The following article by Craig Stephan, entitled “Real Estate Brokers and Agents – What needs to be disclosed?”, was published in the April 2006 edition of the Arizona Journal of Real Estate and Business, Vol. 21, no. 4, at pages 39 et seq.
Real Estate Brokers and Agents – What needs to be disclosed?
Disclosure is one of the main themes in the modern education of real estate professionals. Every licensee in Arizona is required to take renewal classes on this topic. Nevertheless some licensees still lack a basic understanding of the role disclosure plays in a typical real estate transaction. This article aims to explain the vital role of disclosure in a way that will hopefully make it clearer to those who must deal with it on a daily basis.
Disclosure Between Seller and Buyer
There is a Latin phrase that we have all heard when it comes to financial transactions. The phrase is “Caveat Emptor” and it means “Buyer Beware”. This used to be the rule that courts would apply when a buyer complained that he or she was not given important information prior to entering into a financial transaction. Under this rule, the burden was on the buyer to investigate every aspect of a transaction, to make sure that he or she was not being bilked. In a sense, this approach gave a free pass to the seller to withhold information about a deal that only the seller was privy to. The harsh results that followed from the application of this rule led to its demise. The world of “Buyer Beware” is over. The new rule for sellers to follow is the law of disclosure, which is based upon “a judicial policy promoting honesty and fair dealing in business relationships.” Hill v. Jones, 151 Ariz. 81, 84, 725 P.2d 1115 (App. 1986).
In addition, under modern law, duties that apply to the seller often also apply to the buyer. Sellers and buyers in a real estate transaction owe one another a duty of good faith and fair dealing. Hill v. Jones, 151 Ariz. 81, 725 P.2d 1115 (App. 1986), and Lombardo v. Albu, 199 Ariz. 97, 14 P.3d 288 (2000). In short, sellers and buyers must deal fairly with each other. This is the legal basis for seller/buyer disclosure requirements, which are a two-way street. Not only must sellers disclose to buyers, but buyers must disclose to sellers. This is a much fairer approach than the old game of “Buyer Beware”.
Therefore, our first general category of disclosure involves matters that must be disclosed between a seller and a buyer. “Where the seller of a home knows of facts materially affecting the value of the property which are not readily observable and are not known to the buyer, the seller is under a duty to disclose them to the buyer.” Hill v. Jones, 151 Ariz. 81, 85, 725 P.2d 1115 (App. 1986). A material fact is defined as “one to which a reasonable person would attach importance in determining his choice of action in the transaction in question.” Hill v. Jones, 151 Ariz. 81, 85, 725 P.2d 1115 (App. 1986). In other words, if a reasonable party would attach importance to a particular fact in deciding whether or not to enter a transaction, then the fact is material. Some examples of material facts include (1) whether the property is infested with termites, (2) whether a room addition complies with the building code, (3) whether a parcel of land can be developed, (4) whether a house is in a quiet neighborhood, (5) whether a property has city light views, (6) whether a parcel of land has access, (7) whether a water well is contaminated, and (8) whether property is on septic tank or sewer. These are just a few of the myriad examples of possible material facts in a real estate transaction. In general, if a seller knows a material fact about a property that a buyer does not know and cannot readily observe, then the fact must be disclosed to the buyer. Such disclosure is often made in a Seller’s Property Disclosure Statement, however, it can be made in any other written form as well. Disclosure should be timely, i.e., provided far enough in advance of closing to allow the buyer to act on it. Most importantly, the seller should be told that disclosure is a legal requirement, not an exercise in altruism.
Similarly, if a buyer knows of facts materially affecting the transaction which are not readily observable and are not known to the seller, the buyer is under a duty to disclose them to the seller. This would include the fact, known to a buyer, that the buyer probably does not have the financial ability to close the deal. See, e.g., Lombardo v. Albu, 199 Ariz. 97, 14 P.3d 288 (2000). Disclosure of material facts by the buyer should also be made in writing, in order to properly document that disclosure was made.
