Application of the Interstate Land Sales Full Disclosure Act to Condominium Projects and Single Family Homes
April 13, 2007
Robert M. "Bob" Chasnow- Washington
The front page headline of the March 22, 2007, Miami Herald proclaimed: “Nervous Condo Buyers Want Out.” Although the article focuses on rescission rights under the Florida Condominium Act, real estate attorneys now widely accept that the federal Interstate Land Sales Act (the Act) applies not only to homesite lots, but also to condominium units and homes that are not fully complete as evidenced by a certificate of occupancy at the time of purchase.
The Act prohibits the sale or lease of any “lot” without first filing a large registration with the U.S. Department of Housing and Urban Development (HUD), including a comprehensive full disclosure document (Property Report). The Property Report contains 20-30 pages of detailed disclosure information required by regulations promulgated by HUD to which the Act entrusts administration of the law. Once the registration is approved, the developer may commence binding sales as to which it furnishes each purchaser with a copy of the Property Report prior to the purchaser’s signing a purchase agreement which features a statutory seven-day rescission period as do purchase contracts for all HUD-registered subdivisions and condominiums.
Although use of the Property Report provides the condominium developer or homebuilder with a safe compliance route, preparing the Property Report and its accompanying Statement of Record requires detailed and time consuming work by the developer and its counsel. Given the time and resources necessary for a HUD registration, developers often seek alternatives to registration.
The Act provides a number of exemptions (1) some of which exempt the project from the registration requirement of the Act, (2) a smaller number of which will exempt the project from the entire Act, and (3) a few of which operate on an individual lot or unit basis. Falling in the last category, the most widely used exemption is probably the “Improved Lot” exemption (also known as the “Two Year” exemption) pursuant to which the Act does not apply to:
“the sale or lease of any improved land on which there is a residential, commercial, condominium, or industrial building, or the sale … of land under a contract obligating the seller ... to erect such a building thereon within a period of two years.” (emphasis added)
The key question for condominium developers and homebuilders who wish to offer and sell units that are not yet complete but who wish to be exempt under the underlined provision of the exemption is: what constitutes a “contract obligating the seller ... to erect such a building thereon within a period of two years”? It is tempting to include a provision in the sales contract stating that the developer shall complete the construction of the residential unit within two years from the signing of the sales contract and then to feel that safe harbor is reached; however, to avail oneself of the exemption is far more complicated.
HUD Guidelines Set Tough Standards for Improved Lot Exemption and Courts Have Been Supportive
HUD and the courts generally have been thorough in ensuring that the developer’s obligation to construct meets the standard found in the Act. In HUD’s guidelines, issued separately from the HUD regulations, the agency specifies that “the contract must not allow nonperformance by the seller at the seller’s discretion. Contracts that permit the seller to breach virtually at will are viewed as unenforceable because the construction obligation is not an obligation in reality.”
In this article, several contract clauses are addressed which, although apparently compliant, may cause HUD or a reviewing court to consider a purchase contract as ineligible for the Improved Lot Exemption. By careful review of these examples, developers and homebuilders should find solid guidance towards compliance with the exemption. Further, this article will describe the consequence for a developer who operates under the Improved Lot Exemption when in fact, it does not meet the requirements for this exemption. Finally, HUD Property Report will be revisited to discuss its main advantages and drawbacks in order for developers and builders to evaluate their choice of either.
Protection of Specific Performance as Purchaser Remedy
HUD considers contracts that limit the purchaser’s right to specific performance as not exempt under the two-year exemption because without full rights for the purchaser to enforce specific performance, HUD considers the seller’s obligation to build within two years as insufficient to meet the statutory basis for exemption.
A common provision in sales contracts for projects that purport to operate under this exemption is a clause stating that if the developer is unable to complete the building within two years, deposits shall be refunded to the purchaser and both parties shall be released from any and all obligations under the contract. Because this provision negates the right to specific performance, HUD determined that such contracts lack an obligation to construct within two years.
Court decisions support HUD’s approach. For example, the U.S. Court of Appeals, Third Circuit, ruled in a 1990 case that although Pennsylvania contract law allows for the negation of the right to enforce specific performance, a real estate contract construed according to Pennsylvania contract law that negated this right lacked a sufficient obligation to two-year completion, and thus held that reliance by the developer upon the two-year exemption was misplaced. In its ruling, the court based its decision on an early version of the HUD Guidelines that stated “contracts that directly or indirectly waive the buyer’s right to specific performance are treated as lacking a realistic obligation to construct.”
