United States: Making Financing Easier (maybe)

Last year, California's residential developers secured some modest relief from the State's notoriously strict regulatory climate - or so they thought. Assembly Bill 728 ("AB 728"), which became effective January 1, 2004, aimed to encourage more favorable financing from lenders, thereby spurring development of badly needed housing. Specifically, the bill aspired to help developers pre-sell certain units of attached condominium housing (that is, to enter into binding contracts with buyers before construction has been completed) and retain a larger portion of a buyer's deposit in the event of breach. AB 728 presumes that pre-sold units improve project viability which makes lenders more apt to finance the development. However, while its intentions may have been on target, the new bill appears to have missed its mark.

In California, the sale or lease of subdivisions of five or more units falls under the jurisdiction of the Department of Real Estate ("DRE"). In the interest of consumer protection, California law requires the issuance of a final public report by the DRE before any subdivision under its jurisdiction may be offered for sale or lease. The final public report discloses valuable information to the potential purchaser, including covenants, conditions and restrictions, costs and assessments for maintaining common areas, a detailed subdivision map and conditions of sale. The purpose of the public report is to protect the consumer from misrepresentation, deceit and fraud in the public sale or lease of subdivisions.

While a final public report is required before a sale or lease is complete, the DRE also issues conditional public reports pursuant to Section 11018.12 of the California Business and Professions Code. Conditional public reports permit developers to enter into binding contracts with buyers, subject to satisfying certain specified conditions. Before closing, all conditionsmust be satisfied and a final public report must be issued that is not materially different from the earlier conditional public report. Prior to the passage of AB 728, conditional public reports were valid for a period of six months, with a possible six-month extension. Ostensibly, conditional public reports allow developers to enter into binding contracts while construction is underway and before a final public report has been issued. While this system may have had consumer interests in mind, its application has proven harmful to consumers by making construction of attached condominium housing more costly and, therefore, more difficult.

To secure favorable financing, developers need to minimize lenders' risk by demonstrating project viability through the existence of binding contracts with buyers. However, the reality of attached housing is that completion of development and construction most often takes more than the 12 months permitted under the prior law. According to the Senate Local Government Committee, "getting a final subdivision map under the [Subdivision] Map Act can take several years, [so] having a one-year conditional report isn't enough time." After the one-year period, the conditional public report expires and buyers can terminate their contracts - not the kind of risk-reduction most lenders seek. The inadequate one-year period results in more conservative lending at higher prices, which discourages new projects and limits the availability of housing.

In addition, in the event of a termination by buyers, sellers would normally look to the liquidated damages clauses in the purchase contracts for their remedy for breach by the buyers. Before adoption of AB 728, Section 1675 of the California Civil Code limited the amount of liquidated damages developers could receive in the event of a breach. Specifically, if the damages did not exceed 3% of the purchase price, they were considered valid unless the buyers established that the amount was unreasonable. Conversely, if the damages did exceed 3%, the provision was presumptively invalid unless the sellers could establish that the amount was reasonable. The difficulty of securing a significant portion of the deposit contributed to uncertainty, which, in turn, discouraged lending.

In response to these concerns, California enacted AB 728, thereby amending Section 11018.12 of the Business and Professions Code and Section 1675 of the Civil Code. The bill implemented two major changes to address the difficulties of securing financing for certain developments. First, it extended the period for conditional public reports to 30 months for attached residential condominium housing of 25 or more units, with a possible six-month extension, for a total of 36 months. Second, it introduced a new formula for evaluating liquidated damages clauses for the initial sale of units in projects with 10 or more units. Amended Civil Code Section 1675 now provides that when buyers pay more than 3% of the purchase price as liquidated damages, the sellers must prepare an accounting of their costs and revenues allocable to the construction and ultimate sale of the unit, including costs related to the buyers’ default, with- in 60 days of the unit's final sale. Sellers must refund any amount in excess of either 3% of the purchase price or the sellers’ losses resulting from the buyers’ default, as calculated by the accounting, whichever is greater. In theory, then, sellers could retain more than 3% of the purchase price.

At first glance, extending the total permissible term of the conditional public reports from 12 to 36 months appears to ameliorate somewhat the financing problems outlined above. If developers have more time to complete the project and receive the final public report, there is less risk of buyers backing-out of contracts. However, AB 728's attempted solution appears to have overlooked a separate California law: Civil Code Sections 2985-2985.6. These sections provide criminal penalties for sellers who encumber property under contract for sale where the contract contemplates closing outside of one year. In order to prevent application of the foregoing sections, real property sales contracts would have to include provisions requiring a return of the buyers’ deposit before the close of one year, unless the buyers agree at that point to extend the deal. This one-year limitation conflicts directly with the goals of the new 36-month time frame for conditional public reports.

In addition, the new formula for calculating liquidated damages does not appear to provide much relief for developers. To begin with, developers now have the burden of performing an accounting of their loss. Second, AB 728's definition of loss neglected to include the developers’ anticipated profits, which is the traditional method of calculating damages for breach. Instead, the developers will only recover their "losses" to the extent that the price they receive from subsequent buyers is below the developers’ actual cost. In other words, developers cannot recover their lost profit in the event of buyers’ breach. Instead, developers can only recover their out-of-pocket costs, likely to be less than the amount paid by subsequent buyers, resulting in retention by sellers of no more than 3% of the first buyers’ purchase price as liquidated damages. In the end, developers are actually in a worse position under the same circumstances than under the prior law.

While it remains to be seen whether AB 728 will have any appreciable impact on lending and development, additional legislation may be necessary. Certainly, all parties would benefit from some clarity regarding whether binding contracts covered by public reports can contemplate closing outside of 12 months. In addition, if the California Legislature was willing to grant more freedom to buyers and sellers to negotiate liquidated damages clauses, it may want to revisit whether its new formula will achieve the desired result. Until such clarification arises, developers need to be aware of both the criminal penalties which could arise from violating the one-year limitation contained in the Civil Code and the limitations on liquidated damages.

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