Real Estate Memoranda

Authored by Jones Osborn II

I. PURCHASES AND SALES

A. Contracts

101 When to Hire a Lawyer (And If You Do, Don't Tie His Hands Behind His Back)

102 Signing Contracts for a New Company

103 Power of Attorney

104 Notarization of Documents

105 American With Disabilities Act (ADA)

106 Rights of First Refusal

107 Airport Noise

108 Surveys

109 Rule Against Perpetuities

110 Duty to Disclose Defects

111 Release of Earnest Money Prior to Closing

112 Contracts That Must be in Writing

113 Sale of Vacant Land

114 What Does it Mean to Sell Property "As Is"? (Not as Much as You Might Think)

115 What's Wrong with the Standard Form of Purchase Contract?

116 Is An Electronic Signature Legally Binding?

117 Are Contracts With A "Free Look" Enforceable?

B. Remedies

201 Earnest Money

202 Cancellation Provisions

203 Termination for Breach

204 Specific Performance

205 Liquidated Damages

206 Waiver of Jury Trial

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207 Arbitration

208 Escrow Losses

209 Lis Pendens

210 When Can You Place A Lien On Another Person's Property?

C. Deeds and Conveyances

301 General Warranty Deed

302 Special Warranty Deed

303 Quit-Claim Deed

304 Recording Requirements

305 Slander of Title

306 Mineral Reservations

307 Affidavit of Property Value

308 Fraudulent Conveyances and Voidable Preferences -- How Creditors Can Recover Property Transferred to Third Parties

309 Purchase Price Must Be Disclosed To The Public When Recording A Deed

D. Ownership

401 Joint Ownership

402 Ownership by Spouses

403 Disagreements of Joint Owners

404 Nuisances

405 Responsibility for Crimes

406 Towing of Cars

407 Prescriptive Easements

408 Adverse Possession

409 Three Ways Land-Locked Property Can Gain Legal Access

II. MORTGAGES AND DEEDS OF TRUST

A. Terms and Provisions

501 Commitment Letters

502 Assumptions

503 Purchase of Property with Existing Encumbrance

504 Prepayment

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505 Governing Law

506 Releases as Affected by Statute of Frauds

507 Releases Pending Default

508 Adverse Possession

509 Unintentional Mortgages

510 When Are Additional Loans Secured By An Existing Deed Of Trust?

511 How To Remove A Mortgage Or Deed Of Trust From Your Property

B. Foreclosure

601 Judicial Foreclosure v. Trustee's Sale

602 What Can Delay Foreclosure

603 Notice of Foreclosure

604 Renegotiation of Debt and Loss of Priority

605 Statute of Limitations

606 Back Taxes After Foreclosure

607 Deficiency Judgments

608 Deficiencies on "Spec" Homes -- Decision Also Sets Out Rules for Multiple Mortgages

609 Personal Liability for Limited Partners

610 Arizona's Anti-Deficiency Statutes

611 Foreclosure Sales: Who Gets the Money?

612 How to Foreclose on Personal Property

613 When Can You Be Sued For Defaulting On Your Home Mortgage?

III. TITLE INSURANCE

701 Standard Coverage

702 Extended Coverage

703 Endorsements

704 Patent Exception

705 What is Excluded (As Opposed to Excepted) From Your Title Insurance Coverage?

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IV. PROPERTY TAXES

801 Basic Provisions

802 Assessments

803 Back Taxes

V. DEVELOPMENT

901 Water Service

VI. ZONING AND LAND USE LAWS

1001 Downzoning

1002 Legal Challenges to Zoning and Land Use Restrictions

1003 Limits on Local Ordinances

1004 Damages for "Takings"

1005 Right to Sue For Zoning Decision

1006 Required Street Dedications

1007 Variances

1008 Non-Conforming Uses

1009 Contracts Not to Oppose Zoning

VII. SUBDIVISIONS AND LOT SPLITS

1101 Basic Principles

1102 Exceptions

VIII. DEED RESTRICTIONS

1201 Basic Principles

1202 Homeowners Associations

IX. CONDEMNATION

1301 Roadways

X. LEASES

A. Terms and Provisions

1401 Basics of Leasing

1402 The BOMA Standard

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1403 Assignment and Subletting

1404 Non-Disturbance Agreements

1405 Guarantors

1406 Going Dark

1407 CPI Adjustments

1408 Maximum Term

1409 Special Rules Apply to Rental of House or Apartment

1410 Should You Assign Your Lease Or Sublet Your Space?

1411 Make Sure Your Right Of First Refusal Is Not A Watered-Down Imitation

B. Breach and Remedies

1501 Minor Breaches

1502 Termination and Damages

1503 Mitigation

1504 Limitations on Landlord

1505 Tenant Bankruptcy

1506 Landlord's Liens

1507 What To Do If Your Tenant Doesn't Pay His Rent

C. Other Issues

1601 Mechanics' Liens Caused By Tenant

1602 Landlord Liability For Nuisance

1603 Estoppel Certificates

1604 Lease/Option Agreements

1605 Rent Tax

1606 Subleases When Master Lease Terminated

1607 Ground Leases

1608 Sublease Space or Not?

1609 Amending Your Lease? If You Miss This Small Detail, You May Be Out Of Luck

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XI. ENVIRONMENTAL

1701 Innocent Purchaser Defense

1702 Disclosure Requirements

1703 Mortgagee Liability

1704 Wetlands

XII. COMMUNITY PROPERTY

1801 Basics of Community Property

1802 Effect on Real Estate Transactions

XIII. INCOME TAX

1901 Tax-Deferred Exchanges

1902 Renegotiation of Debt

XIV. CONSTRUCTION AND MECHANICS' LIENS

2001 Builder Liability

2002 Joint Checks

2003 Discovery of Hazardous Substances

2004 How to Recover When You Don't Have a Lien

2005 What Is A Pre-Lien Notice And What Should You Do When You Get One?

XV. BROKERAGE

2101 Commission Rules

2102 Does An Out-Of-State Broker Have To Comply With Arizona's Brokerage Laws?

XVI. MISCELLANEOUS

2201 Subrogation

2202 Fixtures

2203 Annexation Pros and Cons

2204 What is a Judgment Lien?

2205 What is an Opinion Letter and Why is it Required?

2206 What Is A Construction Bond And Who Can Collect On It?

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MEMORANDUM #101 When to Hire a Lawyer

(And If You Do, Don't Tie His Hands Behind His Back)

Anyone about to enter into a major contract should consider consulting an attorney. Especially if it is a contract for the purchase or sale of real estate or a business.

A contract which seems clear on its face can have hidden pitfalls and provisions which may be unenforceable or which create more liability than one might expect. Sometimes important issues are completely overlooked. Having a trained professional review the document is usually a good idea, and well worth the cost. It's always cheaper to sign a good contract up front than it is to litigate a bad contract later. Attorneys themselves usually hire another attorney to review important contracts before signing.

Deal Killers. Sometimes the parties to a transaction are warned against going to an attorney on the grounds that they are "deal killers." The truth is that an attorney has no interest in telling his client he shouldn't do a deal he wants to do. The client is disappointed, and the attorney generally earns a smaller fee. A good attorney will do his best to correct the problems so the deal can go forward.

It is true that an attorney will point out any legal problems he sees. In some cases he might even recommend against the transaction. This is what he is hired to do. If a client chooses not to go forward after receiving good legal advice, it is hard to see how that client has been ill-served. On the other hand, if a client should ever feel that his attorney has a negative attitude or some sort of perverse interest in killing a deal, he should immediately raise the issue with this attorney, and if necessary seek other counsel.

I have never heard a client complain that his own attorney "killed a deal"--that is a complaint that seems to come only from the other party to the transaction. The attorney's job is to fully and fairly advise his client in order to help his client achieve his objectives, not to "kill deals."

If You Hire A Lawyer. If you do decide to hire an attorney--don't tie his hands behind his back! By this I mean that you should bring the deal to your lawyer before you sign it. This sounds so obvious that it hardly needs to be stated--but every lawyer is faced with the situation where a client brings in a contract for his lawyer's review after it has been signed by both parties. Of course, the lawyer can still review the contract and advise the client of its legal consequences. Sometimes he can even reopen negotiations if necessary to correct problems or omissions. But it places you and your lawyer at a disadvantage because the other party may refuse to negotiate any necessary revisions or may ask something in return. The best practice is to tell the other party that you just don't sign anything until your lawyer looks it over.

What if you feel that a deal is so good that it will get away if a contract is not signed on the spot? This is understandable, and it happens all the time. The best advice is to try to insert a provision in the contract, handwritten if necessary, stating that the contract is subject to your lawyer's review. This does not give your lawyer as much leeway to correct any problems, because the other party will feel like you are renegotiating the deal and may react adversely to any changes your lawyer suggests. On the other hand, it's better than being legally bound to a bad contract with no escape.

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Conclusion. Give serious consideration to having an attorney review every major contract before you sign. If you can't resist signing the contract on the spot, at least try to insert a provision stating that it is subject to your attorney's review.

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MEMORANDUM #102 Signing Contracts for a New Company

Suppose you're starting a new business venture. Maybe it's just a single real estate deal, or maybe it's a regular operating business. In either case, you will need to sign some contracts to get the venture going. Perhaps you will be buying property or leasing space, or maybe ordering supplies and equipment. Whatever it is, you wisely plan to sign all contracts in the company's name to avoid personal liability.

Your intention is to organize the new venture as a corporation or limited liability company. This makes good business sense. Changes in the law over the last few years have made both the general partnership and the limited partnership obsolete for most purposes. A corporation or a limited liability company can furnish protection against personal liability without double taxation or other income tax problems.

So far, so good. There's only one catch. You have to get the organization legally formed before you sign any contracts. If not, you could have exactly the kind of personal liability you were trying to avoid.

Limited liability companies and corporations are not legally formed until the proper papers have been filed with the state. Unless and until this is done, the company does not exist. This means that any contracts you sign in the company's name will be your personal responsibility. This is so even if you sign as "John Doe, on behalf of the ABC Corporation," or in some similar fashion. This personal liability will not terminate later after the company is formed, even if the company expressly assumes the obligation. If the later company fails, you could be left holding the bag for any contracts you signed before the company's legal existence began.

Exceptions. That's the general rule. There are some exceptions, however. For example, under the Arizona Corporate Code it appears that you would not be liable if you signed on behalf of a corporation without actual knowledge that the corporation did not exist. On the other hand, there appears to be no such exception for limited liability companies--if you sign for a limited liability company thinking that it exists, you are personally on the hook if it turns out that it isn't.

Another exception to the general rule is that you can expressly provide otherwise in the contract. For example, you can provide that the contract is being signed on behalf of a company to be formed, and that after it has been formed and has adopted the contract, the signer will be released from personal liability. In some cases it is also possible to escape liability if it can be shown that both parties to the contract intended the signer to be released after the company was formed--but this is difficult to prove unless it is expressly stated in the contract and should not be relied on.

Conclusion. If you are signing a contract on behalf of a new company, make sure the company has been validly and legally formed. If you know it has not yet been formed or are not sure, put a provision in the contract that you are signing on behalf of a company "to be formed." Also state that as soon as it has been formed and has adopted the contract, you are released from all further personal liability.

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MEMORANDUM #103 Power of Attorney

A Power of Attorney is a document authorizing one person to act for another. In real estate transactions, a Power of Attorney is often used when one of the parties is unavailable and wants someone else to sign the closing documents on his behalf.

The Power of Attorney is a very useful device. However, it can also be a very dangerous device because it can empower one person to deal with another person's assets in ways he may not agree with, or even to enrich himself at the other person's expense by self-dealing. There are also some tricky rules that govern the validity of a Power of Attorney and which can create civil and criminal liabilities. Before you give someone your Power of Attorney, and before you agree to act on behalf of someone else pursuant to a Power of Attorney, there are a few things you should know.

The Parties. First, the basics. A Power of Attorney involves two parties: the person who signs it (the principal), and the person to whom it is given (the attorney-in-fact, or agent).

Scope. Powers of Attorney can be general or special. A General Power of Attorney gives the agent the power to act on the principal's behalf without limitation; in other words, the agent can do anything on behalf of the principal that the principal has the power to do for himself. A Special Power of Attorney, on the other hand, gives the agent the power to do only the things specified in the Power--for example, to buy or sell a specific parcel of property at a specified price. Obviously, you should be very careful about giving anyone a General Power of Attorney. In most cases, a Special Power will get the job done with much less risk.

Duration. Generally, a Power of Attorney continues in effect until (a) it is revoked, (b) it expires by its terms, or (c) the principal dies or becomes legally incapacitated or incompetent at which time it is automatically revoked. Even if it is revoked, it continues to be effective as to third parties who do not know it has been revoked. Therefore, it is usually a good idea to put an expiration date in the Power so that it does not continue for years if you should happen to forget to revoke it.

There is a particular kind of Power designed to survive the disability of the principal, known as a Durable Power of Attorney. This is used when the principal wants the agent to continue to have the power to act on his behalf if the principal should become incapacitated.

Special Requirements. Many states have special statutes governing Powers of Attorney, so it can be risky to use a stationery store form or to copy one from someone else. In Arizona, for example, a Power of Attorney granted by a natural personal must be signed by a witness which is not the principal's spouse or child, and must be notarized by a notary public in addition to the witness. In addition, the Power must contain certain specific language in order to be legally enforceable.

In Arizona, if the agent is to receive any sort of fee, commission, compensation or other benefit in connection with the exercise of the Power, or if the Power authorizes the agent to do something that is not strictly and solely in the principal's best interests, these details must be specifically spelled out in the Power and must be separately initialed by both the principal and the witness. If this is not done, the agent who exercises the Power in a way that is not solely in

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the principal's best interests can be guilty of a criminal offense and may also be sued civilly. For example, if a broker is given a Power of Attorney to sign a Deed for his client and receives a commission on the sale, the broker could be in trouble unless the Power specifically identifies the commission and this provision is separately initialed by both the principal and the witness. Because of the harshness of this provision and the ease with which it can be inadvertently violated, it is best to give a Power of Attorney to someone who is completely removed from the transaction (and it never hurts to have a lawyer look it over).

How to Sign. A constant source of confusion arises from the way a document should be signed by an attorney-in-fact. Here is the way an attorney-in-fact ("Al Agent") should sign for his principal ("Peter Principal"):

Peter Principal, by Al Agent as his attorney-in-fact

Cumbersome as it is, the agent should write all of that out in his own hand in the place where the signature is supposed to go.

Conclusion. A Power of Attorney is a useful but potentially dangerous instrument. Be very careful when granting a Power or agreeing to become an attorney-in-fact for someone else. Seek legal counsel before exercising a Power where doing so creates a benefit for you of any kind, even if your intentions are pure.

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MEMORANDUM #104 Notarization of Documents

Deeds, mortgages, and other important papers often require the signature of a notary public. This can be inconvenient if the document is sent to you at home or while you are on vacation because you have to go out and find a notary. This raises the question: Is notarization really necessary? What does it accomplish, anyway? And what do you do if the document is sent to you while you're in another state or foreign country?

Background. The certificate the notary signs is legally known as a "certificate of acknowledgement" or "jurat." The certificate of acknowledgement is the notary's verification that the signer (a) personally appeared before the notary, and (b) stated that he or she voluntarily signed the document for the purposes contained in the document. A document may be signed outside the presence of the notary, as long as the signer personally appears before the notary when requesting the notarization and states that he or she actually signed the document. It is not legal for a notary public to acknowledge a document for someone who does not personally appear before the notary.

The exact language of the certificate of acknowledgement is not important, so long as it expresses the idea that the signer personally appeared and acknowledged signing the document.

Purpose. In some states, documents will not be accepted for recording unless they are notarized. In other states, such as Arizona, they may be recorded, but will have limited legal effect without the acknowledgement.

For example, under A.R.S. § 11-480(A)(3), a document need only have an original or carbon copy of a signature to be recorded; a certificate of acknowledgement is not required. However, A.R.S. § 33-411 states that a recorded document affecting real property is not deemed to give public notice unless it has been properly acknowledged. Therefore, in Arizona an unacknowledged deed or mortgage can be recorded, but it doesn't offer the same protection as an acknowledged document. Consequently, most documents affecting real property should be properly acknowledged and recorded in order to gain the protections provided by law against other parties who may later challenge title or claim an interest in the property.

The Arizona statute contains a savings clause. This provides that if a document with a defective certificate of acknowledgement is recorded, it will be retroactively treated as valid after it has been recorded for a period of one year.

Acknowledging a document also makes it easier to admit it into evidence in a court proceeding, and can assist in proving its validity.

Who Can Sign Acknowledgement? In Arizona, acknowledgements may be given before a notary public, judge, clerk or deputy clerk of the court, county recorder, or justice of the peace.

If you are in another state when you need to acknowledge an Arizona document, it should not be a problem. An acknowledgement which is valid in the state where given is also valid in Arizona. Just have the document acknowledged by a notary public in the state where you happen to be at the time.

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It can be slightly more complicated in a foreign country, because notary publics are sometimes regarded as high public officials in other countries and may be unavailable for a routine notarization or may be expensive. In such a case, the certificate of acknowledgement may be signed by a local judge or a clerk or deputy clerk of the court. You can also go to the local U.S. Embassy and obtain an acknowledgement from an officer of the U.S. foreign service, a consular agent, or other person authorized by the U.S. State Department to perform notarizations. Commissioned officers in American armed forces overseas can also notarize documents for members of the armed forces and their dependents.

Conclusion. Acknowledgements furnish very important protections, particularly for documents affecting interests in real estate, such as deeds, mortgages, deeds of trust, easements, and deed restrictions. As a general rule, all recorded documents should be notarized.

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MEMORANDUM #105 American With Disabilities Act (ADA)

Anyone purchasing or leasing a commercial building--or even lending money on one--should consider the Americans With Disabilities Act (the "ADA"). This is a federal law enacted in 1990 which can require substantial and expensive changes to buildings and other structures. In general, this law requires such things as wheelchair-accessible entryways, passages and bathrooms, elevators in certain circumstances, Braille signage, lowered telephone and drinking fountains, and so on.

Types of Property. The ADA classifies property as one of three types: (1) places of public accommodation, (2) commercial facilities, and (3) residential dwellings.

Places of public accommodation include such things as hotels and motels, restaurants, bars, movie theaters, shopping centers, schools, and other places where the public gathers. These uses require the highest level of accommodation for those with disabilities. A plan must be adopted by the owner to bring the building into compliance with the ADA over a period of time, regardless of whether other renovations are planned for the building.

Commercial facilities include all privately-owned places of business to which the public is "invited." An example might be the front office of a manufacturing facility. These normally have less stringent compliance requirements until the building is renovated, at which time the requirements become much more burdensome.

Residential dwellings are homes, apartments and condominiums. Normally, these are not subject to the ADA. However, if someone has a home office which is open to customers or other members of the public, the ADA applies. The same is true of rental and sales offices in an apartment or condominium complex.

Compliance. Buildings constructed since 1991 are generally in compliance with the ADA. However, buildings constructed before then may not be in compliance. If that is the case, and if the building is a commercial facility, the law generally requires the building to be brought into compliance if compliance is "readily achievable." Obviously, this is a vague standard and it is not clear how much expense and disruption the owner or lessee must incur to comply with the ADA. However, it is generally thought that the owner is not required to incur disproportionate expense to bring the building into compliance.

When the building is altered or renovated, however, the burden becomes much greater. In this case, the building must be brought into compliance "to the maximum extent feasible." This means that cost is largely irrelevant. Fairly minor alterations or renovations can trigger very expensive compliance requirements. Therefore, be careful when doing work on a building which is not in compliance--or you may end up doing a lot more work than anticipated.

Elevators can be required in multi-story buildings unless the building (a) is less than three stories and (b) has less than 3,000 feet per story. This exception is not available to medical offices or shopping malls. Therefore, if you are purchasing a multi-story building without an elevator, be very sure you understand the ADA requirements. Elevators can be very expensive to retrofit.

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Responsibility. Generally, a landlord is responsible for the public areas of the building, such as sidewalks, parking garages, entryways and lobbies, and the tenant is responsible for its own space. However, this can be changed by agreement of the parties. If you're leasing improved space into which the public may be invited, whether an office, a store, or other facilities, be sure to either check the space for compliance or have the landlord assume full responsibility for any ADA compliance requirements.

When lending money on older buildings, lenders should conduct a compliance survey, since they may end up owning the building in the event of foreclosure. In that event, they could become responsible for ADA compliance.

Enforcement. The ADA may be enforced either by a private suit or by the Justice Department. In a compliance action, the court may enjoin construction that does not comply, or may order the property to be brought into compliance. In addition, in a suit brought by the Justice Department it may seek damages of up to $50,000 for the first violation and up to $100,000 for each succeeding violation.

Conclusion. When purchasing, leasing, or lending money on improved non-residential real estate, particularly if constructed before 1991, consider having an ADA compliance survey performed. These are usually not expensive and can save considerable money down the road. And before remodeling or altering a building--even in a minor way--determine whether you will trigger a duty to bring your building into compliance and if so, the cost.

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MEMORANDUM #106 Rights of First Refusal

Rights of first refusal are very common, and seem to be used in all sorts of business deals. You should avoid them like the plague.

A right of first refusal gives the holder of the right of first refusal (the "Holder") the opportunity to match any offer you receive on your property from a third party. For example, if you receive a million dollar offer on your property that you wish to accept, first you have to offer to sell the property to the Holder for a million dollars. Only after the Holder refuses to purchase the property for a million dollars may you sell it to the third party.

What's the Problem? This seems pretty harmless. Normally, you don't care who purchases your property, and a million dollars from one party is as good as a million from someone else.

So why should you avoid giving someone a right of first refusal? There are several reasons:

First, many buyers are discouraged from doing the work necessary to make an intelligent offer if they know someone else has a right of first refusal. Who wants to investigate a property, determine its value, and then write up an offer if someone else can purchase it out from under them for the same price? The result is that the property becomes less marketable and therefore less valuable.

Second, a right of first refusal can seriously interfere with a timely closing. The reason is that if the parties agree to change the deal in any material way after the offer has been presented to the Holder, they have to go back to the Holder and again offer the property on the revised terms. For example, if the buyer and seller discover a problem shortly before the closing and agree to adjust the purchase price or to change some other term of the deal, the property must again be offered to the Holder, and the Holder's time period must again be allowed to run. The result is often frustration and delay, and sometimes the deal even falls apart as a result.

Third, rights of first refusal are a frequent source of litigation. Many disagreements can arise when a right of first refusal exists. What happens, for example, if an offer is received for only part of the property? What happens if someone offers other property in trade? Both of these situations can cause the kind of disagreements that can lead to litigation.

Another source of litigation, believe it or not, is that people often forget they have given someone a right of first refusal, perhaps years earlier. Later they enter into a contract to sell the property to a third party. If the Holder appears and asserts his rights, the seller is placed in a difficult position and may end up getting sued by the buyer and the Holder, both of whom claim a legal right to purchase the property.

In other cases disputes arise over whether a right of first refusal has been waived, or whether a proper offer has been made. With rights of first refusal, the causes of litigation seem endless.

Conclusion. A right of first refusal is often given as a harmless throwaway in the course of negotiating a deal. This is usually a serious mistake. A right of first refusal is a serious detriment to the value and marketability of property and often leads to litigation. In most situations you should avoid granting rights of first refusal if at all possible.

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MEMORANDUM #107 Airport Noise

We've all heard the phrase "caveat emptor" - let the buyer beware. This is still the general rule for the sale of real estate, and it means that the seller generally has no affirmative duty to disclose to the buyer defects or unfavorable attributes of the property he is selling.

There are exceptions, however. One exception in Arizona is that sellers are required by law to disclose to potential purchasers of residential property that the property is located "in the vicinity" of a military airport.

According to Arizona law, the Arizona Department of Real Estate is required to prepare maps indicating which properties are so located. The seller must then inform himself of this information and disclose it to the purchaser.

Apparently, the statute is designed to warn purchasers of residential property that there may be noise problems, and potentially even crash problems, with the property they are considering for purchase. It is not clear whether the statute applies only to existing houses and apartment buildings, or whether it also applies to raw land that is zoned for residential purposes. The statute simply refers to "residential real property."

Strangely, the disclosure is not required for civilian airports, although the law does provide that any municipality operating an airport may establish areas affected by the airport. If a municipality does establish such areas it is required to record this information with the County Recorder to give notice to all future purchasers of such property that is near a civilian airport.

The statute provides no explicit remedy for failing to make the required disclosure. However, it seems possible that the failure to make a disclosure required by law could be considered fraud, perhaps giving the buyer the right to seek rescission or damages.

Conclusion. If you are selling property that is near a military air base, check with the Arizona Department of Real Estate to see if your property is legally considered to be "in the vicinity." If it is, disclose it in your sales contract and in your deed.

__________________ The statute referred to above is A.R.S. § 28-8484.

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MEMORANDUM #108 Surveys

If you are buying acreage or commercial property, either improved or vacant, you will probably want to have the property surveyed. And if you are buying extended coverage title insurance, you must have it surveyed because the title company will require it.

The survey is important because it discloses the exact physical location of the property, its size, any encroachments, and the location of easements, buildings, walls, ponds, driveways, dedicated roads, setback lines, and other physical features of the property. You can also have the surveyor physically stake the corners so you can see where the property begins and ends.

Whether you intend to require another party (such as the seller) to provide you with a survey, or order one for yourself, you need to specify exactly what kind of survey you want, because there are different types of surveys for different purposes.

To begin with, you should normally specify that you want a survey "prepared by a registered land surveyor in accordance with the Minimum Standard Detail Requirements for ALTA/ACSM Land Title Surveys as established by the ALTA, ACSM and NSPS in 1999." This is the kind of survey you will need if you desire to purchase an extended coverage policy of title insurance, and it is probably the kind of survey you will want anyway because it meets the strictest standards of accuracy and disclosure. Most lenders will also require a survey meeting these requirements.

You must also determine the class of survey that you want. There are four classes of ALTA/ACSM land title surveys. Beginning with the most accurate, they are as follows:

Urban Surveys: These are normally surveys of land lying within or adjoining a city or town. They may also be used for surveys of commercial or industrial properties, condominiums, and apartments.

Suburban Surveys: These are normally surveys of land lying outside of urban areas, often for single family residential subdivisions.

Rural Surveys: These are generally used for surveys of land such as farms and other undeveloped land lying outside of suburban areas which may have a potential for future development.

Mountain and Marshlands Surveys: These are surveys of lands in remote areas with difficult terrain and which usually have limited potential for development.

You may also want the survey to show optional items not ordinarily included in a basic survey. A list of optional items can be selected from Table A to the Minimum Standard Detail Requirements for ALTA/ACSM Land Title Surveys, which is attached. For extended coverage policies, title companies will normally require a survey that includes Items 1 (monuments), 6 (setback, height and area restrictions), 8 (improvements other than buildings), 10 (access), 11 (utilities), 14 (signs of recent construction), 15 (proposed or completed changes in street rights-of-way), and 16 (evidence of landfill or dump). If there is a lender there may be additional

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requirements. It is a good idea to check with your lender before ordering the survey so you know what is required.

The survey should also be certified to the seller, the buyer, the title company, and the lender. Only those to whom the survey is certified are legally entitled to rely on it.

Surveys are usually not required for single family homes unless a large lot is involved or there is reason to suspect a problem.

Conclusion. If you are purchasing a survey or requiring someone else to purchase one for you, be sure to specify exactly the kind of survey you want, and require that it be current - no more than six months old. By knowing what to ask for you will get the survey you need without unnecessarily wasting time or money on a survey that is unsuitable for your purposes.

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MEMORANDUM #109 Rule Against Perpetuities

Options and rights of first refusal are not unusual, especially when dealing with real estate. They can be very useful in the right situation, and very valuable to those that hold them.

A right is valuable, however, only if it is enforceable. Unfortunately, options and rights of first refusal are subject to an ancient legal principle that can make them completely unenforceable if not structured correctly.

This ancient principle is known as "The Rule Against Perpetuities." Its intricacies have befuddled and confounded law students (and even lawyers) for centuries. It can take many hours of study to understand the Rule thoroughly. Fortunately, hours of study will not be necessary for our purposes. We can learn what we need to know quite easily.

Briefly stated, the Rule Against Perpetuities requires that a future interest, such as an option or a right of first refusal, must expire within a certain period of time to be enforceable. The period of time must be specified in the instrument, and it cannot exceed a "life in being" plus 21 years. This sounds strange, but it is not too hard to understand. Here are a few ways the time limit may be structured:

1. The time limit may be for a certain number of years or until a certain specified date, so long as the time limit or date does not extend more than 21 years from the effective date of the agreement. For example, someone could be given an option which he could exercise at any time during the next 21 years. However, an option exercisable at any time during the next 50 years would be invalid, even if an attempt were made to exercise it before 21 years had expired. If it doesn't comply with the Rule, it's invalid from its inception.

2. The time limit may be for the life of a person or persons; for example, a person may be given an option which terminates on his death (or the death of some other named person or persons).

3. The time limit may be for the life of a named person or persons, plus a number of years (not to exceed 21) after his or her death. For example, someone may be given an option which terminates 21 years after his or her death (after death, his or her heirs could exercise the right).

An option or right of first refusal is not enforceable if it has no expiration date, even if it is recorded in the public records. The Rule Against Perpetuities makes such open-ended agreements void on the theory that they clutter up the public records and interfere with the free alienation of property.

The Rule applies only to future interests; it does not invalidate a 99-year lease, for example, because the lessee's rights are fixed upon the execution of the lease, making it a present interest. Under an option or right of first refusal, the holder's rights to the property are not fixed until a future contingency occurs, making it a future interest.

There are exceptions to the Rule:

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1. If it is clear from the context that the option or right of first refusal was intended to be a personal right of the holder, the law will imply that the time limit is that person's life, thereby bringing it into compliance with the Rule, even if no time limit is expressly set forth in the document.

2. If the option or right of first refusal is part of a lease and must be exercised during the term of the lease (even if the lease is for more than 21 years), the right is considered enforceable.

The Lesson. Whenever you negotiate an option or right of first refusal, be sure you place a time limit on it that complies with the Rule Against Perpetuities. In modern times, this is normally no more than 21 years; however, it can also be up to 21 years plus the duration of the life of a specified person. The latter is a little more complicated and should be drafted by legal counsel to insure enforceability.

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MEMORANDUM #110 Duty to Disclose Defects

We all know that intentionally making misleading statements about the condition of real property to a potential buyer is fraud. For example, if a seller falsely tells a prospective buyer that the electrical system of a building is in good shape, knowing it is in a serious state of disrepair, the seller has probably committed fraud against the prospective buyer if he purchases the property in reliance on the misrepresentation.

But what if the seller knows of the defect and simply remains silent? Does the seller have an affirmative duty to disclose defects in the property? Or, can the seller remain silent and pass the problem on to an unsuspecting buyer?

The general rule is that fraud cannot be committed by silence. The governing principle for the sale of real property is caveat emptor, or "let the buyer beware". In other words, the seller doesn't have to volunteer information about defects in the property. It is up to the buyer to discover them. There are some exceptions, however.

First, silence can be fraud if there is a special relationship between the buyer and seller. Where the buyer reasonably expects to rely on the seller to affirmatively disclose known problems, the seller cannot remain silent. Examples of such a special relationship might be a broker and his principal, an attorney and his client, a corporate officer and the corporation, or a partner and the partnership.

Second, silence can be fraud if there has been a specific inquiry. For example, if the buyer asks the seller whether the electrical system is in good shape, it is usually fraud to remain silent or to change the subject to avoid answering.

Third, the failure to disclose a defect can be fraudulent if information is given that is technically true, but misleading. For example, if the seller says that the electrical system has always worked just fine, knowing it is in violation of the building safety code and must be replaced, his silence about the code violation is probably fraudulent because he is intentionally misleading the buyer about the condition of the electrical system--even though his statement is technically true.

Fourth, there may be a duty to speak where the defect is serious and cannot be found by an inspection of the property. It has been held, for example, that a seller of land committed fraud when he failed to disclose to the buyer that the subsurface of the land had been filled and was not suitable for building.

Fifth, there may be a duty of disclosure where the defect is dangerous. A seller cannot put the buyer in danger by failing to disclose a dangerous condition.

Unintentional Fraud. Can fraud be committed unintentionally? For example, what if the seller says the electrical system is in good shape, not knowing that it isn't? Generally, this is not fraud. However, if the seller negligently or recklessly makes a misrepresentation believing it to be true, most courts will consider this to be fraud. For example, if the seller forgets that an electrician told him two years earlier that the electrical system was in bad shape, it is probably fraud if a forgetful seller wrongfully but innocently assures a buyer that the system is fine.

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"As Is" Clauses. Finally, what if the sales contract contains an "as is" clause? Does this protect the seller against fraud? The answer is that such a clause does furnish some protection against claims of fraud, especially as to defects that can be discovered by an inspection. However, an "as is" clause does not provide blanket immunity against fraudulent misrepresentations. If a seller knowingly makes blatant verbal misrepresentations about the condition of the property, it is unlikely that a written "as is" clause in the contract will protect him from a claim of fraud. Nevertheless, such clauses can still provide valuable protection against claims for undisclosed defects where there has been no outright misrepresentation.

The Trend. It should be mentioned that the courts have trended away from the doctrine of caveat emptor in recent years. Although it is still the prevailing rule of law, the courts tend to stretch to find an exception, perhaps reflecting their discomfort over the idea of a seller intentionally concealing a known defect.

Conclusion. In general, one does not commit fraud by selling real property with a known but undisclosed defect. However, silence can be fraud if there is a duty to speak, either because of a special relationship or because a question has been raised. One can also commit fraud by statements that are technically true, but incomplete or misleading, or by failing to disclose very serious hidden or dangerous conditions.

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MEMORANDUM #111 Release of Earnest Money Prior to Closing

It is usually necessary to put up an earnest money deposit when buying real estate. The deposit is normally held by an independent escrow agent, although sometimes it is held by the broker or an attorney for one of the parties.

The earnest money deposit serves two purposes: (1) it shows that the buyer is serious, and (2) it can be forfeited to the seller if the buyer fails to perform. It is usually held by an independent escrow agent so that it can be automatically paid over to the seller if the buyer defaults, or applied against the purchase price if the sale closes.

In a hot market the seller will sometimes ask to have the earnest money deposit be released to him after the contingencies have been satisfied. The seller likes this because it means he will not have any trouble gaining possession of the deposit if the buyer defaults.

If the buyer objects to this idea, the seller may offer to put a signed deed in escrow, pointing out that he has then done everything necessary to close. He will say that the only thing left to be done is for the buyer to come up with the rest of the money.

This sounds reasonable. What could go wrong?

The answer is "plenty."

In most commercial real estate transactions, the seller has to do more than put a deed in escrow. If the seller is a corporation, trust, or limited liability company, copies of organizational documents may have to be produced and be certified as effective and complete. Resolutions, certificates of good standing, and other items may be required. If, for some reason, the seller cannot produce the necessary items, the closing may be delayed.

In addition, surprises can and do occur. Perhaps a tax lien or mechanics' and materialmen's lien attaches to the property just prior to closing. Perhaps an amendment to the title commitment discloses an unknown title defect. Maybe a lawsuit is filed affecting the property, or maybe the seller dies prior to the closing. It is also possible that the property could be damaged or destroyed prior to close of escrow. If any of these things occur, a closing might be delayed or become impossible through no fault of the buyer.

If his earnest money has already been released, the buyer is left in a difficult situation. He must then rely on the seller to give it back (if he hasn't spent it), which could require litigation. At the very least, he has severely weakened his bargaining position and placed himself at risk.

Conclusion. It is a bad idea to allow earnest money to be released prior to the closing. Avoid it if you can. If the seller won't budge and you feel that you have to have the property, negotiate the amount down to the smallest amount possible, and make it clear that the seller has to return the money if the closing does not occur for any reason other than your own failure to perform.

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MEMORANDUM #112 Contracts That Must be in Writing

Lawyers frequently tell their clients to "get it in writing." That's always a good idea because an oral contract is hard to prove and harder to enforce.

According to the law, however, an oral contract is just as enforceable as a written one, with several exceptions. These exceptions--that is, contracts which must be in writing to be enforced--are created by a law known as the Statute of Frauds. According to the Statute of Frauds, certain kinds of contracts have to meet two requirements: (a) they must be evidenced by some sort of written document, and (b) they must be signed "by the party to be charged," before they are enforceable.

When A Writing Is Required. Here are the principal types of contracts that must be in writing to be enforceable:

1. An Agreement to pay the obligation of another; or in other words, a guaranty or suretyship agreement.

2. A contract for the sale of goods or intangibles for $500.00 or more, except when part or full payment has been made or part or all of the property has been delivered.

3. An agreement which is impossible of full performance within a year.

4. An agreement for the sale of real property (or any interest in real property, such as an option, lien, or easement) or for the leasing of real property for more than a year. If such an agreement is made by an agent for his principal, the authority of the agent must also be in writing.

5. An agreement with a broker or agent to sell real property for compensation; or in other words, a real estate listing agreement.

6. An agreement to make, extend or modify a loan of more than $250,000.00, unless the loan is for personal, family, or household purposes.

The Document. The Statute of Frauds does not require a formal written contract. A memorandum, outline, or summary of the deal is sufficient so long as it embodies the basic terms. It does not even have to be written in complete sentences--in many cases, a mere listing of the relevant terms is sufficient. The proverbial "contract on the back of a cocktail napkin" satisfies the Statute and can often be enforced in a court of law.

The Signature. The document does not have to be signed by both parties, so long as it can be shown that both parties intended to be bound by the agreement. The document needs to be signed only "by the party to be charged"--that is, the party against whom the contract is being enforced. This, of course, leads to the curious situation where only one party to the contract can enforce it, but that's the law. So if you sign a contract, make sure the other party signs it too or you may be binding yourself to a contract the other party can enforce but you can't.

Exceptions. As always, there are a few exceptions to avoid unjust results. However, for the most part of the Statute of Frauds is strictly enforced.

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Conclusion. Oral contracts are enforceable, if they can be proven. The exception is where the Statute of Frauds applies, in which case the agreement must be in writing and must be signed by the party to be charged.

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MEMORANDUM #113 Sale of Vacant Land

A number of different laws - some old, some new - apply to nearly every sale of vacant land in the State of Arizona. These laws are scattered throughout a number of different statutes, making it difficult to determine exactly which laws apply to any given sale.

This memo will organize and summarize only the laws that apply to the sale of a parcel of vacant land. This memo does not deal with the sale of land improved with a building (or land sold on a contract obligating the seller to construct a building), and it does not deal with the requirements for legally splitting a parcel of land or creating a subdivision. Most cities and counties, as well as the state, have laws and regulations governing the splitting of lots or the creation of subdivisions. There are even federal laws regulating the sale of lots in large subdivisions.

Categories. For purposes of regulation, Arizona law puts all vacant land into one of three categories:

1. Subdivided Land. Generally, this is land that has been split into six or more parcels as part of a common plan (unless each parcel is 36 acres or more in size). For purposes of this memo we will assume that the property has been legally subdivided by a prior owner, and that the sale is the sale of a single lot.

Here are the applicable legal requirements for the sale of a subdivision lot:

(a) The sales contract must inform the buyer of his right to receive a copy of the public report issued by the Arizona Real Estate Department at the time the subdivision was approved. A contract not containing this disclosure is not enforceable. (A.R.S. § 32-2185.06). The buyer must also be given a copy of the public report before the seller signs a contract agreeing to sell the lot. (A.R.S. § 32-2183(A)). This is true even if the lot has been sold several times since the subdivision was approved--every subsequent seller must inform his buyer of his right to receive a copy and must actually give his buyer a copy of the report, and the buyer must sign a receipt. This requirement does not apply to land zoned and restricted to commercial or industrial use.

(b) The sales contract must disclose the buyer's right to rescind the sale within seven days (or six months if the buyer has not inspected the lot); and if the buyer has inspected the lot, he must sign an affidavit so stating. (A.R.S. § 32-2185.01(D) and -(E)). As in paragraph (a) above, this requirement applies to the sale by the original subdivider and to all subsequent sellers.

(c) The property must have permanent legal access that can be traversed by a conventional motor vehicle. (A.R.S. § 32-2185.02). If the property lacks such access, the buyer has three years to rescind the transaction.

2. Unsubdivided Land. This term is misleading. Under Arizona law, "unsubdivided land" is actually land that has been divided into six or more parcels, each of which is at least 36 acres in size. However, if each parcel is 160 acres or more in size, the parcels do not constitute "unsubdivided land," and are not subject to the following rules.

Here are the requirements that apply to "unsubdivided land":

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(a) The seller must furnish the buyer a copy of the Public Report issued by the State Real Estate Department and obtain a receipt for it from the buyer. (A.R.S. § 32-2195.03(A)).

(b) The sales contract must inform the buyer of his right to rescind within seven days if he has inspected the property (or within six months if he has not inspected the property). (A.R.S. § 32-2195.04(D) and -(E)).

(c) If the land is not within the city limits of a city or town, effective as of May 15, 2000 the law requires the seller to furnish the buyer an Affidavit of Disclosure at least seven days before the closing. The buyer must acknowledge receipt of the Affidavit in writing, and the acknowledgement must be recorded at the closing. The buyer has the right to rescind the transaction for a period of five days after receipt of the Affidavit. In general, the Affidavit contains all sorts of relevant information about the property, including access, utilities, water, flooding, the use of septic tanks, and so on. A form for the Affidavit is attached to this memo. (A.R.S. § 11-806.3).

