cannot stand the full disclosure test. That is, if the deal could not be done if everyone involved, including all lenders, knew everything that was going on, the deal is probably unethical and illegal. The typical lease-option acquisition cannot be done unless the existing lender is kept in the dark about the change in control and occupancy of the property. The bottom line here is that breaking laws or contracts is a serious thing. Not many prosecutions or suits Some gurus respond by saying they have never heard of anyone being prosecuted or sued over a due-on-sale clause. First, note that they are not saying I am wrong, only that you probably won"t get caught. Secondly, there clearly have been such suits, most notably the de la Cuesta decision itself. A 1999 case, Friery v. Sutter Buttes Savings Bank, 61 Cal. App. 4th 869, involved two sales. The lender sued and forced the owner to assume (become personally liable for) the mortgage and agree to move the balloon up by five years. The Wellenkamp case and its similar successors in other states all involved lenders suing borrowers over refusal to comply with due-on-sale clauses. William Bronchick says, "I have spoken to thousands of people across the country and every time I ask "how many people got a loan called for violating the due on sale?" virtually no one raises his hand. Of the dozen or so people who have had a lender call it, they simply ignored it and the lender went away." Note that he does not say no one raised their hand. I would also note that there may be some people in his audiences who should raise their hands, but do not because they do not want to go against the speaker. The borrowers won the Wellenkamp case and some pre-1982 cases in the other states. However, those victories were short-lived from the perspective of real-estate investors in general because the de la Cuesta decision and Garn-St. Germain Act removed all doubt about enforceability of due-on-sale clauses. Why don't they get a letter ruling? For another thing, the gurus are not interested in finding out what the law really is on lease-options. I have long urged them to obtain an IRS private letter ruling on the income-tax legality of their lease-option agreements. The cost of such letter rulings was just drastically lowered. But not a single lease-option guru has ever requested such a ruling, in spite of the fact that it would help his
clients and help the guru market his material. The fact is they know what they advocate is probably illegal and they are afraid to get a ruling. Laches, waiver, and statutes of limitations I make a similar dare regarding whether due-on-sale clauses are enforced. If they are almost never enforced, why not tell the lender what you are doing at the outset? From everything I"ve heard, the lender probably won"t do anything. If that' the case, and the lender belatedly tries to enforce the due-on-sale clause later, the investor might be able to invoke the legal doctrine of laches or waiver as a defense. Black's Law Dictionary offers many definitions. Here is one for each doctrine. Laches omission [by the lender] to do what law requires to protect one' rights under circumstances misleading or prejudicing adverse party [new property owner in subject-to purchase]; unconscionable, undue, unexcused unexplained or unreasonable delay in assertion of right Waiver The intentional or voluntary relinquishment of a known right, or such conduct as warrants an inference of the relinquishment of such right, or when one dispenses with the performance of something he is entitled to exact or when one in possession of any right, whether conferred by law or by contract, with full knowledge of the material facts, does or forbears to do something the doing of which or the failure of forbearance to do which is inconsistent with the right, or his intention to rely upon it. [emphasis added] Delay alone is not enough to invoke laches. The property owner may also have to show that his situation now is different from when the deal was first done and that enforcing the clause after so much delay will therefore harm him in ways that were not true had the lender enforced the clause promptly.' Keeping the transaction secret prevents the laches or waiver "clocks" from starting. It' hard for you to claim the lender waited too long to call the loan if you took steps to conceal from the lender the fact that the due-on-sale-clause-triggering event occurred. Concealment would probably also enable the lender to accuse you of "unclean hands" if you tried to invoke laches or waiver. "Unclean hands" is a legal doctrine that says you cannot win by claiming the other side is being unfair if you, yourself, were unfair to them. Statutes of limitations are time limits on when a prosecutor or civil plaintiff may start a court proceeding. Once the statute of limitations has ended, no prosecution or civil suit may occur. But as with laches and waiver, concealment of the transaction may delay the start of the statute-of-limitations "clock." The law may say that the statute of limitations does not start to run until the lender learns of the due-on-sale-clause-triggering transaction. To the extent that you may want to rely on laches or a statute of limitations, it is in your interest to have the "clock" start as soon as possible. Your enemies There are a number of reasons why there are not more prosecutions or lawsuits regarding due-on-sale clauses. Prosecutors are busy with more serious crimes. Lenders are reluctant to be the bad guy in a public suit. At his Web