The Purchase and Sale of Commercial Real Estate in California

I – Risks are allocated in commercial real estate transactions by the negotiation of representations, warranties, disclaimers, and releases.

A warranty or representation is an affirmation by the seller of a fact or facts relating to the property. See, 3 Witkin, Summary of California Law, Sales §§50-75 (9th ed 1987). Failure of a condition in the agreement generally excuses a party’s performance, but breach of a warranty entitles a party to damages and possibly rescission. Unless a warranty is also a condition, its breach will not relieve the buyer from the duty to perform, although any damages might be offset against any sums owed by the buyer. See 1 Witkin, Summary, Contracts §§721-723.

While warranties allocate the risk of certain potential post closing events and can force sellers to make disclosures, the limits placed on the Seller’s warranties can also serve as a road map for the Buyer’s due diligence.

Beginning with the letter of intent, the Seller’s objective is to give as few warranties as possible, to limit the scope of the warranties given, and to provide that if the Buyer approves the property, the Buyer will be relying solely on its own investigation and purchasing the property “as is.”

Warranties are often heavily negotiated because of the parties’ competing objectives: The buyer wants protection from unknown risks, while the seller wants to eliminate warranties or at least limit them to necessary disclosures. If the purchase price has been discounted, or if the seller is in a liquidation mode, or if the buyer has negotiated a substantial time period during which to conduct a due diligence investigation, the seller may be unwilling to give more than minimal warranties.

II – Sellers should be made aware that they cannot fail to disclose material information about the property in their possession without risk of liability, even if the seller has made no warranties.

In the final analysis, the Seller’s best protection is to make full and fair disclosure in writing about the property. This can be done by qualifying any representations and warranties by the disclosure of problems with the property set forth in one or more exhibits to the purchase agreement.

An “as is” clause will not protect the Seller from the failure to disclose materia! facts known to the Seller which would affect the Buyer’s decision to purchase least when those facts are not readily discoverable by the Buyer. See Loughrin v. Superior Court (1993) 15 Cal. App. 4th 1188; Shapiro v. Hu (1986) 188 C.A. 3d 324.

An “as is” clause will relieve the Seller from liability for defects in the property where the Seller was not aware of the defects even if they were not readily discoverable by the Buyer. Id.

A release with a waiver of Civil Code § 1542 initialed by the Buyer will bolster an “as is” provision, particularly where the purchase agreement delineates the types of risks being released.

In addition, a covenant not to sue is helpful to underscore the understanding of the parties, e.g. in the absence of a breach of warranty that the Seller will not sue the Buyer relating to the condition of the property after the close of escrow. Once again, a fraud claim will not be defeated by such a provision.

III – The extent to which representations and warranties can be obtained from a seller depends upon both the nature of the warranty requested and the relative bargaining strength of the parties.

Some types of properties are traditionally sold without any warranties, such as “real estate owned” or “REOs” which have been foreclosed upon by an institutional lender.

Even where an REO is not involved, institutional sellers will seek to limit certain types of warranties to the actual knowledge of those employees who have had “hands on” involvement with the property.

The Seller’s goal is to limit future liabilities as much as possible.

A. This particular concern can sometimes be resolved with a very short expiration period for the warranties. This “survival period” is negotiable, but will probably be shorter than the applicable statute of limitations.

B. The Seller will want to avoid any “hold backs” in escrow of a portion of the purchase price during the survival period. Depending on the nature of the potential problem and the future of the Seller, the Buyer may seek to negotiate a hold back.

C. It is also helpful for a Seller to negotiate a “floor” (a claim will not be allowed unless the alleged damages exceed a minimum amount) and “ceiling” or upper limit on warranty liability (except where a claim is based on intentional fraud).

The buyer will also want the purchase agreement to specify which representations and warranties survive the closing.

Warranties that the Seller is duly organized, has authority to execute the documents and has obtained all necessary consents to the sale will customarily be given by a Seller.

Warranties with respect to title matters are not customary in California and sellers will take the position that title insurance and endorsements will adequately protect the seller. Also, a seller may provide the buyer with an ALTA survey. The buyer can then specify which title exceptions and survey matters should be eliminated or cured before the closing.

An exception may occur with respect to unrecorded matters and leases. A seller should be willing to warrant that no unrecorded matters affect title, except as disclosed in an exhibit to the purchase agreement or by the ALTA survey discussed above.

A Seller should be willing to warrant that an attached rent roll identifies all leases affecting the property.