3. All Other Land. This category includes all land that is not "subdivided land" or "unsubdivided land." This includes parcels of any size that have not been divided into six or more lots, and parcels resulting from the splitting up of very large tracts of land into six or more lots, so long as each is more than 160 acres. It also includes smaller lots that do not constitute part of a subdivision for whatever reason.

The only specific regulation applying to such sales is that the seller must comply with the Affidavit of Disclosure rules described in paragraph 2(c) above if the land is located outside city limits.

4. General Rules. In addition to the specific rules applying to lots of various sizes, there are rules and regulations applying to the sale of real property of any size, whether or not subdivided. These include the following:

(a) The seller must inform the buyer in writing if the property has been subject to remediation for contamination by hazardous substances. The only exception is if the remediation is so thorough and complete that it meets the standards for residential use. (A.R.S. § 33-434.01).

(b) The seller must inform the buyer of any residential property, including subdivision lots, if the lot is "in the vicinity" of a military airport. The State Real Estate Department has maps indicating which property is so located. (A.R.S. § 28-8484).

(c) The seller must, of course, make any disclosures necessary to avoid fraud. Although the seller of real property is generally allowed to remain silent about defects on the legal theory of caveat emptor, the seller cannot actively mislead the buyer or do or fail to do other things which could amount to fraudulent conduct.

Conclusion. The sale of almost every parcel of vacant land is subject to one or more of the foregoing legal requirements. The failure to properly comply with these requirements can lead to the rescission of the contract or civil or criminal liabilities or penalties. In addition, if land is split or subdivided in connection with the sale, it may be necessary to comply with extensive federal, state, county and/or local subdivision or lot split regulations (which is a separate topic not covered by this memo).

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MEMORANDUM #114 What Does it Mean to Sell Property "As Is"?

(Not as Much as You Might Think)

Contracts for the sale of real property often contain an "as is" clause. This is widely thought to mean that the buyer accepts the property with any and all faults. If there is a defect in the property it is the buyer's problem.

This is not entirely true, however. A recent decision of the Arizona Court of Appeals has made it clear that there are important limitations on the effectiveness of the typical "as is" clause. In the Pima Capital case, the Court held that an "as is" clause did not protect the seller of commercial property against a claim based on the existence of polybutylene pipe (which is inherently defective and eventually leaks) where the pipe was hidden from view inside the walls and where the seller's agent knew of the problem.

What Does It Mean? Based on Pima Capital, the law in Arizona appears to be as follows, at least for commercial properties (including multi-family):

1. An "as is" clause is effective in releasing the seller from responsibility where the defect can be discovered by a reasonable inspection, even if the seller knows of the defect and remains silent.

2. The "as is" clause does not relieve the seller of responsibility for a defect known to the seller if the defect is hidden and cannot be discovered by a reasonable inspection.

3. If the seller's agent (such as a property manager or broker) or employee knows of the defect, the seller is deemed to know of the defect, regardless of whether the seller has actual knowledge.

4. An "as is" clause is effective only for claims based on contract, and not for claims based in tort (such as fraud); however, it might be possible to draft the clause so as to cover some tort claims.

Criticism. One can argue that the Pima Capital case is good law on the grounds that a seller should always be required to disclose hidden defects, regardless of what the contract says. After all, why should the law sanction fraud?

The answer is that there are good reasons for giving the buyer and seller the freedom to agree to an "as is" clause, particularly in sales of commercial property where the buyer and seller are experienced in business. The freedom to agree to an "as is" clause should not be stripped away because there may be situations where the Court does not like the result.

For example:

1. The seller may want a "clean deal" free of the risk of future litigation. He may not want to risk a lawsuit over whether he did or did not have knowledge of a defect. There may be a dispute as to whether the seller actually had knowledge, or appreciated the significance of knowledge he did have, or properly disclosed it to the buyer, or whether the defect is apparent or hidden. The seller may want to protect himself against having to spend thousands of dollars fighting over these issues in court.

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2. The seller may want to avoid the risk that the knowledge of third parties will be imputed to him, as in the Pima Capital case. Under that decision, the seller can be held liable even if he had no knowledge of the defect, if his property manager, broker, employee, or contractor knew of the defect and didn't tell him.

3. The buyer may have agreed to the "as is" clause because he was not particularly concerned about defects at the time of the purchase; for example, where he intends to substantially remodel or demolish the building. The buyer got what he bargained for and should not be allowed to recover a windfall because of the defect.

4. The price may have been reduced in consideration for the "as is" clause, or the seller may have been unwilling to sell without the "as is" clause. It would be unfair for the courts to then impose duties on the seller that the buyer gave up for valuable consideration.

A Sample Clause. It is not clear whether the Pima Capital decision will be reversed or modified. Nevertheless, based on the principles laid down in that case, it may be possible to draft an "as is" clause that is effective in most situations. Such a clause might be worded as follows:

Buyer agrees that except for the express warranties and representations set forth herein, Buyer is purchasing the Property "as is," in its present condition, with all faults. Buyer agrees to purchase the Property subject to all defects, whether hidden or apparent, and whether known or unknown to Seller. Buyer acknowledges that the Property is not new construction and that there may be items needing maintenance, repair or replacement, and that equipment or components in current working order may soon require replacement or repair. Buyer acknowledges that it is Buyer's duty to inspect the Property and Buyer has full authority to do so, as long as Seller's representatives are present and all damage is properly repaired. Seller makes no representation or warranty as to the condition, zoning, size, value, or suitability of the Property for any particular purpose, and Seller shall have no duty to disclose known defects to Buyer, regardless of whether such defects are apparent or hidden. Buyer hereby waives any claims against Buyer based on the condition of the property, whether hidden or apparent, and whether such claims might be based on contract or tort, including but not limited to claims based on negligence or fraud. This paragraph was specifically bargained for and is reflected in the purchase price.

Conclusion. It is not known how effective the foregoing clause might be in providing protection to the seller. However, it does attempt to comply with the reasoning of Pima Capital, and will probably furnish as much protection as the law allows. It almost certainly will not provide protection against outright misrepresentation or fraud or even against remaining silent when there is a duty to speak; for example, when the seller owes a fiduciary duty to the buyer or when a direct question about the defect is asked. The "as is" clause is not a license to commit fraud, but if properly drafted it can offer protection against many other kinds of claims.

__________________ The case referred to above is The S Development Company, et al v. Pima Capital Management Co., et al, Arizona Court of Appeals, Division One, 1 CA-CV 000347, Filed 8/30/01.

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MEMORANDUM #115 What's Wrong with the Standard Form of Purchase Contract?

Commercial property is often bought or sold by using a pre-printed form called a Real Estate Purchase Contract and Receipt for Deposit. This form is usually provided by the Arizona Association of Realtors or some other trade organization which supplies the forms to real estate brokers.

So what's wrong with using the "standard form"? It certainly sounds like the fairest and most economical way to do business.

Actually, nothing is inherently wrong with the form. However, do not assume that the form necessarily represents the customary practice, or that it embodies terms that are fair or appropriate for the particular deal. The reason is simple—in commercial real estate, almost nothing is "standard." Commercial real estate transactions are individually negotiated according to the needs, desires, and relative bargaining positions of the parties. The printed "standard form" may or may not be appropriate for any given transaction.

Specific Provisions. There are a number of considerations that the parties should carefully think through before automatically using a form—and if the form is not suitable, it should either be changed by attaching an addendum, or a new contract should be drafted from scratch.

Among the terms that should be reviewed most closely are the provisions concerning representations and warranties. The form typically provides that the seller will disclose all latent or hidden defects, that the roof does not leak, and that all equipment will be in good working order at close of escrow. Other than that, the buyer agrees to take the property "as is." There is certainly nothing wrong with buying or selling property "as is," without representation or warranty. However, it is rarely in the buyer's best interest. There are a number of important matters that buyers frequently want or need protection against, including the condition of the property, whether lawsuits involving the property are pending or are threatened, whether the seller is aware of any contamination or other illegal conditions at the property, whether the property is under threat of condemnation, and so on. Therefore, if the buyer has decent bargaining power he will normally attempt to negotiate certain representations and warranties so that he will be assured he is getting what he is paying for and that he is not buying somebody else's problem.

Another area that deserves review is the condition of title. The printed form will usually state that the buyer agrees in advance to take the property subject to any existing covenants, conditions, and restrictions, utility easements, rights of tenants in possession, and various other matters. Sometimes such matters do not cause a problem, but in other cases they can cause very serious problems. Therefore, the buyer is better protected by reserving the right to review and approve the title report and all matters of record. That gives the buyer a chance to cancel if any of these matters turn out to be a problem—for example, if there is a utility easement where the buyer wants to build a building, or if there is a deed restriction against the kind of use intended by the buyer. It can be very risky to agree to purchase property without a chance to review and approve all matters that have been recorded against the property, and this is a serious shortcoming of the printed form, at least for the buyer.

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The forms usually provide that any improvement district assessments are to be paid in full by the seller. There is nothing inherently wrong with this, but it should not be considered to be the customary or standard practice. This term is a negotiated one that varies from deal to deal, and if you are a seller it is clearly to your advantage to negotiate a contract that prorates assessments.

The standard form provides that the seller can either sue for specific performance or damages or forfeit the earnest money deposit in the event the buyer does not perform. The buyer, however, usually finds it in his best interests to limit the seller's remedy to the forfeiture of the deposit, which is a fairly customary provision. This is another area where the form may not necessarily represent either the prevailing practice or the desire of at least one of the parties.

The forms provide that a defaulting party must be given 13 days notice before action may be taken to enforce the contract. This may be an appropriate term in many situations, but very often a seller will want to be able to terminate the contract immediately if the buyer does not perform. Again, the form may not comply with the desires of at least one of the parties on an important issue.

Finally, there are often many important terms appropriate to the particular deal that are not mentioned at all in the standard form, such as restrictions on further leases during the escrow period, the necessity for estoppel certificates, contingency or inspection periods, the right to participate in a tax-deferred exchange, and so on. Therefore, when reviewing a form, one should not only focus on the terms and provisions contained in the contract; he should also think long and hard about what should be in the contract, but isn't.

Conclusion. This memo is not intended to provide an exhaustive list of shortcomings or to be a general indictment of the so-called "standard form." It is simply an effort to point out that these forms do not necessarily represent the prevailing custom in many areas because there is no prevailing custom, and that every deal is different. The forms are often an excellent starting point, but they should never be signed without a close and critical reading to make sure that they are appropriate for the particular transaction and adequately protect your own interests. And, of course, we would encourage you to seek legal counsel before you sign if you have any questions or concerns.

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MEMORANDUM #116 Is An Electronic Signature Legally Binding?

In recent years, it has become common for signatures on contracts and other legal documents to be transmitted electronically. For example, a party may execute a purchase agreement or lease and transmit a copy to the other party by facsimile or by an e-mail in the "pdf" format. Either method transmits what is essentially a picture of the signed document.

This raises the question: Is an electronic signature sufficient to bind the parties?

In most cases, the answer is "yes."

Federal and Arizona statutes both provide that a signature may not be considered invalid solely because it is in electronic form. This does not mean that every electronic signature is valid, but it does mean that the fact that a signature is electronic does not, by itself, render it invalid.

So when, exactly, is an electronic signature legally binding?

Two Types of Contracts. For purposes of our analysis, we must first divide contracts into two types. First, there are contracts that do not require a writing and a signature to be enforceable. This covers any contract that could be made verbally, such as an agreement to prepare a tax return for a fee of $500, for example. A contract of this type is binding and can be enforced regardless of whether it is in writing. Second, there are contracts which are governed by the Statute of Frauds, which means that they must be in writing and signed by the party against whom they are to be enforced. An example is a contract for the sale of real estate. A contract of this type is not legally enforceable unless it is in writing and is signed.

Contracts Not Requiring a Writing. If the contract is of the first type, the answer is easy. Anything that will prove the parties agreed to the contract is sufficient to make it binding. Therefore, if it can be shown by e-mail or facsimile communications that the parties did in fact reach an agreement, the agreement is enforceable. For this type of contract, the form of communication is not material.

Contracts Which Require a Writing. If the contract is of the second type--that is, if the contract is subject to the Statute of Frauds-- the rules are a little more complicated. First, the law states that to be enforceable the parties must have agreed to conduct the transaction by electronic means. However, this "agreement" can be implied from the context and surrounding circumstances, including the parties' conduct. In most cases, the fact that the parties have exchanged e-mails or facsimiles and have relied on this form of communication should be sufficient to show the necessary agreement. Of course, the parties could specifically agree not to accept electronic copies, in which case hard-copy originals would be required. This is rarely done, however, and in most cases e-mails and facsimiles are routinely sent back and forth and provide a clear implication that the parties have agreed that electronic communication is acceptable. Second, the electronic communication must be capable of being retained and reproduced by the recipient, which is normally not an issue since most facsimiles and e-mails are easily stored and reproduced.

Therefore, in the great majority of cases, facsimile and e-mail signatures in the "pdf" format are just as enforceable as original signatures on a piece of paper.

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Other Issues. The foregoing discussion deals with signatures transmitted by facsimile and pdf--that is, signatures that are images of an original signature by pen and ink. However, this is not the only type of electronic signature covered by the law. The law is actually broad enough to cover any kind of electronic signature, if it the communication is intended by the sender to be a signature. Thus, if someone sends an e-mail stating that an offer is accepted and "we have a deal--Joe Smith," there is at least the possibility that the courts would conclude that the sender intended the statement to be a signature binding him to the contract, even though he never picked up a pen or signed a piece of paper. This is certainly not a recommended method of executing a contract, but one should be aware that e-mails of this type may turn out to create enforceable contracts even if the contract is subject to the Statute of Frauds.

In addition, the law also provides for the notarization of a document by electronic means. There are detailed requirements set out by statute in order to have an effective electronic notarization; however, this procedure is rarely used. Nevertheless, when it is not possible to obtain an original notarization this alternative may be of considerable value.

The statutes also provide that when records are required by law to be retained, they may be retained in electronic form.

The Arizona statute contains an exception for signatures on wills, codicils, and testamentary trusts, which still require hard-copy pen and ink signatures.

Conclusion. Signatures transmitted by e-mail or facsimile are normally just as enforceable as a live signature on a piece of paper, so long as the parties have agreed, explicitly or impliedly, to conduct business electronically. Nevertheless, for important transactions it is a good practice to follow up electronic signatures with a live signature to avoid potential challenges.

__________________ A.R.S. Section 44-7001 et seq.; 15 U.S.C. Section 7001.

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MEMORANDUM #117 Are Contracts With A "Free Look" Enforceable?

In commercial real estate transactions, it is very common for the buyer to have an inspection period, sometimes known as a "free look." This allows the buyer to tie up the property while he checks it out. In some cases the inspection period is to give the buyer time to obtain land use entitlements or arrange financing. In other cases, the buyer is just given the right to investigate and decide whether he wishes to go through with the purchase. Typically, if the buyer cancels during the inspection period his earnest money deposit is returned.

Clearly, the parties intend for the contract to be enforceable by the buyer if he decides not to cancel. However, a recent California case says that intentions may not be enough and that the seller could be free to cancel the contract at any time.

Requirements for an Enforceable Contract. Before we discuss this particular case, however, we should review the requirements for an enforceable contract. First, there must be an agreement, or a "meeting of the minds." In most real estate purchase contracts this element is present. Second, there must be consideration, which is defined as a legal benefit to the promisor, or a legal detriment to the promisee. In other words, for a contract to be binding on a party, he must promise to provide a benefit to the other party (like the payment of money), or to accept a detriment (like giving up title to property). If a person agrees to convey property to another without requiring anything in return, that contract normally will not be enforced by a court of law because the recipient of the property has not given consideration.

California Case. In the California case, the buyer entered into a contract to purchase ten acres of land. The contract gave him an extended period of time to determine the financial feasibility of subdividing the land for a housing development, to obtain governmental approvals for the project, and to complete certain engineering work. He was given the "absolute and sole discretion" to cancel during the investigation period, and if he cancelled he was to furnish the seller copies of any reports, tests, or other information he obtained concerning the property.

After the buyer had spent a considerable sum in anticipation of purchasing the property, the seller refused to close escrow, arguing that the contract was not enforceable due to a lack of consideration by the buyer. The court agreed with the seller, holding that since the buyer could cancel at any time, he was not legally required to suffer any detriment or to provide any benefit to the seller. In the view of the court, the purchase agreement was really a disguised option for which the buyer had paid nothing. Thus, there was no consideration and no contract. The promises made by the buyer to seek entitlements and do engineering work were "illusory promises" because the buyer could terminate the contract before he was required to do any of them. The fact that the buyer did in fact spend money on the property was not material, because consideration must be given when the contract is entered into in order for the contract to be enforceable.

Arizona Law. As mentioned above, this was a California case. It has been appealed, and it is possible it will eventually be reversed. Nevertheless, it cannot be ignored because all states agree there must be consideration for a contract to be enforceable. Whether consideration is given in a particular case depends on the facts.

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In Arizona, the courts last looked at this issue in 1984 in a case involving Westcor. In that case, the Arizona Court of Appeals for Division 2 (southern Arizona) held that a contract with a "free look" was enforceable by the buyer, even where the contract provided that the buyer had to be satisfied with various specified matters in the buyer's "sole and absolute discretion." The court reached this conclusion by stating that a buyer is required to make a "good faith effort" to satisfy any conditions, and when exercising any right of approval or disapproval the buyer had to act "in good faith." Therefore, reasoned the court, the buyer had indeed given consideration because he had to make good faith efforts to satisfy any conditions and had to exercise his right of approval in good faith. In other words, the buyer did not have the sole and absolute discretion to terminate the contract, even though the contract said that he did!

Clearly, the Arizona court stretched to make the Westcor contract enforceable in order to carry out the obvious intention of the parties. This case has not been overruled and is still the latest pronouncement on this issue by the Arizona courts. However, this decision can be criticized on legal grounds and may not be the strongest precedent. In addition, it was not decided by the highest court in the State. Therefore, it is not binding on the Arizona Supreme Court or on the Courts in Division 1, which includes the Phoenix area. Because the Arizona courts often follow legal trends originating in California, it is possible that in a future case with the right facts an Arizona court may take an approach similar to the California decision.

Conclusion. In order to avoid this possibility and insure that he has an enforceable contract, a buyer could do several things: One, he could agree to take some action or incur some expense prior to exercising his right to terminate the contract. For example, he could agree that he would survey the property and furnish copies to the seller, regardless of his right to terminate. Two, he could pay some monetary consideration for the free look which would not apply to the purchase price, and which was not refundable. There is no guidance as to how much such consideration would have to be, but most likely it would have to be enough so as not to be considered de minimus or immaterial. Third, he could expressly agree that his right to terminate could only be exercised if there were reasonable grounds for doing so. Obviously, these solutions cost the buyer money or limit his flexibility, and could themselves lead to litigation (for example, whether a termination is "reasonable"). Each buyer and his counsel will have to balance the detriment of providing such consideration against the possibility, admittedly small, that the seller may renege and if he does, that his position will be upheld by the courts.

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Additional Note. In light of the Westcor case cited above, one must wonder if it is ever possible in Arizona to give a party to a contract the right to act in his sole and absolute discretion, free of any duty of reasonableness or good faith. There are many cases where the parties desire to do exactly that. Perhaps a party can be excused from these duties if the contract expressly states that a party can act in his sole and absolute discretion, "without regard to any duty to act reasonably or in good faith." Time will tell.

__________________ See Horizon Corp. v. Westcor, Inc., 142 Ariz. 129, 688 P.2d 1021 (1984); Steiner v. Thexton, 77 Cal. Rptr. 3d 632 (2008), review granted Sept. 17, 2008.

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MEMORANDUM #201 Earnest Money

It sounds like asking "Can you ever be too rich?"

Surprisingly, however, it is possible to have too much earnest money.

Virtually every contract for the sale of real estate contains a provision for the forfeiture of earnest money if the buyer defaults. A seller might therefore assume that the more earnest money he obtains the better off he will be if there is a default. This generally is true--but only up to a point.

A recent Arizona case has spelled out the rules.

A provision calling for the forfeiture of earnest money is known as a "liquidated damages" clause. This is because the seller doesn't have to prove how much he was damaged when the buyer breaches his contract--he gets a "liquidated" or previously agreed amount, usually the amount of the earnest money deposit. He thereby avoids the difficult task of proving exactly what the buyer's breach has cost him. In addition, he may avoid litigation altogether, because the escrow agent will often disburse the deposit to the seller on demand, at least if there has been a clear breach.

However, the parties are not free to agree on any amount of liquidated damages they choose. The amount must meet two tests: One, the amount must be a reasonable forecast of the actual damages the seller will suffer if the buyer defaults. Two, the actual damages must be impossible or very difficult to accurately determine.

The reason for the first requirement is that the law will not impose a "penalty" for a breach of contract. Punitive damages are available only for wrongs known as torts, not for breach of contract. In the case of breach of contract, the law will provide only for the recovery of the amount necessary to make the non-breaching party whole. That is, it will seek to place the seller in the same economic position he would be in had the buyer performed. That is why the amount of liquidated damages cannot be excessive or punitive.

The reason for the second requirement is the idea that if actual damages may readily be proven it is better to use this as the measure of recovery rather than resorting to an arbitrary "liquidated" amount. Fortunately, the courts have consistently held that the damages occasioned by the breach of a contract for the sale of real estate are difficult, if not impossible, to accurately determine. As a result, the second requirement is not generally an impediment to the forfeiture of an earnest money deposit.

So how much is too much? There is no clear answer. It depends on many factors, such as the type of property, its liquidity, the condition of the market, whether the sales price was above or below market, and so on. However, the recent Arizona case mentioned above found that the forfeiture of a $290,000.00 deposit, which was equal to six percent of the purchase price, was reasonable. An earlier Arizona case, on the other hand, found the forfeiture of a 25% deposit to be excessive and unenforceable.

If the amount is excessive, the seller gets no liquidated damages at all. Instead, he must attempt to prove exactly what he lost as a result of the buyer's default, because in the absence of

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liquidated damages he can recover only what he can prove he lost. If he can't prove his damages, he gets nothing. Normally, this means the seller must prove that the sale was above market, or that he lost interest on the sales price because it would be months before the property could again be sold even at the same price.

The lesson is that an adequate earnest money deposit is of great benefit to the seller--but he shouldn't be greedy or he may end up with nothing.

__________________ The recent case referred to above is Pima Savings and Loan Association v. Rampello, 86 Ariz. Adv. Rep. 55 (Az. Ct. App., Div. 2, 1991).

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MEMORANDUM #202 Cancellation Provisions

Let's say you are selling some real estate. Maybe you're not too sure about the buyer--you think he's a little flaky, and you wonder whether he can come up with the purchase price. So you decide you need a good tough contract, one that holds the buyer's feet to the fire. You want it to say that if the buyer doesn't close when he is supposed to, you can terminate the contract immediately, without giving him any notice, and forfeit his earnest money.

So you have your lawyer draft up a contract that says just that. If the closing doesn't occur on the specified closing date, the party not in default can immediately cancel the contract and exercise his remedies. Your lawyer also writes in a provision that deletes the thirteen-day cancellation provision on the back of the escrow instructions, just so there is no mistake about the fact that no notice is required to cancel the contract if the other party doesn't perform.

Now let's assume that your buyer signs the contract and puts his earnest money in escrow. At this point you're feeling pretty good, because you know you have the buyer locked up with a good tough contract that demands immediate performance, with no notices, no excuses. The buyer has to close on time or pay the price. You just sit back and wait for the closing date.

This is fine if you understand one thing--you also have to close on the closing date. Most sellers assume this is not a problem. They figure that all the seller has to do is sign a deed, and know they can easily do that before the closing. The buyer has the tough part--he has to come up with the money.

This is usually true. But not always.

What Can Go Wrong? There are a number of things that can trip up the seller. So many, in fact, that it's impossible to list them all. But a few examples can illustrate the point.

Suppose, for example, that the seller is a corporation. Just before the closing date it is discovered that the corporation's charter has been revoked because someone forgot to file the annual report. If this happens, the seller will have to scramble around to reinstate the corporation in time to close. If the reinstatement can't be completed in time, the seller is in default. Or suppose that the seller holds title in his revocable estate planning trust. Just before the closing the title company reminds the seller that it has to see a certified copy of the trust so that it can verify the authority of the trustee to sign a deed for the property. The seller has to search his records to find a copy of the trust instrument, and he just can't seem to remember where he placed it for safekeeping. If he can't find it in time, he's in default. Or suppose the title company discovers that the wife of a prior owner never signed the deed. The seller will have to try to locate the missing wife and obtain her signature on a quit-claim deed before the closing date. If he can't, he is in default.

These are just a few of the thousands of things that can unexpectedly happen to place the seller in default. Often, the seller has to do more than just sign the deed. He has to do all the things necessary to convey clear title and to provide the assurances the title company needs to insure clear title. If, for some reason, these things are not done by the closing date, the seller can suddenly find himself in default and exposed to the legal remedies of the buyer.

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This illustrates that a "tough" contract can sometimes bite the seller as well as the buyer. When notice and time to cure is deleted for the buyer, it is usually deleted for the seller as well.

The Lesson. The lesson is clear. Unless you have a real need to close on a specific date, the safest course of action is to provide in your contract that neither party will be deemed in default until he has been notified and been given a few days to cure. Ten days is usually a reasonable period for this purpose. The thirteen days typically printed on the form for escrow instructions is also reasonable. The worst that can happen, if the buyer doesn't perform, is that you wait a few days longer to forfeit his money. On the other hand, a reasonable notice provision may allow him the time he needs to close, which is not all bad--and it may even prevent you from being in default if the unexpected should happen and you find yourself unable to close on the closing date for reasons beyond your control.

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MEMORANDUM #203 Termination for Breach

Real estate is normally sold by a written purchase and sale agreement. After signing the purchase and sale contract, the parties usually sign another contract--escrow instructions--on a form provided by the title company. This is a three-party contract between the buyer, the seller, and the escrow agent. The existence of two separate contracts--often inconsistent--which purport to govern the same transaction can give rise to some interesting questions.

Suppose you sell some property, and the other party doesn't perform on the closing date. Can you immediately "blow him out" and exercise your legal remedies, or do you first have to give him some sort of written notice and an opportunity to cure?

To answer that question, we must first look at the purchase and sale agreement--not the escrow instructions. If the purchase and sale agreement requires some sort of written notice before cancellation, say ten days, then ten days’ notice must be given. If the defaulting party cures within his ten days, the contract is reinstated and the parties must close. So in that situation, the purchase and sale agreement governs and you can't blow him out the minute he defaults.

What if the purchase and sale agreement says nothing about written notice, but simply specifies a closing date?

In that case, it is first necessary to determine whether the closing date is a material term of the contract. In most cases it is, especially if the contract says that "time is of the essence." However, there may be cases where it is possible to show that the exact closing date was not particularly important to the parties. If that is the case it is probably necessary to give reasonable notice before cancelling.

Assuming that the closing date is material, however, and it usually is, then the contract may be immediately terminated if a party fails to perform on the closing date. No advance notice is required. You can immediately cancel the contract and pursue your remedies, which might be the forfeiture of earnest money, or a suit for damages or specific performance.

That all seems simple enough. An interesting question arises, however, in the common situation where the purchase and sale agreement doesn't say anything about notice, but the escrow instructions do--that is, the escrow instructions contain the typical "thirteen-day cancellation" provision. This is a clause contained in virtually every printed form of escrow instructions used in the State of Arizona. This clause says that if a party doesn't perform, he must be given thirteen days written notice. Only if he fails to cure his default during the thirteen days may the escrow be cancelled. This raises the question: Is it necessary to give thirteen days’ notice to cancel where the purchase and sale agreement is silent but the escrow instructions require thirteen days’ notice? Surprisingly, the Arizona courts say no notice is necessary! The purchase and sale agreement may be cancelled immediately upon default and without advance notice. The result is that the thirteen-day provision contained in the escrow instructions is virtually meaningless! The courts reach this perverse result by reasoning that the escrow instructions are merely a means of carrying out the purchase and sale agreement, are not part of that contract, and do not change it in any way. According to the courts, after the underlying purchase and sale agreement is terminated there is simply no agreement left to be closed, even though the parties

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agreed in writing that they would be given thirteen days’ notice and would have an opportunity to cure any default.

It's not quite that simple, however. As always, there is an exception. In this case, the exception is that if the escrow instructions specifically and expressly state that they are intended to modify the purchase and sale agreement, they do. So if the parties state in the escrow instructions that thirteen days’ notice must be given, and also state that the escrow instructions (or this particular part of the escrow instructions) modify the underlying purchase and sale agreement, then they do, and thirteen days’ notice of default must be given.

The Lessons. We can draw the following lessons from these principles:

1. It is good practice to specify in the purchase and sale agreement whether notice of default is required, and if it is, to specify exactly how many days’ notice must be given before the contract may be cancelled. If you want thirteen days’ notice, say so in the purchase and sale agreement. If you don't want any notice to be required, say that too.

2. It is advisable to state in the purchase and sale agreement that "time is of the essence" so that the closing date will be considered a material term of the contract. This can eliminate one whole area of dispute if there is ever a default.

3. If you want the escrow instructions to change the terms of the purchase and sale agreement, you can do so, but only if the escrow instructions expressly state they are intended to modify the purchase and sale agreement.

4. If you are in danger of defaulting, don't assume you will be given notice and an opportunity to cure just because the escrow instructions say so. If the purchase and sale agreement doesn't provide for notice, you probably aren't entitled to it, and can be "blown out" the minute you default.

__________________ The leading Arizona case in this area is Allan v. Martin, 117 Ariz. 591, 574 P.2d 457 (1978).

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MEMORANDUM #204 Specific Performance

A contract would be meaningless without a means of enforcement. When a contract is enforced in court, the winning party is normally awarded a judgment for money. The measure of damages is the amount of money the claimant needs to recover that he lost as a result of the breach of contract by the other party. After getting his judgment, he may then try to collect by levying on the debtor's assets or by garnishing his income. He may or may not be successful in collecting his judgment. Unless the judgment debtor is a major corporation, it is often harder to collect on a money judgment than it is to get the judgment in the first place.

In some cases, however, the law provides another remedy for breach of contract--specific performance. When specific performance is granted, the court actually orders the breaching party to comply with the contract, and if he doesn't he can be jailed for contempt of court. This is an extraordinary and fearsome remedy, but in some cases it is the only way to truly do justice. What are the circumstances under which this unusual remedy may be sought?

First, it should be recognized that specific performance is a remedy available "in equity," rather than "at law." This means that it is a remedy that is available only under special circumstances, and then only at the discretion of the court. No one has a right to an equitable remedy. The court must find that the imposition of an equitable remedy is fair under the circumstances and that a remedy at law would be inadequate. In addition, the one seeking equity must himself have acted properly and fairly. This principle is embodied in the famous legal adage that "one who seeks equity must come with clean hands."

Second, the terms of the contract must be clear, complete, and specific. The court will not enforce a vague contract or one with missing terms. For example, if a contract for the sale of realty does not specify the form of the deed, the court is unlikely to grant specific performance because the court does not want to write a contract for the parties. The courts will only specifically enforce what the parties have clearly agreed upon.

Applications to Real Estate. Contracts for the sale of real estate enjoy a special status when it comes to specific enforcement. As mentioned above, specific performance is normally not available when there is an adequate remedy at law; that is, when an award of money damages would provide adequate compensation. The courts have long held, however, that every piece of real estate is unique, and that money damages are therefore never entirely adequate. This is based on the notion that the location of a piece of real estate is its primary attribute, and there is only one piece of real estate that can be in a particular location. Consequently, specific performance is frequently available to the buyer (and for some reason to the seller, who will receive only money from the sale) when the other party breaches a contract for the sale of real estate.

For the buyer, it is a potent and valuable remedy, even if the particular piece of property is not all that unique. For one thing, damages are frequently very difficult to prove, and if proven, are often inadequate. This is because the usual measure of damages for the breach of a contract to sell real estate is the amount by which the value of the property exceeds the purchase price. If one is purchasing property at its fair value, there would be no damages under this theory. Additionally, a suit for specific performance allows the buyer to tie up the property for years

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while the litigation works its way through the courts. The seller has to keep paying the taxes and the mortgage if there is one, and can't sell or refinance the property. If the buyer eventually wins the lawsuit, the buyer enjoys the benefit of any appreciation, while the seller has been stuck with the carrying costs. The result is often that the seller is forced to settle the case on generous terms, especially if he has an urgent need to sell the property.

It is possible for a well-advised seller to protect himself from this threat. The best protection is to attempt to negotiate a provision in the contract waiving the remedy of specific performance. If this is not possible, he should at least try to negotiate other provisions to protect his interests. For example, it is sometimes possible to negotiate a provision that the buyer must deposit the purchase price in escrow, and leave it there, during the pendency of any suit for specific performance. This assures the seller that the buyer is serious and is not simply using the suit as a quick expedient to tie up his property and force a settlement. It will also discourage many suits for specific performance from being brought because the buyer will often be reluctant to tie up his money, and those that are brought are usually settled quickly and fairly because both parties want to be free to deal with their assets.

Conclusion. The possibility of specific performance is present whenever there is a dispute involving a contract for the purchase or sale of real estate. When entering into such a contract carefully consider this possibility and what it could mean to you, as a buyer or as a seller. If you are the seller, attempt to negotiate a waiver of specific performance, or at least require the buyer to escrow the purchase price pending a suit for specific performance. If you are the buyer, resist such modifications because they will weaken your position and leave you in the difficult position of trying to prove your money damages if the seller defaults.

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MEMORANDUM #205 Liquidated Damages

Real estate contracts normally provide that the buyer forfeits his earnest money deposit if he fails to perform. This is known as a "liquidated damages" provision because the parties have agreed in advance on the amount of damages; that is, they have agreed that the amount of the earnest money deposit will be the compensation the seller is to receive if the buyer breaches. The seller does not have to prove actual damages, he simply receives the earnest money deposit and the parties are released from further claims.

This provision is normally enforceable as long as the amount is a reasonable approximation of actual damages, and the actual damages are difficult or impossible to actually determine.

What if the seller attempts to get the best of both worlds by providing that he has the option to forfeit the buyer's earnest money deposit as liquidated damages or pursue actual damages? The answer is that it doesn't work. The seller loses his right to liquidated damages and gets only the actual damages he can prove.

Why? The courts have held that the parties entering into such a contract did not have an intent to "liquidate" their damages; that is, they did not intend to agree on a fixed amount for damages. Instead, they agreed to give the seller the choice of taking liquidated damages or actual damages. Presumably, the seller would choose whatever would give him the greatest recovery. Because of that, the courts have held that the liquidated damages provision is a penalty, because it will be chosen only when it will award the seller a greater amount than actual damages. Since the law does not award punitive damages for breach of contract, the liquidated damages provision is void.

The Lesson. If you want the right to retain buyer's earnest money deposit as liquidated damages, always state that it is the seller's sole and exclusive remedy. Never provide that the seller has the choice of taking the earnest money or pursuing actual damages.

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MEMORANDUM #206 Waiver of Jury Trial

We all have heard horror stories about "runaway" juries that award huge and unjustified damages, or that don't understand the evidence. As a lawyer, I believe juries generally do a good job--but even I must admit, sometimes you have to wonder.

If you'd rather not have a jury decide your fate, there's an easy solution, at least where a lease, sales agreement, or some other form of contract is involved--simply put a provision in the document stating that the parties waive trial by jury.

Such a provision often strikes people as unconstitutional, unenforceable, or maybe even un-American. After all, isn't a trial by jury a basic right guaranteed by the Constitution?

It is--but it is a right that can be waived in advance. Although the courts frequently state that they strongly favor trial by jury, a clear and unambiguous waiver is normally enforceable. When a contract contains such a provision, the parties may bring a lawsuit and have a trial, or course, but the trial is to the judge without a jury. The parties receive all the protections and enjoy all the rights and remedies of the American judicial system, but avoid the uncertainty and additional time and expense sometimes associated with a jury trial.

Landlords and lenders, especially, find it desirable to put a clause in their leases waiving the right to a jury trial. This is because more jurors have been tenants or borrowers than landlords or lenders, and therefore tend to be sympathetic to tenants and borrowers. In addition, tenants and borrowers will sometimes make dangerous, but thinly supported, counterclaims that a jury might tend to believe. For example, a tenant might claim that the landlord has done something to ruin his business and that he is entitled to huge damages for lost profits. A borrower may claim that his business was destroyed by the wrongful termination of a credit arrangement. Many landlords and lenders worry about having such claims judged by a jury of sympathetic laymen not familiar with normal business practices.

To be enforceable, jury waivers have to be clear and unambiguous. Here's an example:

The parties to this agreement hereby waive trial by jury in any action, proceeding or counterclaim brought by either of the parties hereto against the other to enforce this agreement, to collect damages for the breach of the agreement, or which in any other way arise out of, are connected to or are related to this agreement or the subject matter of this agreement, including but not limited to the use or occupancy of the premises or any claim of injury or damage arising out of the use or occupancy of the premises. Any such action shall be tried by the judge without a jury.

Even with such a clause, however, the other party may still be entitled to a jury trial if he suffers a personal injury caused by other party's negligence, because the courts are reluctant to enforce waivers outside the business transaction covered by the waiver. For example, if a tenant breaks his neck falling down an unlit stairwell, he is probably entitled to a jury trial no matter what the lease says. In addition, the waiver extends only to the parties to the contract. If there is a separate guarantor, for example, he must separately waive the right to a jury trial in the guarantee itself.

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Conclusion. If you wish to avoid the expense, delay, and uncertainty of a jury trial in a contract or lease dispute, put a clause in your documents waiving the right to trial by jury. If clearly written, such clauses are normally enforceable.

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MEMORANDUM #207 Arbitration

The parties to a contract often include an "arbitration clause" in their agreement. This is an agreement to arbitrate any disputes they may have under the contract rather than to resolve them by a lawsuit in a court of law. The reason the parties choose arbitration usually is because they believe it will be quicker and less expensive. In fact, arbitration is usually quicker and less expensive than litigation in a court of law; unfortunately, it's rarely as quick or as inexpensive as the parties had hoped. Often it costs almost as much to arbitrate a dispute as it does to go to court. Parties to arbitration proceedings generally retain legal counsel to assist them in their presentation, and these counsel prepare just as thoroughly for arbitration as they do for trial.

Other Considerations. There are other factors besides speed and expense that the parties should keep in mind when deciding whether to include an arbitration clause in their agreement.

The most important consideration is that with arbitration the proceeding is less likely to be based on a strict application of the law. Arbitrators are rarely judges or lawyers, and while they are supposed to follow prevailing law they sometimes are not aware of what the law is or how it applies to the particular case. It is also believed that arbitrators are more likely to "split the baby" than a court of law--that is, to fashion a compromise solution (regardless of the law) rather than to decide in favor of one party or another. Whether you, as a party to a contract, find this approach to your advantage or disadvantage will depend on the complexity of the contract, the kinds of disputes that are likely to arise, and whether you would like your dispute determined strictly in accordance with the law or in accordance with your arbitrator's idea of fairness, justice, and compromise.

No Discovery. Another consideration is that there is usually no discovery (such as the taking of depositions and the required disclosure of documents and other evidence) and few, if any, pre-trial motions. On the one hand, this can save time and money because these procedures are expensive and time-consuming. On the other hand, not having these procedures available can actually increase the cost and lead to aberrational results. This is because pre-trial motions often lead to the resolution of a case before it is necessary to conduct a full trial, and because pre-trial discovery narrows the issues for trial, promotes settlement by informing each party of the merits of the other party's case and the weaknesses of their own, and leads to generally fairer decisions because the possibility of surprise at trial is reduced. Clearly, the lack of discovery and pre-trial motions is both an advantage and disadvantage. Generally, the more complex the case, the more useful pre-trial discovery and motions become.

No Appeal. The grounds for appeal from an arbitrator's decision are very limited. The arbitrator is the judge of both the law and the facts, and if he makes a ridiculous and unfair decision contrary to both the evidence and the law, there simply is no remedy. The decision is final. Appeals are limited primarily to cases where there has been outright fraud, misconduct or partiality on the part of the arbitrator, or where the arbitrator exceeded his powers or did not have jurisdiction in the first place. A bad decision or a misapplication of the law is not grounds for appeal; you are stuck with the arbitrator's decision, whatever it is. If you are a party to a contract of major importance to you or your company, you might want to think carefully before you give up the right to appeal by accepting an arbitration clause.

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Extraordinary Relief. The ability to obtain extraordinary or equitable remedies is somewhat uncertain with arbitration. This includes remedies other than a money judgment, such as a restraining order, attachment, or specific enforcement. In Arizona, the courts have approved the issuance of such remedies on a provisional, or temporary, basis pending the outcome of the arbitration hearing. The courts in some other states have gone further and have held that they will enforce a final order for specific performance granted by an arbitrator, but this issue has not yet been addressed in Arizona. One must conclude, therefore, that while such remedies are probably available, it may depend on the state in which the proceeding is brought and the particular remedy that is sought.

Mutuality. If, after considering the above factors, you decide that an arbitration clause is to your advantage, you will need to make sure it is enforceable. To be enforceable, it will need to be mutual--that is, it must apply to both parties. The law in Arizona is that an arbitration clause is not enforceable if it applies to only one party to the contract.

Conclusion. An arbitration clause can be a useful and desirable provision in many contracts. However, it also has its disadvantages. The decision to agree to arbitration should be made deliberately and with full awareness of the advantages and disadvantages.

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MEMORANDUM #208 Escrow Losses

Suppose you're buying some property. You enter into a contract and give the earnest money deposit to the escrow agent. Before you close, the escrow agent goes broke, and the earnest money is gone. Who bears the loss--you or the seller? Clearly, neither one is at fault.

