Commercial Due Diligence. Or Not?

Jane Tang and her company Virginia Oak Venture, LLC brought a lawsuit regarding the purchase of a McKinney Texas apartment community. Ms. Tang was of the view that the amount paid was far in excess of its value.

Tang alleged that the defendants (for my purposes, sellers, broker and agent) severely over-represented the cash flow expected to be derived, and misrepresented the extent of repairs. Tang also contends that she was defrauded by a real estate salesman, his broker, and the prior owners.

The Collin County trial court rendered partial summary judgments in favor of some of the defendants. A jury trial followed against the remaining defendants, all of which ultimately resulted in a loss to Tang.

So she appealed.

With specific reference to the salesperson O.D. Fought, Jr., Tang argued that Fought grossly misrepresented the occupancy levels of the property, its income and expenses, supplied false data to the appraiser and lender, hid from Tang the existence of accurate rent rolls, financial data and a previous purchase of the property for half the price some 10 months earlier, and more.

Tang argued that Fought represented both Seller and Tang, and as such, owed fiduciary duties to both. As evidence to support that conclusion, Tang alleged that Fought located an attorney to create Tang’s LLC, agreed to be personally named as its registered agent, drove her to see 10 properties he was attempting to sell, directed her to a particular lender, and prepared all the documents involved in the deal.

Fought contended that he was merely working hard on the seller’s behalf to sell the apartments, and that he was never acting as Tang’s agent. Evidently the jury believed him.

The evidence furnished to the jury regarding rent rolls and income streams may have been accurate and largely correct as of the month of the sale, although it could also have been misleading. There was indeed evidence of high occupancy levels, but that circumstance changed after the expiration of “signup specials.” There was also the possibility that some evicted residents were allowed to reoccupy apartments, and thus become tenants yet once again.

More confusion followed Fought’s possible misrepresentations about the condition of the property, but it is possible that the jury deemed none of such matters material and disregarded such possible misrepresentations.

Tang then alleged that Fought and his broker committed fraud, since it was alleged that Fought only partially disclosed accurate rent rolls, financial statements and the property’s condition.

The Appellate Court’s analysis of the fraud claim against the sales agent was short-lived, since “. . . Tang made no effort to make an independent investigation to determine the physical condition of the property, the value of the apartment complex, the circumstances of occupancy levels, or other pertinent factors she should have taken into account when making the decision to purchase.”

The Appellate Court found no reason to disagree with the jury’s decisions, so the Defendants prevailed again. See Virginia Oak Venture, LLC and Jane Tang v. O.D. Fought, Jr., et al; No. 06-13-00076-CV; Texas Court of Appeals, 6th District; February 7, 2015.

Lessons learned:

1.  In the past, my stock suggestion to brokers and agents was to encourage the buyers and tenants to conduct as much due diligence as possible within the option period, by hiring independent professionals not suggested by the agents and brokers. In this situation the buyer evidently did none of that, but still the broker and agents were able to adequately defend a claim.

2.  However, I would like to believe that if the buyer had undertaken the normal due diligence I suggest of all buyers and tenants, she would have discovered some or all of these issues and either would not have made the decision to purchase or would have seriously negotiated the purchase price. Southward.

3.  Practice Point: Make clear to all parties who you represent. Do it at the inception – ‘first contact rule’ – but then there is nothing that precludes you from reminding the parties several more times before and at closing, in writing. Keep copies too.

Reprinted with the permission of North Texas Commercial Association of REALTORS®, Inc.

Non-Disclosure is Bad. Fraud is Worse.

Tukua Investments entered into a commercial listing agreement with Century 21 Charlotte Banks, to sell Tukua’s commercial property in Eagle Pass, Texas. The property was advertised as being benefited by a triple-net, licensed nursing and rehab center, with a Tenant paying base rental of $300,000 per year. The listed sales price was $2.75 million.

C-21 found a California buyer at the tail end of an IRS Section 1031 tax-deferred exchange. The Contract was prepared on August 16, 2007. In order to attain the benefits of IRS Section 1031, the buyer needed to identify exchange property candidates not later than October 1, 2007, and close not later than February 13, 2008.

The Contract was signed on September 12, 2007, and presumably Buyer timely identified the nursing / rehab center as a deferred exchange candidate. Buyer first learned of a problem with the new tenant, Signature Healthcare, one month later. At that time, it became evident that Signature was not going to fulfill the terms of the Lease.

As Buyer was exploring the reason and basis for the problem, Buyer inadvertently received a copy of a letter referring to an eviction notice from Tukua to Signature of August 8, 2007 – about one week before the first Contract was prepared and submitted to Tukua.

Since it was then too late for Buyer to designate new replacement property candidates, Buyer could only withdraw from the Contract and pay the gains generated from the sale of Buyer’s California property. The extra income tax bite was over $240,000.

Buyer filed a lawsuit for fraud and negligent misrepresentation against the Seller, Tukua. The jury found for Buyer on both counts, and the trial court converted the verdict into Judgment, awarding over $1.3 million to Buyer. Since the underlying damages were $240k, one might assume that a substantial part of the verdict and Judgment was composed of exemplary or punitive damages – the type that is reserved only for fraud cases.

Tukua appealed.

The Court of Appeals carefully analyzed all of the elements of fraud, Texas style. Buyer claimed that Tukua represented to Buyer that there was a valid 10 year lease. The Appellate Court found that Tukua’s representation was true when it was made. There was indeed a valid 10 year lease. The fact that Tukua claimed that Signature was in default did not affect the validity of the lease. That only gave Tukua the right to terminate the lease, evict Signature, or exercise other remedies.

Further, the Court allowed that the lease did not automatically terminate on default. In point of fact, even the delivery of an eviction notice does not serve to terminate the lease. Termination of rights of possession – yes; full-on lease termination; no.