page, Bronchick admits that his technique triggers the due-on-sale clause (actually, he says "violates"), but then he asks the rhetorical question, "...but who is going to tell the lender?" How about your enemies? The fact that you have lease-options which have triggered due-on-sale clauses is known by or knowable by your enemies. They could raise a stink and possibly thereby get your due-on-sale clauses enforced. Who might do that? Your ex-spouse, current spouse who has filed for divorce, former business partner, tenants or former tenants, buyer or seller who did business with you, anyone in or about to be in litigation with you, neighbors who are feuding with you, current or former disgruntled employees, etc. Talk about living in a "glass house." John Beck says he knows a guy whose business is to search for living-trust due-on-sale clause defaulters. Mortgage lenders tell him when properties have been placed into an inter vivos trust. He then monitors the payment of the water bills to see if the person paying the bills changes. If so, he reports it to the lender and they take whatever action they want to investigate further and possibly call the mortgage. Beck also knows of an attorney who, before de la Cuesta, guaranteed his clients that he would defend, for free, any challenge to his scheme to get around due-on-sale clauses. He teamed up with a southern California escrow company. When the de la Cuesta decision came down, lenders deliberately went after every single deal this guy had set up. The escrow company was forced out of business and the attorney was forced to renege on his guarantee when he was overwhelmed by multiple foreclosure actions. Beck says Dataquick advertises its services to lenders, in part, as a way to detect borrowers in default on due-on-sale clauses. Dataquick believe their sales to lenders are up as a result. In June of 1998, I attended a conference run by Fair, Isaac, the high-tech company that produces the now ubiquitous FICO credit scores. One of the topics being discussed was high-tech ways to detect "silent second" mortgages. Efforts to get around due-on-sale clauses are generally belated "silent second" mortgages or land contracts or "silent assumptions." Most single-family lease options are, in substance and therefore in law, wraparound land contracts, which are a type of second lien. There is also the possibility that a news organization like 60 Minutes or 20/20 will do a story about people getting around due-on-sale clauses, thereby inspiring lenders and regulators to crack down. Rise in interest rates would likely increase enforcement of due-on-sale clauses The Wellenkamp and de la Cuesta cases, both of which involved lenders aggressively enforcing their due-on-sale clauses, occurred in the early "80s. At that time, mortgage interest rates were at record highs---about 18% at the peak. In contrast, the interest rates on the Wellenkamp and de la Cuesta mortgages were much lower. The lenders have a fiduciary duty to put that money back out at current rates. Other lawsuits to enforce due-on-sale clauses during that period were Patton v. First Federal Savings & Loan Association (578 P 2d 152) in AZ, Nichols v. Arbor Federal (250 NW2d 804) in Michigan, Bellingham First Federal Savings & Loan Association v. Garrison (553 P 2d 1090) and Morris v. Woodside (682 P 2d 905) in WA. A conversation among three investors might go like this during a period of increased interest rates. Investor A: Boy, "'m sure glad I have fixed-rate mortgages with that run-up in rates last month. Investor B: I don"t have fixed rates, but my lifetime caps are below the current rates so I"m partly protected. Investor C: I may be in trouble. I have all fixed-rate mortgages, but they are all in technical default because I did lease options. The lenders could call every single one of them. In his article on the subject, William Bronchick says that lenders don"t care about enforcing due-on-sale clauses these days because market interest rates are low. He says, "This trend will probably continue so long as interest rates remain within a few percentage points of existing loans." That may be true, but it implies an unspoken corollary: "This trend will probably NOT continue if [market] interest rates rise more than a few points above existing loan [interest rates]." I found an interesting, albeit legally meaningless, clause in the law. Section 1701j-3(b)(3) says: In the exercise of its option under a due-on-sale clause, a lender is encouraged to permit an assumption of a real property loan at the existing contract rate or at a rate which is at or below the average between the contract and market rates, and nothing in this section shall be interpreted to prohibit any such assumption. That means would you lenders please go easy on the borrowers.' "Guts" William Bronchick sent a brochure that promises to tell seminar attendees "How to Dance Around the "Due on Sale" clause (sic)." But in an email to me he said, ""Get around" is not really what I am saying. The land trust trick DOES violate it, but it reduces your chances of getting caught. If you get caught, you refinance or pay it off. If you can"t, suffer the consequences. No crime. No fraud." At his Web site, he says "...the real question is: do you have the guts to take...the risk of getting caught." Oh, so doing a real estate deal that triggers the due-on-sale clause in the underlying mortgage is a way of proving your manhood. Real men don"t eat quiche, but they do put themselves in situations where they might have to pay off