The answer: In most cases it's you, the buyer. Here's why.

The general rule is that when money is placed in escrow, the risk of loss is on the party who would be entitled to the money if the escrow were terminated at the time the money disappeared. In the case of the sale of property, the courts have generally held that the buyer is entitled to the money, and therefore must bear the risk of loss, until everything has happened that must happen for the closing to occur. This means that the entire down payment must have been deposited, all necessary documents must have been placed in escrow, and sometimes even that the deed shall have been recorded. In other words, until the closing occurs or at least is ready to occur, the seller is not entitled to the money and the buyer bears the risk of loss. The theory is that until the escrow is completely ready to close, it is still the buyer's money so it is his loss if it disappears. If he still wants to purchase the property (or avoid a lawsuit by the seller), he'll have to come up with the money a second time to close.

There are a couple of exceptions, however. First, the parties can agree in the escrow instructions who will bear the risk of loss. As a practical matter this is rarely done, because the parties usually aren't thinking about the possibility of a loss when opening an escrow.

Second, if the escrow holder is the agent of a particular party, rather than being an independent stakeholder, that party will bear the risk of loss. For example, where someone hires a broker to sell his property, the seller is responsible for the loss of the earnest money deposit when the broker absconds with it because the broker was the seller's agent, not an independent stakeholder.

The Lessons. The first lesson is to select a substantial, reputable institutional escrow agent, such as a major title company or bank, in order to minimize the possibility of bankruptcy or fraud. In most cases, you should avoid having a broker or other individual hold the funds.

The second lesson is to avoid having your own agent, such as a broker you have hired, hold the funds, even for a short period of time, because if they disappear it is usually your responsibility.

The third lesson, especially if you're the buyer, is to keep the earnest money deposit to a minimum and don't leave large sums of money in escrow any longer than necessary.

Fortunately, bankruptcy or fraud by an escrow agent doesn't happen often--but when it does it can create major losses. The recent takeover of Charter Title Agency by the Arizona State Banking Department is a recent example where the unrecovered losses are reportedly in excess of $7 million and hundreds of Arizonans will suffer financial loss.

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MEMORANDUM #209 Lis Pendens

The Arizona Court of Appeals has issued a clear warning against clouding another person's title to real estate. In a recent decision, the Court awarded treble damages for the wrongful filing of a lis pendens.

Arizona law provides that anyone involved in litigation affecting title to real property may record a notice of that action. This notice is called a "lis pendens," and is designed to give potential purchasers of the property notice that there is litigation in progress which may affect the title to that property.

In a recent case, the parties were in a dispute over the ownership of a 40-acre parcel, which was part of a larger 740-acre parcel 700 acres of which were not in dispute. Nevertheless, one of the parties filed a lis pendens against the entire 740 acres, in order to "gain leverage." The result of the lis pendens was that a sale of the larger parcel to a third party was delayed by 28 days, while title was cleared.

The Court held that it was improper to file a lis pendens against the entire 740 acres, because title to only 40 acres was at issue. It therefore awarded damages for the lost interest caused by the seller's delay in receiving the sales price. The lost interest was $46,261.32. Because Arizona has a statute allowing treble damages for the wrongful clouding of another's title, the amount was trebled to $138,783.96. In addition, the prevailing party was awarded his attorney's fees.

Conclusion. A lis pendens can and should be filed when title to property is a legitimate issue in a lawsuit. However, a lis pendens should never be recorded just to harass or "gain leverage" over the other party. The same is true of any other form of lien, claim, or encumbrance which could amount to a wrongful clouding of title. The penalty for doing so is treble damages plus attorney's fees.

__________________ The decision cited above is Patterson v. Bianco, 80 Ariz. Adv. Rep. 38 (Feb. 12, 1991).

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MEMORANDUM #210 When Can You Place A Lien On Another Person's Property?

Lawyers are often asked by clients to impose an involuntary lien against another person's real property. For example, a client who is owed money may ask to put a lien on the debtor's property in order to secure his debt and provide a source of payment. Or, a client may ask to place a lien against a parcel of real property he believes he has a contract to purchase where the seller is refusing to honor the contract in order to tie up the property so it can't be sold to anyone else.

Non-Consensual Liens. A lien of this kind is referred to as a "non-consensual lien," because it is imposed without the consent of the property owner. According to Arizona law, however, only four classes of claimants are allowed to file a non-consensual lien. They are (a) a governmental entity or political subdivision, (b) a licensed utility company, (c) a mechanics' lien claimant, and (d) a property owners association created by a recorded declaration of covenants, conditions and restrictions that authorize such a lien. No other person or entity may file a non-consensual lien against another's real property except by court order.

The most common form of non-consensual lien created by a court order is an ordinary money judgment entered as the result of a successful lawsuit. For example, if Adam sues Blake and obtains a judgment for $100,000, he may record that judgment with the County Recorder. Once recorded, the judgment automatically becomes a judgment lien against any real property then owned or thereafter acquired by Blake in that county, and the judgment lien remains a lien against the property even if it is later sold to someone else. This has the practical effect of preventing Blake from selling the property and allows Adam to foreclose on the property to satisfy his judgment. Notice, however, that a lawsuit must first be prosecuted to a successful completion and a judgment must be issued—Adam cannot simply record a lien whenever he wants in order to tie up Blake's property.

Lis Pendens. Another useful tool for tying up property is the lis pendens. A lis pendens, however, is not a lien. It is a document filed with the County Recorder against a parcel of real property giving notice that the filer is claiming an interest in the real property, and it may be filed only after a lawsuit has been filed asserting such a claim. For example, if Adam enters into a contract to purchase a parcel of real property from Blake which Blake refuses to honor, Adam may file a suit for specific performance. Since he is claiming an equitable interest in the property—that is, a claim that has the right to become the owner even though recorded title is still in Blake's name—he has the right to file a lis pendens. This is not a lien, and it does not give Adam the right to foreclose on the property. However, it does give public notice that Adam is claiming the right to purchase the property, so that any future owner would be bound by the outcome of a successful suit by Adam and would have to sell the property to Adam. The result, of course, is to protect Adam's right to purchase the property should he win the lawsuit, but it also has the effect of tying up the property and perhaps putting pressure on Blake if he needs to sell the property. So although it is not a lien, it can have a similar effect. Again, however, it cannot be filed until after a lawsuit has been commenced.

One must be careful in filing a lis pendens or any other non-consensual lien or encumbrance. If the document is known to be frivolous, false, groundless or invalid, or if the lawsuit which is the basis for the filing of the lis pendens is totally and completely without merit, the person filing the

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document can be liable for the greater of $5,000 or treble damages, plus attorneys' fees, and in some cases can even be prosecuted criminally.

Conclusion. The law has strong provisions imposing liability on those who attempt to tie up another's property by the wrongful filing of a lien, encumbrance, or lis pendens. However, after a judgment has been obtained, the successful party has the right to file a judgment lien; and after a non-frivolous suit has been filed claiming an interest in real property, a lis pendens may be recorded. Both are effective means of protecting those with a valid claim against real property owned by another.

__________________ A.R.S. § 33-420, -421; Evergreen West v. Boyd, 167 Ariz. 614, 810 P.2d 612 (1991).

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MEMORANDUM #301 General Warranty Deed

If you are buying property, the best way to take title is by a general warranty deed. This form of deed provides the broadest warranty of title for the buyer and obligates the seller to indemnify the buyer against all manner of title defects.

You should be aware, however, that there are some things that even a general warranty deed doesn't cover.

To understand what isn't covered, let us first look at what is covered. A general warranty deed obligates the seller to provide the buyer with good title free of any liens, easements, encumbrances, rights-of-way, or other defects in title. Normally certain known matters are listed as exceptions to the general warranty--for example, if there is a utility easement across the property, it may be listed as an exception to title. In other cases, title might simply be conveyed "subject to all matters of record," meaning that the warranties cover only unrecorded title defects. In the latter case the buyer must be absolutely sure he has a reliable current title report and that none of the recorded items will pose a problem for him. Except for the items expressly excluded from the general warranty, however, the seller guarantees the buyer good and clear title when he delivers a general warranty deed.

So what is not covered? Here's an example. Suppose the property conveyed by the deed is a farm, and suppose the neighboring farmer has fenced off and has used the north 40 acres for several years, but not long enough to gain title by adverse possession. When the buyer discovers, after the closing, that his neighbor is occupying his land, he might think it is the seller's problem because the seller gave the buyer a general warranty deed. Unfortunately for the buyer, he would be wrong. The seller promised the buyer that the buyer would have good title, and he does. The neighboring farmer has not yet gained title by adverse possession, so the responsibility for evicting him, even if it takes an expensive lawsuit, falls to the buyer. The same would be true of boundary line encroachments, holdover tenants, or other forms of trespass that have not yet ripened into title by adverse possession.

What about the buyer's title insurance? Doesn't the title company have a duty to cure the problem? Unfortunately for the buyer, the answer is the same. The cost, expense and aggravation of curing the problem is the responsibility of the buyer in this situation. This is true even if the buyer purchased extended coverage title insurance.

The Lesson. The lesson for those purchasing real estate is clear. Do not smugly rely on your warranty deed and title policy, even if you have extended coverage. Obtain a current survey and investigate the property yourself. Determine whether others are using or crossing the property on a regular basis or have encroached upon or fenced off a portion of the property. If so, the time to deal with the problem is before you buy, when it's the seller's problem--not after you buy, when it's yours.

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MEMORANDUM #302 Special Warranty Deed

There was a time when real property was almost always sold by General Warranty Deed. The General Warranty Deed requires the seller to guarantee the buyer good title against almost every kind of title defect. In recent years, however, many sellers have refused to give a General Warranty Deed. Instead, they offer a Special Warranty Deed, telling the buyer to rely on the title insurance policy for his protection.

Before a buyer accepts this proposition, however, he should know what a Special Warranty Deed is, what title insurance covers, and what additional risks, if any, he is taking by accepting a Special Warranty Deed.

Special Warranty Deed. A Special Warranty Deed is a deed saying that the seller warrants title against "the seller's own acts and no other." This odd-sounding language means that the seller guarantees good title only against defects that he himself caused. For example, if there is an invalid deed in the chain of title, the seller has no responsibility unless he himself is responsible for the invalid deed. If the title defect is caused by someone else, the seller has no responsibility, and the title defect is the buyer's problem. On the other hand, if the seller has conveyed title by a General Warranty Deed, the seller is responsible for guaranteeing good title regardless of who caused the title defect.

In the seller's view, the Special Warranty Deed seems perfectly equitable, because he doesn't want to be responsible for things he didn't cause. Besides, the seller figures he is paying the cost of title insurance for the buyer's protection, and that ought to be enough to satisfy the buyer. The buyer, however, is paying for good title and doesn't care who caused the defect. He figures if he's paying for clear title, the seller ought to be responsible for delivering it one way or another. After all, the seller is getting paid in good funds--why shouldn't he deliver good title?

Title Insurance. As mentioned above, the seller often justifies the Special Warranty Deed by telling the buyer to rely on his title insurance policy. That's not always a completely satisfactory answer, however. Here's why:

1. A standard owner's policy of title insurance does not cover certain types of title defects, such as rights obtained by adverse possession or prescription, rights of tenants in possession, unrecorded mechanic's and materialmen's liens, or anything that would be disclosed by a survey. A General Warranty Deed generally does cover these matters, so that the acceptance of a Special Warranty Deed together with a standard owner's policy of title insurance still leaves the buyer with less protection than he would get with a General Warranty Deed and a standard policy. In other words, with a Special Warranty Deed the buyer has no protection against anything excluded from the policy unless it was caused by the seller. This problem can be cured by purchasing an extended coverage policy of title insurance which does cover most such excluded matters--however, the cost is rather steep (usually twice the cost of a standard policy), and the prevailing Arizona custom is for the buyer to pay the additional cost. Therefore, the buyer is often faced with the quandary of choosing either to accept some title risks or to pay the premium for extended coverage.

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2. Recovery under a standard policy is limited to the face amount of the policy, which is generally the purchase price. This is usually sufficient to cover the buyer's loss. However, in some cases it is not; for example, when the property is purchased at a bargain price. The seller's duties under a General Warranty Deed generally require him to indemnify the buyer for his loss, which is not necessarily limited to the purchase price. Thus, reliance on the policy of title insurance could provide an inadequate recovery.

3. A title insurance policy, even with extended coverage, may exclude certain items covered by a General Warranty Deed. A title policy, for example, excludes title defects known to the insured, while a General Warranty Deed under some circumstances does not. While this may not seem important on the theory that no one would buy property with a known defect, remember that it is quite possible that the buyer may have known of the defect prior to closing but did not appreciate or fully realize its significance. In such a case, the protection offered by a General Warranty Deed could be valuable.

4. There is always the possibility, however slight, that the title insurer could become insolvent, leaving the buyer with only minimal protection offered by the Special Warranty Deed. While this possibility may seem remote enough to ignore, remember that the same thing was once thought about savings and loan institutions, life insurance companies, and many other financially troubled enterprises. Therefore, there is always a slightly greater element of risk if one relies only on title insurance for his protection.

There is obviously little to be gained from a General Warranty Deed, however, if the seller is not strong enough financially to honor his warranty. In cases where there is a seller carry-back, the buyer may be able to offset his claim under the Deed against the amount he owes the seller. In other cases, however, it may not be worth the effort to insist on a General Warranty Deed if it appears that the seller will be unable to honor his warranty.

Conclusion. When deciding whether to accept a Special Warranty Deed, a buyer must consider many factors, including the likelihood of uninsured title risks, the solvency of the seller, whether there is a seller carry-back, the cost of extended coverage title insurance, and the relative bargaining position of the parties. There is no uniform "right answer"--each transaction must be negotiated on its merits with a full and informed appreciation of the relative risks.

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MEMORANDUM #303 Quit-Claim Deed

A Quit-Claim Deed is a special kind of deed. Unlike a Warranty Deed or Grant Deed, it transfers title without warranty. With a Quit-Claim, the grantor is saying "I'm giving you what I have, if anything, but I'm making no promises." What the grantor has is what the grantee gets. The grantee has no claim against the grantor if title is defective or even if the grantor doesn't own the property.

There are many circumstances where this is a useful and appropriate device. For example, the parties may know that title is questionable, and the buyer of the property may be willing to take the risk of defective title. Another situation is where the parties desire to clear title. There may be an apparent defect in the chain of title, for instance, creating the possibility that a third party may have an interest in the property. By quit-claiming any interest he may have, the third party can cooperate in clearing title without creating any liability for himself.

On the other hand, there are also situations where a Quit-Claim is misused. A common example is where the conveyance is between related parties. A parent might want to convey property to a child as a gift, a sole stockholder might want to convey title to his corporation, or a partnership might want to split title among the partners. In such cases, it is not uncommon for the conveyance to be by Quit-Claim because the grantor does not want to assume any risk that a title defect might later surface. This makes sense and is understandable. Such transactions are usually handled outside of escrow and without purchasing new title insurance.

Title Insurance. What the parties often fail to consider is that the use of the Quit-Claim leaves the parties without title insurance. If they had used a Warranty Deed instead of a Quit-Claim, title insurance would still be effective without any additional cost.

Here's why. Title insurance covers the insured named in the policy--normally the original buyer. It also insures anyone who takes title through that person by operation of law--for example, by inheritance. It does not cover those who purchase from the named insured, or who receive title by gift, in trade, or as a corporate or partnership distribution. However, the policy does continue to insure the named insured against claims arising from covenants of title given when the property is conveyed to a third party. This means that when title is conveyed by Warranty Deed, the grantee can assert any claim he might have for defective title against the grantor, who can then obtain indemnification from the title insurance company. The net result is that the title insurance policy provides the money to insure against the title defect in the hands of the new owner without the payment of any additional premium.

There is one potential risk, however. If the property has risen in value between the time of the original policy and the time of the conveyance, the claim under the Warranty Deed may be greater than the amount of the policy, leaving the grantor exposed to this portion of the claim. If the parties remain friendly, this should not be a problem because the claimant can simply waive his claim to the extent it exceeds the policy limit. If there is a question in this regard, another solution is to limit the warranty in the Deed to the dollar amount of the policy at the time the conveyance is made.

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Conclusion. A Quit-Claim Deed is useful, but is not always the best choice when the conveyance is between related parties. If you are considering giving or accepting a Quit-Claim Deed, particularly between related parties, think through the title insurance ramifications to insure that you do not inadvertently divest yourself of protection which could be available without cost.

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MEMORANDUM #304 Recording Requirements

The Arizona legislature recently adopted a new law changing the requirements a document must meet to be recorded with the County Recorder. It is important to be familiar with these requirements, because a document that does not meet them may be rejected by the Recorder and returned days or even weeks later. In the meantime, you may lose the lien priority or the other benefits which you are trying to establish by the recording. Or, the party who signed the document may be unavailable or unwilling to execute a new document that does comply with the requirements.

The new requirements are as follows:

1. The document must be no larger than 8-1/2 by 14 inches.

2. The type size must be no smaller than 10 point type. Normal typewriter characters meet this requirement, but many of the printed forms currently in use do not. For example, the pre-printed deed of trust used by most title companies does not comply.

3. The first page of the document must have a top margin of at least two inches.

4. The side and bottom margins must be at least one-half inch.

In addition to the new requirements, the following old requirements must also be met:

1. Each document must have a caption briefly stating the nature of the instrument.

2. The document must be legible.

3. The document must have original signatures or carbon copies of such signatures, except when otherwise provided by law, and the signatures must be acknowledged by a notary public.

4. Any document which modifies a previously recorded document must state the date of recordation and the document number or docket and page of the document being modified.

Anyone who has occasion to record documents, such as mechanic's liens, deeds of trust, easements, or releases of encumbrances, should make note of these requirements to avoid what could be a very costly delay in the effective date of the recording.

The new law is effective January 1, 1991.

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MEMORANDUM #305 Slander of Title

The public recording statutes are of tremendous benefit to the real estate industry. In fact, it is hard to imagine how any kind of major real estate transaction could be carried out if the parties to the transaction could not rely on the information on file at the office of the county recorder.

The reason the public records are so essential is that it is often impossible to know who owns a given parcel of real property, who may have liens and easements against it, and who may be claiming other interests in it, just by looking at it. The only way these things can be determined for sure is by an examination of the public records. In addition, the public records establish priorities--normally, the first to record has the senior interest. This allows lenders to know that their liens have senior status when they lend against real property, and purchasers to know they have clear title when they buy. Without the assurances provided by the public records, the entire industry--including the construction, brokerage, and title insurance industries--would probably grind to a halt.

Because of this, and because of the individual harm that can be done when false information is recorded against a parcel of property, it is vitally important that the public records remain as accurate as possible and that a means be provided to correct false, incorrect, and invalid information.

In Arizona, this is accomplished in several ways.

First, there is a common law right to sue someone who wrongfully clouds your title. This action is referred to as an action for "slander of title." In order to bring such an action, three things must be shown: (1) the information must be false, (2) the person recording it must be acting with malice, or intent to harm, and (3) actual damages must result. This does not clear the public records--however, it does compensate the property owner for his loss, and provides a strong incentive to make sure that anything that is recorded is accurate.

Second, Arizona has a statute that provides for monetary damages when someone records a document claiming an interest in or a lien against real property knowing or having reason to know that the document is forged, groundless, incorrect, or invalid. Under this statute, the person recording the document is liable for the greater of $5,000 or three times the actual damage, plus court costs and attorney’s fees. If a person is named in such a document, but did not cause it to be recorded himself, he must release it within twenty days of written demand or he will be liable for the greater of $1,000 or three times the actual damages, plus court costs and attorney’s fees. This statute also makes it a misdemeanor to record such a document, and allows the property owner to bring an action to have it removed from the public records at the expense of the person who recorded it. See A.R.S. § 3-420.

Third, another Arizona statute requires that anyone who holds a mortgage or deed of trust must release it within thirty days of being paid in full. If he fails to do so, he is liable for any damages that result, even if the failure was unintentional. In addition, if he fails to release the lien within thirty days of written request by certified mail, he is liable for the greater of actual damages or $1,000. See A.R.S. § 3-712.

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Fourth, Arizona has a statute allowing a property owner to bring a quiet title action to eliminate any clouds on his title. This is a lawsuit where those who may be claiming an interest in the property are named as defendants. At the end of the lawsuit, the court determines whether the claims are valid--and if they are not, a judgment is entered striking them from the public records--or in other words, "quieting title." This same statute provides that before bringing a quiet title action the property owner may tender a quit-claim deed and five dollars to the person claiming the interest. If he fails to execute and return the quit-claim deed within twenty days, he will be liable for the plaintiff's attorneys fees and court costs if the plaintiff is successful in the action to quiet title. This provides an incentive for those holding invalid claims against property to release them voluntarily. Arizona's quiet title statute is found at A.R.S. § 33-1101 to -1104.

Conclusion. The public records are of tremendous value to those dealing in real estate and normally can be relied on with confidence. When erroneous information is found, there are remedies available to get it corrected. Conversely, this means that it is essential to be careful when recording information that may affect another's title--because if it is incorrect or invalid, you may be liable for substantial damages.

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MEMORANDUM #306 Mineral Reservations

You get your title report and it shows a federal reservation of mineral rights. No one seems to know exactly what it means, and it's often ignored. The problem can get critical, however, when an out-of-state lender, investor, or purchaser gets a look at the title report. He's never seen such an exception before, and is horrified at the thought of an open pit mine on his property.

First, what is a federal mineral reservation and what does it mean? In general, it gives a mining operation the right to pursue its claim on your land. However, the operation must reimburse the landowner for certain kinds of surface damage. Obviously, it's often prudent to get rid of the reservation, especially if a mining operation would be detrimental to your anticipated use of the property or would interfere with financing or a sale.

Second, how is this done?

Fortunately, there is a simple but little known Bureau of Land Management (BLM) program under which federal mineral reservations can be removed from land titles.

Under the BLM program, the owner or prospective buyer of land subject to a federal mineral reservation can acquire the reserved mineral rights upon application to BLM and payment of the processing costs. The BLM charges a flat $1,300 processing fee up front. The evaluation of a large parcel of land or of a mineralized area may end up costing much more, and the owner must pay this additional cost before BLM will convey the mineral estate. It takes BLM about two years to process an application. The process can be accelerated if the owner hires a mineral surveyor approved by BLM to independently evaluate the mineral potential of the land. Otherwise, BLM determines whether a formal mineral evaluation involving the taking of samples is required, and then performs it itself. Obviously, the more sampling involved, the higher the cost. Depending upon the location of the property, it may be possible to get a fairly solid answer from the BLM up front about whether a formal evaluation will be required.

If BLM's evaluation shows that the land has no known mineral potential (meaning the potential for development of an economically viable mining operation), BLM will convey the reserved mineral interest to the landowner upon payment of the application processing costs only. If the evaluation shows mineral potential, BLM will only convey the mineral rights upon payment of the appraised value of the mineral rights and a showing that the surface owner's use of the land would be more in the public interest than development of the minerals.

The BLM program is an avenue worth exploring in instances where title insurance against exercise of the reserved mineral rights cannot be obtained, which is quite common, or when the reservation interferes with a sale or financing. There are also other considerations that affect whether it makes sense to remove the reservation in particular circumstances. For example, in some cases it might make more sense for the owner to stake his own mining claims on his property. If the land is within city limits or an urbanized area, it may be less important to remove the reservation. Cities can, to a certain extent, regulate mining operations through zoning laws. In addition, if land is fully developed, a miner may not want to risk potentially large surface damage claims. Also, if a third party already has mining claims on the property,

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BLM will not convey the minerals until the claims have been acquired or extinguished by the landowner.

There are some developments pending at the federal level that may reduce the risks of mineral rights reservations. The fees for holding mining claims are rapidly rising, and may discourage mineral prospecting and development activity except in areas where there are truly commercially exploitable mineral deposits. Also, Congress is considering legislation to limit the activities of prospectors and miners in areas where the land surface is privately owned, making it less likely that mineral development activities will occur on these lands.

Conclusion. Federal mineral reservations can be removed, although it may cost some money and take some time. In certain cases, however, it's clearly worth doing, both because it protects your property from possible intrusion and because it makes your title more saleable (or lendable).

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MEMORANDUM #307 Affidavit of Property Value

An Affidavit of Real Property Value is a written statement under oath giving the sales price or value of a specified parcel of real property. Under Arizona law, an Affidavit of Value must be attached to every deed sent to the County Recorder for recording (with certain exceptions). In addition to value, the Affidavit also provides certain other information about the property, including its size, use, terms of sale, and the address to which the tax bill should be sent.

Normally, the actual sales price is the value entered on the Affidavit. However, when only nominal consideration is paid for the property or where non-cash consideration is received, an estimate of fair market value must be used instead. The Affidavit must be signed by both the buyer and the seller or their agents, and must be notarized. It is available for inspection by the public.

Purpose. The primary purpose of the Affidavit is to assist the County Assessor in valuing property for the property tax. Although the regulations of the County Assessor provide that the values on Affidavits are to be used in establishing valuation levels and valuation formulas in general, experience would indicate that the amount listed on the Affidavit often turns up as the value shown on the next property tax bill for that parcel. Therefore, if the transaction is one where fair market value is estimated, it is good to use a conservative estimate.

Being public, the values shown on the Affidavits are also used by appraisers to obtain "comparables," by newspapers and other publications to gain information about particular sales, and by other members of the public, such as realtors, who have an interest in knowing the sales price of a particular parcel of property.

Exemptions. Certain types of transactions are exempt from the requirement of an Affidavit. If an exemption is claimed, it must be noted on the Deed with the appropriate statutory citation. The exemptions, with citations, are as follows:

1. A deed representing either payment in full or a forfeiture under a recorded contract of sale (A.R.S. § 11-1134(A)(1)).

2. A lease or easement (A.R.S. § 11-1134(A)(2)).

3. A deed to or from a governmental entity (A.R.S. § 11-1134(A)(3)).

4. A quitclaim deed to quiet title (A.R.S. § 11-1134(A)(4)).

5. A conveyance pursuant to court order. (A.R.S. § 11-1134(A)(5)).

6. A deed of gift (A.R.S. § 11-1134(A)(6)).

7. A deed to provide or release security or a trustee's deed after foreclosure of a deed of trust (A.R.S. § 11-1134(B)(1)).

8. A deed to correct an earlier recorded deed (A.R.S. § 11-1134(B)(2)).

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9. A deed between husband and wife or parent and child with only nominal consideration (A.R.S. § 11-1134(B)(3)).

10. A sale for delinquent taxes (A.R.S. § 11-1134(B)(4)).

11. A deed to partition real property (A.R.S. § 11-1134 (B)(5)).

12. A deed resulting from a merger of corporations (A.R.S. § 11-1124(B)(6)).

13. A deed by a subsidiary corporation to a parent corporation for no consideration or nominal consideration or solely for cancellation of the subsidiary's stock (A.R.S. § 11-1134(B)(7)).

14. A deed from a person to a trustee or from a trustee to a trust beneficiary with only nominal consideration (A.R.S. § 11-1134(B)(8)).

15. A deed to and from an intermediary for the purpose of creating a joint tenancy estate or some other form of ownership (A.R.S. § 11-1134(B)(9)).

16. A deed from a husband and wife or one of them to both husband and wife to create an estate in joint tenancy with right of survivorship (A.R.S. § 1134(B)(10)).

17. A deed from two or more persons to themselves to create an estate in joint tenancy with right of survivorship (A.R.S. § 1134(B)(11)).

18. A beneficiary deed with only nominal actual consideration (A.R.S. § 11-1134(B)(12)).

In all other cases the Affidavit of Value must be submitted with the deed.

Conclusion. An Affidavit of Property Value must be attached to every deed before it will be accepted for recording, unless an exemption is available. If an exemption is claimed, it must be noted on the deed. The Affidavit is open for public inspection making it impossible to keep the sales price of real property secret once the deed has recorded.

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MEMORANDUM #308 Fraudulent Conveyances and Voidable Preferences

How Creditors Can Recover Property Transferred to Third Parties

Persons facing financial difficulties sometimes try to protect or hide their assets by transferring them to others. Those facing imminent bankruptcy may favor friends and relatives by paying their debts ahead of others, or may be pressured to pay one creditor ahead of another. (As the squeaky wheel gets the grease, oftentimes the creditor with the biggest hammer gets the payment). In all such scenarios the law provides a way for the unpaid creditors to recover these transferred assets.

Fraudulent Conveyances. In general, a fraudulent conveyance is a transfer of money or property, usually without equivalent consideration, which is either intended to keep the asset out of the reach of creditors or which jeopardizes the ability of the transferor to pay his debts. For example, a person facing a large lawsuit or a pending business failure might transfer assets to a relative or friend, hoping to put them beyond the reach of his creditors.

Under the law, there are two types of fraudulent conveyances. The first is when the transfer is made with the intent to hinder, delay, or defraud a creditor, regardless of whether equivalent consideration is received for the transfer. Intent to defraud can be inferred from such things as whether the transfer was concealed, whether the transfer was to a relative or friend, whether a lawsuit was pending or threatened against the transferor, whether the transfer was of substantially all the transferor's assets, whether the debtor retained possession and control of the assets after the transfer, and whether the debtor was insolvent at the time of the transfer or became insolvent shortly thereafter. These indicia sometimes referred to by the courts as "badges of fraud," and are an indication that the transferor intended to make the transfer to defraud his creditors.

The second situation occurs when a transfer is made without receiving reasonably equivalent consideration for the transfer, and the transferor was either insolvent at the time of the transfer, became insolvent as a result of the transfer, or was about to engage in activities where his solvency could be jeopardized. A transfer to satisfy an existing debt is considered equivalent consideration, so long as the value of the property transferred does not exceed the amount of the debt; therefore, a transfer to satisfy a debt is not, in and of itself, necessarily an indication of a fraudulent conveyance. This is because the net worth of the debtor has not decreased--he has fewer assets, but his obligations have declined by an equivalent amount. Theoretically, at least, the debtor's ability to pay his debts has not changed.

When there has been a fraudulent transfer, the creditor can bring a lawsuit to recover the asset from the third party transferee. If the transferor has filed bankruptcy, the trustee in the bankruptcy has the right to pursue and recover the transfer for the benefit of all creditors.

Voidable Preferences. A voidable preference occurs when a debtor transfers money or property to pay a pre-existing obligation within 90 days (or in some cases a year if the transfer is to an insider) of filing bankruptcy. Notice that unlike a fraudulent transfer, a voidable preference is created even though the debtor receives equivalent consideration in the form of a reduction in his debt.

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An example of a voidable preference might be when a businessman pays off debts owed to certain creditors ahead of others within 90 days prior to filing bankruptcy, perhaps because he is friendly with them, or perhaps because the particular creditor is more aggressive in its collection efforts or has threatened to cut off future supplies. In such cases, the trustee in bankruptcy can recover the assets so that they can be ratably distributed among all creditors in the manner provided by the bankruptcy laws. The law's purpose in avoiding preferences is so that all creditors can fairly share the bankrupt's remaining assets, rather than just those favored by the bankrupt.

The voidable preference rule can be an important one for creditors, particularly when they see a debtor in financial trouble transferring his assets to preferred creditors, while others go unpaid. Although the right to pursue recovery of a preference exists only in the context of a bankruptcy and belongs exclusively to the bankruptcy trustee, unpaid creditors do have a remedy. Creditors who are not getting paid can join together to file a petition seeking to force the debtor into an involuntary bankruptcy so that preferential payments can be recovered by the bankruptcy trustee and shared by all creditors in the manner provided by the bankruptcy laws.

It should be noted that the payment of a previously secured debt is generally not considered a voidable preference. This is because the secured creditor is entitled to full payment (up to the value of its collateral) ahead of general unsecured creditors in a bankruptcy. Since the pre-bankruptcy payment to the secured creditor did not deplete the funds available to pay creditors (because the secured creditor would have received priority payment ahead of other creditors anyway), the rationale for requiring return of the funds to provide for a ratable distribution does not apply.

There are a number of exceptions and other technical rules relating to voidable preferences, most of which will not be discussed here. However, one important exception is that payment of obligations which are made on a current basis or in the ordinary course of business are generally not considered to be preferences. Those doing business with someone in financial trouble should not ordinarily be concerned about having to refund payments received on a current basis for goods and services, even though the payments are received within 90 days of filing. The purpose of this "ordinary course" exception is to encourage those who are doing business with a troubled company to continue doing so.

Conclusion. The law provides remedies, in the form of fraudulent conveyance and voidable preference actions, to assist creditors in recovering assets that have been improperly transferred to third parties. Without these laws, debtors would be free to transfer, hide and conceal their assets and to prefer some creditors over others.

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MEMORANDUM #309 Purchase Price Must Be Disclosed To The Public When Recording A Deed

Arizona law requires an Affidavit of Real Property Value to be filed whenever real property is deeded from one party to another. This is a notarized document signed under oath by the parties to the transaction or their representatives stating the purchase price or value of the property, the amount of the down payment, and other information. Unless an exemption is available, the County Recorder is instructed by law to refuse to record any deed not accompanied by a properly completed Affidavit of Value. When filed, the Affidavit is a public record available for inspection by anyone who desires to see it.

Purpose of Affidavit. The Affidavit is used by the County Assessor to assist him in valuing property for tax purposes. While the Affidavit does not necessarily establish the value of the property for tax purposes, it is a factor that may be considered by the Assessor. As a result, property owners are often unhappy with the requirement of filing an Affidavit, particularly when the sales price of the property is far above the amount then shown on the Assessor's rolls. In addition, since the Affidavits are public information, some owners dislike having to file them, preferring to keep the purchase or sales price of their property private.

It should also be noted that Affidavits are also used by appraisers, brokers, investors and others to help determine the value of a given piece of real property.

Non-Cash Transactions. An Affidavit is required even when no cash is paid; for example, when there is an exchange of properties, or when an owner deeds his property into a limited liability company in order to reduce his risk of liability. In these cases, the parties are required to state the fair market value of the property in the Affidavit. Value, of course, is a matter of opinion, and a property owner concerned about the valuation of his property for tax purposes can be expected to take a conservative approach when stating the property's value. The ability of an owner to do this, however, may be limited when there is a recent appraisal of the property, or when a loan has recently been placed on the property which is in excess of the value the owner would like to use. Affidavits are executed under oath, meaning that there could be a violation of law if clearly erroneous information is intentionally placed on the Affidavit.

Exemptions. There are a number of statutory exemptions to the requirement of filing an Affidavit. If one of the exemptions is available, it must be stated on the face of the deed before the County Recorder will accept the deed for recordation.

The most commonly-used exemptions are the following:

1. A deed of gift.

2. A deed releasing a mortgage or deed of trust, including a trustee's deed recorded after a foreclosure.

3. A deed between a husband and wife or parent and child with only nominal consideration.

4. A deed resulting from a merger of corporations.

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5. A deed from a subsidiary to a parent corporation for no consideration or for the cancellation of the subsidiary's stock.

6. A deed into or out of a trust with only nominal consideration.

Notice that there is no exemption for a deed into a corporation, partnership or limited liability company by a stockholder or owner. Similarly, there is no exemption for a distribution by any such entity to a stockholder or owner. This has caused consternation on more than one occasion because a property owner conveying his property into a wholly-owned company without cash consideration cannot understand why he or she must file an Affidavit, particularly when it might lead to an increase in property taxes. This situation can arise, for example, when a lender requires that the property securing the loan be conveyed to a so-called "single purpose entity," or when a corporation is liquidated and its assets are distributed.

Conclusion. The filing of an Affidavit of Property Value serves a useful purpose both for the government and for those involved in the real estate industry. However, if you are a property owner wishing to maintain your privacy or minimize your property taxes, be aware of the exemptions and if possible, avoid unnecessary conveyances where an Affidavit might be required.

__________________ A.R.S. § 11-1131 et seq.

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MEMORANDUM #401 Joint Ownership

Sometimes two or more people will jointly purchase real property, usually as an investment. Land in particular is often purchased this way, but sometimes vacation or income properties are also purchased jointly. The intent is usually to break the cost down into smaller, more affordable units.

There are a number of ways to implement joint ownership. For example, property can be purchased by several people as co-tenants, or it can be purchased by a partnership or other entity made up of the co-owners.

Co-Tenancy. This simplest way to share ownership is to take title as co-tenants, so that each owner owns an undivided fractional interest in the property. Many properties have been purchased this way over the years. Although this form of ownership is simple, it can create a number of problems, including the following:

a. The property can be sold only by unanimous agreement of all owners. One uncooperative owner can block a sale or lead to a lawsuit for petition.

b. One of the co-owners may transfer his interest to a third party, forcing the other owners to become co-owners with a new person without their consent.

c. Most actions involving the property require the signature of all co-owners, creating difficulties if some are unavailable or refuse to cooperate.

d. There is no enforcement mechanism if some owners refuse to pay their share of taxes, insurance, or other expenses.

e. Title can become clouded over time as individual co-owners die, become divorced, put their interest in trust, and so on.

Fortunately, these problems can be easily avoided with a little foresight.

Co-Ownership Agreement. One solution is to enter into a recorded co-ownership agreement. Each joint owner still holds title to his own share of the property, but the agreement can provide a mechanism for selling the property (perhaps by majority vote), a right of first refusal to help avoid unwanted co-owners, and an agreement to share expenses. Sometimes such agreements also provide for an "unwinding" mechanism, whereby any partner can set a value on the property, and the other owner or owners have to either sell to the first co-owner or purchase his interest at that price. In short, co-ownership agreements are flexible, and can be drafted to provide whatever provisions the co-owners desire.

Some people like to hold title this way because they feel more comfortable having recorded title in their own name, rather than in a partnership or some other entity in which they own an interest. A disadvantage with this approach, however, is that over the years title can become clouded as people die, judgment or tax liens attach to certain co-owners, property is transferred, and so on. The more owners there are, the more title problems that can arise. In addition, each co-owner has unlimited liability if a lawsuit should arise out of the property.

Formation of Entity. To avoid these problems, an entity can be formed to hold title. In the past, general partnerships, limited partnerships, C corporations, and S corporations have all been

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used for this purpose. Today, however, a limited liability company is usually the best choice. In some cases, however, a Subchapter S corporation may be better, based on tax considerations. A tax consultant can help you determine the best choice for the type of property you have in mind.

There are two principal reasons why a limited liability company or a subchapter S corporation are superior to ownership by co-tenancy, even with a co-ownership agreement. The first is that the limited liability company provides what its name implies--limited liability. The same is true for a corporation. If someone is injured on the property, or possibly if environmental problems arise, these entities can provide valuable protection from unlimited liability. The second is that title is held by a single owner--the limited liability company or corporation. This greatly facilitates keeping title clear and in conveying or otherwise dealing with the property.

One disadvantage of using an entity to hold title, however, is that the individual members or shareholders cannot engage in a tax-deferred exchange when the property is sold. The entity itself may engage in an exchange, but the individual members or shareholders cannot because they hold an interest in the entity, not in the property itself. This can be a problem if some of the co-owners want to do an exchange but others do not.

Conclusion. It is generally unwise to hold title as co-tenants unless a co-ownership agreement is executed to facilitate the sale of the property, payment of expenses, and other features designed for the mutual protection and convenience of the co-owners. In most cases, an even better solution is to form a limited liability company or subchapter S corporation to hold title, both to provide for limited liability and for the convenience of holding title in a single entity.

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MEMORANDUM #402 Ownership by Spouses

In Arizona, a community property state, a married couple may hold title to real property in a number of ways.

Community Property. Under this form of ownership, each party in essence owns an undivided one-half interest in the property. However, neither party can convey the property, or even his interest in the property, without the joinder of the other; in other words, both spouses have to act together to convey or encumber community real property. The spouses can agree to terminate the community property status of the property, but neither can do it by himself as long as the parties remain married. Real property acquired by either spouse during marriage with community funds is community property regardless of whether the deed so states. However, either spouse may disclaim an interest in the property, which is normally done by recording a Disclaimer Deed executed by the appropriate spouse renouncing any interest he or she may have in the property.

Tenants in Common. Property can also be held as tenants in common. If the parties are not married, it is presumed that this is the manner in which the property is held when there are multiple owners. In other words, if property is simply conveyed to Smith and Jones, it will be presumed that they are tenants in common and that each owns an undivided one-half interest. Under this arrangement, each owner has an undivided fractional interest in the whole property. The fractional interest of either party can be conveyed to a third party, mortgaged, or left to his heirs without affecting the interest held by the remaining owner or owners. The parties holding property as tenants in common have no fiduciary duty to one another, although they do have a duty to act in good faith. It is usually a good idea for tenants in common to have a co-ownership agreement spelling out their respective duties, such as the procedure for collecting and paying the property taxes, maintaining and managing the property, and so forth.

Joint Tenants With Right of Survivorship. This form of ownership is similar to a tenancy in common, except that when one of the joint tenants dies, his interest terminates and the remaining joint owner or owners succeed to his interest. It is not favored by the law, and one ordinarily cannot create a joint tenancy without using the words "joint tenancy with right of survivorship" to make it absolutely clear that this is what the parties intended. It is sometimes called a poor man's will, because the property passes to the surviving joint owner without the necessity for probate. However, there are other ways to avoid probate, such as the establishment of an estate planning trust, that work equally well, and which can save significant estate taxes if the estate is large.

Joint tenancy can be terminated upon the conveyance by any owner of his interest. At that point, the parties become tenants in common. Joint tenancy can also be terminated by an action for partition, as described above. Holding title as joint tenants with right of survivorship has many of the problems of tenancy in common, but may prove useful in some instances for persons related by blood where estate taxes are not a consideration.