Contract Provision on Limitation of Specific Performance and Damages
It is less clear in many states whether or not contract provisions that limit the purchaser’s rights to damages would render a contract non-exempt and thus subject to all the provisions of the Act. With respect to the matter of whether damages may be limited or certain types of damages may be limited or negated, HUD’s position is that only specific performance is required to be preserved as a remedy since it is that remedy which speaks most directly to construction of the dwelling. However, HUD recognizes that state law will determine the issue of if, and to what extent, a contract remedy clause will affect the seller’s obligation to construct a residential unit within two years.
The issue has been litigated in Florida. The Florida Supreme Court ruled in a 1990 case that contracts operating under the exemption may not limit specific performance or the right to seek damages. Also, in a 1998 case, the Florida First District Court of Appeals ruled that “the exclusion of consequential or special damages from a buyer’s remedies available may not, as a matter of law, nullify the two-year completion exemption.” There have been other rulings on this issue in Florida, but even in the state in which this issue has been most heavily litigated, the end result is that it is unclear whether or not the limitation of certain types of damages would be acceptable to state courts.
Because this issue is not settled in most states, developers should exercise caution when attempting to limit specific performance or damages with regard to their two-year obligation provisions. It is important to keep in mind that if the obligation to construct is not supported by the purchaser’s remedies, such a contract is vulnerable to being found by HUD or a reviewing court as not exempt.
Contract Provision on Circumstances Permitting Nonperformance
Provisions regarding impossibility of performance and force majeure clauses must also be carefully crafted to ensure that they will not be interpreted by courts as undercutting the obligation to complete construction within two years. As with limitation of damages sought by purchasers, state law controls in determining whether or not a specific provision undercuts the seller’s obligation to complete construction within two years.
The cases on impossibility of performance due to an “act of God” are almost completely limited to cases where one party seeks to be wholly discharged from its obligations under a contract. For example, in Florida, courts recognize that the doctrine of “impossibility” must be applied with caution and is not available concerning intervening difficulties which could reasonably have been foreseen and thus controlled by an express provision of the agreement.
Brunner and O’Connor on Construction Law (BOCL), a national legal reference set, recognizes that “bad weather” is the most common force majeure event but “there are ... other common force majeure events such as earthquakes, strikes, certain fires, lightning, flood and other natural disasters.” BOCL cites “act of God” as having been defined by one Florida Statute governing pollution as “an unforeseeable act exclusively occasioned by the violence of nature without interference of any human agency.” Further, BOCL cites only this Florida Statute and a “weather case” (“excessive amounts of rain”) as having been found to qualify to excuse delay in performance of a construction contract.
In a 1996 Florida appellate case, the court reviewed a contract provision which provides that the seller’s completion of the home within two years is “subject to delays which are recognized under Florida law as excusing performance, such as the unavailability of materials, strikes, labor problems, governmental orders, and acts of God.” Upon review of Florida case law, the court held that only “acts of God and certain rare acts of government” give rise to the defense of frustration of purpose or impossibil¬ity. The court concluded that “unavailability of materials, strikes, and labor problems” do not give rise to the contract defense of impossibility or frustration of purpose, and therefore, inclusion of such terms in the contract renders the two-year exemption unavailable to the developer/builder. The court held that the buyer is entitled to rescission and other remedies including attorneys’ fees permitted under the Act.
Because the provision was found by the court to be defective, then irrespective of the fact that any delays in performance may or may not have occurred and despite the fact that the home was completed and deeded, the sale was adjudged non-exempt under the Act.
Many state courts have developed varying precedent regarding enforcement of force majeure clauses. It seems that it is best to “keep it simple” when drafting these types of clauses. If even one item is mentioned as constituting impossibility of performance, but this item is not recognized under state law as a sufficient event for impossibility of performance, the entire sales contract is deemed non-exempt. Thus, one example of a conservative force majeure clause is: “Seller estimates it will substantially complete construction of the Unit, in the manner specified in this Agreement, by a date no later than two years from the date purchaser signs this contract, subject only to delays caused by matters which are legally recognized as defenses to contract actions pursuant to the laws of the State of [fill in state name here]. If any delays caused by matters which are legally recognized as defenses to contract actions pursuant to the laws of the State of [state name here] occur, Seller has the option to extend the estimated time of completion.” This clause limits potential mistakes, such as including even one excuse is not recognized as a defense to contract actions in that jurisdiction, that would thus create a non-exempt contract.
