AN UNEXPLODED BOMB IN THE BASEMENT:  A COMMERCIAL-PROPERTY SELLER’S HANDY GUIDE TO DISCLOSURES UNDER CALIFORNIA LAW

“An ‘as is’ provision may therefore be effective as to a dilapidated stairway but not as to a missing structural member, a subterranean creek in the backyard or an unexploded bomb buried in the basement, all being known to the seller.” Lingsch v. Savage, 213 Cal.App.2d 729, 735-36 (1963)  

THE THREE LEGAL BASES FOR AN OBLIGATION TO DISCLOSE 

One question that we real-estate attorneys hear frequently from our clients is “What do I need to disclose to the prospective buyer about the property?”  To answer that question, one needs to understand the three legal bases for the disclosure obligation: the common law, statutes, and the purchase contract itself.

COMMON-LAW DISCLOSURES 

We have inherited from the English the body of law and jurisitic theory that was in force at the time of the American Revolution; that system is known as the common law.  In California, it is well established that in any real property sale transaction, the seller has a common-law duty to disclose to the buyer facts that: (i) are known or accessible only to the seller, (ii) materially affect the value or desirability of the property, and (iii) are not known to or within the reach of the diligent attention and observation of the buyer.  (See Holmes v. Summer, 188 Cal.App.4th 1510, 1518-19 (2010).)  (This duty applies to both commercial and residential transactions, but this article is limited to commercial transactions.)
It is often debatable as to whether a given fact needs to be disclosed in order to satisfy this common-law duty, as the circumstances of each property and each transaction are unique.  There are, however a number of judicial decisions that provide guidance; here are just a few examples of facts that are likely to be material:

• known building-code violations
• the improvements are built on fill
• the improvements were built without permits and in violation of zoning regulations
• the structure has been condemned
• water infiltration in the soil
• raw land is fill
• net income for property has been overstated
• third-party inspection reports for the property
• notices from a government official or other third parties alleging some adverse condition on the property
• any claim made by the seller to any insurance company regarding any condition of or occurrence at the property
• any unusual circumstance or event near the property, including criminal activity, disease, industrial accident, casualty or other act of God, and soil subsidence or slide
• any unusual noise, disturbance or other condition seasonally or generally affecting the property, but not apparent during the marketing period.

If you are a seller pondering whether you are required to disclose a given fact, it can be useful to imagine yourself in the buyer’s position and ask “is this a piece of information that would affect my decision to buy this property if I were the buyer?”  Clearly, the best practice is, when in doubt, disclose (yes, that is easy advice for a lawyer to dispense, but it is nonetheless wise counsel).  And it is best to make the disclosure as early as possible in the transaction—preferably before the execution of the purchase contract, and in all events well before the expiration of the buyer’s due-diligence period.  Those disclosures should be made in writing, of course, and it is prudent to obtain the buyer’s written acknowledgement of receipt.

The scope of the common-law disclosure obligation is indeed broad, but it does not extend to obvious defects or those defects that the buyer could discover by a reasonably prudent inspection.  Note, too, that the seller’s obligation is limited to disclosing facts, and does not require the seller to educate the buyer on the ramifications of those facts.  For example: if the seller discloses the existence of an easement, it is up to the buyer alone to determine the effect that easement will have on the value and desirability of the property.  Similarly, the seller has no duty to explain the consequences of the property being located in a flood zone.

Bear in mind that the common-law duty is distinct from the duties that arise from statutes or the purchase contract (discussed below) – even if you have disclosed all information mandated by the statutes or the purchase agreement, you may not have satisfied the common-law obligation.

STATUTORY DISCLOSURES

The California legislature has imposed an ever-expanding list of disclosure obligations on sellers, but the majority of those obligations apply only to transfers of real property involving one to four dwelling units.  However, because the commercial-property disclosure obligations are scattered throughout many different codes, and often lumped in with the residential requirements, it is no simple thing to list all the necessary disclosures that apply to a commercial seller.  To further complicate matters, there are also disclosure obligations imposed by local jurisdictions (see, for example, the East Bay Municipal Utility District’s Consolidated Regional Private Sewer Lateral Ordinance, which applies to the cities of Alameda, Albany, Emeryville, Oakland, and Piedmont, and took effect on May 24, 2019).