Property can also be held as community property with right of survivorship, which is similar to community property except that title to the entire parcel vests in the survivorship should one spouse die.

Ownership Entity. Another way for husband and wife to hold title to real estate is through the use of an entity, such as a partnership, corporation, limited liability company, or trust. Trusts are

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sometimes used to hold property owned by one or both parties to a marriage, usually as part of an estate planning arrangement to minimize estate taxes and to insure that the property and its proceeds are disposed of upon death or incapacity in accordance with the wishes of the owner. If an entity of some sort is to be used to hold title, it is usually advisable to consult legal counsel to make sure you fully understand the tax and other advantages and disadvantages of each of the possible entities, and to obtain expert assistance in the preparation of the necessary documentation.

Conclusion. There are a number of choices available when married couples jointly own real property. Because the value of real property is often significant and the tax and legal aspects are of great concern, careful thought should be given to the manner of holding title. Professional advice is often advisable.

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MEMORANDUM #403 Disagreements of Joint Owners

Joint ownership of real property is quite common. Often two or more persons will jointly purchase property, perhaps as a shared residence or investment. Sometimes joint ownership results unintentionally--for example, as the result of inheritance or divorce.

Disagreements Common. Whatever the reason, as time passes joint owners may find that they do not agree on matters relating to the property. One may want to sell the property, the other may want to keep it. One may want to borrow against it, the other may want to keep it free and clear. One may want to improve it, the other may want to leave it as it is. When real property is involved, the sources of disagreement are endless.

The Solution. Fortunately, the law provides a solution--an action for partition.

Originally, this meant that either owner could file an action asking the court to fairly divide the property into the appropriate number of parcels, deeding one to each joint owner. Sometimes, however, this just isn't a practical solution. For example, suppose the property is a single family residence or a building of some kind. Or suppose it is a small lot which cannot be legally subdivided. Maybe the division of property is just not feasible for some other reason, or would drastically reduce the total value of the property. In each of these cases, physically dividing the property is not a satisfactory solution.

To allow for situations like these, the law now allows the property to be sold, dividing the proceeds rather than the property itself.

The procedure for the sale varies from state to state. In some states the sale is conducted like a foreclosure sale by the sheriff. Other states allow a receiver or commissioner to sell the property in a more conventional manner.

In Arizona, the court appoints three disinterested commissioners who must first physically divide the property in a fair manner if they can. If they determine that the property cannot be fairly and equitably divided, or that the value of the property will be depreciated by physically dividing it into separate parcels, they are to so inform the judge. If the judge agrees, the judge then appoints one commissioner to sell the property in the manner directed by the judge. This gives the judge the discretion to decide whether the property should be auctioned off on the courthouse steps, listed with a broker, or sold in some other manner. Regardless of how it is sold, the proceeds are divided among the co-owners in accordance with their ownership interests.

Conclusion. If you and your co-owner cannot agree on the management or disposition of real property, you can file an action for partition to have it physically divided. If physical division is not feasible or would result in the depreciation of the property, the court may order it sold and the proceeds divided.

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MEMORANDUM #404 Nuisances

Most people know that you can go to court if your neighbor causes a nuisance. The court can order the neighbor to cease causing the nuisance, award damages, or both.

Just what is a nuisance? It has proven to be an unusually difficult thing for the courts to decide. Whether something is or is not a nuisance often depends on the facts and circumstances of the particular case. However, in general terms it is usually considered to be something that unreasonably disturbs one in the free use, possession, or enjoyment of his property. Common examples are continuous loud noises, vibrations, bright lights, noxious fumes, odors or smoke, violations of the common laws of decency, and so forth. The courts often perform a balancing act, considering such things as the character of the neighborhood, the utility of the use, and whether the alleged nuisance preceded or commenced after the complaining party's use.

What if branches from trees or bushes on an adjoining property encroach across your property line, dropping leaves, blocking your view, or causing unwanted shade? Is this a nuisance? Can you go to court to force your neighbor to trim back his trees and shrubs?

Most courts say not. Encroaching branches and roots simply are not normally considered nuisances, although some courts will allow an action if the encroachment is causing substantial damage. That doesn't mean you are without remedy, however. That remedy is self-help, which is always permissible to cure this kind of encroachment. The trees and shrubs can be trimmed back to the property line whether the neighbor likes it or not, and even if it kills the plants. Even though the courts may offer no relief, every property owner has the right to remove encroaching branches and roots by his own hand, and is protected from any liability for damages to the plant when he does so.

For most typical nuisances, however, there is little to do but go to court if the neighbor won't cooperate.

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MEMORANDUM #405 Responsibility for Crimes

Imagine a dark night, about 11 p.m. A young lady visits an automated teller machine in a shopping center. As she returns to her car, a man steps out of the shadows in the parking lot and grabs her purse. When she refuses to give it up, he strikes her with a pipe, then escapes with the purse. The young lady is left unconscious in the parking lot. She survives, but is disfigured and crippled for life. She files suit against the owner of the shopping center for $3,000,000.

Now imagine that you own the shopping center where the crime was committed. Could you be liable?

The answer is--maybe.

General Rule. The general rule is that a property owner is not liable for crimes committed on his property by third persons. As with most general rules, however, there are exceptions. In this case, the exception arises out of another general rule that requires property owners to use reasonable care to make their property safe for "invitees"--those whom they expressly or impliedly invite onto their premises, such as customers.

Background. The law first began to recognize that property owners had a duty to keep invitees safe from the criminal acts of third parties in the case of innkeepers because of the special vulnerability of travelers. Gradually this duty was expanded to cover the owners of all types of property, such as apartments, shopping centers, theaters, and office buildings. However, under current law the property owner is liable only if two conditions are met. Those conditions are:

First, the crime must have been reasonably foreseeable. This means that the property must be located in a high-crime area, or the property owner must have received notice of prior criminal activity on or about the property. Clearly, the occurrence of prior criminal acts on the property itself (rather than in the general area) is very persuasive in proving foreseeability. In addition, crimes against persons or crimes involving violence are more likely to show foreseeability than crimes against property, such as vandalism. On the other hand, if a crime should be unexpectedly committed against a customer in a previously safe area, the landlord normally will not be liable.

Second, the area where the crime was committed must have been under the control of the property owner. If the crime in the above example had been committed inside a store, the shopping center owner wouldn't be liable because he had turned over to his tenant (the operator of the store) control of the area inside the building. The areas under the control of the owner usually include the parking area, surrounding grounds, and common lobbies or entrances.

The Lesson. If you own any property where people are expected to come upon the premises, you need to take reasonable steps to make the common areas safe from crime by providing adequate lighting, fencing, and so on. If you are in a high-crime area, and especially if you learn of any serious crime on your property, you are at risk of a major lawsuit unless you take additional steps to protect your invitees. This might include security personnel, extra lighting, television monitors, and perhaps the posting of warnings. You also may want to request extra patrols from the local police if you can get them. Finally, make sure you have plenty of liability insurance coverage--at least $2,000,000, and $5,000,000 or more if it's available. The premium is small compared to the risk and cost of major litigation.

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MEMORANDUM #406 Towing of Cars

If you've ever had your car towed away for parking in an unauthorized spot, you know how maddening it can be, especially if the towing company demands hundreds of dollars for towing and storage charges to get your car back.

On the other hand, if you are a property owner plagued by trespassing cars on your property, you may be equally upset by the difficulty of keeping your property free of unwanted automobiles.

The Ground Rules. Over the years, the Arizona legislature and the courts have developed a body of law governing this area. Happily, there is something good in this body of law for everyone. Here is a summary.

1. Unless a property owner meets specific posting requirements, he is deemed to have consented to parking on his property by members of the general public. In other words, unposted property is fair game for parking.

2. To be properly posted, the following requirements must be met:

(a) The signs must be clearly visible and readable from any point within the parking area and each entrance.

(b) The specific restrictions must be set forth on the signs, such as "no parking," or the price of parking in the case of unmanned pay lots.

(c) A statement that unauthorized vehicles will be towed away.

(d) The maximum cost to be charged for towing, storage, and other fees.

(e) The telephone number and address where the car owner can locate his vehicle.

3. If a property has been properly posted, the car may be towed away. It cannot be "booted" or held ransom to force payment of a release fee; to do so is criminal theft.

4. If properly towed away, the towing company is entitled to payment for its reasonable charges; provided, that such charges cannot exceed those authorized by city ordinance (if the particular city has adopted such an ordinance).

5. The towing company cannot assert a lien (that is, hold the car ransom) to force payment of its charges. If the car owner demands the car, it must be released regardless of whether the charges have been paid.

6. If the charges are not paid, the towing company can sue to recover them from the car owner.

7. If the towing company refuses to release the car on demand, it is criminal theft.

Exceptions. These rules do not apply to abandoned or junk cars, which are subject to a different set of rules. A vehicle is presumed abandoned after 72 hours on private property. If you believe an abandoned vehicle is on your property, the best bet is to contact the police or the State Motor Vehicle Department.

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In addition, these rules do not apply to cars voluntarily taken to a garage or storage facility for mechanical work or storage. In either of these cases, the garage or storage company does have a valid lien for its charges and may legally refuse to release the vehicle until paid.

Conclusion. Cars can be legally towed away in Arizona, but only if certain specific requirements are met. Under no circumstances may a car towed away without the owner's consent be held to force payment of the towing and storage charges.

__________________ Applicable statutes and cases are A.R.S. § 9-499.05(B), Adage Towing & Recovery, Inc., v. City of Tucson, 1996 WL 337065 (Ariz. App. Div. 2); Capson v. Superior Court, 139 Ariz. 113, 677 P.2d 276 (1984).

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MEMORANDUM #407 Prescriptive Easements

It is generally known that you can gain title to land by adverse possession. Under this rule of law, someone wrongfully and openly occupying land for ten continuous years automatically becomes its owner.

A similar rule applies to easements. The wrongful, open, and continuous use of another's land for ten years can create a permanent easement to continue that same use indefinitely. An easement obtained in this manner is called a prescriptive easement.

The easement can be for any of a number of uses. Most often, it is for access. For example, prescriptive easements are commonly created for roads, driveways, and paths. However, prescriptive easements can also be created for parking, utility lines, a drainage or irrigation ditch, or other kinds of uses normally created by easement.

A prescriptive easement differs from adverse possession in that adverse possession requires continuous and exclusive possession and occupancy of the land, while a prescriptive easement requires only a non-exclusive use for a particular purpose. If land is fenced off, farmed, or improved with a building or structure, title by adverse possession may accrue. If the land is driven or walked across, or utility lines or ditches are placed across it, a prescriptive easement may accrue.

Requirements. In order for a prescriptive easement to arise, the following three requirements must be met:

The use must be open, notorious and visible. In other words, it must be readily apparent that someone is using the property. Secret or hidden uses, such as a non-apparent buried pipeline, do not create a prescriptive easement.

The use must be "hostile" or "adverse" to the owner. This means essentially that the use must not be with the permission of the owner. The person claiming a prescriptive easement must either be making the use knowing it is a trespass, not caring whether it is a trespass, or erroneously thinking he has some right to make the use. For example, someone continuously driving over a corner of a neighbor's lot, thinking it is part of his own property because of an erroneous belief as to the location of the property line, is acting "adversely" to the owner even though he does not intend to trespass. On the other hand, if he was granted permission to drive across the property by the owner, he is not acting adversely to the rights of the owner and a prescriptive easement will not accrue.

The use must be continuous and peaceable. To be continuous, it must be regular and uninterrupted. A prescriptive easement cannot be created where a utility line is placed on another person's property for eight years, is removed for one year, and then is again placed on the property for eight more years. The use must be for ten consecutive years. To be peaceable, the use cannot be interfered with by a lawsuit or a physical eviction, removal, or blockage. A lawsuit for trespass, for example, breaks the ten year period. So does the physical removal or blockage of the use, even for a day, such as removing a utility line or putting a fence or locked gate across a road. It is not necessary that the blockage actually stop the use--if the user tears it down, the ten year period is nevertheless interrupted and must start to run all over again because the use has not been "peaceable". A mere letter demanding the abandonment of the use or threatening legal action, however, does not stop the running of the ten-year period.

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Exception. There is one universal exception to the rule of prescription or adverse possession--it does not apply to the state or federal government. No one can gain rights to government property as a result of unauthorized use or adverse possession.

Conclusion. If you are buying land, inspect it closely or have it surveyed, because prescriptive rights are not recorded in the public records. If you own property, be alert to unauthorized users. If you see a vehicle trail developing across your land or notice an unauthorized power line, pipe or ditch, you should either (a) construct a fence, gate, ditch or berm to interrupt the use or remove it from your property, or (b) enter into a lease or other consensual arrangement with the user so that the use will not be adverse. Posting the property at the same time may be helpful, but posting alone will not get the job done. Take photographs and keep a file of your actions if you interrupt an adverse use. Know where your property boundaries are and periodically inspect the property. If you fail to do so, you may be allowing someone else to gain easements across your property that could interfere with your own future use or development.

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MEMORANDUM #408 Adverse Possession

Most people have heard of the doctrine of adverse possession. In general terms, it is the rule of law that says if you occupy someone else's property as your own for a certain number of years, you become the owner. A common example is where a fence encroaches on a neighbor's property.

As with most legal principles, however, the details make all the difference.

Requirements. There are four requirements for gaining title by adverse possession:

1. Possession of the property must be actual, open and notorious. This means that the use or possession of the property must be apparent to a casual observer. Fencing off the property, growing crops on it, constructing a building on it, or using it for parking or storage all constitute actual, open and notorious possession of the property. One cannot secretly gain title by adverse possession.

2. Possession must be continuous and peaceable. This means that the possession must be continuous for the necessary number of years without interruption, given the nature of the property. If the possession consists of growing crops, for example, it would only be necessary to possess the property during the normal growing season, so long as crops were grown every year. It also means that the possession cannot have been interrupted by the owner, either by physical removal or the commencement of a lawsuit for trespass or ejectment. For example, if an encroaching fence were torn down or the trespassers forcibly ejected, the possession would not be considered "continuous and peaceable," and the use would be treated as having been interrupted. If the fence were reconstructed, or the property were re-entered after ejectment, the period of time necessary to gain title by adverse possession would start all over again. On the other hand, a verbal order to remove the encroachment, the posting of a "no trespassing" sign, or even a letter from an attorney, is not considered sufficient to break peaceable continuity of possession.

3. Possession must continue for the specified number of years. In Arizona, the time period is ten years in most cases. However, in certain situations the period of time can be as short as five or even three years, particularly where the claimant claims the property under "color of title"--in other words, where the claimant claims the property by a deed or other instrument that is later found to be ineffectual or invalid for some reason.

4. Possession must be adverse. This is the area of greatest controversy and misunderstanding. The courts say that the possession must be "hostile," or "under claim of right" to be adverse. However, it is not necessary that the possession be done with malice or ill will. What the courts mean is that the possession must be adverse to the owner's rights. Where possession is notorious, visible, and continuous and is done without the permission of the owner, it is presumed to be adverse. This can occur when the claimant actually thinks he owns the property; for example, where a fence or building encroaches on a neighbor's property, and everyone just assumes the fence or building in the right place. Or it can occur where the claimant knows he doesn't own the property but uses it anyway as a willful and knowing trespasser. However, adverse possession does not occur where the use is made with the permission of the owner, or even if the

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claimant erroneously thinks he has permission, because he is not possessing the property adversely to the owner.

It is also said that a use which starts as a non-adverse use normally stays non-adverse. That is, one usually cannot convert a permissive use to an adverse use, at least without taking action to clearly inform the owner that the character of the use has changed from permissive to hostile.

Tacking. The time period for adverse possession can be satisfied by adding together, or "tacking," the consecutive time of possession of two or more claimants if there is "privity" between them. For example, if the owner of a house with a fence which encroaches on his neighbor's land sells the house, the period of time necessary to gain adverse possession continues to run because the first owner conveyed his position in the property to the second.

Disability. If the property owner is under eighteen years of age or is mentally incompetent when the adverse possession begins, adverse possession does not start to run against his property until the disability is removed. However, if the owner is competent when the adverse possession begins, the running of the time period is not tolled because of a later disability.

Title. One gaining title by adverse possession has good title, as good as title by recorded deed--however, it isn't reflected anywhere in the public records. Therefore, in order to perfect record title to property gained by adverse possession, one of two things must be done: (1) the former owner must be persuaded to execute a quit-claim deed to the claimant (usually done under threat of lawsuit), or (2) a quiet title action must be successfully pursued, and the resulting judgment recorded. Only then will the public records confirm that good title has been gained by adverse possession.

Conclusion. Title to real property is frequently lost by adverse possession--usually as the result of an encroachment of some sort. As a result, it is prudent to order a survey and to personally inspect any property you are considering purchasing for signs of adverse possession. You may also wish to consider purchasing an extended policy of title insurance, which protects against claims of adverse possession. If you own property, it is prudent to inspect it periodically to make sure no one else is in the process of gaining title to your property through adverse possession, and if they are, to take prompt action to remove them. It is an old adage that "those who sleep on their rights lose them." Adverse possession is a good example of how this can occur.

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MEMORANDUM #409 Three Ways Land-Locked Property Can Gain Legal Access

From time to time a property owner will find himself landlocked. Fortunately, there are three ways to cure that situation. They are (1) an easement by implication, (2) a private way of necessity, and (3) prescription. These three means of obtaining access, which are often confused with one another, are described below.

Easement by Implication. An easement by implication, sometimes called an implied way of necessity, is automatically created when a property owner sells off a portion of his property that has no access. In other words, if a property owner creates a landlocked parcel by selling part of his own property, he is deemed to have granted the purchaser of the landlocked parcel an easement across his own property so that the purchaser has a means of access.

An easement by implication does not necessarily require that the property be completely landlocked—it is enough if the easement across the seller's property is "reasonably necessary." For example, a property might have legal access by virtue of an easement contained in the original patent, but if the easement has not been improved and is impassable because of trees, mountains, washes, or other impediments, an implied easement giving useable physical access across the seller's property would be implied.

An easement by implication is also transmitted from owner to owner, even if not asserted. For example, an easement by implication might be created by the sale of a remote parcel of unused rural land. Even if the owner at the time of the creation of the easement does not assert the right to use the implied easement, it continues to exist over the years and passes from owner to owner as the property is sold. It is not lost because the original owner took no action to use or enforce the easement.

Easement by Necessity. An easement by necessity, also referred to as a private way of necessity, is an easement that can be created by means of a private lawsuit which is very similar to a condemnation action brought by the government. If the landlocked property owner can show that an easement across another's property is "reasonably necessary" to gain access to his own property, he can bring an action to condemn an easement, but he has to pay fair market value, the same as the government.

As with an easement by implication, it is not necessary that there be no other legal access, only that the other means of access is not reasonably useable. However, the courts are fairly strict on this issue, and have denied easements by necessity where another means of access was available, even though the other easement was on a poorly maintained meandering roadway more than twice as long as an easement through the defendant's property. Easements by necessity are also denied where there is the possibility than an easement by implication might exist, unless the party pursuing the easement can prove that an easement by implication does not exist. In short, the courts are quite protective of private property rights against the claims of others seeking to obtain an easement against the will of the owner.

Easement by Prescription. An easement by prescription is created by the open and continuous use of another's property for access, utility lines, or similar purposes without the owner's permission for a period of ten years or more.

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To gain an easement by prescription, the easement must be open and apparent. A buried pipeline that is not detectable from a normal inspection of the land would probably not be sufficient to create a prescriptive easement.

The use must also be without the express permission of the owner. It is not considered permission where the owner observes the use and remains silent. Usage under these circumstances is considered to be "adverse" to the interests of the owner, and may create a prescriptive easement.

The use must be continuous for ten years or more. If the owner blocks off the easement for a few months so that it cannot be used, the ten year period is interrupted and the use must exist for ten years from the point it is resumed before prescriptive rights accrue.

It should be noted that the use created is only for type of use, and only to the extent of the use, that was engaged in during the ten year period. For example, prescriptive rights created by a footpath cannot be used for a paved highway or power lines.

In addition, prescriptive easements cannot be created against governmental bodies.

Conclusion. Owners of landlocked property may have as many as three legal means of obtaining access. Unfortunately, it may be necessary to bring suit to claim these rights against an uncooperative neighbor, but access obtained by litigation is usually better than no access at all.

__________________ See A.R.S. Sec. 12-1201; Bickel v. Hansen, 169 Ariz. 371, 819 P.2d 957 (Ariz. App., 1991); Tobias v. Dailey, 318 Ariz. Adv. Rep. 11, 998 P.2d 1091 (Ariz. App. Div. 1, 2000).

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MEMORANDUM #501 Commitment Letters

The loan commitment letter is an indispensable part of every construction project and of every acquisition of real property purchased with borrowed money. The commitment is, in essence, a contract in which the lender promises (in return for a non-refundable fee) to make a loan if certain conditions are met. If, for some reason, the lender doesn't fund the loan the result is usually a financial disaster for the borrower sometimes leading to bankruptcy, litigation, or both. Obviously, the borrower needs a commitment letter he can rely on and enforce against the lender.

Consequently, the wording of the loan commitment letter is every bit as important as the wording of the purchase contract. It is, therefore, important to read the commitment carefully and to negotiate the modifications necessary to protect your position.

As a borrower, there are three areas of particular concern: (1) Is the commitment enforceable? (2) Can you satisfy the conditions for funding? (3) Are you giving away your ability to negotiate fair loan documentation?

Enforceability. Your commitment is worthless if it is not enforceable. The lender could refuse to fund if it changes its mind about the feasibility of the project, finds that interest rates have moved up, or decides that it just doesn't want to fund for any other reason. Unfortunately, this does happen.

In order to be enforceable, the commitment must contain all the material terms of the loan. For example, it must contain the name of the borrower, the exact amount of the loan, the interest rate, and the terms of repayment. One recent case held that a commitment letter tying the interest rate to the lender's "standard interest rate quoted from time to time" was not specific enough and that the commitment was unenforceable. In order to avoid this problem, it is best to specify exact terms whenever possible rather than "standard rates," or "usual or customary terms," and so on.

Conditions. Every commitment letter sets forth an exhaustive list of conditions that must be satisfied before the lender has a duty to fund the loan. Sometimes these conditions are so comprehensive and numerous that it seems impossible to satisfy them all. As a borrower, however, it is critical that you review each and every one of these conditions to assure yourself that you will be able to satisfy them and, more importantly, that you will be able to document that they have been satisfied. You should try, whenever possible, to eliminate conditions that must be satisfied "to the lender's satisfaction," or which give the lender the right to refuse to fund if it "deems itself insecure," or which are based on other discretionary determinations by the lender. These kinds of provisions can give the lender an opening to refuse to fund.

Documentation. Commitment letters will often provide that the loan documentation--such as the note, the deed of trust and the loan agreement--will utilize the lender's standard forms, or that the documentation will be prepared to the satisfaction of lender's counsel. These provisions should be qualified to allow reasonable input from your own counsel. Otherwise you may be agreeing in advance to dangerous and unreasonable provisions that your own counsel may be powerless to protect you from.

Conclusion. The commitment letter is an important part of nearly every major development or acquisition. It should be reviewed carefully, preferably by your own legal counsel, and its terms

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negotiated so that you have a fair and enforceable commitment with terms you know you can satisfy.

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MEMORANDUM #502 Assumptions

The real estate industry is currently facing a paradox--interest rates are lower than they've been in decades, but money is tighter than ever before. In other words, money is cheap, but you can't get it. The only exception seems to be single family home loans, which are plentiful and cheap.

This means that the best way to sell property is often for the buyer to assume the existing loan. This idea, however, is usually thwarted by the dreaded "due-on-sale" clause. This is a provision in the note or mortgage allowing the lender to call the loan if title to the property is transferred.

What can you do if you want to purchase or sell property by using an assumption of an existing loan?

First, read your note and mortgage. If there's no "due-on-sale" clause in the documents, the loan is freely assumable. Of course, most mortgage loans do have "due-on-sale" clauses, but a lot of the older ones don't. This is generally true of VA loans originated before March 1, 1988, and FHA loans originated before December 1, 1986, both of which may be assumed without qualifying. FHA loans dated after December 1, 1986, may be assumed only if the buyer qualifies. Don't just ask your lender--read the document yourself. Lenders will sometimes say the loans are not assumable even when they are. Remember, in the case of "due-on-sale" clauses, silence is consent.

Some people think you can avoid a "due-on-sale" clause by using an agreement of sale, or land sales contract, so that a deed won't be recorded until the full purchase price is paid years in the future. Unfortunately, this normally will not work. It's just another way of transferring ownership of real estate even if no deed is recorded, and the lender can invoke the "due-on-sale" clause if it learns of the transaction.

Sometimes you can avoid the "due-on-sale" clause by selling the partnership or corporation that owns the property, instead of the property itself. It depends on how the loan documents are worded. However, proceeding in this manner could have unforeseen tax consequences, so before doing it, it's best to check with your attorney and tax advisor.

If the loan does contain a "due-on-sale" clause and you can't find a way around it, the next question is whether the property securing the loan is residential with less than five units, or some other type of property.

Non-Residential. If the property is not residential (or if it is residential with five or more units), the law says that the lender can freely enforce the "due-on-sale" clause. This means essentially that apartment, commercial, and industrial lenders can call their loans whenever the loan documents allow them to. Again, read your loan documents. The only way to get an assumption in this case is to request one from the lender, who is free to say yes or no, or to impose any fees, interest rate increases, or other conditions it may desire.

Residential. If the loan is secured by residential property with less than five units, the rules are a little different.

Unfortunately, the general rule is still the same--the lender can call the loan upon the sale of the property. However, under federal law there are a few exceptions where the "due-on-sale" clause cannot be exercised, regardless of what the loan documents say:

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1. A transfer to a relative resulting from the death of a borrower.

2. A transfer to a former spouse as part of a divorce settlement.

3. A transfer to a spouse or child of the borrower.

4. A transfer into an estate planning trust where the borrower continues to occupy the property.

5. The placing of a second mortgage on the property.

In most all other cases, however, the lender can call the loan upon sale if the loan documents allow it to.

Conclusion. If you want to do an assumption, check the loan documents first. If they contain a "due-on-sale" clause, see if an exception applies. If not, you must request permission from your lender. And if you get it, get it in writing.

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MEMORANDUM #503 Purchase of Property with Existing Encumbrance

When property with a pre-existing mortgage is sold, one of five things can happen:

1. Prepayment. The mortgage can be paid in full at the time of sale. Under this scenario, the buyer either pays cash from his own funds or obtains a new mortgage to finance all or a portion of the purchase price. The buyer, of course, is liable for the new mortgage unless the new mortgage is non-recourse. The seller, obviously, is not liable, since he has nothing to do with the new mortgage, and the old one is paid off at the closing. If there are prepayment fees, they are paid by the seller unless the parties agree otherwise.

2. Subject To. The pre-existing mortgage can be left in place without the buyer assuming personal liability for payment. In this case, the seller remains liable for the mortgage. The buyer, on the other hand, has no personal liability for the payment of the mortgage, but may lose his property to foreclosure if he doesn't pay it. This arrangement is usually characterized by language in the contract stating that the buyer takes title "subject to" the existing mortgage. For clarity, the contract should also explicitly state the buyer is not assuming personal liability to the seller or the mortgage holder for the payment of the mortgage. This sort of arrangement is possible only when the mortgage does not have a "due-on-sale" clause.

3. Assumption. The buyer can expressly assume liability for the payment of the mortgage. In this case, both the buyer and the seller are personally liable to the mortgage holder for payment. However, if the seller is forced to pay it as a result of the buyer's default, he has a claim for indemnification against the buyer. These transactions are usually characterized by language stating that the buyer assumes the mortgage or that he agrees to pay it when due. This arrangement is possible only when there is no "due-on-sale" clause.

4. Novation. The mortgage holder can leave the mortgage in place, releasing the seller and accepting the buyer as the only responsible party. This requires the mortgage holder to sign a novation agreement whereby he agrees to accept the buyer in place of the seller as the responsible party. In most cases, mortgage holders are reluctant to release anyone from personal liability so these arrangements are not often seen.

5. Wrap-Around. The buyer can execute a new mortgage to the seller that includes the amount of the pre-existing mortgage, in which case the seller remains liable for and agrees to pay the pre-existing mortgage. The buyer would be liable to the seller for the full amount of the new mortgage, but would have no liability for the pre-existing mortgage. This is often referred to as a "wrap-around mortgage," a "wrap," or an "all-inclusive mortgage." It is a complex arrangement with many dangers and pitfalls that needs to be structured carefully and with full knowledge of the risks and benefits.

Conclusion. In any sale of real estate encumbered by a mortgage it is necessary to carefully review the mortgage and all related documents to determine whether the mortgage is assumable, whether it contains a "due on sale clause," whether it contains a transfer or prepayment fee, or whether there are other restrictions or provisions which must be considered. This should be done before the deal is struck so that you aren't stuck with any unanticipated fees or legal problems. However the parties structure the transaction, they should draft clear and explicit provisions

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concerning the duties and liabilities of the parties with respect to any pre-existing mortgage. Much needless litigation has been generated by relying only on such shorthand phrases as "subject to" or "to be assumed." Regardless of the phraseology used, the courts say that the guiding principle is the intention of the parties — it is therefore essential to make this intention clear and unmistakable in the contract documents.

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MEMORANDUM #504 Prepayment

Most mortgage notes expressly allow prepayment at any time, and some prohibit it altogether. What happens if the note is silent on this issue?

The surprising answer is that generally there is no right to prepay! Under the traditional rule, you simply cannot prepay the note if the holder declines to accept payment (unless you pay all the future interest that would have accrued in the absence of prepayment--normally an unacceptable alternative). A few recent cases around the country have departed from this view, however, and a couple of states have passed statutes which change the traditional rule. Nevertheless, many states still adhere to the principle that prepayment is not a right unless it is explicitly granted in the note. Many other states (including Arizona) have not yet decided the issue but may follow the traditional view if presented with the question. Therefore, if you take out a mortgage loan be sure that the note expressly gives you the right to prepay. Otherwise, you may be prevented from prepaying a mortgage you want to prepay or may have to pay a large fee to the mortgage holder to obtain its consent.

Penalties. Some notes give the borrower the right to prepay, but provide for a prepayment penalty. These penalties are enforceable. There is an exception, however, where the prepayment arises out of an eminent domain (condemnation) action against the property or an insurance payment arising out of the destruction of the property. In these situations the note holder may not charge a prepayment penalty unless specifically authorized by the note or mortgage. In addition, a few states have adopted statutes which limit the amount of prepayment penalty which may be charged on residential loans. In general, however, prepayment penalties are enforceable.

A Solution. There is a way to free the property from the lien of a mortgage that cannot be prepaid without prepaying the note. This technique can be useful if the property owner wishes to subdivide or sell off a portion of the property or to refinance it with a larger loan. The solution, which has been allowed by the courts in several states, is for the property owner to provide substitute security which is the substantial equivalent of cash. The substitute security could be, for example, cash held by a trustee or escrow agent, a pledged certificate of deposit insured by the federal government, or collateralized short-term treasury bills. Other real property, even if it is worth more than the original security, is not considered the substantial equivalent of cash. The party requesting the substitution must pay all costs and expenses associated with the substitution, and just continues to pay the note as the payments come due. The Arizona courts have not yet ruled on the availability of this technique, but it seems to meet with approval wherever considered.

The Lessons. If you are signing a mortgage note, be sure the note expressly allows prepayment. If you are the holder of a mortgage note that doesn't address the issue of prepayment, in most states you cannot be required to accept a prepayment, and may wish to refuse prepayment or negotiate a fee for consenting. And if you need to free your property from the lien of a mortgage note that does not permit prepayment (or that permits it only with a large penalty) you may wish to consider providing substitute security.

__________________ States with reported cases following the traditional view of allowing prepayment only when authorized by the note include Connecticut, Maryland, New Hampshire, and New York. See Dugan v. Gryzbowski, 332 A.2d 97 (Conn. 1973); MacIntyre v. Hark, 528 So.2d 1276 (Fla.Ct.App. 1988); Promenade Towers Mut. Housing Corp. v. Metropolitan Life Ins. Co., 597

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A.2d 1377 (Md. 1991); Patterson v. Tirollo, 581 A.2d 74 (N.H. 1990); Arthur v. Burkick, 520 N.Y.2d 638 (App.Div. 1987).

States allowing prepayment where the note is silent include Louisiana, North Carolina (by statute), Pennsylvania, and Florida (by statute). See Spillman v. Spillman, 509 So.2d 442 (La.Ct.App. 1987); Hatcher v. Rose, 407 S.E.2d 172 (N.C. 1991); Mahoney v. Furches, 468 A.2d 458 (Pa. 1983); Fla. Stat. Ann. § 697.06; N.C. Gen. Stat. § 24-2.4.

States with statutes limiting prepayment penalties include Alaska (Alaska Stat. § 06.30.585), California (Cal. Civ. Code § 2954.9, Connecticut (Conn. Gen. Stat. Ann. § 36-9g(c)), Illinois (Ill. Comp. Stat. Ann., 815 ILCS 205/4(2)(a)), Iowa (Iowa Code Ann. § 535.9), Kansas (Kan. Stat. Ann. § 17-5512), Louisiana (La. Rev. Stat § 9:5322), Massachusetts (Mass. Gen. Laws Ann. ch 183, § 56), Michigan (Mich. Comp. Laws Ann. § 438.31c(2)(c)), Mississippi (Miss. Code Ann. § 75-17-31), Missouri (Mo. Rev. Stat. § 408.036), New Mexico (N.M. Stat. Ann. § 56-8-30), New York (N.Y. Gen. Oblig. Law, § 5-501(3)), North Carolina (N.C. Gen. Stat. § 24-2.4), Ohio (Ohio Rev. Code Ann. § 1343.01.1), Oregon (Or. Rev. Stat. § 82.160-.170), Pennsylvania (Pa. Stat. Ann. § 6020-155(g)(7)), Rhode Island (R.I. Gen. Laws § 34-23-5), and South Dakota (S.D. Codified Laws Ann. § 52-8-8).

Cases discussing the right to substitute collateral include Mahoney v. Furches, 468 A.2d 458 (Pa. 1983); Spillman v. Spillman, 509 So.2d 442 (La.Ct.App. 1987); Skyles v. Burge, 789 S.W.2d 116 (Mo.Ct.App. 1990).

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MEMORANDUM #505 Governing Law

Lenders often cross state boundaries when making real estate loans. For example, a California lender may make a loan secured by Arizona real estate, or an Arizona lender may make a loan secured by Nevada real estate.

Institutional lenders nearly always have a set of standard forms. These forms usually provide that the law of the lender's home state governs the transaction. For example, a California lender loaning money in Arizona will normally provide that California law governs the transaction. In most cases, no one pays much attention to these provisions. However, a recent Arizona case has shown how important they can be.

The Law. First, a little background. The laws governing any given transaction can be divided into two categories--(1) procedural law, and (2) substantive law. If the particular issue of law is procedural, the law of the state where the case is heard (the forum state) will always apply. On the other hand, if the issue is substantive, the parties are free to choose the state whose law will govern so long as (a) that state has some relationship to the transaction, and (b) the chosen law does not violate the public policy of the forum state.

Now that we know the ground rules, we need to see how they can actually affect a transaction.

The Case. In a recent case decided by the Arizona Supreme Court, an Arizona resident borrowed money from a California lender. The loan documents provided that California law would govern the transaction. When the loan went into default, the lender conducted a trustee's sale in Arizona and then sued for a deficiency judgment in an Arizona court. A suit for a deficiency is permissible under Arizona law, but is not permissible under California law following a trustee's sale (although it is following a judicial foreclosure). The Arizona Supreme Court held that because the right to a deficiency judgment was substantive, rather than procedural, the parties' agreement that California law governed the transaction would be enforced. This meant that California law would apply to the Arizona lawsuit, and the lender had no right to a deficiency judgment. This is a case where a sophisticated lender, by insisting on the law of its home state, actually cost itself a deficiency judgment of more than four million dollars.

The Lesson. The lesson of this case is clear. If you are a borrower or a lender engaged in an interstate loan transaction, pay to close attention to the choice of law provision. Arizona borrowers, in particular, should be wary of any loan provision calling for the law of another state, because Arizona has adopted a number of statutes that protect borrowers. These statutes, among other things, limit deficiency judgments by providing that the borrower is entitled to a credit against his debt in an amount equal to the fair market value of the property that is foreclosed upon or its sale price at the foreclosure sale, whichever is greater. Many other states do not have such limitations on deficiency judgments, meaning that an Arizona borrower agreeing to the law of a foreign jurisdiction may be waiving these valuable rights without even knowing that he is doing so. On the other hand, an Arizona lender insisting on Arizona law may be unnecessarily limiting his potential recovery in the event of default.

Therefore, when borrowing or lending money across state lines, it is always a good to policy to check with counsel in the other state before agreeing on the choice of law provision so you know

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exactly what you are getting or giving up by doing so. If you don't, you may be in for a very expensive surprise.

__________________ The case referred to above is Cardon vs. Cotton Lane Holdings, Inc., 123 Ariz. Adv. Rep. 3 (1992).

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MEMORANDUM #506 Releases as Affected by Statute of Frauds

When a large parcel of land is sold with seller financing, it is typical for the parties to negotiate "release provisions." This enables the buyer to release parcels of property from the seller's deed of trust as the purchase money note is paid down. For example, it might be provided that ten acres can be released from the deed of trust for each $100,000 reduction in the principal balance of the note. The released property can then be developed or sold by the buyer free and clear of the seller's purchase money deed of trust.

Normally, only the trustor (the buyer, in our example) signs the deed of trust. The beneficiary (seller) just accepts the deed of trust without signing it. This custom arises out of the fact that a deed of trust is generally a one-sided agreement--all the duties and obligations are placed on the trustor. The beneficiary just receives the benefits of these duties and obligations, and is not required to do anything under the terms of the deed of trust. For the most part, no one involved in a real estate transaction even thinks about having the beneficiary sign the deed of trust.

A Big Mistake. This can be a very big mistake if the deed of trust contains release provisions. Why? Because of something called the Statute of Frauds. This is a law dating back to 17th century England which has been adopted in Arizona and throughout the United States. It provides, among other things, that an agreement for the sale of real property must be in writing and must be signed "by the party to be charged" in order to be enforceable against that party in a court of law.

The Statute of Frauds can render release provisions unenforceable if the beneficiary doesn't sign the deed of trust because the beneficiary in this case is the "party to be charged"--that is, the party against whom the document is to be enforced--when it comes to the release provisions. Since the beneficiary didn't sign, the theory is that he can't be "charged," or made to comply with this provision.

Sometimes this is not a problem. For example, if the release provisions are also contained in the sales contract or the escrow instructions, it may be sufficient to satisfy the Statute of Frauds. So even though the beneficiary didn't sign the deed of trust, he did sign something in the transaction that embodies the release provisions. A problem arises, however, when the release provisions are negotiated later, or when they are changed in some manner between the time the contract is signed and the closing, as often occurs. This can render the release provisions unenforceable, even though the remainder of the deed of trust remains enforceable against the trustor.

The Lesson. The lesson is simple and obvious. If you give a deed of trust with release provisions, make sure the beneficiary signs it. This insures that you won't have any legal problems when it comes to enforcing your release provisions.

__________________ A recent case holding release provisions unenforceable under these circumstances is Passey v. Great Western Associates, 174 Ariz. 420, 850 P.2d 133 (Ariz. App. 1993).

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MEMORANDUM #507 Releases Pending Default

Frequently a deed of trust against raw land will have what are known as "release provisions." These provisions allow the owner of the land to have portions of it released from the deed of trust as the debt is paid down.

Property owners who are about to default on a debt secured by land normally will take any releases to which they are entitled before defaulting. This has happened with increasing frequency over the last several years as the land market has collapsed. There is nothing legally improper with taking such releases on the eve of a default, and there is usually nothing the noteholder can do to prevent it. Nothing, that is, unless the property owner admits to the noteholder he is going to default. If that happens, the rules suddenly change, according to the Arizona Court of Appeals.

In a recent case, a property owner told the noteholder as a courtesy that he was going to default in a balloon payment that was due in several days. Shortly thereafter, he complied with all the requirements necessary to obtain a release, which included tendering a partial payment of the note and furnishing a legal description and survey. The noteholder then refused to grant the release, arguing, among other things, that the owner was not entitled to a release because he was in default. The default? Something called "anticipatory repudiation," which is a statement by a party to a contract that he intends to breach the contract in the future. When this happens, the courts say that the party has repudiated the contract and is therefore in breach of the contract as of the time he makes the statement. Because the deed of trust allowed releases only when there was no default, the owner lost his right to a release by telling the noteholder he was going to default. In other words, the property owner's honesty cost him his release.

Other Points. In this same decision, the Court issued a couple of other interesting rulings. The first is that release provisions must be complied with strictly and exactly. The Court held that a release request for 29.9897 acres was invalid where the deed of trust specified all releases must be at least 30 acres. The theory of "substantial performance," which is often applied to other contracts, does not apply when a release is requested. If you want a release, it is not enough to substantially comply with the requirements--you must comply exactly.

The second is that a noteholder apparently may recover a personal judgment for attorneys' fees under a non-recourse note. Although this portion of the opinion is somewhat unclear, it seems to imply that because the attorneys' fees provision in the note did not itself contain a non-recourse limitation, the non-recourse nature of the note applies only to the obligation to pay principal and interest.

The Lessons. There are several valuable lessons we can learn from this decision.

1. If you want to obtain releases under a deed of trust, do not tell the noteholder you intend to default later.

2. If you own a note and the payor requests releases, ask him if he is going to default. If he says he is, refuse to grant the releases.