Warranties with respect to absence of claims, litigation, condemnation and similar matters are often given by Sellers if qualified by the “actual knowledge” of specific persons who are knowledgeable regarding the property. The Seller will also want to provide that the employee with actual knowledge will not be personally liable for breach of a warranty.

The use of “to the best of Seller’s knowledge” may create problems since it may imply some level of diligence which is not adequately defined. The Buyer will argue that such a warranty includes what the Seller actually knows, plus what he or she should have known after a reasonable investigation.

An absolute warranty has no limitation and will be very difficult to obtain from a sophisticated Seller, except for matters such as those set forth in paragraph E. above.

Warranties with respect to the accuracy of financial information regarding the Property can be a major source of negotiation.

If the information is incorrect, the parties should negotiate who will bear the loss. This is a different issue than determining whether the Seller has “knowledge” and whether the knowledge is “actual” or “best” with an implied obligation to investigate.

If a warranty is given it should cover the accuracy of all expenses included in pass throughs to the tenants of the property.

Warranties regarding lists of tenants, rent rolls, lists of service contracts and true copies of documents are customarily provided by the Seller. However, Tenant estoppel certificates are the customary method for Buyers to confirm the accuracy of information regarding leases.

A form of the estoppel certificate should be attached to the purchase agreement.
A major issue in the sale of an office building or other multi-tenant property is the percentage of estoppel certificates that must be returned to satisfy the condition, it usually being agreed that certificates must be received from tenants under certain major leases and a specified percentage of other leases. Seller may negotiate the option to give a warranty or Landlord’s Estoppel Certificate to cover the estoppel certificates that are not received from the tenants.

The Purchase Agreement should specify that the estoppel certificates confirm all information given by the Seller with no material comments or corrections.

Warranties regarding compliance with zoning laws and building codes are virtually impossible to obtain from Sellers in view of the difficulty of knowing whether a building is in compliance. The usual compromise is to obtain a warranty that no written notice from a governmental agency that the property is not in compliance has actually been received.

Environmental warranties usually present serious negotiation problems.

Sellers should be willing to warrant that they, and their tenants, have not created any environmental problems. However, if an environmental investigation has been conducted, the warranty should be qualified by the contents of the environmental reports which will be provided to the buyer.

Environmental insurance may fill the void of some environmental warranties. It can take weeks to months to negotiate a policy of environmental insurance, so start early if it appears that this insurance may be required to close the deal.

If the Buyer is seeking to transfer some risk to the Seller, it may also be preferable to use an indemnity clause rather than negotiate a warranty that may be qualified by someone’s actual knowledge.

Sellers should include a provision that if a Buyer finds a warranty to be inaccurate prior to the losing, the Buyer cannot close in reliance on the false warranty and seek damages post-closing. See Jue v. Smiser (1994) 23 Cal App. 4th 312.

IV – Even if warranties are given, the buyer’s lawyer must advise the client to undertake a thorough study of the potential risks and liabilities associated with the acquisition.

While the client might focus on economic issues, such as the viability of the leasing market and comparable land values, the attorney should properly advise the client regarding the possible risks and liabilities which could be imposed upon the Buyer of the property.

Of particular importance is the need to communicate with the client regarding the client’s expectations of what the lawyer intends to do and what the client will do itself or through its staff. It is particularly important to discuss the entire due diligence program with the client and the probable cost of the legal work involved.

Many lawyers don’t perform diligence work that might be expected by the client because they believe. The work will be time consuming and the client will be unwilling to pay.

V – Special warranty and disclosure issues.

Undeveloped Land – – the Seller should make it clear he or she will not be responsible for any problems with entitlements or improvements to the land, and should provide that the Seller is selling the property subject to any unrecorded lien that may be created by a subdivision map or bonds to insure the completion of improvements, or that the Buyer should obtain its own bonds to complete the improvements.

Apartment Buildings – – warranties or representations about the number of units can give rise to litigation if any of the units has been “bootlegged” or is not legal.

Residential Property – – the C.A.R. form currently in use does not contain an “as is” provision or any warranties. The form does provide that the property is sold “7.A.(a)… in its PRESENT physical condition as of the date of Acceptance and (b) subject to Buyer’s investigation rights…” It is up to the parties or realtors to negotiate a more comprehensive “as is” provision or any warranties. Care should be taken on behalf of the seller of a residence with respect to physical or structural problems. The following documents can be used to protect the Seller’s interests.

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