all their mortgages on 30-days notice. There are enough risks in real estate without your unnecessarily adding another huge one. Ethics In his discussion of getting around due-on-sale clauses, Bronchick says, ""Ethics" is a matter of opinion." Actually, he uses a much cruder phrase. Ethics are usually a set of rules promulgated by some authority, like the Ten Commandments, the Golden Rule, or the Bar Association Code of Professional Responsibility. In many cases, like the Bar Association, the promulgater has authority to discipline or expel members who violate the pertinent code of ethics. Even when the person in question is not subject to organizational discipline, most people like to behave in an ethical manner. I have never heard a real estate guru admit to being unethical or to advocating unethical practices. The core ethical code that I suggest is Tell the truth Keep your promises Treat others as you would like to be treated If Bronchick or anyone else wants to dismiss that set of principles as merely my opinion, they should do so explicitly rather than shrug off "ethics" in the abstract. Conspicuous by its absence in Bronchick' dismissal of ethics is the ethical code he recommends. By saying everyone has an opinion on ethics, he implies that his opinion differs from mine. But he makes no statement about what he thinks the appropriate code of ethics is. Many lawyers seem to regard ethics as a "gnat" which they learned to "swat" in "word parsing" class in law school. The ethical code of many lawyers appears to be that whatever you can get away with is OK. I agree with Shakespeare when it comes to those lawyers. People who are trying to get around due-on-sale clauses often lie to lenders or insurance companies, or ask others to do so. A borrower who promised to notify his lender of a change in ownership or a change in occupancy other than a straight less-than-three-year lease must violate that promise to keep a lease-option secret. In general, getting around a due-on-sale clause is a behavior pattern that few would want done to them if they were the lender, a behavior pattern that few would do to their best friend or a close relative. If you wouldn't want it done to you and wouldn"t do it to a friend or relative, how can you claim to be ethical when you do it to someone else? In fact, people who try to get around due-on-sale clauses rationalize their behavior by claiming lenders are evil and therefore deserving of unethical behavior on the part of the investor. That's bogus. Violations of pertinent codes of ethics Real estate agents and attorneys who are involved in such a deal might lose their license if the facts came out. They have an extra duty of disclosure and must comply with professional codes of ethics above and beyond what the average Joe must do. Here are some pertinent passages from the Realtor'® and Bar Codes of Ethics: Pertinent parts of the Realtor'® Code of Ethics Code provision Comment Preamble REALTORS'® can take no safer guide than that which has been handed down through the centuries, embodied in the Golden Rule, "Whatsoever ye would that others should do to you, do ye even so to them." If you made a mortgage loan, would you want one of your borrowers to ignore your due-on-sale clause and conceal the triggering transaction from you? Article 2 REALTORS'® shall avoid exaggeration, misrepresentation, or concealment of pertinent facts relating to the property or the transaction. Participants in subject-to deals almost invariably try to conceal the transaction from the lender. Standard of Practice 2.1 REALTORS'® shall only be obligated to discover and disclose adverse factors reasonably apparent to someone with expertise in those areas required by their real estate licensing authority. At the very least, an agent should recognize that triggering a due-on-sale clause warrants recommending that the client discuss the matter with their attorney. A blanket admonition to discuss the whole deal with an attorney is not sufficient. The agent should identify the due-on-sale issue specifically as a dangerous legal issue. At '§9:87 of Miller and Starr's California Real Estate Law 2d, they say, Both the seller and the real estate broker have a duty to disclose to a buyer any material fact that would affect the buyer's decision to buy, or the price or terms of purchase. The broker specifically has the duty to inform the buyer of the due-on-sale clause in every real estate transaction. (Eby v. Reb Realty, Inc., 9th Circuit, 1974, 495 F 2d 646) Thus the advice of the broker to 'hide' the transfer by use of an installment contract or wraparound deed of trust exposes the broker to liability for damages suffered by the buyer. Law clients who follow legal advice to hide a transfer of real estate can sue the attorney for malpractice if they suffer damage as a result. American Bar Association Model Rules of Professional Responsibility Rule Comment Rule 4.1 In the course of representing a client a lawyer shall not knowingly: (b) fail to disclose a material fact to a third person when disclosure is necessary to avoid assisting a criminal or fraudulent act by a client... Similar to 18 U.S. Code '§1001 California State Bar Rules of Professional Conduct Rule 3-210 Advising the violation of law A member shall not advise the violation of any law, rule, or ruling of a tribunal unless the member believes in good faith that such law, rule, or ruling is invalid. Note that this does not say you can recommend the violation of a law or rule because you think the client won't get caught.