3. If you request a release, comply with all the requirements strictly, exactly, and on time.

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4. If you are signing a non-recourse note, be sure the note specifically says you have no personal liability for attorneys' fees, costs, or any other amount payable by reason of the note or deed of trust.

__________________ The decision referred to above is Aboud v. DeConcini, 115 Ariz. Adv. Rep. 51 (Ariz. App. 1992).

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MEMORANDUM #508 Adverse Possession

Most of us are familiar with the doctrine of adverse possession. This is the rule of law that says if you wrongfully possess property for ten years, you own it. It usually happens because of a misplaced fence or a building that encroaches on a sliver of neighboring property. It is also possible, however, for a whole parcel to be adversely possessed--for example, when a farmer uses another's land as his own.

An interesting question arises when the land has a mortgage on it. Does adverse possession wipe out the mortgagee's interest, along with the owner's? Or does the adverse possessor take subject to the mortgage?

An Example. Imagine this scenario. An absentee landowner owns ten acres. A neighbor starts farming it as his own, and the landowner does nothing about it. The landowner then gets a mortgage on his property. Ten years later, the landowner defaults, and the mortgage holder forecloses and purchases the property at the sheriff's sale for a credit bid. Who owns the property--the neighbor who has been farming it, or the former mortgage holder who foreclosed?

In Arizona, the answer is clear. The mortgage holder owns the property, because the courts in Arizona have said that adverse possession does not run against a lienholder until he has a right to possession. This means that so long as the mortgage is not in default, the mortgage holder has no right to foreclose and obtain possession of the property, and therefore his interest is not subject to adverse possession.

However, once the mortgage goes into default, adverse possession does begin to run against the mortgage holder, because he then has the right to foreclose and obtain possession. There is even some indication from other jurisdictions that an extension of the indebtedness after it has become due will not stop the running of adverse possession.

Where mineral rights have been conveyed to someone other than the owner of fee title the result is the same. The owner of severed mineral rights has no right to possession of the surface, meaning that adverse possession does not run against his interest in the minerals. He can lose his interest in the mineral rights only if someone adversely possesses the mineral rights themselves--for example, by conducting unauthorized mining operations.

Although the same theory applies to judgment liens against property, the result is different. A judgment lien gives the lienholder the right to foreclose on the property at any time. Therefore, a judgment lienholder has the right to possession at any time, and is not protected from adverse possession. His judgment lien can be wiped out by a third party's adverse possession.

Other Jurisdictions. Not all jurisdictions follow the Arizona rule. Some states hold that someone gaining title by adverse possession takes it free and clear of any liens and encumbrances. In these states, mortgage holders must remain vigilant to the possibility of adverse possession on their security or they may lose it to a third party.

At least one other state holds that a lienholder loses his interest to the adverse possessor, but only if the adverse possession began before the mortgage was created. Apparently, the theory is that the lienholder is deemed to have notice of any adverse possession existing at the time his mortgage is granted, but is not required to continuously monitor the property for later claims of adverse possession.

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Conclusion. In Arizona and some other states, a mortgage holder need have no concern over the loss of his lien by adverse possession, at least until such time as the mortgage is in default. If an extension of a defaulted mortgage is to be granted, however, it is a good idea to inspect the property and make sure there are no claims of adverse possession.

In other states, the rule is different, and investigation may be advisable before placing a long-term mortgage on property that may be subject to a claim of adverse possession.

__________________ Arizona cases dealing with this issue are Stat-o-matic Retirement Fund v. Assistance League of Yuma, 189 Ariz. 221, 941 P.2d 233 (Ariz. App. 1997); Berryhill v. Moore, 180 Ariz. 77, 881 P.2d 1182 (Ariz. App. 1994).

Other cases dealing with this issue are Coe v. Finlayson, 41 Fla. 169, 26 So. 704 (1899); Hart v. Lake Josephine Co., 149 Fla. 745, 1 So.2d 635 (1941); Broad v. Warnecke, 144 S.W.2d 1005 (Tex. Civ. App. 1940), affirmed 138 Tex. 631, 161 S.W.2d 453 (1942); Stryker v. Rasch, 57 Wyo. 34, 112 P.2d 570, (1941), adhered to 57 Wyo. 52, 113 P.2d 963 (1941); Stokes v. Maxwell, 53 Ga. 657 (1875); Gorton v. Roach, 46 Mich. 294, 9 N.W. 422 (1881). Additional research may be conducted at West Key Number Mortgages 143 and Adverse Possession 42 and 106(1).

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MEMORANDUM #509 Unintentional Mortgages

Human beings are ingenious and creative creatures--especially when money is involved. Over the years people have created all sorts of arrangements to make sure money is paid or other obligations are performed when due. Instead of using a regular mortgage or deed of trust, some inventive people have created self-enforcing devices intended to provide a more effective means of securing the desired performance.

Some examples:

• Property has been deeded to a lender with an agreement that it would be deeded back to the borrower when the loan is repaid. If the loan isn't repaid, the lender just keeps the property.

• A deed to real property has been held in escrow by a third party, to be returned to the debtor when the loan is paid, or given to the lender in the event of a default.

• A landlord has lent money to his tenant after the lease has been in effect for a period of time for a purpose unrelated to the lease, with a written agreement that the failure to repay the new loan would be considered a default under the lease, the same as the failure to pay rent. If the loan isn't repaid, the tenant is evicted.

In each of these cases, the parties intended to create a form of security which could be quickly and easily enforced without resort to the courts. In each of these cases they have failed, because they have created a real estate mortgage without intending to. Unfortunately for these inventive creditors, a mortgage can be validly enforced only by judicial foreclosure; in other words, by a lawsuit in a court of law, exactly what they were trying to avoid in the first place.

The Governing Principle. The governing rule of law is simple. If the parties intend to secure an obligation with an interest in real property, they have created a mortgage. A mortgage, whether created intentionally or accidentally, can be foreclosed only by a lawsuit.

Exceptions. As always, there are some exceptions:

1. If the parties meet all the statutory requirements for creating a deed of trust, they have created a deed of trust and not a mortgage. This does not mean that summary foreclosure is available, however. If a deed of trust is created, the lender must follow the statutory rules for a valid foreclosure, including giving 90 days’ notice of the trustee's sale, publication, posting, and so on.

2. If the obligation to be secured is the purchase price of the property and is owed to the seller (and not a third party), the parties may have created a statutory Agreement for Sale. Under a statutory Agreement for Sale, the purchaser's interest in the property may be forfeited in the event of default, but only if certain specified requirements are followed, including the giving of notices and allowing lengthy periods of time to cure.

3. If the obligation is the payment of rent, (and not a new loan unrelated to the lease), the termination of the leasehold estate is not considered the foreclosure of a mortgage.

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4. If the parties actually intend to create a bona fide sale of property with an option to repurchase, a mortgage is not created. This exception is hard to establish, however, because it looks suspiciously like a mortgage. Among other things, the courts will expect to see that the purchaser is given full possession of the property and that the repurchase price approximates or exceeds fair market value before they will begin to believe the transaction is a true sale, and not a disguised attempt to provide security.

Conclusion. Be careful when trying to create a new kind of security interest in real property. You may accidentally create a mortgage which can be foreclosed by only court action. A better course of action may be to use a regular deed of trust. Even though you will have to follow certain procedures to foreclose, it is still much faster and cheaper than judicial foreclosure.

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MEMORANDUM #510 When Are Additional Loans Secured By An Existing Deed Of Trust?

Most mortgages and deeds of trust contain a so-called "dragnet clause." This is a provision stating that if the lender loans additional money to the borrow pursuant to a new promissory note which recites that it is secured by the existing mortgage or deed of trust, the additional loan will in fact be secured by that mortgage or deed of trust.

Arizona courts have long held that dragnet clauses are valid. Therefore, additional loans may be secured by an existing deed of trust with a dragnet clause. However, that's not the end of the story--even though the additional loan is secured, the real question is whether it is secured with the same priority as the original loan.

Example. As an example, assume Original Lender lends Borrower $100,000 in Year 1. The loan is secured by a deed of trust with a dragnet clause. In Year 2, Different Lender loans Borrower $200,000 and secures it with a second deed of trust against the same property. In Year 3, Original Lender lends Borrower an additional $300,000 using a promissory note stating that the additional loan is secured by the original deed of trust. Clearly, the total of $400,000 lent by Original Lender is secured by the original deed of trust. The real question, however, is whether the last $300,000 lent by the Original Lender is senior or junior to the intervening $200,000 loan. The answer to this question can be critical if the value of the property is only $400,000. If it's senior, the Original Lender has adequate security. If it's junior, he doesn't.

In answering this question, the law first asks whether the additional loan by the first lender--sometimes called a "future advance"--is optional or obligatory. An optional advance is one the lender is not contractually required to make. An obligatory advance is one the lender is contractually required to make. An example of the latter might be a revolving line of credit where the lender is required to make additional advances from time to time as requested by the borrower up to a predetermined limit.

Obligatory Advances. If the advance is obligatory, the additional advance will have priority over any intervening deed of trust if, and only if, the recorded senior deed of trust discloses the lender's obligation to make obligatory advances. This is true even if the lender has actual knowledge of the junior encumbrance. This makes sense, because a lender who agrees to make additional advances must know in advance that he will not have his security prejudiced by a junior lender. On the other hand, if the requirement to advance additional funds is not disclosed in the deed of trust, any additional advance made after an intervening lien is recorded will be junior to that lien. This also makes sense, because it provides assurances to the junior lender that his priority will not be defeated by additional obligatory advances made by the senior lender.

Optional Advances. If the advance is optional, its priority depends on whether the original lender had actual knowledge of the intervening lien. If the original lender was aware of the intervening lien, his additional advance will be junior to it. If he was not aware of the intervening lien, his additional advance will be senior to it and will have the same priority as the original loan. It is important to note that constructive knowledge is not adequate in this situation. The courts require actual knowledge. Therefore, since recording provides constructive notice, it makes no difference whether the intervening lien is recorded. If the original lender has no actual knowledge of the intervening lien, even if it is recorded, his additional advance will be senior. The rationale offered by the courts is that a lender whose deed of trust contains a dragnet clause should not have to check the public records when making additional optional advances. Anyone

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making a secured loan which is junior to a deed of trust with a dragnet clause is therefore on notice that he must make sure the senior lender has actual notice of his loan.

The foregoing discussion assumes that there has been an intervening lien between the senior lender's first and second advances. If, however, the first lender's additional advance occurs before the new third party loan, the first lender's additional advance will always be senior so long as the senior deed of trust contains a dragnet clause.

The Lessons. We can derive several lessons from these principles. First, if you are a lender who has agreed to make additional obligatory advances, make sure this is disclosed in your deed of trust so that the additional advances will retain the same priority as the original loan. Second, if you are a lender considering an optional advance, be sure that your deed of trust contains a dragnet clause, and even if it does, be aware that your additional advance will be junior to any intervening liens of which you have knowledge. (And even though actual knowledge is required for this purpose, it is good practice to get a title report to make sure there are no junior liens so that you do not have to fight the battle over whether you had or did not have actual knowledge). Third, if you are a lender considering a loan which will secured by a junior deed of trust, make sure you read the senior deed of trust to determine whether it provides for obligatory advances because your loan would become junior to any additional advances by the senior lender. Fourth, if you are a lender whose deed of trust is junior to a deed of trust with a dragnet clause which does not provide for obligatory advances, (a) find out from the senior lender how much is then secured by the senior deed of trust because you will be junior to all then existing loans secured by that deed of trust, and (b) also give the senior lender actual written notice of your lien so that he cannot prejudice your position by making optional advances that would, in the absence of his actual knowledge of your loan, be senior to your deed of trust.

__________________ See La Cholla Group, Inc., v. Timm, 173 Ariz. 490, 844 P.2d 657 (Ariz. App. 1993).

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MEMORANDUM #511 How To Remove A Mortgage Or Deed Of Trust From Your Property

A mortgage or deed of trust is normally recorded against real property when the property is given as security for a loan. Lenders are very careful to see that their mortgages and deeds of trust are properly recorded when they make a loan. Unfortunately, they are not always so careful about releasing their mortgage when the loan has been repaid.

This is not only unfair to the borrower, but it creates liability for the lender. Arizona law specifically requires the holder of a mortgage or deed of trust to file a release in the proper public records within 30 days of repayment. If the mortgage holder fails to do so, he is liable for any resulting damages. In addition, if the mortgage is not released within 30 days after written demand, there is also an automatic penalty of $1,000 payable to the property owner.

Payoff Statement. It is usually necessary to pay off an existing mortgage when selling or refinancing property. This is normally done through escrow. The escrow agent requests a statement from the lender stating the principal balance of the loan, the amount of interest that is accruing on a daily basis, and any other amounts owed to the lender. This information from the lender is known as a "payoff statement," or sometimes just a "payoff."

Arizona law requires the holder of a mortgage to furnish a payoff statement within 14 days after it is requested. If the holder fails to do so, he or she is liable for any damages that result plus $500. The mortgage holder may not charge more than $30 for the payoff statement.

The mortgage holder should send the escrow agent a recordable release of the mortgage along with the payoff statement, with instructions to record it when the escrow agent is prepared to forward the amount of money necessary to satisfy the existing mortgage. The escrow agent then sends the payoff amount to the holder of the existing mortgage concurrently with the recording of the release.

Release by Title Company. Sometimes, however, the release is not immediately available or is not recorded for some reason. Sometimes the lender promises to send a release later and the escrow agent closes the transaction with the release "to come." If the release doesn't come, and if the title company has actual knowledge that the mortgage has been paid, the title company may in certain circumstances sign and file a release on behalf of the mortgage holder. For this solution to be available, the mortgage must be for less than $500,000 and the mortgage holder must be given advance written notice that the title company is preparing to file a release. Although this procedure is not often used, it is sometimes a convenient way to remove from the public records a mortgage held by an inattentive or unresponsive lender.

Old Mortgages. Occasionally a title report will turn up an old mortgage that has been paid off for years but never released. The mortgage holder may have long since died or (if a corporation) become defunct, making it impossible to get a release. In this case, the law provides an expiration date so that the old mortgage does not forever cloud title. If the mortgage indicates on its face the date by which it is to be paid in full, the mortgage expires ten years after that date. If there is no such date on the face of the mortgage, it expires 50 years after it was recorded. The date can be extended if the holder of the mortgage files a notice to that effect with the county recorder before the expiration date. Once the mortgage has expired, it is the same as if it had been properly released.

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Quiet Title Action. If none of the foregoing is sufficient to clear title, the property owner's last resort is an action to quiet title. This is actually a lawsuit filed in Superior Court which asks the court for a judgment that the mortgage or other cloud on the title is void and that the property owner holds clear title to the property. If successful, the judgment may be recorded with the County Recorder and is sufficient to release the mortgage or other cloud on title.

Although this is an expensive and time-consuming remedy, if it is preceded by a proper written demand along with a quit-claim deed and a check for $5.00 payable to the holder of the encumbrance, the property owner is entitled to recover his attorney's fees if his or her suit to clear title is successful. Very often the tender of the quit-claim deed with the check is sufficient to convince a recalcitrant holder of a mortgage that it is time to cooperate.

Conclusion. Anyone holding a mortgage or deed of trust that has been satisfied should promptly record a release in order to avoid penalties and claims for damages. Occasionally, an old mortgage or deed of trust will cloud title long after it has been paid in full. Arizona law provides a number of remedies to the property owner to clear his or her title.

__________________ Note: The terms "mortgage" and "deed of trust" were used interchangeably above. Either term is intended to cover both.

Citations: A.R.S. § 33-715 (payoff statements); A.R.S. § 33-712 (penalty and damages for failure to release mortgage or deed of trust); A.R.S. § 33-707 (release by title company); A.R.S. § 33-714 (expiration of old mortgages and deeds of trust); A.R.S. § 12-1101 et seq. (quiet title).

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MEMORANDUM #601 Judicial Foreclosure v. Trustee's Sale

It is well known that there is no reason to accept a mortgage in Arizona. If you want a lien against real property, you should always take a deed of trust, never a mortgage.

Why? Because a deed of trust allows the secured party to foreclose in either of two ways--by conducting a non-judicial trustee's sale, or by filing a judicial foreclosure action in state court. A mortgage, on the other hand, allows only judicial foreclosure.

Assuming you have a deed of trust, it is often assumed--erroneously--that there is never any reason to proceed by way of judicial foreclosure. This is a misconception. In some situations it is clearly better to foreclose judicially.

This comes as a surprise to many people because the advantages of a non-judicial foreclosure, often referred to as a trustee's sale, are well-known. It is normally much quicker and cheaper to proceed by way of trustee's sale because the whole procedure is handled outside the courtroom. To conduct a trustee's sale, it is only necessary to give certain notices, wait ninety days, and then auction off the property in a private office.

Contrast this with a judicial foreclosure, where it is necessary to commence a foreclosure lawsuit in state court, serve all interested parties with a summons and complaint, and wait for a hearing date before the judge, which may be delayed for months, particularly if the debtor decides to fight the foreclosure. After obtaining a judgment of foreclosure, it is then necessary to get the sheriff to schedule and conduct a sheriff's sale. Even then, it's not over. The debtor has six months following the sale to redeem the property--that is, to buy it back--by paying off the debt and all expenses incurred in connection with the foreclosure. As you can see, it can be a year or more before the entire matter is settled and clear title to the property can be obtained.

Why, then, would anyone ever want to proceed by way of judicial foreclosure?

Right of Irrevocable Acceleration. There is one, and only one, reason--the right of irrevocable acceleration.

Under Arizona's deed of trust statute, the debtor can reinstate--that is, stop the trustee's sale and cure the default--by paying the past due amounts and any late charges and expenses. He doesn't have to pay off the entire note. He can do this any time before the trustee's sale actually takes place. The practical effect is that the debtor may have at least three months, and more often four or five months, in which to make up his back payments, stop the trustee's sale, and return the debt to a current status.

Contrast this with a judicial foreclosure. Once a foreclosure proceeding has been filed with the clerk of the court, there is no right of reinstatement. The debt is accelerated, which means it comes due and payable in full. The debtor cannot stop the proceedings by paying just the past due amounts--he must pay off the entire balance of the note, or the foreclosure can be pursued to completion.

Reasons for Acceleration. Why would a note holder want to avoid the possibility of reinstatement? There may be a number of reasons:

1. The loan may be at a below-market rate of interest. In this situation, the note holder may want to use a default by the debtor as a way to force him to pay off the loan

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so that he can reinvest the money at a higher rate of interest elsewhere, or perhaps negotiate a higher rate of interest with the debtor in exchange for dropping the foreclosure. If the note holder simply commences trustee's sale proceedings, the debtor might scrape together enough money to bring the note current, thereby keeping the loan in effect for many more years.

2. The debtor may be troublesome. He may be continually late in his payments, he may be combative or litigious, or he may be abusing the property securing the note. In this case the note holder may decide he would just as soon be rid of the troublesome debtor and his promissory note once and for all. Judicial foreclosure is the way to accomplish this.

3. The note holder may want to acquire the property securing the note. If the note holder thinks the debtor will not be able to refinance or otherwise come up with the money to pay off the loan in full, he might want to accelerate the loan and attempt to acquire the property at the sheriff's sale by a credit bid--that is, by bidding the amount he is owed, so that he can pick up the property without the actual payment of cash. Since properties normally sell for bargain prices at sheriff's sales, the note holder might figure he can pick up a good piece of property cheaply and with no cash out of pocket if he irrevocably accelerates the debt and squeezes the debtor.

4. The note holder might believe that the value of the property securing the loan is deteriorating. This might be the case, for example, if the property is located in an area that is becoming a slum. In this case, the note holder might think his interests are best served by forcing a payoff before the value of his security deteriorates further.

5. The note holder might want to force the early payoff of the loan for any number of other reasons--for example, he might want to get out of the mortgage lending business in the area, or he might want the money to buy other property or make other investments. By irrevocably accelerating, he knows he can force the early payoff of the loan.

Conclusion. If you hold a note secured by a deed of trust, don't automatically assume you should commence a trustee's sale if there is a default. Before making that decision, consider first whether it is to your advantage to irrevocably accelerate. If so, weigh the disadvantages of a judicial foreclosure against the advantages of acceleration. You might find it advantageous to foreclose in court, even though it can be slower and more expensive.

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MEMORANDUM #602 What Can Delay Foreclosure

Most states have deed of trust statutes that provide for the quick and inexpensive foreclosure of liens against real estate. Under these statutes, certain notices are given, and after a specified period of time, generally about 90 days, the property may be sold at auction. Often the lienholder purchases the property with a "credit bid," which means that he pays for the property with the cancellation of all or a portion of his secured debt. He then has title to the property and can dispose of it at his leisure, or can retain it indefinitely if he so desires. No court proceedings are necessary, and the process normally moves very quickly and inexpensively.

This is not always the case, however. There are a number of things that can happen to slow the process down and increase the expense. It is essential to consider these potential problems if you are (a) lending money on property as an investment, or (b) taking back a deed of trust on property you are selling.

Bankruptcy. The most common problem is that the debtor files bankruptcy. Upon the filing of bankruptcy, any further foreclosure proceedings are immediately halted. This is known as the "automatic stay." At this point, the lienholder should seriously consider hiring bankruptcy counsel to review the situation and protect his interests.

Delay and expense are not the only adverse things that can result from a bankruptcy. Depending on the type of property and the type of bankruptcy, there is also the risk that the lien could be reduced in amount or even entirely released, or that the interest rate or other terms of payment could be modified. Normally, the lien is not released except to the extent that the value of the property at the time of filing bankruptcy is less than the amount of the debt. If the lien is reduced, the lienholder becomes an unsecured creditor for the amount by which the lien is reduced, which often means that little or nothing is paid with respect to this portion of the debt. Because value is a matter of opinion, a lienholder may be unhappy with the amount by which his lien has been reduced by the bankruptcy court, feeling that he could have done better had he been allowed to foreclose.

Even if the amount or terms of the secured obligation are not changed by the bankruptcy court, there is certain to be delay and expense while the bankruptcy case proceeds, or at least until the court can be persuaded to lift the automatic stay so that the lienholder can proceed with his foreclosure.

Litigation. Any debtor who wants to stop a non-judicial foreclosure can file an action with the court to enjoin the foreclosure. Of course, the debtor is supposed to have good grounds to file such an action, but in the desperation created by a pending foreclosure many debtors are able to come up with some sort of basis for seeking an injunction. For example, the debtor might claim that the foreclosure was not conducted strictly in accordance with the law or that there was an agreement that the debtor was to be granted an extension of time, that the debtor has an offsetting claim, or that the creditor defrauded the debtor in some way or otherwise engaged in inequitable conduct. The kinds of claims that may be made are limited only by one's imagination, and depend largely on the facts of the individual case. Whatever they are, however, they slow down the foreclosure and increase its expense, even if ultimately resolved in favor of the lienholder.

Tax Liens. Federal tax liens recorded subsequent to a deed of trust are subordinate to the deed of trust. Not even the I.R.S. can step in ahead of a properly perfected deed of trust. On the

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other hand, even though tax liens are subordinate, they have special privileges that can cause delay and expense to the lienholder.

Any federal tax lien that is filed at least 30 days before a scheduled trustee's sale can cause a problem. In this situation, the District Director of the I.R.S. must be given notice of the sale at least 25 days before it occurs. If this notice is not properly and timely given, the tax lien survives the foreclosure and moves up in priority because the foreclosing party's lien and any other junior liens have been wiped out by the foreclosure. Even if the notice is properly given, however, that's not the end of the problem. The I.R.S. has 120 days from the date of the trustee's sale to redeem the property from the purchaser for the sales price plus interest at 6%. Because of this 120-day right of redemption, the sale of the property becomes more difficult. Usually, the lienholder purchases the property by a credit bid and then waits 120 days to resell it. Thus, a 90-day foreclosure can turn into a 210-day wait.

It is possible to seek a waiver of the I.R.S.'s redemption rights by submitting certain information. This information is intended to show that the redemption right is of no value. However, even the seeking of the waiver can involve additional time and expense, and there is no assurance it will be granted. Many lienholders find it better just to wait the 120 days.

Conclusion. To be sure, modern deed of trust statutes are a vast improvement over the old procedure which required judicial foreclosure (which is in essence a lawsuit). In most cases, the deed of trust procedure works exactly as intended. However, anyone contemplating the acceptance of an obligation secured by a deed of trust on real estate should be aware that a simple and inexpensive foreclosure is not guaranteed. It is a good idea to make sure your debtor is financially sound before accepting any obligation secured by a deed of trust, even if the value of the security is adequate. It is usually the debtor in financial straits that goes into default, files bankruptcy, commences litigation, or becomes subject to tax liens. If any of these things occurs, delay and expense are certain to follow.

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MEMORANDUM #603 Notice of Foreclosure

The primary reason for using a deed of trust instead of a mortgage is speed of foreclosure.

A traditional mortgage requires the filing of a lawsuit, which is then followed by a sheriff's sale of the property. Even after the sheriff's sale the debtor usually has a period of time to buy it back, normally six months. This is known as the right of redemption. By the time all is said and done, it can take more than a year and thousands of dollars to complete the foreclosure process.

With a deed of trust, however, a private sale can be conducted after 90 days’ notice, and there is no right of redemption. The trustee's sale is final, quick, and inexpensive.

Because of this accelerated procedure, the courts construe the deed of trust statutes strictly against the lender. If there is any ambiguity or question about the validity of a foreclosure proceeding, the decision will usually be in the borrower's favor.

An Example. An actual example illustrates this point. A borrower signed a note providing that if a payment was missed, the lender could not accelerate the note until the borrower had been given 30 days written notice. During the 30 days, the note allowed the borrower to make the late payment, plus any late charges, and thereby avoid foreclosure.

In this particular case, the borrower did default. The lender sent a written notice of the default, as required by the note, and one day later gave the statutory 90-day notice of the trustee's sale. The lender then completed the sale at the end of 90 days, and the borrower sued to set it aside.

The Question. Did the lender have to give a 30-day notice plus a 90-day notice, or could both notices run at the same time?

The Arguments. The borrower argued that he was entitled to receive the 30-day notice and the 90-day notice consecutively. In other words, the lender would have to first give the 30-day notice specified in the note, and only after 30 days had passed without a cure could the lender give the 90-day notice, or 120 days total. Under this theory, the borrower could cure during both the 30-day period contained in the note and during the 90-day period prior to the sale by making the late payment plus any late charges and expenses.

The lender argued that there was no reason these two periods could not run concurrently. The borrower received the 30 days required by the note and the 90-day notice required by law for the trustee's sale, even though they both ran at the same time.

The Decision. As you surely guessed, the court resolved the issue in favor of the borrower. The court said that if a note requires notice, that notice must be given and the time to cure must expire before the statutory 90-day notice may even be given. The result is that whenever a note gives the borrower the right to receive notice of default and an opportunity to cure, the borrower is entitled to receive two notices and two cure periods, one after the other.

The Lesson. Always be very careful to comply fully with all the terms of the note and applicable law when foreclosing a deed of trust, and resolve all ambiguities in favor of the borrower. Usually it is advisable to obtain experienced legal counsel to conduct the foreclosure.

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In addition, if you are a lender, be reluctant to provide lengthy cure periods in the note or deed of trust, because these will only add to the time it takes to foreclose if there is a default.

__________________ See Schaeffer v. Chapman, 176 Ariz. 326, 861 P.2d 611 (Ariz. App. 1993).

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MEMORANDUM #604 Renegotiation of Debt and Loss of Priority

Suppose you own a note secured by a mortgage or deed of trust (for convenience, I will refer to both as a "mortgage").

It would not be terribly unusual for the debtor to come to you for some relief if he's having trouble making the payments. He might want the interest rate lowered, the payments amortized over a longer period, or a balloon payment postponed. Being a reasonable person, you might be inclined to work out a deal--after all, it's better than foreclosing--but you would probably ask for you something in return. For example, you might agree to stretch out the payments, but in return you might want to kick the interest rate a point or two.

Although this seems perfectly straightforward and reasonable, it can also result in the application of the rule that "no good deed goes unpunished."

The Problem. The problem arises when the debtor has placed a junior lien on the property, because the modification of your note may cause your mortgage to lose priority--that is, to become junior to the junior mortgage. If this happens, your mortgage is still enforceable--it just becomes a second mortgage instead of a first mortgage.

Three rules govern this situation.

Rule No. 1 is that if the modification does not make the loan more onerous to the borrower in any way, your mortgage retains its priority. Thus, if you grant concessions but take nothing in return, your priority remains intact. An example might be stretching out the payment schedule but leaving all the other terms the same. However, if you trade a concession for a benefit--for example, if you lower the monthly payments in return for an increase in the interest rate--you may lose priority, in whole or in part, even if the restructured loan, taken as a whole, is more favorable to the borrower. In most cases, priority is lost only to the extent the loan becomes more onerous, such as the amount of additional interest that becomes payable. However, in some cases, where the overall change endangers the junior lender's security, the priority of the entire mortgage may be affected.

Rule No. 2 is really an exception to Rule No. 1: If the mortgage specifically allows modifications to the note, priority is not lost, even if the restructured note is more onerous (see the sample language below). This exception is not available in every state, so legal counsel should be consulted before relying on this exception. The law in Arizona appears to favor this exception, although there has been no case exactly on point.

• Warning to Junior Lienholders. If you are about to accept a junior mortgage, review the first mortgage carefully. If it contains a provision allowing the note to be modified, you are on notice that the senior obligation may be increased or made more onerous in some manner, which could endanger your security.

Rule No. 3 is simply that if the junior lienholder consents to the modification and agrees that it will not affect his priority, then it won't.

Conclusion. It will not hurt your legal position to give your debtor a break as long as you receive nothing in return. If you do desire to receive something in return, it is best to order a title report to see if a junior encumbrance has been placed on the property. If so, the best advice is to

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seek legal counsel to make sure the transaction is handled in a way that will not adversely affect the priority of your mortgage.

If you are accepting a junior mortgage, read the senior mortgage carefully to determine whether there is any provision which could allow the obligations secured by the senior mortgage to be enlarged. If so, you will need to take steps to eliminate the possibility that your security could be denigrated by a modification to the senior mortgage.

__________________ A good state-by-state review of this topic is contained in Restatement of Property Third, Mortgages, § 7.1 et seq.

Sample language: Here is the wording for a provision allowing modification to a mortgage without losing priority: "This mortgage shall also secure all extensions, amendments, modifications, or alterations of the secured obligation including amendments, modifications or alterations that increase the amount of the secured obligation or the interest rate on the secured obligation." If you are accepting a first mortgage, try to include this language in your mortgage so that you will have the flexibility to restructure the debt if necessary without losing priority.

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MEMORANDUM #605 Statute of Limitations

Sometimes the holder of a note does not sue when the note goes into default. If the note is secured by a deed of trust or mortgage, sometimes the holder chooses not to foreclose. The reasons are varied--perhaps the holder of the note wants to give the debtor more time, perhaps the holder is doubtful about his ability to collect and does not want to incur the expense of suit, or perhaps the holder just never gets around to doing anything about the default. Strange as it may seem, it happens all the time.

Whatever the reason, at some point the right to enforce the note is barred by the statute of limitations. When this occurs, the note becomes unenforceable and any mortgage or deed of trust securing it must be released.

The question is, exactly when does the statute bar enforcement?

If the note is a single payment note, the answer is simple-- enforcement is normally barred six years after default, or in other words, six years after the maturity of the note, unless suit is filed in the meantime.

The question is a little more complicated where an installment note is concerned. Does the entire note become unenforceable six years after the first payment is missed? Or do the missed payments become individually unenforceable six years after their respective due dates?

In Arizona and most other states, the answer is, "it depends."

First, a little background. Most installment notes provide that the holder may accelerate the note if a payment is missed. This means that the entire unpaid balance can be called immediately due and payable at the option of the holder. Without such a provision, the holder would have to wait for each payment to become due before action could be taken to collect that payment. Obviously, this would be a cumbersome and unsatisfactory procedure, so a right of acceleration is a customary provision in an installment note. Notice, however, that an acceleration clause is not automatic--it requires some action by the holder of the note to accelerate, such as written notice to the maker of the note.

For an installment note, there are two rules that govern how the statute of limitations applies. First, if the note is not accelerated, the statute begins to run individually with respect to each installment as of its individual due date. Thus, it is possible after a period of time to have some defaulted payments that are barred (those more than six years in arrears), and some that are still enforceable (those less than six years in arrears). Payments not yet due--that is, future payments--continue to be enforceable, but only when they become due, at least until such time as the note is accelerated.

Second, if the note is accelerated, the statute begins to run on all future installments as of the date of acceleration, because acceleration makes all the future payments immediately due and payable. However, if any prior installments have previously been missed and remain unpaid as of the date of acceleration, the statute of limitations will have begun to run at the time those payments were missed with respect to those payments only.

There is one further complication. The statute is tolled-- that is, it temporarily ceases to run--during any period of time that the holder cannot sue because he is under 18 years of age or is of unsound mind, or while the debtor is residing out of the state. For example, if the debtor resided

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out of state for two years after a default and then returned, the statute would be extended to a total of eight years.

Conclusion. If you take an installment note, be sure it has an acceleration clause. If it goes into default, be careful not to let the statute of limitations run if you ever intend to enforce it, even if it is secured by a mortgage or deed of trust. If you are buying property subject to an old mortgage or deed of trust, investigate thoroughly before you rely on assurances that it has been released or that enforcement has been barred. Finally, do not accelerate an installment note until you are ready to file suit or foreclose, because acceleration triggers the running of the statute of limitations as to future payments, and you may as well give yourself as much time as possible if no immediate action is contemplated.

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MEMORANDUM #606 Back Taxes After Foreclosure

Real property taxes are secured by an automatic statutory lien against every parcel of taxable real property, but they are not the personal obligation of the property owner. This means that the government can sell the property if the taxes are not paid, but cannot personally sue the owner. Anyone purchasing tax certificates from the government stands in the same position — after a specified period of time, the purchaser of the tax certificate can foreclose on the property and collect from the proceeds of sale.

Priority. Tax liens are prior to all other liens and encumbrances, regardless of when they were recorded. If the property is sold for back taxes, all existing mortgages are wiped out and the purchaser at the tax sale takes the property free and clear. Conversely, if a private mortgage is foreclosed, it has no effect on the lien for taxes, because the tax lien is senior to all others. Whoever purchases the property at the tax sale will have to pay the back taxes.

Other things affecting title, such as judgment liens, mechanics' and materialmen's liens, claims of homestead, and homeowner's association dues and assessments are also junior to the tax lien. The purpose of this rule, of course, is to insure that the government is in first place so that property taxes always get paid.

Exceptions. If this theory were taken to its logical conclusion, everything affecting title to the property would be terminated by a tax sale. Experience has shown that such a rule would be harsh and unwise. As a result, three exceptions have developed.

The first exception is for public roadways, easements, and rights-of-way. It is the universal rule that public roads and easements are not affected by a tax sale, regardless of the seniority of the tax lien. This makes sense and avoids the obvious problems that would be created if public rights-of-way were terminated every time there is a tax sale.

The second exception is for private easements. This exception exists in most (but not all) states. Some states, like Arizona, have a specific statute that provides that private easements survive a tax sale. In some other states this exception is recognized by the courts as a matter of common law. It is a very useful and beneficial rule that preserves access to property and utility line easements after a tax sale, much like the exception for public rights-of-way. A few states, including Florida, Maryland, and New Jersey do not recognize this exception, and in these states private easements are terminated by a tax sale.

The third exception is for restrictive covenants, sometimes called deed restrictions. This exception has been recognized in a number of states but expressly rejected in others. Some states, like Arizona, have not yet addressed the issue. States that recognize this exception believe it would be unfair and destructive of property values to have restrictive covenants become void after a tax sale. In a leading case, the court held that deed restrictions prohibiting the sale of alcohol on all lots in a subdivision should survive the tax sale of a single lot in that subdivision. The contrary rule, of course, would free one lot from the restriction while all the others would continue to be bound by it, an obviously unfair situation which could harm the value of all the remaining lots.

Conclusion. Tax liens are senior to all other liens and encumbrances and upon a tax sale all such liens and encumbrances are terminated. Some states provide that private easements and restrictive covenants will survive a tax sale.

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If you hold a deed of trust or mortgage against real property, it is a good idea to periodically check to make sure that the taxes are current. If you have to foreclose, you will be responsible for all back taxes. And if a tax sale occurs, your lien could be wiped out.

__________________ An excellent summary of the law in this area may be found at 7 ALR5th 187.

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MEMORANDUM #607 Deficiency Judgments

Arizona law limits the amount of the deficiency judgment that can be obtained after foreclosure and provides a number of other unusual protections for debtors.

Main Features of New Law. The main features of Arizona's laws on deficiency judgments are as follows:

• Deficiency Judgments. The debtor's obligation is reduced by the greater of (a) the fair market value of the foreclosed property or (b) the actual sales price paid for the property at the foreclosure sale, at least if the debtor properly exercises his rights.

• Other Property. Debtors can also get credit for the fair market value of any other real property executed on to satisfy a deficiency.

• Guarantors and Partners. The new law applies to guarantors, partners, and anyone else liable for the mortgage debt. However, creditors may, if they choose, proceed directly against guarantors by a separate lawsuit. In this case, the guarantor does not receive credit for the fair market value of the mortgaged real estate unless and until the creditor chooses to foreclose on it. However, it appears that a guarantor does receive credit for the fair market value of the guarantor's property which is executed upon by the creditor.

• Principal Residence. A creditor cannot execute upon the debtor's principal residence until all other known real property is taken. The debtor may file a certified list of his other real property to insure that the creditor proceeds first against such property. This means that a troubled borrower has the chance to save his house if his other assets are sufficient to satisfy the borrower, and prevents the creditor from putting pressure on the debtor by threatening to take his house first.

• Procedure. To receive credit for the fair market value of his other property taken to satisfy a deficiency, the debtor must file an application with the court within 30 days of the execution sale. If this deadline is missed, the new law does not apply to that property.

• Suit on the Note. The creditor can always release his security and proceed directly on the note, free of the provisions of the new law. However, this is rarely done unless the collateral is worthless.

Exceptions. The new law doesn't apply to debt secured by single family homes or, obviously, to non-recourse indebtedness.

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MEMORANDUM #608 Deficiencies on "Spec" Homes

Decision Also Sets Out Rules for Multiple Mortgages

A recent decision by the Arizona Supreme Court excludes certain single-family properties from the protection of Arizona's anti-deficiency judgment statutes. The same decision also establishes a surprising rule as to what happens when a creditor holds two mortgages on the same property and decides to foreclose on one or the other.

Anti-Deficiency Exception. First, the anti-deficiency part of the decision. It is well known that Arizona has statutes prohibiting a creditor from obtaining a deficiency judgment on a purchase money note secured by a single family home or duplex on two and a half acres or less. The Arizona Supreme Court also decided a couple of years ago that a creditor could not avoid these statutes by simply releasing his mortgage and suing on the note. As a result, the law was thought to be clear that the holder of a purchase money note secured by a single family home or duplex on two and a half acres or less was limited to foreclosure, period--he could never sue on the note.

However, the Arizona Supreme Court has now created an exception. The Court held that the statutes do not apply to a builder where he does not intend to live in the house himself. The Court reached this decision because the statute states that it applies to property that is "limited to and utilized for a dwelling." The Court noted that the houses in question were not completely finished and therefore were not capable of being used as a dwelling, had never actually been lived in, and were held for resale to others. One wonders what decision the Court would have reached had the builder quickly finished the houses and rented them out, because the Court has held in another case that a rental house was included within the statutory definition.

In summary, any developer or builder of a "spec" house or a house built for sale to another person should be aware that he is probably not entitled to the protection of the statute until the house is completed and either sold, occupied, or rented out.

What Happens When Creditor Has Two Mortgages. Now, the part of the decision dealing with the rights of a creditor who has two mortgages on the same property. The rules laid down by the Court are simple but surprising: (1) the lender can foreclose on the first mortgage and then sue on the note that was secured by the second mortgage (but which was wiped out by the foreclosure of the first mortgage); or (2) the lender can foreclose on the second mortgage, but if he does so, he cannot then sue on the first mortgage--the debtor is released from all liability on the note secured by the first mortgage! The rationale for the decision is that when the creditor makes his credit bid at the trustee's sale, he is deemed to have allowed for the amount of the first mortgage, just as any third party purchaser would; or in other words, he is considered to have paid the amount of his credit bid plus the amount of the senior lien, and the debtor's debt is deemed paid to that extent (which means that it is paid in its entirety).

Keep in mind that this rule does not apply to mortgages secured by single family homes or duplexes for which the debtor has no personal liability, or other non-recourse notes; these notes can never be sued on, because foreclosure is the only remedy.

This decision does not mean that one should automatically foreclose first on the senior mortgage in every case. All relevant factors need to be considered, including the relative amounts of the

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two mortgages, the value of the property, whether there are intervening liens, whether there are likely to be third party bidders, the ability of the debtor to satisfy a personal judgment and so forth.

In summary, anyone holding two liens on the same property needs to carefully consider his options when deciding which mortgage to foreclose on first, since a wrong decision could be very costly. In most cases, consultation with legal counsel is advisable.

__________________ The decision is Mid Kansas Federal Savings and Loan Association of Wichita v. Dynamic Development Corporation, Case No. CV-89-0447-PR (Jan. 10, 1991).

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MEMORANDUM #609 Personal Liability for Limited Partners

The limited partnership is sometimes used for real estate investments. It has the favorable tax attributes of a general partnership, while at the same time providing limited liability for the limited partners. Sometimes the limited partners' liability isn't as limited as you might think, however.