Examples of Other Contract Provisions Leading to Finding of Non-Exemption
Several other areas of a residential sales contract commonly cause problems for this exemption. Provisions to watch for are any which may give the seller an option to cancel the agreement. Many of these provisions are commonplace contract provisions, but if included in a contract for the sale of an incomplete residence, may render the sale fully subject to all provisions of the Act.
Clauses that allow the seller to cancel the contract may render the sale non-exempt. For example, if the contract is dependent upon the buyer obtaining financing, and the buyer cannot obtain such financing, the contract must look for the buyer to cancel the contract, not the seller; since federal regulations provide that “the inability of the buyer to obtain construction financing will not relieve the seller from the obligation to build.” Another commonplace example that could render a sale non-exempt would be a provision allowing the seller to cancel the contract if it was not willing to resolve an exception to the title found unacceptable to the buyer. Yet a further frequent example that could render a sale non-exempt is a provision allowing the seller to cancel the contract if the property is destroyed during the construction period. If such a loss or damage occurs the contract should provide for the seller to notify the buyer in writing and give a recommendation regarding if the home or condominium unit should be rebuilt or not. However, ultimately the buyer’s consent must be given to cancel the contract; the decision must not fall unilaterally to the seller.
Another common misunderstanding about the two-year obligation is that it begins from the time the developer signs the contract for purchase. The HUD Guidelines provide that it is the date the purchaser signs the agreement which triggers the start of the two-year period. Make sure your contract is drafted with this provision.
Presale Provisions
HUD permits the developer to qualify the obligation to complete construction by allowing provisions that give the developer the right to withdraw sales contracts if a certain percentage of units in a multi-unit project are unsold from a period not to exceed 180 days from the date the first contract is signed. However, this will not qualify the time-period of the two-year obligation, and it still starts, on a unit by unit basis, from the date each purchaser signs the sales contract. Effectively, this may limit construction time to 18 months.
Self Determination vs. HUD Advisory Opinion
HUD specifies that the two-year exemption is a self-determined exemption. Although this may be tempting to developers, the many places in which a contract can be rendered non-exempt make compliance with this exemption difficult and sometimes risky without experienced counsel.
For developers looking for confirmation as to whether or not their contracts meet the two-year exemption requirement, HUD allows for developers and attorneys to submit copies of the sales contracts and descriptions of the project in order to specifically ask whether HUD considers their contract exempt pursuant to the Improved Lot Exemption. This process can be utilized prior to the time sales are commenced. Although filing for a HUD Advisory Opinion adds a cost and time delay (generally HUD has a 30-day review period), an affirmative opinion provides the developer with a fair degree of assurance should the contract be questioned later. HUD Guidelines provide that it may ask for local counsel’s opinion on questions of state law, so an applicant should be aware of the possibility.
Why Undertake a HUD Registration?
Given the restrictions placed on the sale of lots under the two-year exemption and the risks involved to developers trying to comply with the exemption, registration may offer some advantages over operating under an exemption, including that the developer may limit remedies available to purchasers. Accordingly, it is more common to find with registered projects contract provisions limiting purchaser remedies to return of their deposit if the developer fails to construct the building. Further, the developer may sell units in their project as early as they wish and need not wait until within two years of completion of construction. On the other hand, as stated earlier in the article, registration includes several disadvantages including one that is often overlooked – where the deed is granted more than 180 days after the purchaser signs the sales contract, then in the event of purchaser default, the seller may retain only up to 15 percent of the purchase price or actual damages – whichever is greater. Overall, however, if the proof is in the pudding, HUD reports a substantial increase in registrations of condominium projects and both condo developers and homebuilders are paying much more attention to key provisions of their contracts.
Conclusion
Far more condominium and single family home developers are paying attention to the Act. Surely their customers are doing so – mainly as a weapon to cancel out of deposits even after closing and deeding. This statute is no longer “your father’s Oldsmobile” and, in a slow housing market, it is an important law to understand and apply to each and every sale of a new condominium unit and single family home.
For more information, e-mail Robert M. Chasnow at robert.chasnow@hklaw.com or call toll free, 1-888-688-8500.