On the fraud point the Appellate Court concluded that representations about future rents or income are typically statements of opinion. Not representations of fact. As such, there can be no actionable fraud claim.

The Buyer then claimed that Tukua had not truthfully represented the conditions, rights, benefits and validity of the lease and that there were serious issues existing with Signature Healthcare.

The Court of Appeals found an appellate decision from Dallas in 1961 stating “A company does not have a duty to disclose all of its financial difficulties while conducting business if it is actively working towards remedying the situation. Silence on the issue alone is not enough to constitute fraud.”

Standing alone it seems this position is subject to challenge, given the facts of this case. However, the Appellate Court then uses several pages to investigate further, and conclude that for an unknown reason this Buyer did not complete the normal due diligence of a typical commercial real estate purchaser. No one from the Buyer’s team really questioned Signature about why they weren’t paying rent. No one asked about unresolved licensing issues.

It seems possible that no Estoppel Statement (or equivalent) was requested of Signature by the Buyer and basically the Buyer just assumed that all was well. That leads me to think that perhaps Buyer was purchasing this parcel for cash, since normally a lender would insist on an Estoppel in this situation.

The Appeals Court overturned the lower court’s judgment. Tukua wins; Buyer loses.

See Tukua Investments, LLC v. Spenst; No. 08-11-00014-CV; Texas 8^th Court of Appeals, August 14, 2013.

Lessons learned:

1.  This case was decided on very narrow facts. Don’t count on getting the same results. Our rule of law, to avoid the courthouse, is unchanged: Disclose too much, not too little. Err on the side of over-communications.

2.  Доверяй, но проверяй. What’s the matter - your Russian a bit rusty? It’s from an old Russian proverb and rhyme – doveryai, no proveryai. Trust, but verify.

3.  Practice Tip: I live in the world of Tenant-Estoppels. We don’t obtain them in multi-family transactions because as a practical matter it is impossible. But we obtain them in every other commercial transaction involving tenants of a significant size. Even if a lender is not involved, commercial buyers need to receive updated, current Tenant Estoppel Certificates, signed by each Tenant. Not the kind that the Landlord signs through a lease-derived power-of-attorney paragraph.

 Reprinted with the permission of North Texas Commercial Association of REALTORS®, Inc.

Puffery vs. DTPA

Paul Kramer builds houses in Tarrant County. Expensive houses. He built a $2 million house for Melissa and Scot Hollmann.

As construction progressed, the house developed a moisture leak. Kramer sent an email to the Hollmanns telling them not to worry because it had been fixed.

After the Hollmanns moved into the house, it developed additional moisture problems involving the windows, HVAC and roof. The Hollmanns continued to receive assurances from Kramer, but when mold moved in the Hollmanns moved out.

And then in 2010 the lawsuits started.

Hollmanns asserted claims against the architect and several subcontractors, and then added Kramer for violations of the Texas Deceptive Trade Practices Act, breach of contract, breach of warranty and negligence. Most of the parties settled before trial, but not Paul Kramer.

The jury awarded approximately $1 million in damages to the Hollmanns after finding that Kramer engaged in false, misleading or deceptive acts. The trial court rendered judgment for the plaintiffs. Paul Kramer appealed.

Kramer’s appeal was primarily based on the theory of “puffery.” That is, that the statements he made and emails he sent contained merely his own opinions, not factual representations.

The trial court found that Kramer told the Hollmanns that the house would be a “magnificent home with a quality level rarely seen in Tarrant County,” that it would be a “kick butt house,” that “this is going to be a really great house,” that it would be “one of the finest homes in the city” and that the Hollmanns would be “pleased as punch.”

The Court of Appeals, perhaps after checking with Urban Dictionary or their 13-year old children, decided quickly that the term “kick butt house” and “pleased as punch” are slang terms comprising opinions, not statements of fact or factual representations.

The Court further advised that Kramer’s claim that the house will be “really great” is too indefinite to constitute an actionable misrepresentation.

Then the Court took a hard look at the other two statements made by Kramer: “magnificent home with a quality level rarely seen in Tarrant County,” and “one of the finest homes in the city.”

Careful evaluation and consideration of previous Texas appellate decisions led the Court of Appeals to decide that these statements were also subjective impressions and did not contain specific representations. Consequently and according to Texas law, all five statements were mere puffery and expressions of opinion – not representations of fact.

But wait there’s more. Kramer made other statements such as “Please don’t worry about the leak that was recently fixed,” and “We feel very strongly we have now identified the problem. Moisture in the walls by the leak will be handled immediately and will not pose a future problem . . . [T]he sills are the culprit” and “You can be sure that any nonsense associated with the resolution of all open issues will cease as of this moment.”

I think it was Kramer’s claim that “there is nothing inherently wrong with the house” that likely put the Hollmanns over the edge, after the house had been infested with mold. The Hollmanns vacated one month later.

The jury found that the latter statements were actionable under the DTPA. The trial court agreed, as did the Court of Appeals.

Hollmanns win. Kramer loses.

See Kramer v. Hollmann; 02-22-00136-CV; Texas Court of Appeals 2^nd District, Fort Worth; November 21, 2012.

Lessons learned:

1.      There is a thin line between statements of opinion and statements of fact or representations.

2.      Although not part of this case, TREC agents and brokers can be held liable and accountable for their statements of fact and misrepresentations, as can Texas property owners, builders, developers, contractors, sellers and landlords.

3.      Paul Kramer filed for bankruptcy protection on December 31, 2012, in Case Number 12-46996-DML-11, US Bankruptcy Court Northern District of Texas, Fort Worth Division. So, sometimes even when you are sure you have won . . . you haven’t really.


Reprinted with the permission of North Texas Commercial Association of REALTORS®, Inc.