A Typical Example. Let's look at the typical use of a limited partnership in the context of a real estate investment. Suppose that a promoter wants to form a group of investors to purchase a large parcel of land. The seller of the land might want a $250,000 down payment, with the balance payable over ten years. The promoter gets the seller to agree that the promissory note for the balance of the purchase price will be "non-recourse," meaning that the seller's only remedy in the event of default is to foreclose on the land. In other words, he can't sue anyone personally to collect on the balance of the note, he can only take back the land.

Our promoter forms a limited partnership to purchase the land. The promoter will be the general partner. He seeks investors to put up the money, each of whom will become a limited partner.

When marketing limited partnership interests, he proudly informs each prospective investor that he negotiated a non-recourse note for the deferred balance of the purchase price so that in the event (unlikely, of course) that the real estate market collapses, the partnership can simply walk away from the investment without further liability.

He also points out that each limited partner will be required to contribute his or her share of the annual payments needed to meet the payments on the non-recourse promissory note. Because these capital contributions are required by the partnership agreement pursuant to a specified schedule, each investor will have the comfort of knowing that every other investor will have a legal obligation to pay his or her share of the note when it comes due.

This sounds pretty good. Every investor will have the duty to make his share of the annual payment so that the partnership isn't left short if one or two investors decide that they don't want to make payments any more. And if things get really bad, the partnership can just decide to walk away from the investment without any further liability on the purchase money note.

When the Market Crashes. Unfortunately, there's one big problem. Let's assume that the worst happens, and the real estate market crashes. The property is no longer worth even the unpaid balance of the note. As a result, the general partner informs the investors that the partnership is dropping the property and will make no further payments. He tells them that even though they will lose all the money they have contributed, at least they won't have to keep paying the note.

The seller of the property has good counsel, however, and instead of just foreclosing on the property when the payments stop, he forces the limited partnership into bankruptcy and has a trustee appointed to assume control of the partnership's assets. Upon reviewing the situation, the trustee immediately notices that each limited partner has agreed to make certain specified capital contributions to the partnership. The trustee has a duty to collect these funds and to use them for the benefit of the partnership's creditors--in this case, the holder of the non-recourse note. So he sues the limited partners, and they have no choice but to keep paying into the partnership the money necessary to make the payments on the non-recourse purchase money note in accordance with the original schedule of required capital contributions. The unfortunate result, from the

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investors' point of view, is that a non-recourse purchase money note has in essence been converted into a full-recourse note that they have to continue to pay even though they would prefer to walk away from the property and take their loss.

You may be wondering if a smart general partner can avoid this problem when he decides it's time to walk away simply by amending the partnership agreement to provide that no further capital contributions are required. The answer is that sometimes he can, and sometimes he can't. If the certificate of limited partnership was filed prior to the purchase of the property, a subsequent amendment to the certificate generally has no effect on any pre-existing creditors of the partnership. In that case, the limited partners have to make the payments. There are also other theories a creditor can use to attack such a last-minute amendment. In addition, it should be mentioned that there are various defenses the general partner's counsel can employ to try to defeat the creditor's strategy. All things considered, it is difficult to say who will prevail. Each case depends on its own facts and circumstances, but the possibility clearly exists that the limited partners will be required to continue their payments.

The Lesson. If you invest in a limited partnership, look carefully at any claim that the debts of the partnership are non-recourse. If you agree to make capital contributions to the partnership, there is a good chance you will be required to make these contributions if the partnership decides to walk away from its obligations, even if those obligations are non-recourse. If in doubt, seek advice from counsel familiar with real estate, limited partnership and bankruptcy issues. Don't automatically assume that the liability of a limited partner is the same as that of a shareholder in a corporation.

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MEMORANDUM #610 Arizona's Anti-Deficiency Statutes

In Arizona, the general rule is that a lender can seek a deficiency judgment after foreclosure if the property securing the loan does not sell for enough to satisfy the debt in full. There is no "one action rule," as there is in California, which precludes a deficiency judgment after foreclosure in many cases. In "one action" states, the lender generally must elect to either sue on the note or foreclose - he can't do both. If he forecloses by means of a trustee's sale, he can't seek a deficiency; he must be satisfied with the proceeds of the sale.

Non-Recourse Loans. The parties can always agree to make a secured loan non-recourse, of course. Such a provision should always be clearly set forth in the mortgage or deed of trust if that is what the parties intend.

Often, commercial non-recourse loans have "carve-outs," which are certain circumstances under which the lender can hold the borrower personally responsible, even though the loan is otherwise non-recourse. The most common "carve-outs" are losses arising from:

(a) Waste caused or permitted by the borrower (i.e., damage to or deterioration of the property resulting from improper care or neglect by the borrower).

(b) Environmental liabilities arising out of the property.

(c) The borrower's failure to pay property taxes accruing against the property when due.

(d) The borrower's misappropriation of rents produced by the property (instead of using them to operate and maintain the property or to pay debt service to the lender).

The reason lenders often insist on these "carve-outs" is that they detract from the lender's security. If the lender's recourse is to be limited to the property, the lender wants assurances that the value of the property will not be depleted by the borrower's acts or omissions.

Fair Market Value Protection. Even though there is not a "one action" rule in Arizona, Arizona does provide some protection for borrowers against liability arising out of the failure of a property to sell for its full fair market value at the foreclosure sale. If the property sells for less than the debt, the borrower has the right to ask the court to determine its fair market value. If the fair market value is found to be higher than the sales price, the borrower is entitled to credit for the higher amount. This protects the borrower from an unfairly low sales price and encourages the lender to make a credit bid equal to or near the fair market value of the property.

Statutory Exemptions. There are also statutory provisions in Arizona that prohibit deficiency judgments in certain cases involving residential real property. These statutes preclude a deficiency judgment where (a) the property is two and one-half acres or less, (b) the property is limited to and used as a single one-family or single two-family dwelling, and (c) the loan is a "purchase money loan," which means it was a loan used to pay all or a portion of the borrower's purchase price for the property. A loan which replaces or refinances a purchase money loan is also considered a purchase money loan. It is not clear, however, what happens if the refinanced loan is larger than the original loan. It is possible that the portion of the loan producing the excess funds might be considered a full recourse loan.

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Even if the residential loan is not a purchase money loan, it nevertheless becomes non-recourse if the lender chooses to foreclose by means of a non-judicial trustee's sale. On the other hand, if the lender chooses to proceed by judicial foreclosure the loan is full recourse, meaning that the lender can seek a deficiency. A borrower, therefore, should not automatically assume a loan is non-recourse just because it is secured by qualifying residential property—it must also be a purchase money loan to be non-recourse regardless of the method of foreclosure.

The statutes also provide that there is recourse to the extent the lender suffers a loss from waste committed or allowed by the borrower, even if the loan is otherwise non-recourse.

A Caveat. Sometimes lenders making a commercial or business loan will also take a lien on the borrower's house as additional security. Lenders should be extremely careful when doing this. If the lender should foreclose on the residence by trustee's sale, any unpaid portion of the loan becomes uncollectable as a result of the anti-deficiency statutes. Even though the additional property was designed to provide additional security, it can also create a loss if the lender is not careful with its foreclosure and collection procedures.

Conclusion. A purchase money loan secured by qualifying residential property is automatically a non-recourse loan (except to the extent to which the borrower causes or permits waste). However, if the loan was used for other purposes the loan is non-recourse only if the lender chooses to foreclose by trustee's sale; if he chooses judicial foreclosure, the loan is full recourse. Any other loan can be made non-recourse if the parties so agree.

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MEMORANDUM #611 Foreclosure Sales: Who Gets the Money?

In most cases no money changes hands at a foreclosure sale. Why? Because if there were equity in the property the owner would have sold it to avoid foreclosure.

In the typical case the lender makes a "credit bid," which means he bids all or a portion of what he is owed, and takes title to the property in return for the cancellation of all or a portion of the outstanding debt.

On occasion, however, property does sell for more than the debt. When this occurs, it raises an interesting question—namely, who gets the money?

Distribution of Funds. First, of course, the money generated by the foreclosure sale goes to pay the costs of sale, including title fees, trustee's fees, and attorneys' fees. Next, the money goes to pay the debt which is being foreclosed.

After that, the law says that any money goes to "other obligations" secured by the deed of trust or mortgage (and we'll come back to that), then to pay off any junior lienholders whose position is wiped out by the foreclosure, and finally to the owner of the property, who is entitled to receive any leftover equity in the rare case where there is some.

Now, to back up a little—what are these "other obligations" which must be paid before the junior lienholders and the owner are entitled to anything? According to a recent decision of the Arizona Court of Appeals, these consist only of obligations which run directly in favor of the foreclosing lienholder, and not those owed to third parties. For example, if the foreclosing lienholder had paid property taxes to protect his position, he would be entitled to be repaid out of the sales proceeds because the reimbursement obligation runs to him. But, if these taxes were due and unpaid at the time of the sale, these delinquent taxes would not be paid out of the sales proceeds, because this is an obligation owed to the taxing authorities, not to the mortgage holder. This is so even if the mortgage or deed of trust requires the owner to pay the taxes (as they always do).

Why It Matters. Who cares? The purchaser at the foreclosure sale, any junior lienholders, and the owner. Why? Because if taxes and assessments are paid out of sales proceeds, it means the purchaser at the foreclosure sale buys the property with the taxes current, and less money is left over for the junior lienholders and the owner. On the other hand, if the taxes are not paid, the purchaser gets the property with a tax lien, and there is more money left over for the junior lienholders and owner.

As mentioned above, the Court has said the money goes to the junior lienholders, if any, and then to the owner. This means anyone bidding on property at a foreclosure sale must take into account any taxes and assessments against the property, as well as senior mortgages or liens, because these are not satisfied out of the sales proceeds and will have to be paid by the purchaser. The buyer at a foreclosure sale, in other words, does not necessarily get the property free and clear.

As a result, it is necessary to carefully review a title report on any property you wish to buy at a foreclosure sale, and to be sure you know the exact amount of any taxes, assessments, and senior

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liens because they will be your responsibility. Buying property at a foreclosure sale can be tricky, and legal counsel is usually advisable.

__________________ The case referred to above is Hanley v. Pearson, 389 Ariz. Adv. Rep. 35 (Ct. App. 12/26/02).

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MEMORANDUM #612 How to Foreclose on Personal Property

The procedure for foreclosing on real property is fairly well known. There is the 90-day notice of the sale, publication, and posting of the property, followed by a public sale at which anyone can appear and bid.

The procedure for foreclosing on personal property is a bit different (and much faster).

Background. One may wonder why a publication that deals with real estate is reviewing the foreclosure procedure for personal property. The reason is because there are a number of situations when it may become necessary to foreclose on personal property in connection with a real estate transaction. For example, an owner of a business located on leased property may have sold his business, subleasing the real estate and selling the personal property. If the buyer defaults he can terminate the lease, but he also needs to have a security interest on the personal property so that he can recover it along with the real estate. For certain kinds of properties - a restaurant or a car wash, for example - it is extremely important to be able to recover both the personal property and the real estate, because the equipment is not only valuable, it is essential to the operation of the property. In such cases, it is important to properly create and perfect a security interest in the personal property at the time of the sale and to follow the proper procedures when foreclosing. Another example where a foreclosure of personal property might be necessary is where real estate has been sold together with a large amount of specialized equipment needed to operate the real estate - for example, a golf course. If a lienholder ever needs to foreclose on this type of property, he will want to be certain he can recover the equipment along with the real estate and that no intervening liens have attached to the equipment.

Creation and Perfection of Security Interest. Whenever a lien on personal property is desired, it first must be created. This is done by an instrument called a security agreement which describes the lien and the lienholder's rights. A security agreement can be included as part of a deed of trust against real property, or it can be a separate document. In addition, the lien must be "perfected." For most kinds of property, this is done by filing a UCC-1 financing statement with the Secretary of State or the County Recorder, depending on the type of property, although for motor vehicles, mobile homes, trailers and the like it is done by filing with the Motor Vehicle Division of the Department of Transportation. In rare cases, perfection is accomplished by other means which are beyond the scope of this memo. Perfection protects the priority of the creditor's lien against intervening liens and purchasers.

Simultaneous Foreclosure with Real Estate. Where a deed of trust on real estate also explicitly creates a security agreement against specified personal property, which is fairly common, foreclosure can be simple. The law allows the foreclosure of the real estate to also operate as a foreclosure of the personal property, and both the real and personal property can be sold as a unit in a single sale. This is not always the most desirable way to proceed, as discussed below, but when it is it is easily accomplished and is essentially no different than foreclosing only on the realty.

Separate Foreclosure. Where there is no deed of trust to be foreclosed, or where it is desirable to foreclose on the personal property separately from the real property, the procedure is as follows:

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The first step is to notify the defaulting party of the default and to accelerate the debt so that the entire unpaid balance of the obligation becomes due.

The second step is to give the defaulting party, any guarantors and any other lienholders notice of the time and place of the sale of the collateral. There is no minimum amount of notice required by statute, but it does say that unless the parties have agreed otherwise, ten days is presumed to be adequate (compare that to the 90-day notice required to foreclose on real estate). If the property is perishable, less than ten days may be appropriate. Even though it is not specifically required, it may be prudent to also give notice to the public at large, possibly by publishing or posting, so that the debtor cannot claim there was inadequate notice of the sale; however, no specific type of notice is required - it is only required that the notice be reasonable under the circumstances.

The third step is for a public sale to be held, at which time third parties and the creditor may bid. The sale may be held at any reasonably convenient location. The creditor is allowed to apply the proceeds of sale to his costs and his unpaid obligation. The creditor should disclaim all warranties at the foreclosure sale, or the law will imply warranties of title, possession, and quiet enjoyment, thereby creating potential liability for the creditor. If the property does not sell for enough to satisfy the obligation, the creditor may sue for a deficiency. If there is a surplus, it must be turned over to junior lienholders or the defaulting party.

Additional Issues. There may be situations where a creditor finds it desirable to conduct separate foreclosure sales of personal and real property, even though the deed of trust covers both. For example, it could be advantageous to proceed with a quick foreclosure of the personal property in order to protect its value or to prevent it from disappearing during the 90-day waiting period required under a deed of trust. There also may be situations where real and personal property secure separate obligations, making a single foreclosure impossible. In either case, care should be taken to structure the sale in the way most advantageous to the creditor and to avoid losing the right to a deficiency. It is possible that one foreclosure could prevent the subsequent foreclosure under the anti-deficiency rules, either because of fair market value protections or because of inadvertent violations of the foreclosure procedures. Therefore, it is essential to consult with experienced legal counsel when conducting a foreclosure, particularly where both personal and real property are involved, to insure that the creditor's rights are not prejudiced.

Related Rights and Remedies. As an alternative to foreclosure, the defaulting party and the creditor can agree that the creditor may retain the collateral in full satisfaction of the debt, thereby avoiding the necessity for a sale but also releasing the defaulting party from the risk of a deficiency judgment.

The creditor may demand at any time after a default that the debtor assemble the collateral and make it available to the creditor, or the creditor may by peaceful means use self-help to take possession of the collateral pending the actual sale. If the creditor cannot obtain possession without creating a disturbance, it may be necessary to seek a court order to obtain possession.

Procedure Must Be Commercially Reasonable. Although there are a number of specific procedural requirements, there are many areas where the statutes do not furnish clear guidance. This does not mean, however, that the creditor can do whatever he pleases. The overriding principle when foreclosing on personal property is that the creditor must act in a "commercially reasonable manner" under the circumstances. This term cannot be adequately defined, of course, but if a creditor's actions are deemed by a court to be unreasonable the creditor may be liable for damages, the sale may be set aside, a guarantor may be released, or his right to a deficiency may

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be lost. For example, a court may find a creditor did not behave in a commercially reasonable manner if he did not give adequate notice of the sale, if he did not prevent perishable collateral of deteriorating, or if he failed to prepare the collateral for sale in a manner reasonably designed to maximize its value.

Conclusion. Care should always be taken in foreclosure actions, whether involving real estate, personal property, or both. There are often strategies available to maximize the creditor's recovery or to enhance his leverage. The procedures are strict, and those who are not familiar with the rules risk losing their security or the right to a deficiency judgment.

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MEMORANDUM #613 When Can You Be Sued For Defaulting On Your Home Mortgage?

The collapse in home prices has left many homeowners owing more on their personal residence than it is worth. Because of this, many homeowners are on the verge of defaulting on their home mortgage, and are wondering if the lender can sue them if they do.

The General Rule. The general rule, which applies in most cases, is that the lender cannot sue a borrower who defaults on his or her home mortgage. This is because Arizona has an anti-deficiency law that protects homeowners, in the great majority of cases, from personal liability in the event they default on their mortgage.

In order to enjoy the benefit of this law, however, the mortgage (which, for purposes of this memo, includes a deed of trust) must be secured by property no larger than 2.5 acres in size that is "limited to and utilized for either a single one-family or single two-family dwelling." A condominium unit qualifies, even though it may be part of a development with a large number of units, as long as the mortgage encumbers no more than two units. And clearly, the typical single family home or townhouse qualifies. On the other hand, a mortgage loan secured by raw land or a commercial property does not.

It is not necessary for the dwelling to be the principal residence of the borrower. It can be a vacation home, or even a rental unit. Furthermore, it is not necessary for the property to actually be occupied at the time, so long as construction has been completed and it is suitable for occupancy. Thus, even though the statute states that the property must be "utilized" as a dwelling, this means only that it must be suitable for being so utilized. The owner is therefore entitled to the statutory protection even after vacating the property.

The Exception. There is an important exception to the general rule. If the mortgage is not a "purchase money mortgage," the lender can, if it proceeds in a certain manner, obtain a personal judgment for the obligation.

The key is the definition of "purchase money mortgage." Under Arizona law, a mortgage is considered to be a purchase money mortgage only if the proceeds are used to purchase the residence which secures the loan. For example, if a home equity loan is taken out to purchase a boat, it is not a purchase money mortgage. Or, if a mortgage is placed on an owner's principal residence in order to obtain money used to purchase a different property, such as a vacation home or rental, it is not a purchase money loan.

It is important to note that if a purchase money mortgage is refinanced and replaced with a new mortgage, the new mortgage is still considered a purchase money mortgage. This is true even if the loan is refinanced for more than the original loan and the extra money is used for other purposes, and even if the new mortgage is from a different lender.

As mentioned above, a lender must proceed in a certain manner in order to obtain a personal judgment for a non-purchase money loan secured by a qualifying residence. Specifically, the lender must either (a) waive its security and sue on the note, or (b) conduct a judicial foreclosure of its mortgage and then sue for a deficiency. If the lender forecloses by conducting a non-judicial trustee's sale, which is the most common way to foreclose, the anti-deficiency law applies and the lender cannot take further action against the borrower.

Second Mortgages. The foregoing rules apply to both first and second mortgages. They also apply to so-called "wiped-out seconds," which are second mortgages which have been voided by

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the foreclosure of the first. In such a case, the creditor holding the wiped-out second mortgage cannot sue to collect on its loan except in the case of a non-purchase money obligation or when the loan is not secured by a qualifying single or two family dwelling.

Conclusion. In most cases, a homeowner cannot be held personally liable for the repayment of the mortgage on his or her personal residence. However, if the homeowner has taken out a home equity loan and used the proceeds for something other than the purchase of the home or refinancing an existing purchase money loan, there can be personal liability for the repayment of that loan.

__________________ A.R.S. §33-729; A.R.S. §33-814; Baker v. Gardner, 160 Ariz. 98, 770 P.2d 766 (1988); Mid Kansas Fed. Sav. & Loan Ass'n. v. Dynamic Dev. Corp., 163 Ariz. 233, 787 P.2d 132 (App. 1989), vacated 167 Ariz. 122, 804 P.2d 1310 (1991); Resolution Trust Corp., v. Segel, 173 Ariz. 42, 839 P.2d 462 (1992); Nydam v. Crawford, 181 Ariz. 101, 887 P.2d 631 (1994).

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MEMORANDUM #701 Standard Coverage

It is almost automatic to purchase title insurance when buying real property or making a loan secured by real property. However, other situations often arise where the purchase of title insurance would be appropriate, but isn't considered simply because no one thinks about it.

Before we get into the details, however, let's take a quick look at the basics.

A standard owner’s policy of title insurance insures the owner of real property against four risks (subject to certain exceptions):

l. That title is vested in his name;

2. That there is no defect in or lien against the title;

3. That title is marketable; and

4. That the property has legal access.

A lenders policy, which is normally purchased in connection with the making of a loan secured by real estate, insures the lender against the above four matters, and in addition, insures the lender:

1. That the mortgage or deed of trust is valid; and

2. That the mortgage or deed of trust is prior to all other liens and encumbrances (other than those listed on the policy as being senior).

Now, let's look at some situations where title insurance may be appropriate, other than the usual sale or loan transactions:

Leases. A ground lease is one common transaction where title insurance should be considered. A leasehold estate in land can be insured just like fee title. It can be obtained either in connection with the making of a new lease or an assignment or sublease under an existing lease. A leasehold policy furnishes protection against a defect in title that might cause the termination of the lease, such as a problem with the landlord's title, the invalidity of the lease for some reason, and so on. A leasehold policy should be considered whenever substantial reliance is being placed on the validity of a ground lease--for example, when a building is to be constructed on a ground lease, or a critical parking area is being leased in connection with the establishment or expansion of a business. In such situations the loss of the leasehold can be just as devastating as the loss of fee title and should normally be insured against. However, it is normally not possible or practical to insure leases of space in a building, such as an office or store.

Easements. A standard owners policy insures that the property has legal access. In some situations, however, an additional easement or accessway is critical to the buyer's use of the property. For example, it may be important to have access for deliveries by way of a private easement to the rear of the property. In such a situation, the validity of the auxiliary easement itself should be specifically insured. There is usually no charge for this additional coverage if obtained in connection with the original policy insuring the fee.

Options. Real property subject to an option can also be insured, and normally should be. An example where insurance is wise might be an option to purchase an adjacent site for the

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expansion of a business. If the optioned property is not owned by the optionor or is subject to title defects, the business owner should have the protection of a title insurance policy to indemnify him against the loss. Such policies insure that the optionor has title and the title is marketable, but do not insure that the option agreement itself is valid--that determination should be made by your legal counsel. Nevertheless, an option policy does provide important protection and should be considered.

Improvements. Title insurance is limited to the amount specified on the face of the policy, which is usually adequate at the time it is purchased. However, over time additional improvements may be placed on the property, or the property may increase in value. In either of these situations, the property owner may want to consider increasing his title coverage so that he is fully protected if title proves defective.

Incorporation and Dissolution. Sometimes the owner of a business will quit-claim property to his corporation, partnership or limited liability company, or a subsidiary may quit-claim title to a parent corporation or vice-versa. Sometimes a corporation or partnership will quit-claim property to its shareholders or partners upon dissolution. What the grantor may not realize is that the title policy insures the original owner, not the new owner. The result is that the conveyance of the property when the form of the business entity changes deprives the owner of its existing title insurance protection. The solution to this problem is simple and inexpensive, however--all that needs to be done is to purchase an endorsement to the existing policy to cover the new entity, or the shareholders or partners in the case of dissolution. This is available, however, only if the ownership shares are exactly the same. For example, if a shareholder conveys property he owns to a corporation he owns only 95% of, the endorsement is not available, because the ownership is not exactly the same. Another slightly more risky solution is to convey title by a general warranty deed, so that the business entity has a claim against the grantor, which may then seek indemnity under its original policy. In any event, the situation should be reviewed to avoid creating an unnecessary title risk.

Gifts. A gift of a property by quit-claim deed raises the same issue as discussed above. An endorsement should be obtained in order to avoid loss of coverage.

Deed in Lieu. Accepting a deed in lieu of foreclosure can be especially dangerous without title insurance. It is sometimes assumed that the grantee takes title in the same condition as if he were to foreclose--that is, free of all liens and encumbrances junior to his mortgage or deed of trust. This is not the case, however. The grantee takes title subject to any additional liens, encumbrances or title problems that have attached to the property since the mortgage or deed of trust was placed on the property. Since the mortgagor is usually in financial trouble, it is not unusual to find tax or judgment liens against the property when a deed in lieu is offered. Therefore, it is critical to examine a current title report for the property before accepting a deed in lieu and to obtain a policy at the time of conveyance.

Conclusion. Title insurance provides critical and economical protection against various types of title risk. Those dealing with real estate should consider title insurance whenever dealing with any interest in real estate in order to make an intelligent and informed decision as to whether title insurance is advisable.

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MEMORANDUM #702 Extended Coverage

Whenever real estate is sold, it is customary for the seller to purchase title insurance for the buyer. This guarantees the buyer that he will receive marketable title to the property, that there will be no liens or encumbrances against the property, and that the property will have access to a public road. All of these guarantees are limited by (a) specific items listed on the policy, and (b) certain standard exclusions and exceptions. This is the coverage furnished by a "standard owner's policy."

If the buyer wants "extended coverage," it is customary for the buyer to pay the extra premium over and above the cost of the standard policy. The cost is normally an additional 40% to 50% over the cost of the standard policy. In addition, someone will have to pay for a current ALTA/ACSM land title survey, because an extended coverage policy cannot be issued without it.

Buyers often ask whether they should buy extended coverage. To answer that question, we first need to know what is covered by an extended coverage policy that is not covered by a standard policy.

Exclusions. A standard policy contains four exclusions from coverage not contained in an extended coverage policy. They are:

1. Rights or claims of parties in possession not shown by the public records. This mainly includes tenants with unrecorded leases, those claiming by adverse possession, and those who are in possession and claiming under some other theory (maybe they think they inherited the property from their deceased uncle).

2. Encroachments, overlaps, boundary line disputes and any other matter which would be disclosed by an accurate survey and inspection of the property. This refers mainly to buildings, fences, and driveways which go onto an adjoining property, the encroachment of such things from an adjoining property onto the property being insured, or the overlap of two parcels along a boundary line.

3. Easements or claims of easements not shown by the public records. This refers to any unrecorded easement, including one obtained by long use (called "prescription").

4. Unrecorded mechanics' and materialmen's liens. This refers to the unrecorded claims of contractors, subcontractors, laborers, suppliers, and certain professionals who have worked on the property or delivered supplies to it but who have not been paid.

When extended coverage is purchased, these four exclusions are deleted; or in other words, you have insurance coverage against these four items. That is the difference between standard coverage and extended coverage.

In deciding whether to purchase extended coverage the buyer must evaluate (a) whether there is a significant chance of a claim based on one of these matters, (b) whether he is willing to take this risk or desires to pass it on to the title insurance company, and (c) the amount of the additional premium.

Chance of Claim. In evaluating the chance of a claim covered by extended coverage the buyer must first consider the physical features of the property and its location. A survey should be

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carefully reviewed, if available; but in any case, the property should be physically inspected, and an aerial photo should be studied, if one can be obtained. The buyer should ask himself the following questions: Does it appear that third parties may have farmed or grazed the property, crossed over it for years to gain access to other property, or erected a wall or fence that may encroach upon it? Are there buildings or other improvements on the property, and if so, does it appear that there are people (other than the owner) in occupancy? Is an unidentified party currently using the property for farming, grazing, or any other purpose, or has anyone fenced the property off, other than the owner or his tenant? Does it appear that any improvements to the property were recently made that might give rise to mechanics' liens? Is there any improvement, such as a fence, wall, or road, that may encroach onto the property from a neighboring lot? Is the property a large tract of undeveloped land or a large commercial property? Is the property described by a long and complex legal description (as opposed to being a platted lot)? Affirmative answers to any of these questions may indicate an increased chance of a claim covered by an extended coverage policy.

Decision to Pass Risk. Whether a particular buyer desires to accept the risk of a claim covered by extended coverage depends on several factors, including the buyer's general attitude toward risk. Some buyers have a more cautious approach toward risk, and would rather pay the premium to avoid it. Institutional purchasers and trustees will usually purchase extended coverage because they are dealing with the assets of others and believe it inappropriate to take unnecessary risks, and sometimes they even have a flat policy of always purchasing extended coverage. Finally, the size of the transaction can be a consideration, because some buyers are willing to take a gamble on a small transaction, but not on a large one with the potential of a crippling loss. It is rarely thought necessary to purchase extended coverage for a typical single family home.

Cost of Coverage. As mentioned above, the cost of extended coverage is usually 40% to 50% more than the cost of the standard coverage policy, plus the cost of the survey. On a $1 million transaction, the standard coverage would probably cost about $2,400.00, and the extended coverage about an additional $1,100.00 or so. However, if the property is being purchased with a loan from an institutional lender, the lender will insist on an ALTA loan policy, which is similar to an extended coverage owner's policy. If an ALTA loan policy is being purchased, the additional cost of an owner's extended coverage policy is minimal. Therefore, you may as well get the extended coverage in this situation because it is almost free.

Conclusion. Whether a particular purchaser ought to pay the premium for extended coverage depends on a number of factors, including the physical features of the property and its location, the nature of the buyer and his approach to risk, and the cost of the additional coverage.

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MEMORANDUM #703 Endorsements

Anyone purchasing real estate knows they should obtain a policy of title insurance. A standard owner's policy guarantees the buyer (subject to certain exclusions and exceptions) that he will have marketable title, that there will be no undisclosed liens or encumbrances, and that the property will have access to a public road. Extended coverage, which can be purchased at additional expense, deletes certain of these exclusions and furnishes even broader coverage.

Nevertheless, there are still a number of things that aren't covered, even with extended coverage. To protect against these things, special endorsements are available. These endorsements are rarely offered by the title insurance company on their own; usually, they must be specifically requested. Since you can't request what you don't know about, it is useful to review some of these endorsements.

Some of the more common ones are:

Zoning. This endorsement guarantees that the property has a specified type of zoning and that certain listed uses are allowed on the property. It also insures against losses arising out of the failure to meet minimum lot sizes or dimensions, the failure to comply with floor area restrictions, the failure to comply with setback lines, and the failure to comply with height restrictions. (Sometimes referred to as an LTAA 17; CLTA 100.17; or ALTA 3.1 endorsement.)

Violation of Deed Restrictions. This endorsement protects the owner against losses arising out of existing violations of any covenants, conditions or restrictions recorded against the property. (CLTA 100.5.)

Street Abutment. This endorsement insures that the property abuts and has access to a specified physically open street. Although the standard policy insures the owner that he has access to some street, it is often important to know that he has access to a particular street. For example, a parking lot may abut a particular street, or the property may need access to a particular street for business reasons. In such cases, this endorsement can provide valuable protection. (CLTA 103.7.)

Non-imputation. An owner's policy of title insurance normally excludes coverage for matters known to the insured but not disclosed to the insurance company. This can cause a problem where the insured does not have actual knowledge, but the knowledge is imputed to him by operation of law. An example is where one partner in a joint venture is also the seller of the property and has knowledge of an undisclosed title problem, but the remaining partners and the venture itself do not. In this case, the endorsement would provide protection to the remaining partners regardless of the fact that under applicable law this knowledge would otherwise be imputed to the joint venture, thereby voiding coverage with respect to the undisclosed defect. (CLTA 107.6.)

Same Property as Shown on Survey. This guarantees that the insured property is exactly the same property as that described on a specified survey. It eliminates any risk that the survey inadvertently describes the wrong property. (CLTA 116.1.)

Contiguity. Where the purchaser is taking title to two or more parcels of adjacent property, this endorsement provides a guarantee that the parcels are contiguous and that there are no strips or gaps between them. This is especially useful if the property is to be developed with a single

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building spanning the two parcels, or is otherwise to be used as an integrated whole. (CLTA 116.4.)

Patent. This endorsement protects the owner against any damage to his improvements arising out of any exceptions shown in the patent; for example, the right to remove minerals. (Special Endorsement No. 5.)

Special Extended Owner's. This endorsement, which is available only with an extended owner's policy, offers a variety of protections, including assurances that there are no present violations of any covenants, conditions and restrictions and that there are no encroachments from adjacent properties or onto adjacent properties, and insuring against losses to improvements, including lawns, shrubbery or trees, arising out of the use of a specified easement across the property or the extraction or development of minerals from the property pursuant to a mineral reservation. For example, if an underground power line easement must be dug up, this endorsement would cover damage to any improvements or landscaping destroyed or damaged as a result.

A number of other specialized endorsements are also available covering a large variety of situations. For example, there is an endorsement available which protects a property owner with an easement across another's property from the risk that the easement will be lost due to the failure of the owner of the other property to pay his property taxes. There is an endorsement that guarantees a purchaser of land that he can increase his coverage when he develops the property, even if pre-existing title defects are discovered in the meantime. Other endorsements are available to cover special risks related to condominiums, to increase coverage to keep up with inflation, or to insure the holders of mortgages or deeds of trust against certain kinds of title risks.

Some title companies are also willing to draft custom endorsements to meet the purchaser's needs when a standard endorsement is not available.

Many endorsements can be obtained at nominal cost, and in some cases, without any charge at all. In other cases, they are individually priced when requested to reflect the specific risk insured against. Obviously, the greater the perceived risks, the higher the premium.

Conclusion. Title insurance endorsements can provide specific protections against risks not otherwise covered by a standard, or even an extended, owner's policy. Often, the need for these endorsements can be determined from a close reading of the preliminary title report or survey. In other cases, the risk can be recognized by a knowledgeable purchaser or his counsel. Generally, the cost of a special endorsement is very reasonable and should at least be considered whenever a non-covered risk is recognized.

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MEMORANDUM #704 Patent Exception

Virtually every owner's policy of title insurance issued in Arizona contains a "patent exception." This is a standard provision which excludes title insurance coverage for "reservations in patents or in Acts authorizing the issuance thereof."

Is this something you should be concerned about if you are purchasing real property? The answer is - "sometimes."

What Is a Patent? First, let's define what is meant by a patent. In property law, the patent is the instrument by which the government first transfers title to real property to a private individual. In essence, it's a deed from the government. Because most land in Arizona was originally owned by the Federal government, the first recorded deed for property in Arizona is usually the patent. This means that if title is searched back through time, the search ends with the patent.

Patents are issued under the authority of a law, or Act, that spells out the details and conditions of the patent. Oftentimes the patent reserves mineral rights of various kinds, or certain water rights, or even easements.

The Patent Exception. As mentioned above, virtually every owner's title insurance policy issued in Arizona contains the standard patent exception, which is very general. Some policies will also contain an additional and more specific patent exception set forth in what is known as "Schedule B, Part II," which is the specific list of title insurance exceptions for the particular property being insured. This specific exception often (but not always) summarizes the type of exceptions contained in the patent. For example, policies often contain an exception stating something like the following:

"Reservations contained in the Patent from the United States of America, reading as follows: Subject to any vested and accrued water rights for mining, agricultural, manufacturing, or other purposes, and rights to ditches and reservoirs used in connection with such water rights as may be recognized and acknowledged by the local customs, laws and decisions of courts, and also subject to the right of the proprietor of a vein or lode to extract and remove his ore therefrom, should the same be found to penetrate or intersect the premises hereby granted, as provided by law."

This specific exception is obviously helpful because it alerts the buyer to the nature of the patent exception so he can decide for himself whether there might be a problem.

When To Be Concerned. Because patent exceptions are so commonplace, it is tempting to ignore them. In most cases, the patent exception never causes a problem because the rights reserved in the patent are never exercised, or if they are, they are exercised in a manner which causes no damage to the property.

Every so often, however, the patent exception does cause a problem, sometimes a big one. If your policy contains a patent exception, as most do, you may not have insurance to protect you against that problem. Therefore, it is wise to pay at least some attention to the patent exception and to consider the risk it may pose for you as a property owner.

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An actual case can illustrate the type of problem that can occur. Recently, an individual purchased several adjacent parcels of land in north Scottsdale for the purpose of combining them into a single lot and building a large home. His title policy contained a general patent exception, but it didn't specify that each of the parcels was subject to the reservation in the patent of a 33-foot public roadway easement along one or more boundaries. This meant that the parcels could not be combined because there were unused public roadway easements crossing the middle of the assembled parcels. When he filed a claim with the title insurance company to indemnify him against the loss caused by the undisclosed easements, it denied coverage because of the general patent exception.

The first step in protecting yourself is to examine the patent exception in the commitment for title insurance to see if the nature of the patent exception is disclosed. This will help you decide if it is a problem. If the patent exception set forth in the commitment is silent about the nature of the patent exception, or if you wish to be particularly careful (as you might be for a large purchase) you can order a copy of the patent from the title company and review it for yourself.

If, after reviewing the patent exception, you still believe you may have a problem, you might decide to cancel the purchase or in some cases you may decide to purchase a patent endorsement to your title policy. The price of the endorsement is normally very reasonable, and it can provide substantial additional protection. Because patent endorsements differ in exactly what they cover (for example, some cover only damage to improvements while some cover all losses), you should carefully read the endorsement before purchasing it to make sure it covers what you want to cover. (Some title companies refer to the most complete endorsement as Special Endorsement No. 6.)

Conclusion. Do not blithely ignore the patent exception in your commitment for title insurance. Be sure you understand the nature of the reservations contained in the patent, and if they appear to be a potential problem, consider whether you should decline to purchase the property or obtain a patent endorsement.

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MEMORANDUM #705 What is Excluded (As Opposed to Excepted) From Your Title Insurance Coverage?

Every commitment for title insurance contains a list of exceptions disclosing the liens, easements, restrictions, and other matters that will not be covered by the policy. These are the specific items that a particular property is burdened with, and they will generally be described by title, date, and recording information. They are sometimes referred to as the "Schedule B items." For example, a property may be subject to deed restrictions, an easement for a power line, and an existing mortgage, each of which will be described with particularity in the "exceptions" portion of the commitment. If not removed prior to the closing, they will eventually become exceptions in the insurance policy itself, meaning that the buyer has no insurance protection for matters arising out of the listed exceptions.

Even experienced buyers, however, often ignore the exclusions set forth in the commitment. Exclusions are different from exceptions in that exclusions are a description of general types of matters that the policy simply does not cover.

Exclusions. All policies issued in the State of Arizona are subject to the same or very similar exclusions. They may be summarized generally as follows:

• Claims arising out of laws, ordinances, or governmental regulations, unless there is a recorded notice of a violation or a lien resulting from the violation. Examples include zoning laws, building codes, parking requirements, lot split or subdivision requirements, and environmental matters. This is sometimes known as the "police power" exclusion, and it means that the policy does not insure against any loss arising out of the government's inherent power to regulate the use of real property.

• Losses arising from the exercise of the power of eminent domain, or condemnation, unless notice of the pending condemnation has been recorded against the property or the condemnation has been completed. This means that the buyer has no title insurance protection if all or a portion of his property is condemned or threatened with condemnation after the closing unless notice of the pending condemnation was filed with the County Recorder prior to close of escrow. Of course, the buyer is entitled to compensation from the government, which may or may not be adequate under the circumstances.

• Claims arising out of matters known to the buyer but which are (a) not recorded and (b) not known to the insurance company, unless disclosed to the insurance company in writing. This prevents the insured from sandbagging the insurance company by purchasing property with a known title defect, and then pursuing a claim against the title company. If a buyer knows of a title problem not shown on the commitment, he should notify the insurer in writing to avoid risking his coverage.

• Losses arising out of matters attaching or created after the date of the policy. This might seem obvious, but inexperienced purchasers sometimes assume that title insurance policies protect them against title problems even if they arise out of claims attaching after close of escrow, which is simply not the case.

• Claims that are based on the failure of the buyer to pay fair value for the property. Basically, this means there is no insurance if the sale is later set aside on the

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theory of "fraudulent conveyance," which is a law designed to protect creditors from an insolvent debtor disposing of his property for less than fair value. Therefore, if a buyer has reason to believe the seller is in financial trouble and that the property is being sold for substantially less than its fair value, the buyer should be aware that he may have no title insurance protection if the sale is later set aside. Successful fraudulent conveyance claims are typically brought against relatives, friends, or others receiving preferential treatment from an insolvent seller, but they can be brought against any purchaser who fails to pay fair value to an insolvent seller.

• Claims based on a sale being deemed a voidable preference under the bankruptcy laws. In general, this means that when a property is sold or transferred for less than fair value within 90 days of the bankruptcy of the seller, the buyer has no claim against the title insurance company if the sale is later set aside by the bankruptcy court.

Conclusion. Exclusions cover matters that occur relatively infrequently. However, if they void coverage in a particular case, the results can be disastrous. Therefore, it is important to be aware of the exclusions from coverage that are a part of every policy and to take steps to protect yourself if you are purchasing property where an exclusion may apply. If you know of a potential problem covered by an exclusion, you should discuss it with the title company to see if the exclusion can be deleted or if an endorsement insuring over it can be purchased. If not, you should consider carefully whether you ought to proceed with the purchase.

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MEMORANDUM #801 Basic Provisions

Anyone owning real property in Arizona should have a basic understanding of the state's real property tax system. The reason is obvious--if you don't know the rules, you may end up paying substantially more in taxes than you have to.

Here's how it works:

Valuation. Every parcel of real property is valued for purposes of the property tax. Values are established by the County Assessor each year, and are based in large part on the price at which similar properties are selling. Sales price information is generated from the affidavit of real property value that must be filed whenever a deed is recorded. This means that when you purchase property, the Assessor will know what you paid and may consider that information in valuing your property, as well as the sales price of other similar properties that have recently been sold.

Although the Assessor should assess all properties at their true fair market value, he often falls behind when property values are increasing. If this occurs, everyone with similar property is entitled to the same treatment--that is, he can't value one piece of property at full fair market value if other similar properties are generally valued at a lesser amount. This gives the property owner two ways to challenge his own valuation--(a) he can argue that the fair market value of his property is overstated, or (b) he can argue that his property is valued higher than other similar properties even if his own valuation is below its fair market value.