Here are some of the most commonly required disclosures for commercial-property sales:

• FEMA special flood hazard areas (Cal. Gov. Code § 8589.3)
• Flood inundation zones (Cal. Gov. Code § 8589.4)
• High fire hazard severity zones (Cal. Gov. Code §51183.5)
• Earthquake fault zones (Cal. Pub. Res. Code § 2621.9)
• Seismic hazard zones (Cal. Pub. Res. Code § 2694)
• Wildland fire risk areas (Cal. Pub. Res. Code § 4136)
• Known hazardous substances (Cal. Health & Safety Code § 25359.7)
• Delivery of California’s Commercial Property Owner’s Guide to Earthquake Safety (Cal. Government Code §§ 8875.6 and 8893.2)

The California Association of Realtors has published a “Seller Disclosure Chart” that is an easy-to-use reference guide for determining the applicability of the California statutes to various transactions: https://www.car.org/en/riskmanagement/disclosure-charts/sales-disclosure-chart.  This is the most comprehensive disclosure guide I have found; I encourage you to consult it often.

Occasionally, I see seller-oriented purchase contracts in which the buyer is purportedly waiving its right to receive the disclosures dictated by California statutes.  Those waivers are not likely to be upheld by a judge, as I believe they contravene public policy, and I would advise a seller against relying on them.

CONTRACT-BASED DISCLOSURES 

Parties are free to, and in fact do often, negotiate disclosure obligations which exceed both the statutory and common-law duties; these disclosures are typically expressed as representations and warranties by the seller.  For example, in the absence of a representation or warranty by the seller that the property complies with all zoning, the seller is not required to disclose a nonconforming use caused by change in the zoning ordinance–unless the seller has actual knowledge of nonconforming nature of use (because of the common-law duty).  However, if the seller makes an affirmative representation about zoning, the seller has assumed the burden of investigating zoning and disclosing to the buyer the existence of a nonconforming use.  This burden can be reduced back down to the common-law level of obligation by restricting the representation to the actual present knowledge of Seller, without duty of investigation or inquiry.

Because of the complexity and severity of the potential consequences of a badly written clause (which can include rescission of the contract as well as an action for damages), the representations and warranties provision in a purchase agreement is often one of the most difficult for the parties to reach agreement on.  There is far from universal agreement about how extensive seller’s representations and warranties should be, and the issue typically comes down to the relative bargaining strength of the parties.  However, as a general rule of thumb, I think a fair guiding principle is that the seller should not be obligated to make representations and warranties as to facts that can be readily ascertained by the buyer or verified by third parties.  For example, if a buyer seeks assurances that the property in question is a legal parcel that complies with the California Subdivision Map Act—which is a legitimate concern–the party most appropriate to provide such assurances is the local city or county, by means of certificate of compliance, rather than the seller.  Similarly, it is appropriate to ask that the seller represent that, except as disclosed, there are no leases affecting the property, since the seller is uniquely qualified to supply that information.

THE IMPACT OF AS-IS CLAUSES 

Comprehensive “as-is” and other exculpatory provisions have become almost universal in purchase agreements in recent years; however, while those provisions are useful to limit the scope of the seller’s contractual disclosure obligations, they will not necessarily reduce the seller’s common-law disclosure duty.  The principal (and entirely defensible) purpose of a comprehensive “as-is” provision is to reinforce the notion that the buyer is obligated to independently inspect the property, and a well-crafted provision can assist the seller in defending against a claim that the seller failed to disclose defects that the seller should have known about but did not due to the seller’s failure to inspect.  However, there is a very strong public policy in California against the enforcement of any contractual provision that is intended to eliminate or minimize a party’s liability for fraud or other wrongful acts.  Even the best-written contract will not protect a seller who knowingly defrauds a buyer.  (See the quote from Lingsch v. Savage above, and California Civil Code section 1668, which states “All contracts which have for their object, directly or indirectly, to exempt anyone from responsibility for his own fraud, or willful injury to the person or property of another, or violation of law, whether willful or negligent, are against the policy of the law.”).

CONCLUSION 

The property information to be disclosed, and the timing and method used to disclose such information, are topics of great import to buyers and sellers alike.  This is an area that an experienced lawyer can add a lot of value, but it is also advisable that any seller take the time to understand its disclosure obligations under the common law, the statutes, and the purchase contract itself.  A little common sense goes a long way in this process—but in all events, do remember to tell the buyer about the unexploded bomb in the basement.

DISCLAIMER:  This article does not constitute legal advice.  Readers should consult with their own legal counsel for the most current information and to obtain professional advice before acting on any of the information presented.

BIOGRAPHY:  Tom Stewart is a named partner of Stewart Ward & Josephson LLP.  He specializes in commercial real estate transactions, and can be reached at tstewart@swjllp.com; 916-569-8121.  

 

 

 

 

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