In addition, the party making the disclosure must tell the whole truth. If some facts are disclosed and others are withheld, this may amount to a false representation. See Hill v. Jones, 151 Ariz. 81, 84-85, 725 P.2d 1115 (App. 1986). Moreover, “a duty to disclose may arise where the buyer makes an inquiry of the seller, regardless of whether or not the fact is material.” Hill v. Jones, 151 Ariz. 81, 86 at footnote 3, 725 P.2d 1115 (App. 1986), citing Universal Inv. Co. v. Sahara Motor Inn, Inc., 127 Ariz. 213, 215, 619 P.2d 485, 487 (1980) (In a commercial real estate transaction, “Inquiry by the buyer about the condition of the electrical system would have imposed a duty on the seller to disclose all it knew”). “A party of whom inquiry is made concerning the facts involved in a transaction must not, . . . conceal or fail to disclose any pertinent or material information in replying thereto, or he will be chargeable with fraud.” Nat. Housing Indus. v. E. L. Jones Develop. Co., 118 Ariz. 374, 379, 576 P.2d 1374 (App. 1978), citing 37 Am.Jur.2d, Fraud and Deceit, § 150, pp. 207-08 (1968). Therefore, if a party to a transaction wants to trigger the duty to disclose specific non-privileged information, especially information which is material to the transaction, one option is to request the information of the other party. The request should be in writing and should ask for a written response. Any response given must be complete, accurate, and not misleading.
In summary, the duty of good faith and fair dealing is the modern legal basis for requiring disclosure between parties to a real estate transaction. This duty of good faith and fair dealing also provides the legal foundation for the Seller’s Property Disclosure Statement. The duty to disclose material facts not observable by or known to the other party is a two-way street. The duty rests upon both sellers and buyers.
Disclosure Between Licensees and Clients
The second general category of disclosure involves parties who are on the same side of a transaction, i.e., real estate licensees and their clients. As you probably know, real estate licensees are agents of their clients. Under the law, an agency relationship imposes on an agent the duty of utmost good faith, integrity, honesty, and loyalty in the agent’s dealings with the client. Musselman v. Southwinds Realty, Inc., 146 Ariz. 173, 175, 704 P.2d 814 (App. 1985). More importantly, real estate licensees are fiduciaries because they possess knowledge and skill in real estate transactions that is superior to that generally possessed by their clients.fn1 Therefore, the client relies on the licensee for protection and information in a real estate transaction. The high degree of duty placed on the licensee serves to protect the client. The law views it as particularly egregious if one in the superior position of a fiduciary uses his or her superior knowledge to take advantage of a client. The two key elements in all of this are (1) the licensee’s superior knowledge and skill which makes the licensee a professional, and (2) the client’s reliance on the licensee to employ this superior knowledge and skill in exercising professional judgment about a transaction.
Moreover, “Courts have imposed on fiduciaries an affirmative duty of good faith and full and fair disclosure of all material facts, as well as an affirmative obligation to employ reasonable care to avoid misleading their clients.” Burkons v. Ticor Title Ins. Co. of Calif., 165 Ariz. 299, 308, 798 P.2d 1308 (App. 1989). In other words, a licensee (1) must disclose all material facts to the client, and (2) must use due care not to mislead the client. This means that if a licensee develops or receives information about a transaction that is or may be material to the client, the information must be disclosed to the client. The failure to disclose the information amounts, at a minimum, to a breach of fiduciary duty. In addition, a licensee must use due care to make sure that information passed to a client remains true and correct. If circumstances change during the course of a transaction, making prior information incorrect, then the licensee must use due care to update the information so that the client is not misled. The failure to update material information passed to a client constitutes negligence, or professional’s malpractice.
As a professional, a licensee has a duty to investigate material facts relating to a transaction, so that he or she can inform and advise the client about the transaction. This duty to investigate is often referred to as performing one’s due diligence. The duty of a real estate broker to investigate a transaction for a client is well summarized in a California case:
“The broker as a fiduciary has a duty to learn the material facts that may affect the principal’s decision. He is hired for his professional knowledge and skill; he is expected to perform the necessary research and investigation in order to know those important matters that will affect the principal’s decision, and he has a duty to counsel and advise the principal regarding the propriety and ramifications of the decision. The agent’s duty to disclose material information to the principal includes the duty to disclose reasonably obtainable material information. . . The facts that a broker must learn, and the advice and counsel required of the broker, depend on the facts of each transaction, the knowledge and experience of the principal, the questions asked by the principal, and the nature of the property and the terms of sale. The broker must place himself in the position of the principal and ask himself the type of information required for the principal to make a well-informed decision. This obligation requires investigation of facts not known to the agent and disclosure of all material facts that might reasonably be discovered.” Field v. Century 21 Klowden-Forness Realty, 63 Cal.App.4th 18, 25-26, 73 Cal.Rptr.2d 784 (1998) (internal citations omitted).