Each year the Assessor sends the property owner a postcard setting forth two values for his property--(1) the full cash value and (2) the limited value. The postcard also indicates the deadline for appealing the value. Appeals can be pursued by the property owner himself, his attorney, or a property tax appeal service; however, professional help of some sort is usually worth the price. Appeals frequently result in reduced valuations, so don't be hesitant to consider an appeal if you believe that your property is overvalued.

The full cash value is the full value of the property as determined by the appraiser. This is supposed to be the actual value of the property. The limited value is the value at which your property will actually be taxed. The limited value can never exceed the full cash value, but they can be the same and often are.

The purpose of the limited value is to keep the taxable value of the property from increasing too fast. Whenever the value of your property increases, the limited value will limit the increase in any given year to the greater of (a) 10% over the previous year's taxable value, or (b) 25% of the difference between the previous year's limited value and the current year's full cash value. The result is to slow down the rise in property taxes for property owners who have property that is increasing in value so that they will have time to adjust to the higher level of taxation.

There are a number of things that can cause the protection furnished by the limited value to disappear--that is, to cause the property to be taxed at its full cash value, regardless of the limited value. They are:

(a) A change in use; for example, conversion of a house to a commercial office.

(b) Modification of the property by construction, destruction or demolition.

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(c) A split, subdivision, or consolidation of the property.

Therefore, if you own property which has a limited cash value substantially below its full cash value, be careful of unnecessarily taking any of the above actions, because they could result in a dramatic increase in your property taxes. For example, selling off a small piece of a much larger tract could cause the whole tract to be stepped up to its full cash value for tax purposes. Many people have been inadvertently caught in this trap over the years because they weren't aware of the tax consequences of their actions.

Assessment. There is another interesting feature to Arizona's tax system--the assessment ratio. Each type of property has its own assessment ratio, which is expressed as a percentage. The more common classifications are:

(a) Commercial and most industrial--25%.

(b) Agricultural and vacant land--16%.

(c) Residential, including apartments--10%.

(d) Non-commercial historic property--1%.

This means that residential property is taxed at only 10% of its full cash or limited value (whichever is lower), agricultural is taxed at only 16%, and so on, depending on the use of the property. As a result, a million dollar residential property will be taxed as though it's worth only $100,000.00 (or $10,000.00, if it qualifies as historic property). To determine the dollar amount of the tax on any given parcel of property, you would multiply the tax rate by the valuation (the lower of full cash or limited) by the assessment ratio.

Clearly, if you believe you have a historic property it will pay to look into qualifying your property for the historic building category, since this could reduce your taxes by up to 90%.

There are also certain classes of property that are exempt from the property tax, consisting mainly of charitable, religious, and governmental properties.

The tax rate itself is set by various governing bodies and is comprised of a number of levies for state, county, school district, bonds, and so on, and changes each year.

Payment. Property taxes are assessed annually and are payable in two installments. The installment for the first half of the calendar year is due October 1 and is delinquent November 1, and the installment for the second half is due March 1 of the following calendar year and is delinquent May 1. There is no reason to pay the taxes prior to delinquency.

If the taxes are not paid on or before the date they become delinquent, a tax certificate is sold at public auction. The certificate bears interest at the rate established by auction, but no more than 16% per annum. This means that past due taxes bear interest at a rate established when the certificate is sold, and which may vary from property to property and year to year. After the taxes have been delinquent three years, the purchaser of the certificate can commence an action to foreclose on the property.

Conclusion. It is the property owner's responsibility to see that his taxes are paid. If you haven't received a tax bill within the last year, contact the Assessor's office to make sure they have your correct address and that your taxes are current. When you get your notice of valuation (the postcard), review it carefully and file a timely appeal if your valuation appears to be too high.

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Before you split, subdivide, change the use or engage in new construction or demolition of your property, carefully review your property tax situation to determine whether the contemplated action will cause an increase in your taxes so that you don't get hit with an unfortunate and expensive surprise.

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MEMORANDUM #802 Assessments

If you invest in real property, sooner or later you'll probably receive notice that an improvement district is being formed which will result in a special assessment against your property.

Special assessment districts are normally formed to pay for such things as roads, sewers, sidewalks, water service, street lights, and other municipal improvements. According to the law, however, these things can be paid for by special assessments only if the particular improvement is of "special benefit" to the properties in the district. If the improvement is of "general benefit" to the residents of the city, it should be paid for by general taxes, not a special levy on those within the district.

An example of an improvement that is properly paid for by a special assessment is lighting along a residential street. The lighting is clearly of primary benefit to those who own property in the area, and the cost of the improvement can be legally assessed against those property owners.

An example of an improvement that is not properly financed through an improvement district is a sewer plant that serves the entire city. Since it benefits the residents of the city in general, it is not proper to charge its cost to any particular group of property owners.

Some improvements furnish both a general and a local benefit--for example, the opening of a major roadway, which serves the needs of both adjoining property owners and those passing through to other destinations. In this case, the law requires the city to apportion the cost between the local property owners and the population at large, based on the amount of benefit received by each. It is the policy of the City of Phoenix, for example, to allocate at least 50% of the cost of any street to the general fund on the theory that all streets benefit both the local property owners and the city at large.

Special assessments can be levied in a lump sum, but are more frequently payable over a longer period, usually ten years. The assessment is not the personal obligation of the property owner--it is simply a lien against the property, meaning that if it is not paid, the city can sell the property to pay the assessment. Nevertheless, the assessments are usually only a small fraction of the value of the property, and since they are prior to consensual liens, such as mortgages, the effect is that the property owner is forced to pay the assessment.

Before an assessment can be levied, the law requires the city to publish notices in a local newspaper and to post notices at 300 foot intervals along the line of the proposed improvement. If you see such a notice in the vicinity of your property, it is important to read it closely in order to determine whether you wish to oppose the assessment.

How To Fight A Special Assessment. When you receive notice that a special assessment is about to be levied upon your property, you have five possible avenues of attack if you want to oppose it:

1. You may file an objection to the amount of property included within the district. In most cases you would either object to the inclusion of your property within the district, or argue that more property should be included along with your property in order to spread the assessment among more owners. The objection must be filed with the city clerk within fifteen days of the last publication or posting of notice of the formation of the district. The objection, if proper, will be heard and ruled upon by the city council.

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You should appear at the council meeting and present your case. It is also proper to contact your council representative prior to the meeting to explain your concerns.

2. If you can gather the support of the owners of a majority of the frontage of the property within the district, you can file a protest against the proposed improvement. The protest is a legal document which must be done properly so that it meets all statutory requirements, and it must be filed within fifteen days of the last publication or posting. However, if properly and timely filed, the protest will automatically terminate the formation of the district for a period of six months, after which the city or interested property owners may try again if they choose. However, having been stopped once, it is unlikely that the proponents will try again until they are sure they have sufficient supporters to be able to proceed.

3. You can challenge the assessment in court, by claiming that the particular improvement is of city-wide benefit and is not properly chargeable to a local district. Although these challenges have succeeded, the courts are reluctant to upset the city's determination if there is any reasonable justification for the city's position. In other words, it is possible to prevail with this sort of challenge, but only if the case is clear.

4. You can challenge the way the assessment was allocated among the various property owners in the district. This also requires a court action. The law requires the assessments to be allocated among the property owners in accordance with the benefit they receive from the improvements. In the case of local street improvements, the assessments are generally allocated in accordance with street frontage, and this is very difficult to challenge. In the case of sewer or other projects, cities have come up with a number of other methods of allocating assessments, nearly all of which have been upheld if there is any basis for the allocation. Among the factors that have been considered are size, street frontage, number of permissible residential units, and zoning. So although this is a possible method of attack, it is one that should be undertaken cautiously because it is also one on which it is very difficult to succeed.

5. You can challenge the legality of the whole procedure if you can discover some way in which the city failed to follow the statutory procedures--for example, by failing to give proper notice of the formation of the district. Unfortunately, in most cases this will only result in the city starting over again in order to do it properly, so it is probably not a permanent solution.

How To Form A District. In some cases, a property owner doesn't want to fight the formation of a district--he wants to see one formed in order to provide for the installation of improvements that will increase the value or utility of his property. There is no procedure set forth in the law allowing a property owner or a group of property owners to form a special assessment district on their own. However, property owners interested in forming a district should contact the city staff, who will generally start the procedure to form the district, but oftentimes only if the interested property owners first gather petitions favoring the district from the owners of more than half of the frontage owners, so that the city knows it will not be facing a valid protest. In the case of the City of Phoenix, owners of at least 60% of the frontage must sign a preliminary petition before the city will proceed. Other municipalities have other policies.

Conclusion. The assessment district statutes provide a useful and workable means to finance improvements of benefit to local property owners, often with the city paying a portion of the cost. In some cases, however, a property owner may oppose the particular improvement for any

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of a number of reasons. If that is the case, the most successful avenue of attack is generally to collect protests from the owners of more than 50% of the frontage. However, in the case of major assessments, particularly if they involve improvements which will benefit the community in general more than the local property owners, it may be possible to use litigation or the threat of litigation to force the city to reallocate a larger share (or all) of the costs to the city's general fund and away from the local property owners.

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MEMORANDUM #803 Back Taxes

Every owner of real property has to pay property taxes. There are a few exceptions, of course. For example, the property of governmental units, schools, charities, churches, and certain other non-profit organizations is exempt from taxation so long as it is not used for profit-making purposes. Some states also have limited exemptions for indigent widows, orphans, veterans and the like. But in general, if you own real property you can expect to pay an annual property tax.

Lack of Notice. What happens if you don't receive your tax bill for one or more years, and the back taxes begin to pile up? After a few years the bill can become huge especially when interest and penalties are added in.

This unfortunate state of affairs seems to occur with some regularity. Usually it is because the tax bill is sent to the wrong address. The property owner may move and forget to tell the assessor, which often happens. The tax bill may be sent to a lender who pays the taxes out of an impound account - but after the loan is paid off the lender may fail to tell the assessor, and the tax bill continues to be sent to the lender who just ignores it. Sometimes the treasurer just makes a mistake in transcribing his mailing list. Whatever the cause, you can be blissfully unaware of the taxes piling up until it's too late. Believe it or not, it's actually possible to lose your property to taxes without ever having received actual notice.

Is This Constitutional? You might ask how a property owner can be stuck with interest and penalties or lose his property if he never received a tax bill. That's a good question. Both the Federal and Arizona Constitutions provide that property may not be taken without "due process of law." The first requirement of due process is notice. One can hardly be said to have received due process if he is never notified of a pending procedure to take his property. On the other hand, the government must have dependable tax revenues to operate, and one should not be able to avoid taxes by failing to tell the county treasurer where he lives.

To resolve this problem the courts have developed a flexible standard for determining when adequate notice has been given. In criminal cases, where a person's life or liberty may be in jeopardy, actual notice is nearly always required, usually by arresting the person and bringing him before a judge. In a civil suit, the requirements for adequate notice are also strict, usually requiring personal service, but in certain circumstances "constructive notice" may be allowed. This might consist of publication in a newspaper if the party cannot be found and served. However, in the case of a tax levy, the requirements are generally much more lax. As long as the taxing authority provides for some kind of reasonable notice and an opportunity to be heard, it is likely to be considered adequate.

Statutes. Most states have statutes providing for something less than actual notice when it comes to taxes. Typically, the statutes will provide for publication in a newspaper for several weeks, together with mailed notice to the taxpayer's last known address. It is up to the taxpayer to keep the treasurer informed of his current address and to make sure his taxes are paid when due.

In Arizona, the statutes say that notice of taxes shall be published once a week for four consecutive weeks in a newspaper, and that "no other demand for taxes is necessary." Of course, the county treasurer sends you a tax bill, but it is not a legal requirement.

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If your taxes are not paid, the treasurer is required by law to send you a notice of the delinquency by September 1 of the following year, to your "last known address." There is no requirement that you actually receive it, or that this address be your correct current address. The same sort of notice is required when the tax lien on your property goes up for sale. Additional notices are required if the tax lien is foreclosed, including publication, mailing, and posting of the property; however, actual notice to the property owner is never required, as long as the treasurer does the things required by statute.

Mortgage Holders. Mortgage lenders often require the tax bill to be sent to them so that they can insure that the taxes are paid. Unfortunately, many lenders fall into the habit of ignoring the tax bills after the loan as been paid off, not bothering to notify either the county treasurer or the borrower. This allows the tax bills to pile up if the property owner doesn't realize he hasn't been receiving his tax bills. To cure this situation, the Arizona legislature passed a statute several years ago providing that:

1. The county treasurer must send a copy of the tax bill to the owner at his last known address, even if the lender is paying the taxes.

2. When the loan has been paid off, the lender must either return the tax bill to the treasurer with the borrower's last known address or forward it to the borrower, notifying the treasurer it is doing so.

3. If the lender fails to comply with (b), it is responsible to the owner for all resulting interest and penalties.

This statute does not excuse anyone from taxes, penalties or interest, but at least it provides the property owner with a source for reimbursement of interest and penalties where the lender has failed to give the required notice.

Conclusion. If you are a property owner, make sure you know the status of the taxes against your property, and check up on it every year or so, even if your lender is paying your taxes through an impound account. This is especially true if you own multiple properties, because it is easy for one property to slip by unnoticed. Do not assume that everything is all right just because you haven't received a notice that taxes are past due. And if you change your address, be sure to notify the assessor. Remember, it is the property owner's responsibility to make sure his taxes are paid.

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MEMORANDUM #901 Water Service

In Arizona, an arid state, water is obviously critical to the development of real property. Normally, potable water is obtained in one of three ways—from the city, from a private water company, or from a well.

City Service. For property located within the city limits, the usual choice is city water. This raises the question of whether the city is obligated to provide water to all land within its borders, and if so, at what price and on what terms.

As a general rule, a city is not required to extend water service to new unserved areas, even if those areas are within the city limits. The decision to extend or not extend its service area is a decision that a city may make in its discretion based on the cost of extending its lines, the availability of water supplies, the existence of adequate treatment facilities, and other relevant factors. In addition, the city may impose reasonable line extension charges and other fees as a condition of extending service to a new area.

However, where a property is located in a zone that is already served by city water lines, the city cannot arbitrarily refuse to provide service to a particular property.

Municipalities are not subject to regulation by the Arizona Corporation Commission, as are private water companies. The Corporation Commission has the power to grant franchises to private water companies, to require them to serve properties within their franchised areas, and to regulate the rates that can be charged. Because water service is a natural monopoly which is critical to the owners of property, and because of the lack of regulation of city-owned water companies, the courts have stepped in to impose certain duties on cities and towns when they undertake to provide water service. Although municipalities still have considerable freedom in the operation of their water systems, they cannot arbitrarily cease providing water service to those who are receiving it and must act in a reasonable and non-discriminatory manner in setting rates and charges for service.

Municipalities are not required to serve property located outside the city limits, but may do so if they choose. However, once a municipality begins to serve property outside city limits, it cannot cease such service.

If the municipality agrees to supply water to County residents pursuant to a negotiated contract, it can charge whatever is provided for in the contract. However, if there is no contract (as, for example, when a city takes over a private water company which services County residents), the charges for water must be reasonable. They may be higher than the municipality charges its residents, but still, they must be reasonable. For example, the courts have said that a city may provide water to its residents at cost, but may make a reasonable profit on service outside its boundaries.

If the city undertakes to serve property outside its boundaries which is located in another municipality, there is a statute which limits what the city can charge the owners of that property for water service. According to the statute, the rate must be either the same rate charged to its own residents, the rate charged by the other city to its residents, the rate charged by a private water company in the other city, or the rate agreed to by both cities based on a cost study. The statute contains an exemption for surcharges adopted before July 1, 1986, so long as the surcharge does not exceed thirty percent of the rate charged by the city to its own residents.

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Private Water Companies. In areas served by a private water company, service is governed by rules, regulations, and decisions of the Arizona Corporation Commission. Normally, a private water company must provide service to all property located within its franchise area. However, private water companies are allowed to require those seeking service in new areas to advance the funds needed for line extensions or other facilities necessary to provide the water. These deposits are usually refundable in whole or in part over the following ten years based on the amount of water that is purchased by the customer at the rate of 10% of the annual billings from that customer.

Wells. In some cases, property may be served by a private well. However, sufficient water is often not available or is located too far below ground to be economically feasible to pump. Sinking a well may also be too expensive to justify service to a single property. Wells serving multiple properties can present operational and maintenance problems, and at some point may come under regulation by the Corporation Commission as a de facto public utility. In addition, there are limits on the amount of water that can be legally pumped from a well in many areas. It is rarely feasible for a subdivision or other large development to rely on private wells.

Conclusion. Water service is critical to property purchased for development. Always thoroughly investigate the availability and cost of water service when purchasing property. Do not assume that because the property is in a city that water will automatically be available.

__________________ See Jung v. City of Phoenix, 160 Ariz. 38, 770 P.2d 342 (1989); Town of Wickenburg v. Sabin, 68 Ariz. 75, 200 P.2d 342 (1948); A.R.S. Sec. 9-511, -511.01, and -516.

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MEMORANDUM #1001 Downzoning

Downzoning is the rezoning of land--normally over the objection of the landowner--to a less intensive use. For example, commercial land may be rezoned for residential use, or residential land may be rezoned to a less dense residential category. The usual result is that the land is worth a lot less after downzoning than it was before.

Many of those in the real estate industry seem to believe that the government does not have the power to downzone property. "They can't do this--it's unconstitutional," is the reaction often heard by the real estate lawyer when his client first learns of a pending downzoning. Unfortunately, however, downzoning is perfectly legal, within certain limits.

As Arizona cities and towns continue to revise and update their general and specific plans, and as local and neighborhood groups become more powerful, the amount of downzoning undoubtedly will continue to increase. It is therefore important for all landowners to know the basic rules governing downzoning and what avenues they have available to protect existing zoning.

Constitutional Limitation. As mentioned above, there are certain limitations on downzoning. The first limitation is the constitutional prohibition against taking private property without just compensation. This has been interpreted as meaning that property cannot be rezoned to a category which leaves it with no reasonable economic use. Such a rezoning amounts to a condemnation or "taking" by the jurisdiction, and must either be set aside or the jurisdiction must purchase the property for its fair market value. For example, residentially zoned land could not be rezoned exclusively for parks or open space without compensating the landowner for the value of his land. This limitation, however, rarely applies, and if the land is left with almost any practical use, the courts will hold that it is not a condemnation.

Existing Uses. The second limitation is that rezoning cannot be used to terminate an existing use; that is, a use which commenced prior to the rezoning of the property and which continued to the date of rezoning. Under such circumstances, the zoning is said to be "vested." For example, a city cannot terminate an existing retail nursery business by rezoning the land on which it is located for strictly residential uses. It is critical, however, that the use be an established existing use. It normally is not sufficient if the property merely has been purchased with the intention of using it for a particular purpose.

How to Protect Yourself. How does a landowner protect his zoning in the face of a threatened downzoning? The first step is to keep informed of any pending revisions to the general plan or the formulation of specific plans covering the property. The landowner should appear at any hearings for such plans and explain why the zoning on his property should not be changed. This is very important, because if the landowner fails to appear, he will likely be told in later rezoning hearings that the city is merely carrying out the provisions of the plan, and that the landowner should have made his objection known when the plan was being adopted.

After the plan has been adopted, it is generally more difficult to successfully oppose the rezoning. However, it is usually worth a try, both by appearing at any planning commission and council hearings and by lobbying elected representatives. In addition, the landowner can usually file a protest requiring a three-quarter vote to approve the rezoning.

The landowner might also try to protect his zoning by taking action to "vest" the zoning, which is another way of saying that he must commence the use of the property pursuant to the higher

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zoning category. The question then becomes, what is sufficient to vest zoning as an existing use?

The Arizona courts have held that it is possible to vest the zoning, and thus avoid the downzoning, by making substantial expenditures toward the development of the property in accordance with its existing zoning, even if the actual use of the property has not begun. For example, starting construction of an apartment building is likely to vest apartment zoning, even though no apartments have yet been rented. Spending money for the purchase of the property itself, however, is not a qualified expenditure, even if the price paid by the landowner reflects the higher zoning category. There have been local cases where commercial property was downzoned to residential within months of its purchase at commercial prices. The loss to the landowner can be enormous in such cases.

One Arizona case has held that the expenditure of several hundred thousand dollars for architectural fees, feasibility studies, building permits, and clearing of land, all pursuant to a special use permit for the intended construction, is sufficient to vest the zoning. On the other hand, there is also authority indicating that construction must actually have been commenced pursuant to a valid building permit before the zoning is vested. It is thought by some that site preparation and the construction of footings is the minimum amount required to vest zoning, although the cases in this area are somewhat inconsistent and unclear.

The Arizona courts have indicated that a city may not refuse to issue a building permit because of the pending downzoning proceedings. Therefore, a landowner faced with threatened downzoning should, if he is financially able to do so, consider protecting his zoning by immediately obtaining a building permit and commencing construction of his intended development. While the law is not clear enough for one to know whether such actions, particularly in the face of a pending downzoning, will furnish absolute protection, in most cases the potential loss from the downzoning is large enough to make the attempt worthwhile.

Conclusion. Although downzoning is not automatically unconstitutional, there are a number of steps a landowner can take to protect existing zoning. The chances of success are highest if the landowner keeps himself informed of the city's plans for his property and takes action at the earliest possible time.

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MEMORANDUM #1002 Legal Challenges to Zoning and Land Use Restrictions

Can the government rezone your property over your objection? And if it does, can you make the government pay for it?

These questions are often in the background of public discussions of various city zoning actions designed to preserve "amenities," "open space," "lifestyle," and "neighborhoods." Threats of legal action are common, and the rhetoric often escalates. To better understand the legal basis of these discussions, let's take a look at the legal reality--by that, I mean the law as it actually exists today.

Legal Challenges. Any time property is rezoned over the owner's objection, the action is subject to three distinct legal challenges: First, it may be challenged as an invalid exercise of the police power. Second, it may be challenged as an unconstitutional taking of private property. Third, it may be challenged on the grounds that the existing zoning has become vested. Often, these three issues--although distinct legally--are described in the public debate simply as a matter of "property rights."

In what is probably the most typical case, the government will rezone raw land to a less valuable use. For instance, a city may rezone commercial land to residential, or multi-family to single family, often to implement its general land use plan. In other cases, the city may change the zoning on developed land to preserve an existing use. For instance, property used as a golf course may be rezoned from residential (which permits golf courses and other uses) to a category that allows the property to be used only as a golf course. This prevents redevelopment and presumably insures that the property will continue to be used as a golf course.

Police Power. The zoning of property--or the changing of existing zoning--is an exercise of the police power. This is the power possessed by legislative bodies to adopt laws and regulations governing the actions of its citizens. Any exercise of the police power restricts the actions of certain people, and sometimes causes an economic loss. This loss to certain individuals is said to be justified because of the benefit to the community in general. The truth is that without a police power, civilization could scarcely exist.

The courts will rarely invalidate a zoning ordinance on grounds that it is an invalid exercise of the police power. In order to do so, they must find that the law or ordinance is not reasonably designed to promote the public health, safety, morals, or general welfare. In making this determination, the courts give great deference to the legislative bodies, and will rarely second-guess their actions unless it is clear that no legitimate public purpose is advanced by the law or ordinance. The courts have often held that zoning intended to enhance the "quality of life" or to promote "spiritual, physical, aesthetic, or monetary values" is a valid exercise of the police power. Nevertheless, one Arizona case has held that a total ban on building in mountainous areas for aesthetic purposes alone is not a valid exercise of the police power. In general, however, it is usually extremely difficult, perhaps next to impossible, to challenge a zoning case on the grounds that it is an invalid exercise of the police power.

Unconstitutional Taking. Both the Federal and the Arizona Constitutions provide that private property cannot be taken for a public use without just compensation. The question thus becomes, when does rezoning amount to a "taking" of property?

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The famous Supreme Court Justice Oliver Wendell Holmes set forth the often-quoted (but rarely helpful) general rule in a zoning case decided in 1915, when he wrote:

"Government could hardly go on if to some extent values incident to property could not be diminished without paying for every such change in the general law.... But...the implied limitation must have its limits.... When it reaches a certain magnitude, in most if not all cases there must be an exercise of eminent domain and compensation."

In the years since that decision, the courts have gradually developed a body of law to determine the limits of the zoning power. If a zoning ordinance goes "too far," the law requires compensation for the property owner. Contrary to the popular opinion, zoning does not go too far simply because it causes a loss of economic value, even if it is a very substantial loss. Thus, commercial property can be rezoned to low density residential, regardless of the fact that the property owner may suffer a huge financial loss. Similarly, under existing law property being operated as a proprietary golf course may be rezoned in a manner that will permit only that use.

Zoning goes too far--and amounts to a confiscation of private property that must be paid for--only when the zoning precludes any reasonable use. This means that property cannot be rezoned as open space, or as a public park, or as a protected wetland, unless the government is willing to pay the owner the fair market value of the property.

Sometimes a city will grant a property owner a "density transfer" in connection with the rezoning of his property. Scottsdale did this a number of years ago when it rezoned the McDowell Mountains to prohibit development, but gave the property owner increased density on some other adjacent property. Recently, the City of Phoenix did the same thing when it rezoned the Biltmore Golf Course from residential to golf course and also gave the owner high-density residential zoning on a portion of the property. The court in the Scottsdale case held that this was not sufficient, even if the value of the density transfer was equal to the value lost because of the rezoning. The Constitution requires that condemned property be paid for in cash, not development rights or density transfers.

Vesting. The third challenge a property owner may mount against a rezoning is to claim that his existing zoning has "vested." This is not a constitutional argument at all--it is merely an issue of estoppel. It is based on the theory that at some point, after a property owner has acted in reliance on existing zoning, he is entitled to prevent the government from changing it. It is a principle based on fairness and equity, not constitutional requirements.

This issue is treated somewhat differently in different states. However, in Arizona and most other states, zoning is not considered vested until the property owner has (1) obtained a valid building or similar permit for his intended development, and (2) has undertaken substantial physical construction on the site or has incurred substantial expenditures in preparation for construction. The determining factor is the activity that has actually occurred at the time of the rezoning, not the owner's plans for the future. Clearly, the mere purchase of a parcel of property, even if the purchase price reflects the value of the current zoning, is not enough to vest zoning and prevent it from being changed.

Conclusion. In all but the rarest of cases, it is impossible to mount a successful legal challenge to a rezoning. To rezone or not to rezone is primarily a political issue. High profile zoning cases are fought out among those with vested interests ostensibly based on arguments of private

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fairness and public good. The reality is that they are often decided by elected officials not unmindful of the political consequences of their decisions.

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MEMORANDUM #1003 Limits on Local Ordinances

A recent decision by the Arizona Supreme Court has set down some limits on the zoning powers of town and city governments that could have far-reaching effects. The case is known as the Jachimek case.

In the Jachimek case, the Supreme Court voided a City of Phoenix zoning ordinance that required use permits for liquor stores, bars, pawn shops, blood banks, boarding houses, and certain other uses, but only if located in a certain area near downtown Phoenix descriptively known as the "Inebriate District." If located elsewhere, no use permit was required.

Basis for the Decision. First, the reason for the Court's decision.

The Court began its discussion by stating that Arizona cities and towns have no inherent zoning authority. Any power they have to zone property must be specifically granted to them by the State of Arizona, and may be exercised only in the manner dictated by the State in its enabling legislation. The Court then observed that although Arizona's cities and towns have been given certain specified zoning powers, these powers are limited by a requirement that all zoning regulations must be uniform throughout any given zone.

The Inebriate District flunked the "uniformity" test because liquor stores, pawn shops, and the other specified uses could be conducted on property zoned C-2 without a use permit everywhere in the city except in the Inebriate District. In the Inebriate District, a use permit was required, even though the underlying C-2 zoning was the same.

The Court, therefore, held that because a use permit was required only in the Inebriate District, the regulations were not uniform as to all property zoned C-2 and were void.

The Consequences. The Court decided only that the City of Phoenix "Inebriate District" zoning regulation was void. But the City of Phoenix (and other cities as well) have other "overlay" districts that treat property with the same basic zoning differently. For example, the City of Phoenix has Residential In-Fill, High-Rise, High-Rise Incentive, Mid-Rise, Historic Preservation, and Hillside Districts, all of which place different regulations on property within the same underlying zoning classification. This raises the question of whether these districts, like the Inebriate District, are vulnerable to legal challenge.

The answer is that some probably are and some probably aren't.

Arizona statutes do specifically grant towns and cities the power to set up certain special zoning districts, including:

(a) Floodplain districts.

(b) Historical preservation districts.

(c) Districts with adverse topography or soil or water problems, which presumably includes hillsides.

(d) Age specific districts (designed for retirement communities.)

Since regulations dealing with these matters are specifically authorized by state law, they are probably valid, even though they create a problem with "uniformity." However, other types of

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overlay districts, such as high-rise and residential in-fill, are not specifically authorized and could be in jeopardy.

Conclusion. The ultimate consequences of the Jachimek decision are as yet unknown. They may be minimal, or they may be far-reaching. The various overlay zoning districts are presumed valid until someone brings a lawsuit to challenge them, and this may or may not occur with respect to any given district. If it does occur, no one can be certain how the courts will rule. It is also possible that the cities may attempt to head off any future challenges by lobbying for a change in the State statutes to obtain specific authorization for such overlay districts. In any event, those owning, purchasing, or lending on properties subject to a zoning overlay district should be aware of the Jachimek decision and its potential for leading to the invalidation of some or all of these districts.

__________________ Jachimek et al. v. Superior Court, CV-91-0373-AP (Opinion Filed November 7, 1991).

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MEMORANDUM #1004 Damages for "Takings"

We all know that governmental laws and regulations can interfere with the free use of private property. In many cases, they can also detract from its value. For example, if the city rezones a parcel of property from commercial to residential, it not only restricts the ability of the owner to use the property for certain purposes, in most cases it also reduces the value of the property.

Does the government have to compensate you when it passes a regulation that lowers the value of your property? What if the regulation makes the property virtually worthless? These are fascinating questions that American courts have been wrestling with for more than a hundred years. The answers are still being developed.

Recent Developments. In recent years there have been a number of cases decided by the United States Supreme Court that seem to strengthen the claims of property owners to compensation when government regulations hurt the value of their property.

This string of cases started with Nollan v. California Coastal Commission. In this 1987 case the Supreme Court held that a homeowner could not be required to dedicate a public access easement across his property to the beach as a condition of tearing down and rebuilding his house. The Court said that if the Coastal Commission wanted a public easement to the beach, it would have to pay for it.

The Nollan case was followed in 1992 by the celebrated case of Lucas v. South Carolina Coastal Council. In this case the South Carolina Coastal Council passed regulations requiring a beachfront landowner to leave his property, for which he had paid almost a million dollars, in an undisturbed and natural condition. The Supreme Court held that this was the equivalent of condemning the property and that the Coastal Council would have to purchase the property from the owner at its fair market value because of this regulation.

The third case in the string was Dolan v. City of Tigard, where the city told a property owner who wished to expand his store that he would have to dedicate a green belt and pathway along an adjacent creek. The Supreme Court said this was not a permissible requirement, because the dedication was not related to the expansion of the store. It was just an example of the city using its power to withhold a building permit as a lever to force someone to dedicate property for the general benefit of the public.

These cases have led many to believe that a new era has dawned in the protection of private property rights, led by the United States Supreme Court. The truth is that while these cases represent a change in emphasis, they really do not signal a complete change in direction, even though the property owner won and the government lost each of the cases.

An Example. One shocking example will illustrate the point.

In 1971 a local developer built a high rise building in central Phoenix and leased it to a single user on a long term lease. The developer was required by the city to spray the structural portions of the building with an asbestos-containing material for fire control purposes. Sixteen years later the city adopted an ordinance requiring all high rise buildings to install sprinkler systems. In order to retrofit the building with a sprinkler system, thereby disturbing the asbestos, it would have been necessary to remove the asbestos at a cost that rendered the building economically valueless, given the existing lease. Left undisturbed, the asbestos was not dangerous and would not have to be removed.

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The developer introduced evidence that this regulation, if enforced, would render the building valueless, and therefore was a complete taking, just like the Lucas case. The Arizona Court of Appeals did not agree.

The Court said that requiring money to be spent to comply with a safety regulation is not an unconstitutional taking of property, even if the amount of money exceeded the value of the property. The Court said that a property owner "has no property right to be exempt from fire safety laws."

Where Are We Now? What do these cases mean to the property owner? Although these cases may seem inconsistent, it is possible to distill from them several general principles of law.

First, compensation normally must be paid if there is a physical taking or invasion of the land, such as requiring an easement across private property. This is what happened in the Nollan case.

Second, there is an exception to the first rule if the taking is related to and required to mitigate the actions by the landowner; for example, a landowner can be required to dedicate a street right-of-way if the development of his property can be expected to add to the traffic in the area.

Third, any land use regulation which directly prohibits the landowner from doing anything of economic value with his property amounts to a taking. This is what happened in the Lucas case, where the Coastal Council told the landowner he had to leave his land in a natural state.

Fourth, regulations to protect the public health and safety are generally not takings, even if compliance with them costs more than the affected property is worth. This is why the requirement that the developer of the high rise building had to install fire sprinklers was valid, even though the regulation had the practical effect of rendering the building a total loss.

Conclusion. In short, although the Constitution offers protection against physical takings and against regulations which completely prohibit any use of your property, the government still has plenty of latitude in enacting regulations that can affect, or even completely destroy, the value of your property.

__________________ The cases cited above are Nollan v. California Coastal Commission, 438 U.S. 825, 97 L.Ed. 2d 677, 107 S.Ct. 3141 (1987); Lucas v. South Carolina Coastal Council, 112 S.Ct. 2886, 505 U.S. 1003, 120 L.Ed. 2d 798 (1992); Dolan v. City of Tigard, 512 U.S. 374, 114 S.Ct. 2309, 129 L.Ed. 2d 304 (1994); and Third & Catalina Associates v. City of Phoenix, 895 P.2d 115, 182 Ariz. 203 (1994).

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MEMORANDUM #1005 Right to Sue For Zoning Decision

It happens all the time. A property owner fails to get the zoning he wants, or gets zoning he doesn't want. He immediately turns to his lawyer and says, "Can we sue?"

Failure to Get Zoning. First, let's look at the case where the owner applies for zoning and doesn't get it. In a recent actual case, the property owner applied to change his zoning from light industrial to general industrial. The change was consistent with the general plan. The property was bordered on two sides by light industrial and on two sides by general industrial. The planning staff recommended approval. The planning and zoning commission unanimously recommended approval. No one objected. In spite of all this, the County Board by Supervisors denied the change without apparent reason.

The property owner sued and won. The trial court ordered the Board of Supervisors to grant the requested zoning. In ordering the change in zoning, the trial court said the Board's decision was arbitrary, and that there was not even a "fairly debatable" issue as to whether the zoning was proper.

It was a short-lived victory, however.

The County appealed and won. In reversing the trial court, the appeals court said that the courts had no power to order zoning changes. Zoning is a legislative function, not a judicial one. The courts cannot act as a "super zoning commission." Under the doctrine of separation of powers, the courts cannot order a legislative body to grant new zoning, no matter how compelling the case.

Unwanted Zoning. The rules are different when the government imposes unwanted zoning on someone's property. In this situation, the zoning is subject to challenge in the courts.

However, it's not easy. The owner normally must show that the zoning leaves the property without any reasonable use. It is not enough to show that the property owner suffered a large financial loss from the rezoning, or that the new zoning is inappropriate or unwise. He must go further and show that the property has been rendered practically useless. If he can do this, he can force the government to either set aside the new zoning and replace it with the prior zoning, or to purchase the property for its fair market value.

Conclusion. If the government denies your request for new zoning, you are out of luck. The courts cannot help you. However, if the government puts new zoning on your property that leaves it without any reasonable use, you may have a chance to get the zoning overturned in court--but even then it won't be easy. It is always an uphill battle to challenge zoning in courts, but usually worth the fight if the value of your property has been destroyed.

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MEMORANDUM #1006 Required Street Dedications

It is not unusual for a city (or county) to grant zoning subject to the dedication of a street right-of-way. For example, a city may approve a rezoning request on the condition that the owner dedicate another twelve feet of right-of-way along the front of his property so that the existing street can be widened by an additional lane. Sometimes the property owner is also required to pave the street or put in sidewalks, curbs and gutters in order to get zoning.

Obviously, if the city wanted to widen the street in the absence of a zoning application, it would have to purchase the street for its fair market value and pay to have it improved. But because the owner wants rezoning, the city may attempt to use its leverage to get the street widened and paved for free.

Is This Legal? Some people say this sounds a lot like extortion. If zoning is appropriate, shouldn't it be granted without requiring dedications or street improvements?

Is this legal? The answer is yes--within limits.

As a general rule, two tests must be met. First, there must be a logical connection between the use allowed by the new zoning and the dedication. Second, the dedication or improvement must be "roughly proportional" to the burden created by the new use. Let's look at these two tests.

Connection. The law says there must be an "essential nexus" (a logical connection) between the new use and the "exaction" (the required dedication or improvement). This means that the dedication must logically eliminate or reduce the problem created by the new use. In one famous Supreme Court case, a city argued that because a new beach house would block the public's view of the ocean, the homeowner could not build unless he dedicated a path from one side of his property to the other along the beachfront. The Court held that this exaction was not legal because the dedication of the pathway along the beach didn't do anything to improve the view of the ocean for those whose view was blocked. It did make it possible for people to walk along the beach, a worthy goal, but it didn't help the problem the government said it was trying to solve. In the words of the Court, there was no "essential nexus" between the problem and the solution. The city was just using its discretionary power to obtain property without paying for it.

In the context of a street dedication, this would mean that if the new zoning didn't do anything to increase traffic, a dedication or street improvement could not be required. An example might be a rezoning from apartments (a high traffic use) to a self-storage warehouse (a very low-traffic use). Since the new use doesn't increase the traffic, the city has no right to require a dedication to widen the street.

Proportionality. The law also requires that there be some "rough proportionality" between the new use and the exaction. For example, the city could not require the dedication and paving of a four-lane highway where there is only a minor increase in the intensity of the use. Most often, this means that the city cannot require a property owner to pave adjacent streets to arterial standards. The additional cost of bringing the street from local up to arterial standards must be paid by the City, because it is cross-town traffic that creates the need for the arterial street, not the local traffic generated by the new use on the property.

This is not an easy test to apply. It is always difficult to know how much new traffic a given use will generate, and how much new roadway will be required to accommodate it. It is not feasible to dedicate 15% of a street, for example, if the new use is expected to cause a 15% increase in

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traffic. In practice, the city usually requires whatever dedications it believes are necessary to satisfy its plans for the particular street, be it a local, collector, or arterial. However, unless the use is a truly major generator of traffic, paving to local street standards is all that will normally be required. If it can be shown that the new use will produce no appreciable increase in traffic, no dedication or paving may be required; but it is usually up to the landowner to raise the issue. In cases where only a minor increase in traffic is expected, it is sometimes possible to work out an arrangement where the landowner contributes some funds to the city for road construction, but isn't required to pay the full cost of improving the roadway.

Other Applications. The principles described above are not limited to rezonings and street dedications. They also apply to building permits, use permits, and other discretionary approvals allowing for an expanded or different use of real property. In addition, they also apply to exactions other than street dedications and improvements--for example, drainageways, pedestrian and bike paths, green belts, and so on. All exactions must satisfy the same two tests before they can be required as a condition of rezoning or some other type of land use approval.

Practical Considerations. As a practical matter, these protections are difficult to realize. If a developer is ready to proceed with his project, he wants to get his zoning as quickly as possible and start construction. He doesn't want to spend months or years in court challenging the exaction. In addition, many developers do not want to alienate the city planning staff by contesting a street dedication. However, in appropriate cases it may be possible to persuade the staff that what they are asking for is not legal or appropriate and convince them to back off their demands. And it's always possible to take them to court if the case is egregious enough.

Conclusion. There is an extensive body of law, consisting or ordinances, statutes, and state and federal court decisions, outlining the extent to which street dedications, improvements and other exactions may be imposed as a condition of rezoning. The government does not have an open-ended right to require whatever it wants. In general, the exaction must be designed to help cure the problem created by the change in land use, and must be roughly proportional to the problem created. Overreaching exactions can sometimes be adequately addressed by negotiation with city officials; but if not, litigation (or the threat of litigation) is the ultimate remedy.

__________________ In Arizona, the governing statutes are A.R.S. §§ 9-462.01 and 11-810 and -811. A leading court decision is Transamerica Title Ins. Co. v. City of Tucson, 23 Ariz. App. 385, 533 P.2d 693 (1975).

The leading U.S. Supreme Court decisions are Nollan v. California Coastal Comm'n, 483 U.S. 825, 107 S.Ct. 3141, 97 L.Ed.2d 677 (1987); and Dolan v. City of Tigard, 512 U.S. 374, 114 S.Ct. 2309, 129 L.Ed.2d 304 (1994).

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MEMORANDUM #1007 Variances

The existence of rules creates the need for exceptions. A variance is an exception to the rules contained in the zoning code. Because the zoning code is rigid and cannot take into consideration the specific attributes of each and every parcel of real property, variances are available to do justice in cases where the strict application of the rules would be unfair or inappropriate.

Variances are normally granted by the Board of Adjustment. However, in some of the larger cites variances are granted by the zoning administrator, with appeals being decided by the Board of Adjustment.