In summary, real estate licensees are agents of their clients, and owe fiduciary duties to their clients. This includes the duty of full disclosure to the client of all material facts relating to the transaction. In addition, the licensee must use due care not to mislead the client. Finally, the licensee must investigate the transaction in order to be able to provide material information and professional advice to the client. The licensee’s greatest legal exposure is to the client, because the failure to comply with legal duties may result in breach of fiduciary duty or in professional’s malpractice. Licensees should remember that they are on the same side as the client, and should act accordingly.
Disclosure Between Licensees and Non-Clients
As stated above, the seller and the buyer are required to deal with one another on the basis of good faith and fair dealing. This duty of good faith and fair dealing owed by principals to one another also extends to their agents. While licensees owe fiduciary duties to their clients, they “shall also deal fairly with all other parties to a transaction.” Ariz. Admin. Rule R4-28-1101(A). In other words, licensees owe a duty of good faith and fair dealing to those who are not their clients. Therefore, the third general category of disclosure involves licensees and non-clients, and is based upon the duty of good faith and fair dealing.
The licensee’s duty of fair dealing toward non-clients does not require investigation of the client in order to pass information to the non-client. Remember, the licensee works for the client, and not for the non-client. However, fair dealing does require disclosure to a non-client of circumstances that a reasonable licensee would perceive as evidence of fraud. Aranki v. RKP Investments, Inc., 194 Ariz. 206, 208, 979 P.2d 534 (App. 1999), referencing Burkons v. Ticor Title Ins. Co., 168 Ariz. 345, 353, 813 P.2d 710, 718 (1991) (analogizing to the duties of escrow agents). Therefore, if a licensee learns information which would lead a reasonable licensee to suspect that a fraud is being perpetrated, this must be disclosed to all parties to the transaction. In addition, a licensee, like the principal, must disclose adverse material information that is not readily observable by or known to the other party.
More importantly, Administrative Rule R4-28-1101(B) provides:
“A licensee participating in a real estate transaction shall disclose in writing to all other parties any information the licensee possesses that materially or adversely affects the consideration to be paid by any party to the transaction, including:
1. Any information that the seller or lessor is or may be unable to perform;
2. Any information that the buyer or lessee is, or may be, unable to perform;
3. Any material defect existing in the property being transferred; and
4. The existence of a lien or encumbrance on the property being transferred.”
This rule requires disclosure in writing to all other parties to the transaction of certain information that materially or adversely affects the consideration to be paid by any party. The broadest category of information referred to in the rule is probably item number 3, “Any material defect existing in the property being transferred.” This could conceivably apply to anything from a construction defect in a home to the fact that land is located in a floodplain.
In addition, every licensee should be aware that under Arizona law, the foregoing Administrative Rule provides minimum standards of care for licensees toward non-clients. Lombardo v. Albu, 199 Ariz. 97, 100-101, 14 P.3d 288 (2000). This is significant, because it means that a violation of this rule constitutes negligence on the part of the licensee. Therefore, a non-client harmed by the licensee’s violation of the rule can bring an action under the theory of negligence per se. In such an action, the violation of the rule creates liability and the non-client must prove only causation and damages. Therefore, it is important that licensees be aware of the above Administrative Rule and comply with its provisions.
In summary, licensees owe a duty of good faith and fair dealing to non-clients. Evidence of fraud in the transaction must be disclosed to all parties. Adverse material facts not readily observable or known to other parties must also be disclosed. Finally, a licensee must take care to comply with Administrative Rule R4-28-1101(B), since violation of the rule constitutes negligence per se. Pursuant to the rule, a licensee must disclose in writing to all other parties to the transaction, certain information that materially or adversely affects the consideration to be paid by any party.
Hopefully, the foregoing provides a useful guide for real estate professionals with respect to disclosure in a real estate transaction.
fn1 “A licensee owes a fiduciary duty to the client and shall protect and promote the client’s interests.” Arizona Administrative Rule R4-28-1101.
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Real Estate Brokers and Agents – What needs to be disclosed?
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