Use Variances. The typical municipal or county zoning ordinance contains thousands of rules, both broad and specific, restricting what can be done with real property. Some of these rules limit the use of the property, depending on the zoning category. For example, some property is zoned for residential uses, other property is zoned for commercial uses, and so on. Exceptions to rules governing the use of the property are referred to as "use variances."

Area Variances. Other parts of the zoning code regulate such things as setbacks, heights, minimum lot sizes, parking requirements, and so on. Exceptions to these rules are referred to as "area variances."

There is a difference of opinion as to whether relief from a density limitation requires a "use variance" or an "area variance." On the one hand, density limitations would appear quite similar to such things as setbacks, height limitations, and lot coverage limitations, all of which are clearly area variances. On the other hand, increasing density is almost the same as changing the zoning to a higher zoning category, because one of the main differences between zoning categories is density.

The distinction between use variances and area variances is important, because Arizona law provides that the Board of Adjustment may grant area variances, but is prohibited from granting use variances.

Requirements For A Variance. Under Arizona law, a variance may be granted where the strict application of the zoning ordinance will deprive the property of the privileges enjoyed by other property with the same zoning because of "special circumstances." These "special circumstances" include such things as the size, shape, topography, or location of the property or its surroundings.

As an example, a variance might be granted reducing the side yard setback if a lot is unusually narrow. This would be a typical area variance.

Self-Imposed Hardship. Variances cannot be granted if the "special condition" is self-imposed. For example, if a property owner sells off part of his lot, he cannot later get a variance from the side yard setback on grounds that the lot is too narrow, because he created the problem himself by selling off part of his lot. However, if the lot is too narrow because the city condemned part of it to widen the street, a variance would be available.

Specific Jurisdictions. Each jurisdiction has its own particular requirements for obtaining a variance, although they all generally follow the criteria described above. In Phoenix, for example, the property owner must meet the following four requirements:

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1. There must be special circumstances or conditions applying to the property which do not apply to other properties in the zoning district.

2. The special circumstances must not have been created by the owner.

3. The variance must be necessary for the preservation and enjoyment of substantial property rights.

4. The variance will not be materially detrimental to the neighborhood or to the public welfare in general.

The specific requirements in other jurisdictions can be determined by checking the applicable zoning code.

Conclusion. If there is something special or unusual about your property which makes it difficult to comply with the existing zoning, you may wish to consider applying for a variance. However, variances are not available to change the use of the property or in cases where the problem was created by the property owner.

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MEMORANDUM #1008 Non-Conforming Uses

The term "non-conforming use" is often used indiscriminately to refer to a zoning violation. This is actually a misuse of the word. In zoning law, a "non-conforming use" is a term of art with a very specific meaning.

Definition. A non-conforming use is a use that was legal when established but which later fails to conform because of a change in the law. This can occur when (a) new zoning is imposed on property which is previously unzoned, (b) the property was rezoned from an old zoning category to a new zoning category, or (c) the zoning category is not changed but the uses allowed in that category are changed. The term is normally not used to describe a run-of-the-mill zoning violation.

A non-conforming use can be legal or illegal, depending on the specifics of the law in the particular jurisdiction. As a general rule, however, a use which was legal when commenced remains legal after a change in the law. For example, suppose a gasoline service station was legally established under county zoning. If the land is later annexed into the city and rezoned for residential purposes, the gasoline station is normally permitted to continue to operate as a legal non-conforming use, even though it is located on land zoned for residential uses, because the use was legal when commenced. Billboards are another frequent non-conforming use because they are usually legal when constructed, but may later become non-conforming because of changes in the law designed to eliminate the perceived visual blight caused by billboards.

Laws allowing the continuation of non-conforming uses are based on ideas of fairness and equity, but they also have a Constitutional underpinning. Terminating an existing land use as a result of a change in the law raises the issue of a "taking" which might require the government to compensate the landowner. The U.S. Constitution, of course, provides that "private property shall not be taken for public use, without just compensation." Closing down an existing business because of a change in the zoning laws is often thought to be such a "taking."

This does not mean the property is completely exempt from the zoning laws, though. There are certain limitations.

Abandonment. The first limitation is that the non-conforming use must be continuous. If the property owner fails to use the property for the non-conforming use for a specified period of time, usually about six to 24 months (depending on the jurisdiction where the property is located), the use is considered abandoned and cannot be reinstituted. In the City of Phoenix, this period is 365 days. Under the Phoenix ordinance, if the use is discontinued for a year it cannot be started again.

Change in Use. Most ordinances provide that one non-conforming use cannot be changed into another non-conforming use. This means that the service station in the above example could not be converted into a bar or a factory.

On the other hand, some limited changes in use may be allowed. In the City of Phoenix, for example, one non-conforming use may be changed into another non-conforming use so long as the new use is "no more deleterious" to nearby properties and a use permit is secured from the City. This might allow a shoe repair shop to be converted into a flower shop, or something similar.

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Expansion. Most jurisdictions impose limits on the amount of expansion a non-conforming use can undertake. In the City of Phoenix, for example, a non-conforming use cannot expand its floor area or the square footage of the lot devoted to the use by more than 50% of what it was when the use became non-conforming.

Conclusion. A non-conforming use is not just an ordinary zoning violation--it is a use which was legal when established but which later fails to conform because of changes in the law. Non-conforming uses are generally legal as long as they operate continuously, are not expanded beyond specified limits, and are not changed into another prohibited use.

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MEMORANDUM #1009 Contracts Not to Oppose Zoning

It is not unusual for a landowner to sell his residential acreage, keeping a corner for future commercial use. Because homeowners frequently object to nearby commercial rezonings, it might seem like a good idea to put a provision in each contract or perhaps in a deed restriction prohibiting the future owners of the residential property from objecting to the future commercial rezoning of the retained property.

Unfortunately, this doesn't work.

Under Arizona law, contracts or deed restrictions limiting a person's right to object to a rezoning, the issuance of a building permit, or any other governmental act affecting real property are against public policy and are unenforceable. The Arizona Legislature feels that every citizen should have the right to appear and be heard when governmental decisions are being made which affect real property, regardless of whether that person has previously agreed to remain silent or to support the action.

Conclusion. Agreements not to object to rezoning are unenforceable. This leaves the developer or landowner with two choices if he wants to protect a potential commercial use on his remaining property. One, he can attempt to get his zoning before selling the surrounding property. Two, he can put a notice in the deed restrictions informing the residential purchasers that the remaining property is intended for future commercial use. The latter approach certainly does not guarantee success and does not keep the neighbors from objecting; however, it does deprive them of the often-heard (and often effective) argument that they had no idea when they bought their homes that commercial uses were planned in the vicinity.

__________________ The statutes referred to above are A.R.S. §§ 32-2181(I) and -2195(I).

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MEMORANDUM #1101 Basic Principles

Property owners often assume they are free to sell off part of their land without obtaining any sort of advance approval. Unfortunately, this assumption is not always correct. There are a number of governmental requirements that can apply when real property is divided into smaller parcels. Some of these requirements are not well known, even among those active in real estate.

In Arizona, selling off part of a parcel of land will usually result in either a subdivision, a resubdivision, or a lot split requiring advance governmental approval, or at least compliance with certain specific laws and ordinances.

Subdivisions. If land is divided into six or more parcels for the purpose of sale, it usually constitutes a "subdivision," as defined by law. The same is true if the property is divided into six or more parcels for the purpose of entering into leases of a year or more. There are a few exceptions--for example, a subdivision is not created when property is divided into parcels of at least 36 acres each, or when agricultural land is leased, or when improved property, such as apartments, offices, and retail space, is leased. In addition, the division of property into six or more large lots of between 36 and 160 acres each does not create a legally-defined subdivision, but does trigger certain requirements similar to those for subdivisions. Only when each parcel exceeds 160 acres are you totally free of subdivision-type requirements.

It is considered a subdivision if two or more persons act in concert to divide a property into six or more lots. For example, if a property owner devises a plan to sell five lots to each of his relatives, and each relative then divides the lots into two more lots for resale, they have created a subdivision under the law because they have acted together to create ten lots out of a single parcel. However, it is not considered a subdivision if property is sold to five different purchasers, each of whom decides, entirely on his own and without any advance plan or understanding, to divide his own parcel into two or more pieces for resale.

If a subdivision is created, certain fairly onerous state and local requirements must be met, which may include the submission of a subdivision report to the State Real Estate Department, proving an adequate water supply, preparing properly engineered plats, installing streets and utilities, and so on. These requirements vary from city to city and county to county, but the more urban areas generally have the more strict and expensive requirements. Lots may be sold only after all of these requirements have been satisfied. As a result, landowners wanting to sell their land in a number of smaller parcels usually are very careful to avoid creating a "subdivision" under the legal definition.

Lot Splits. You might think you are free from governmental requirements if you plan to divide your lot into five or fewer parcels because you're not a "subdivision." Unfortunately, that's not quite true. Although the requirements are less strict, you are still subject to certain governmental controls. First, state law requires that each parcel (a) must have proper legal access to a public roadway, and (b) must be of the proper size and have the proper dimensions to meet the zoning category in which the property is located. If these requirements are not met, the deficiency must be stated in the deed. Even if stated in the deed, the problem is not solved because a building permit normally cannot be obtained if a lot does not have proper access or does not meet the zoning code, often leaving the property practically worthless unless and until the problems are corrected.

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Second, many municipalities have lot split ordinances which require advance approval for a lot split even where the split does not create a subdivision. In addition, a "resubdivision" is usually required where a lot in an existing subdivision is to be further split. Splitting a lot without advance approval is a violation of the city's ordinance and will make it impossible to get a building permit until a proper lot split application is approved. In addition, an illegal lot split can lead to all sorts of unexpected problems. For example, the minimum lot size or dimension may not be met, or there may be inadequate room to meet setback or parking requirements. If this is discovered years later, someone may end up with a worthless piece of property or one that is in violation of law. If the land is already improved with buildings, setback or building code violations can result from the lot split. For example, two buildings might be legally constructed in close proximity on a single lot--however, when the buildings come under separate ownership, certain fire wall, fire door, and separation requirements contained in the building code, as well as regular setback requirements, can be violated. These can be expensive and difficult to cure after the fact.

Finally, it should be remembered that the splitting of a lot (legal or illegal) allows the county assessor to ignore the limited cash assessed value of the property and bring both parcels up to their full cash value for property tax purposes.

Lot split problems sometimes occur in shopping centers or other commercial developments where the owner sells off a pad or building to a particular user. The same problems can occur when a lender forecloses on a pad or building which is part of a larger development, because the foreclosure creates a de facto lot split of property that was previously under unified ownership. At that point, the lender must cure any problems created by the lot split before it is in a position to sell the property.

Conclusion. Whenever you (a) are assembling properties which you may later want to resell in separate parcels, (b) desire to divide a single property into two or more parcels, or (c) are considering loaning money on a portion of a larger parcel, be sure you consider the subdivision and lot split laws, building code requirements, and zoning ordinances. The potential problems are always easier to deal with if you know about them before the transaction is consummated.

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MEMORANDUM #1102 Exceptions

In general, a subdivision is created under Arizona laws when a parcel of land is divided into six or more lots. This is true even if the parcels are separated by a roadway.

However, parcels separated by (1) a street created by the state or a political subdivision, (2) an interstate highway, or (3) a roadway that has been maintained by the state or a political subdivision and continuously used by the public for the last five years, are not considered "contiguous" and presumably would not be aggregated to determine whether a subdivision had been created. In other words, the property on one side of the street can be divided into five lots, and the property on the other side of the street can be divided into five lots, without creating a subdivision. The statutory language would seem to indicate, however, that even lots separated by streets could comprise a subdivision if marketed with a common theme, name, or promotional effort. Consequently, those seeking to take advantage of this exception are advised to proceed very carefully and avoid anything that might tie the two projects together.

The law also provides that parcels are not deemed contiguous when separated by physical barriers, such as a mountain, cliff, river, canyon, canal or lake not created by the owner within the preceding five years. This means that parcels separated by a qualifying physical barrier are treated the same as parcels separated by a street.

Another provision of Arizona law is that the sale of contiguous lots acquired from different persons are exempt from the subdivision laws if (1) they were not acquired for the purpose of development, (2) they are not located in a platted subdivision, (3) each lot has the same legal description as when acquired, and (4) the seller is in compliance with all other governmental requirements. Contiguous lots can be resold without complying with the subdivision laws if they were originally acquired from separate sellers and the other requirements set forth above have been satisfied. This means that if you buy six contiguous lots from six different sellers you can resell them to six different buyers without complying with the subdivision laws.

Municipalities. For some unexplained reason, a "subdivision" is defined differently when the land is located within the boundaries of a city or town. Ordinarily, state law defines a subdivision as the creation of six or more lots; however, in a city or town a subdivision is created by the division of property into (1) four or more lots, (2) two or more lots where a new street is created by the split, or (3) two or more lots, where the original lot was part of a recorded plat. This is a confusing exception to the general law governing subdivisions, but must be kept mind if your property is located in a municipality.

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MEMORANDUM #1201 Basic Principles

Sometimes they are called "deed restrictions." Sometimes they are referred to as a "declaration of covenants, conditions, and restrictions." Sometimes they are just called "CC&R's." The law calls them "covenants running with the land." For purposes of this memo, we'll call them "deed restrictions," even though there is often no deed involved. Whatever you call them, they are the same thing.

In essence, a deed restriction is an obligation or benefit that attaches to a parcel of real estate which is enforceable by or against future owners. Over the years, nearly every piece of urban real estate has been subject to at least one set of deed restrictions. They can be of substantial benefit and can impose substantial burdens on property. It therefore pays to understand what they are and how they work.

Enforceability. To be enforceable, a deed restriction must have four characteristics:

(a) It must be in writing.

(b) There must be an expressed intention that it "run with the land" and bind future owners. Obligations set forth in deeds are sometimes held to be personal contracts between the parties to the deed if it is not clear that the obligation is intended to bind future owners. For example, if the deed merely states that the grantee cannot use the property for a specific purpose, or that the property is conveyed "subject to" some kind of restriction, the covenant probably will not bind future owners. The deed must specifically state that the restriction runs with the land and binds future owners.

(c) It must touch and concern the land, which normally means that it must relate to the use of the land itself.

(d) There must be privity of estate, which means essentially that there must be an unbroken chain of title between the parties for the deed restrictions to be enforceable by one owner against another. Someone outside the chain of title cannot sue to enforce deed restrictions.

Deed restrictions are usually set forth in a recorded deed, declaration, or other instrument. However, recordation is not a requirement for enforceability--they just have to be in writing. On the other hand, if someone buys property not knowing of the restrictions, he is not bound by them if they're not recorded. Consequently, it is essential to record them if you want to bind future owners who might not otherwise know about them.

Under Arizona law, a provision in a deed restriction which prohibits solar panels is unenforceable.

Three Types. In order to be enforceable, the courts have held that the deed restrictions must be one of three types. The first kind is where a general scheme of development is laid out for a large parcel of land by its owner before it is subdivided and developed. This is the type of deed restriction normally used for planned communities, subdivisions, and condominium or townhouse developments. Each owner has the right to enforce the covenants against any other owner. Sometimes an owners association is set up, and it usually has the right to enforce the restrictions also.

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The second kind is where the grantor of property places a condition or limitation on land that he deeds to another in order to benefit land that the grantor retains. If properly worded, the grantor and future owners of his land may enforce the restriction against the grantee and all future owners of the grantee's land.

The third kind is where adjoining landowners place restrictions on their lands for their mutual benefit. Again, if properly worded, the future owners of each parcel can enforce the restrictions against the future owners of the other parcel.

Amendment. Unless the deed restrictions themselves provide for a means of amendment, they can normally be amended only by the unanimous consent of the property owners. If there are encumbrances against the property, it may be necessary to obtain the consent of the lienholders as well.

Deed restrictions for subdivisions and other developments usually contain provisions allowing amendment by majority vote, or in some cases, a specified supermajority. However, the courts have imposed an important limitation on the amendment of deed restrictions. If the amendment affects lots non-uniformly, the amendment must be unanimously approved by the lot owners even if the deed restrictions themselves say that they can be amended by a majority vote. For example, suppose the deed restrictions in a residential subdivision provide that lots may be used only for single family homes. Further suppose that a group of owners wants to amend them to provide that an office building may be constructed on certain lots which border a busy street because these lots are no longer suitable for housing. Or suppose certain owners want to remove the restrictions from those lots so they're no longer restricted at all. This sort of situation often occurs when a developer is doing an assemblage of residential lots for a commercial development. In such a case, every single lot owner would have to approve of the amendment, even if the deed restrictions provide that they can be amended by majority vote, because the change does not affect all lots uniformly. Although this might seem undemocratic and contrary to the intent of the deed restrictions, it does keep a majority of the lot owners from ganging up on the minority for their own benefit.

Zoning. It is often thought that zoning overrules private deed restrictions. For example, it is sometimes claimed that if property is rezoned for commercial purposes, it may be used for business purposes regardless of deed restrictions limiting its use to a single family home. This is a misconception. Deed restrictions and zoning ordinances are completely independent of one another. Both must be complied with. If the deed restrictions prohibit one use, and the zoning ordinances prohibit another, they both apply and the property can't be used for either purpose.

Abandonment. Deed restrictions can become unenforceable through abandonment. This occurs when the neighborhood changes in such a way that there are numerous violations of the restrictions. For example, a restriction against business uses can be deemed abandoned if a large number of the lots are converted to business use and no enforcement action is taken. Or, a restriction against wooden fences in a subdivision can be deemed abandoned after a large number of owners construct wooden fences in violation of the restriction. However, several violations are not enough. The number of violations must be large enough, all things considered, to evidence a general disregard and abandonment of the restrictions. In addition, the restrictions are deemed abandoned only as to the specific kind of violation. Widespread violations of a prohibition on wooden fences, for example, would have no effect on provisions prohibiting commercial uses, and vice versa.

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Conclusion. Deed restrictions are now so common that it is scarcely possible to buy a piece of urban property that is not subject to at least one set of restrictions. Review them carefully, because they can have a major effect on the value and utility of your property. They may prohibit certain kinds of uses, or may place liens against the property for owners association dues or assessments. If you desire to impose deed restrictions of your own, or if you desire to amend existing restrictions, be sure to meet the requirements set forth above so that they will be enforceable against future owners. Consultation with legal counsel is usually advisable.

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MEMORANDUM #1202 Homeowners Associations

From time to time we hear stories about overzealous and overbearing homeowners associations making life miserable for their members. This does occasionally occur, and homeowners associations do have considerable power over the homeowners within their jurisdiction. Their powers are not without limits, however, and they do have certain legal responsibilities.

A properly functioning homeowners association can help maintain an attractive and well-kept neighborhood with common amenities, thereby increasing property values. A poor association can allow the appearance and maintenance of the neighborhood to slip, or worse, can create problems and hard feelings where none should exist.

Duties. Homeowners associations are governed by a board of directors which are elected by the homeowners. As board members, these elected representatives have a fiduciary duty to the homeowners to act in their collective best interests. Admittedly, determining whether a board member's actions meet this test is not easy, and board members do have considerable leeway. Nevertheless, this is the overriding principle which must govern their actions. They could, conceivably, be taken to court for violating this duty, although this rarely occurs.

Homeowners associations also have a number of specific duties which are imposed by statute, including the following:

1. Holding regular meetings that are open to all members of the association. Even though the meetings are open, there is no obligation to allow non-board members an opportunity to speak or otherwise participate in the meeting. At least 48 hours’ notice of the meetings must be given to the members by mail, posting, or other reasonable means.

2. Furnishing a prospective purchaser of a property governed by the association with a package of information including the following:

(a) A copy of the bylaws, declaration, and rules of the association. A declaration is a recorded document similar to a deed restriction which grants the association its powers and imposes restrictions on the property owner.

(b) The name, address, and telephone number of a contact for the association.

(c) The amount of the association's assessment, the amount of reserves held by the association, and the association's current budget.

(d) A statement of any known alterations to the property being sold which violate the declaration or rules of the association.

Powers. The powers of a homeowners association are derived partly from applicable law and partly from the bylaws and the recorded declaration. Usually, the bylaws and declaration give the association broad powers to approve additions or alterations to units, to insure that the individual properties are properly maintained, to levy assessments to maintain and improve the common areas, and to adopt rules and regulations governing the use and appearance of all property within its jurisdiction. It is this latter power that often causes friction between the association's board and the homeowners. This is sometimes due to the particular provisions of the rules and regulations, but more often it arises out of the manner in which they are enforced. No one likes to be told what they can and cannot do with their own property, and the routine

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enforcement of rules can turn into a nasty battle. Homeowners association boards are well-advised to use tact, persuasion, and reason whenever possible in the enforcement of their rules. Property owners are well-advised to recognize that the association does have a certain amount of legal authority over the use of their property, and that a legal battle with a homeowners association is usually a losing proposition.

Arizona law authorizes homeowners associations to impose liens to collect their assessments. If the liens are not paid, the association can foreclose the liens in a manner similar to foreclosing a mortgage. The lien automatically expires if not foreclosed within three years of the date the assessment was due.

Homeowners associations also have the power to impose reasonable fines for violations of the rules and regulations and to levy late charges for tardy assessments. These late charges and fines may also be enforced by a lien.

Limitations. There are certain specific limitations imposed by law on the powers of homeowners associations.

The first limit is on the power to increase the regular assessment. Arizona law provides that the regular assessment cannot be increased by more than twenty percent per year without the approval of a majority of the members. Of course, if the declaration imposes a lower limit, then the lower limit will apply.

Another limit is on the amount of late charges that may be levied. A late charge may be imposed for tardy payment of assessments, but an assessment cannot be considered tardy unless more than 15 days have passed after due date. The amount of the late charge may not exceed the greater of $15.00 or ten percent of the amount due.

Finally, there is a limit on fines for violations of the rules of the association. A homeowners association may impose reasonable monetary fines for violations of its rules, regulations, bylaws and declaration only after giving the homeowner notice and an opportunity to be heard. This means he must be given an opportunity to present his side of the story to the board before the fine is imposed. The notice to the homeowner must include a statement of how the fine will be enforced, which is normally by the assertion of a lien against the owner's property. The key word in determining whether a fine is enforceable is "reasonable." Although "reasonable" is not defined in the statutes, it is intended to mean that the size of the fine must be in proportion to the infraction. An outrageously large fine for a minor violation may well provoke litigation—an expensive, time-consuming, and divisive process that boards should try to avoid if possible. The only appeal a homeowner has to contest a fine is to the courts.

Conclusion. Although homeowners associations are supposed to act reasonably, and most do, they also have considerable leeway in exercising their powers. There are some statutory limitations on their power, but the ultimate control over an overbearing board (short of litigation) is for the homeowners to elect a new board. Anyone contemplating purchasing property governed by a homeowners association should carefully read the rules, regulations, bylaws and declaration, and should be willing to accept substantial limits on his property rights if he decides to proceed with the purchase.

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MEMORANDUM #1301 Roadways

The law gives the government the right to build roads across private property, so long as it pays for the land. This right to compensation is guaranteed by the U.S. and most state constitutions, including Arizona's.

The right to compensation isn't as broad as some might believe, however. There are some types of economic damage caused by the building and improvement of roads that do not require compensation to the property owner.

For example, if the city re-routes a heavy flow of traffic away from a commercial property to some other roadway, the city is not responsible for the loss of business or the diminished value of the property caused as a result. Conversely, if the city decides to re-route a heavy flow of traffic onto a residential street making the houses practically uninhabitable, the result is the same--no compensation. In addition, no compensation is payable where a property owner temporarily loses business due to reduced traffic while a street is under repair or renovation.

The courts have also held that the harm to a business caused by the construction of a raised median, which make it more difficult for customers to enter the property, does not create a claim for compensation. The same is true for other traffic control measures, such as the establishment of one-way streets or the installation of right-turn-only points of ingress and egress.

In most cases, the government is free to change the grade of a roadway abutting a property without compensating the owner for the damage caused as a result, such as difficulty in entering or leaving or reduced visibility.

The courts have also held that the loss of an existing freeway access was not compensable, as long as the property owner had other reasonable means of access to his property.

On the other hand, the property owner is entitled to compensation where the government takes away his only access, or where the access that is left is inconvenient, circuitous, or impractical. And clearly, the government is always liable where it actually takes title to a strip of land for roadway widening or for curbs, gutters, sidewalks, or other public purposes. This is true for the underground installation of a pipe, sewer or electrical line, even though the effect on the surface use is minimal or non-existent.

Conclusion. Whether a landowner is entitled to compensation for a road construction or improvement project often depends more on the legal nature of the "taking" than on the economic damage suffered by the landowner. Often times a very minor intrusion can result in significant compensation, while an economically devastating action can leave the owner entirely without remedy. If a change in a roadway causes you economic harm, the best bet is to review the action with your legal counsel to determine whether you might be entitled to compensation.

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MEMORANDUM #1401 Basics of Leasing

If you are not in the business of leasing office space on a regular basis, some of the customs and practices can be a little confusing. This can put you, the tenant, at a disadvantage, because the building owners and their brokers deal with these things every day. In order to help level the playing field, this memo reviews some of the basics so that you will be prepared when you start your search for office space.

Types of Leases. Most first class office space is leased on a "base year" or "expense stop" basis.

Under a "base year" lease, the first year's rent usually includes about everything--utilities, taxes, insurance, janitorial services, repairs, and so on. This is usually referred to as a "full service" rate. However, that's just for the first year. After that, the building owner figures out how much the operating expenses of the building have increased over the base year. He then charges this increase back to the building's tenants in proportion to the amount of space each is leasing. This means that your rent will go up each year to cover increases in taxes, insurance, and other operating expenses of the building.

The "expense stop" lease is similar, except that instead of using a base year, all operating expenses over a stated amount are passed through to the tenant. For example, the expense stop might be $5.00 per square foot per year. If it costs $6.00 to operate the building, the tenants pay the other $1.00. If the expense stop figure is equal to the actual operating expense of the building in the first year of the lease, the base year lease and the expense stop lease are exactly the same. However, with an expense stop lease you need to verify the actual operating expenses of the building before you can figure out what the rent will really be.

Another kind of lease, which is sometimes used for smaller properties or for shorter term leases, is a "gross" lease. Under a gross lease, the total amount of rent is fixed in advance, and none of the operating expense increases are passed through to the tenant. In other words, it is a "full service" lease for its entire term.

Operating Expenses. If you are negotiating a lease with a base year or expense stop, carefully review the definition of "operating expenses," because this directly affects the amount of rent you will pay after the first year. Operating expenses typically include taxes, insurance, maintenance, repairs, janitorial fees, utilities, management fees, and most other miscellaneous expenses of operating a building. Items such as tenant improvement allowances, leasing commissions, interest, general corporate overhead, and the costs of expanding or adding to the building should be excluded from the definition of operating expenses. Any capital items included as an operating expense (such as the replacement of an air conditioning unit) should be amortized and charged to the tenants over the useful life of the improvement. Finally, the lease should allow reasonable audit rights so that you can periodically review the operating expense charges to ensure that they are correct.

Tenant Improvements. Leased space normally will have to be built out if the building is new, or modified if the building has been occupied by a prior tenant. These improvements are called "tenant improvements" or "TI's." Depending on the particular lease, they are either constructed by the landlord without regard to a dollar limitation, or paid for by the landlord pursuant to a tenant improvement allowance of a specified number of dollars per square foot. If the landlord is taking care of the tenant improvements, you should be sure that they are specified in detail so that the landlord will construct exactly the improvements you need and expect. If the

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improvements are to be constructed pursuant to a TI allowance from the landlord, you should consult construction experts to make sure that the allowance will be sufficient to pay the full cost of the necessary improvements. Somehow, TI's always seem to cost far more that one would imagine. Any cost over the TI allowance has to be paid by the tenant. In either case, tenant improvements can be a big dollar item and deserve a great deal of care and attention. Architects, construction specialists, or other experts should be retained to assist you.

Building Load. An understanding of the concept of the "load factor" is critical when shopping for office space. This is because office leases require the tenant to pay rent based on the number of "rentable square feet" leased by the tenant. However, the space actually occupied by the tenant, called the "useable" space, is only about 85 to 92% of the "rentable" space. This results from the fact that common lobbies, hallways, restrooms, storage rooms, and the like are allocated to the tenants in proportion to their usable space. This allocation of unoccupied space is called the "load." Therefore, in a building with a 10% load, a tenant leasing 10,000 square feet of useable space would actually being paying rent on 11,000 square feet, because he's paying for a share of the common areas. Clearly, it is important to know a building's load factor when comparing rents. Sometimes a higher quoted rate is actually cheaper than a lower one, depending on the load factor. The higher the load factor, the less useable space you are getting for your money.

Tenant's Share. A tenant's "share" is the amount of rentable space allocated to that particular tenant, as compared to all of the rentable space in the building. For example, a tenant leasing 30,000 square feet in a 100,000 foot building would have a 30% share. This figure is then used to allocate operating expense increases; that is, that particular tenant would have to pay 30% of all increases in operating expenses over the base year. The tenant's share of operating expenses is unrelated to the building's load factor, although these two figures are sometimes confused by tenants.

Parking. You should make sure that sufficient reserved spaces are assigned to you to adequately handle your customers and employees. If the building does not assign reserved spaces, will not assign enough reserved spaces to meet all your parking needs, or charges more for them than you want to pay, it is important to investigate the building to make sure that the building, when fully leased, will have sufficient unreserved parking available to accommodate all tenants. This may require a sophisticated analysis of the type of tenants the building has or is likely to attract, because some uses, such as call centers, generate a much higher parking burden than general office uses. Nothing is worse than signing a long term lease and then learning that you will face a continual shortage of parking.

ADA. The landlord should warrant that the building and the leased space will comply with the Americans with Disabilities Act upon the commencement of the lease. Alterations to meet these requirements can be extremely costly.

Term and Options. Most office leases run from five to ten years. Often the tenant will have one or more options to extend for additional terms. Frequently, the landlord will not be willing to fix the rent for the option period, preferring that it be set at "market rates." This is acceptable to most tenants; however, the tenant should be sure that there is a fair way to establish market rent, perhaps by arbitration. It should never be left to the landlord's discretion.

Signage. Don't forget signage. If you need prominent signage, you should negotiate specific signage rights in the lease.

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Alterations. Leases typically provide that the tenant may not make alterations to the premises without the landlord's advance written consent, which may not be unreasonably withheld. Most leases also provide that any such alterations must be removed upon the expiration of the lease if so requested by the landlord. This is not unreasonable; however, you should request a provision requiring the landlord to give notice, when approving alterations, whether it will require removal at the termination of the lease. This allows you to determine in advance whether you wish to incur the expense of the alteration by knowing whether it will have to be removed upon termination.

Subleases and Assignments. Leases almost always require the landlord's approval to a sublease or assignment, not to be unreasonably withheld. However, some leases also define an assignment as any transfer of control, such as the transfer of stock by shareholders, merger, and so on. The latter provisions should not be accepted if your company is public or has numerous shareholders, or if it might be considered a target for an acquisition or merger. On the other hand, where the business is owned by a single shareholder or is a family run enterprise, it may be legitimate for the landlord to have the right to approve changes in control.

Default Provisions. Every office lease specifies a number of events that constitute a default by the tenant, including the failure to pay rent. You should negotiate for a provision stating that the failure to pay rent or any other failure to perform under the lease will not become a default until you have been given reasonable written notice and an opportunity to cure. This will avoid the risk that the lease could be terminated or other sanctions imposed if the rent is not paid due to inadvertence, problems with the mail, and so on. Generally, five to ten days' written notice is considered reasonable for monetary defaults, and 30 days for non-monetary defaults.

Expansion Rights. If you believe that your business might expand during the term of the lease, you may wish to negotiate for expansion rights for adjacent space, or perhaps a right of first refusal when additional space becomes available in the building. Although useful, expansion rights can be difficult to negotiate, and can normally be obtained only by major tenants.

Relocation Rights. Many leases contain a relocation provision which allows the landlord to relocate the tenant to different space within the same building, usually at the landlord's expense. Although this is very convenient for the landlord when trying to assemble blocks of space for a new tenant, it is a tremendous inconvenience for the tenant. It should be resisted if at all possible. The larger tenants are usually able to have this provision deleted from their lease although the landlord may hold firm for smaller tenants or in a tight market.

Nondisturbance Agreement. You should insist that the landlord provide a nondisturbance and attornment agreement from the building's lender. This is a document stating that the lender will honor the tenant's lease should it ever foreclose on the building. Without such an agreement, the lender would be free to terminate your lease or increase the rent after completing a foreclosure, and might well do so if rents have increased since you signed your lease.

Special Requirements. Before beginning your search for new space, make a list of your special requirements. Do you require special air conditioning for computer equipment? Do you have large file storage requirements or a library that will require above-standard load bearing capacity for the floors? Do you need heating and cooling after normal business hours? (If so, be sure to ask about the cost per hour). Do you have special internet or phone line requirements? You can save a lot of time and avoid catastrophic mistakes by carefully thinking through your requirements in advance and then making sure that they are adequately addressed in the lease.

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Conclusion. The modern office lease is a complex and lengthy document, and can represent a large claim on your cash flow over a number of years. Experienced brokerage and legal representation is very important. The "standard leases" tendered by landlords are often one-sided documents which put the tenant at a material disadvantage. Experienced help can help you avoid the hidden pitfalls and to obtain a fair lease.

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MEMORANDUM #1402 The BOMA Standard

Several years ago I did a memo describing the BOMA standard for office leases. Since then the standard has been revised. This memo updates and supersedes the earlier one.

Most office space today is leased by the square foot. Even though tenants will go to great lengths to negotiate the best rate per square foot, they often have little understanding of how the square footage is determined, which can be as important as the rate itself.

In order to simplify and standardize the measurement of office space, the Building Owners and Managers Association International ("BOMA") has adopted a uniform standard for the measurement and leasing of office space (the "BOMA Standard"). Although no one is required to use the BOMA Standard, most major landlords do and many leases specify that space shall be determined in accordance with the BOMA Standard.

The BOMA Standard relies on two important definitions—"usable area" and "rentable area." In order to understand how space is determined under the BOMA Standard, it is necessary to understand these two terms.

Usable area can generally be considered as the private space tenants can use to house their own personnel, furniture and equipment. It is measured from the office side of the common corridor walls, the inside of exterior building walls, and the middle of partition walls separating the tenant's space from space occupied by other tenants. It does not include restrooms, elevator shafts, fire escape stairwells, electrical and mechanical rooms, janitorial rooms, elevator lobbies, or public corridors (for example, a corridor leading from the elevator lobby to the entrance of a tenant's office).

Rentable area is more inclusive--it consists of all the space on a given floor except for major vertical penetrations, usually consisting only of the elevator shaft and fire-escape stairwell. It is measured from the inside surface of exterior building walls and the office side of the walls of major penetrations. Unlike usable space, rentable space includes restrooms, electrical and mechanical rooms, janitorial rooms, elevator lobbies and public corridors.

Rates are quoted on the basis of rentable area. To determine the amount of rentable area leased by a particular tenant, a ratio must be established (sometimes known as the "load factor") so that each tenant will pay his proportionate share of the elevator lobbies, restrooms, corridors, and other common areas not included within each tenant's usable area. This ratio, or load factor, is determined by dividing the total rentable area by the total usable area. This will usually result in a figure of about 1.10 to 1.15. To determine tenant's basic rent, his usable area is multiplied by the load factor, and the result (which is the rentable area) is then multiplied by his rate per square foot.

It is important for the tenant to compare rates on the basis of usable space, because that is the private space the tenant will have available for its business. An inefficient building with a high load factor will cost the tenant more per usable square foot than he may realize. There are significant differences in the load factor among buildings, so the cost-conscious tenant should make sure he understands his rate per usable square foot as well as per rentable square foot.

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A few other points about the BOMA Standard are worth noting:

1. The BOMA Standard is now figured on the entire building. Formerly, it was figured on a floor-by-floor basis. Today, ground floor lobbies and mechanical rooms serving more than one floor (regardless of where located) are considered when calculating the rentable and usable areas. As a result, each floor's load factor is the same. This change has the effect of increasing the load factor, which allows landlords to collect more total dollars while charging the same nominal rent.

2. The "load factor" under the BOMA Standard should not be confused with the common area expense allocation for such items as utilities, landscaping, window cleaning, insurance and property taxes. These expenses are often passed through to the tenant (in whole or in part) in proportion to each tenant's rentable space; however, the share payable by any given tenant is calculated strictly in accordance with the lease provisions and is completely separate from the load factor. Often there is a "base year," generally the first year of the lease, where the landlord pays all operating expenses. In subsequent years, the tenant pays only his share of any increases in operating expenses over the base year.

3. The BOMA Standard is intended to apply only to office space, and has no application to industrial, retail, or residential space.

4. Structural columns and minor vertical penetrations for such things as plumbing and telephone lines are not deducted from either usable or rentable space.

One final point--if you are leasing a significant amount of space, have your space physically measured by an independent professional before you sign your lease in order to verify your usable space and the load factor. Errors are common, and can add up to huge dollar amounts over the life of a lease.

For a complete copy of the BOMA Standard, contact the Building Owners Managers Association International, 1201 New York Avenue, N.W., No. 300, Washington, D.C. 20005.

__________________ Example: A tenant quoted an annual rate of $20.00 per rentable square foot is paying $22.00 per usable square foot in a building with 1.1 load factor, and $23.00 in a building with a 1.15 load factor. This represents a $50,000.00 difference for a 10,000 square foot tenant over the life of a five-year lease.

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MEMORANDUM #1403 Assignment and Subletting

Most leases provide that the tenant cannot assign or sublet without the consent of the landlord.

This isn't quite as simple as it sounds, however. Whether such a clause is enforceable depends on the particular wording of the lease, the landlord's reason for refusing to consent, and even the location of the leased property.

Wording of the Lease. There are some leases, of course, that contain no restrictions on the right to assign or sublet. In this case, the general rule is that the lease is freely assignable and sublettable. The landlord simply has nothing to say about it. The original tenant does, however, remain liable if the assignee or subtenant defaults.

Most leases do, however, provide that the tenant may not assign or sublet without the landlord's consent. In this case, the question is a little more complicated. If the landlord has good cause for refusing to grant consent, he may legally refuse to do so. However, if he does not have good cause, his right to withhold consent depends upon the state in which the property is located because the law on this point varies from state to state. In most states the landlord may withhold consent even without good cause. The lease is simply enforced as written, no matter how unreasonable the landlord might be. In Arizona and a few other states, however, he may withhold consent only if he has good cause--that is, in these states the landlord may not unreasonably withhold his consent to a sublease or assignment.

What if the lease requires the landlord's consent, and also expressly states that the landlord may unreasonably withhold his consent? Does this overrule the principle that the landlord must act reasonably in those states that require him to do so? The answer is yes. If the lease expressly states that the landlord may unreasonably withhold his consent to a sublease or an assignment, then the general rule is that he may withhold consent for any reason or no reason at all.

How to Judge Reasonableness. The concept of reasonableness is by its nature a vague and imprecise term. There are, however, certain guiding principles in judging a landlord's refusal to grant consent in those states where the landlord must act reasonably. It is clear that he may not withhold consent simply to negotiate an increase in the rent, even if the rent is far below market. The issue of rent increases is, of course, behind a good many refusals to consent, because the landlord often tries to use his power to withhold consent as a means to negotiate an increase in rent. Legitimate reasons for withholding consent may include a lack of financial strength on the part of the new tenant, his lack of experience at running a business of the type to be conducted at the leased premises, or his poor reputation and moral character. In addition, the landlord may withhold consent if he has not been furnished enough information about the assignee or sublessee to make an informed decision. The duty is on the tenant to furnish such information, not on the landlord to dig it out from his own investigation.

The Lessons. If you are a landlord, your lease should, if possible, contain a provision that you may unreasonably withhold your consent to an assignment or sublease, for any reason or no reason at all. If your lease doesn't contain such a provision, you must act reasonably, at least in Arizona. You can't withhold consent in order to force an increase in the rent. The courts have

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often awarded substantial damages against landlords who have unreasonably withheld their consent without the right to do so.

If you are a tenant, try to negotiate an express provision that requires the landlord to act reasonably--and if you can't get that, at least try to avoid a provision allowing your landlord to act unreasonably. And when you request consent, be sure you furnish all relevant information, including the financial statements of the proposed new tenant.

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MEMORANDUM #1404 Non-Disturbance Agreements

You've signed the lease and moved into your new space. You got a great deal of course, but the move was still expensive. Upgraded tenant improvements, moving expenses, lost productivity--all these things take their toll in time, money and energy. At least you won't have to move again for ten years.

Or will you?

Unfortunately, many tenants neglect to get the one thing that will protect their lease if their landlord gets into financial trouble--a non-disturbance and attornment agreement. This is a short agreement signed by the project's lender saying that the lender will honor your lease if it forecloses its mortgage. This is the "non-disturbance" part of the agreement. The tenant agrees, in return, to accept the lender as the landlord and to pay the rent directly to him. This is the "attornment" part of the agreement.

Without such an agreement, the lender does not have to honor your lease if he forecloses. This is because the lender's encumbrance existed prior to your lease, and when the lender forecloses, all junior interests, including your lease, are wiped out.

A similar situation occurs where the project is on a long-term ground lease. If the ground lease is terminated, your lease also terminates unless you have a non-disturbance agreement.

After a foreclosure or ground lease termination occurs, the lender or lessor may offer you a new lease to let you stay on the same terms. Or, he may demand more rent, or may even force you to leave if he has other plans for the space. It's up to him, and he can be expected to act for his own advantage, not yours.

The Lesson. Therefore, if you are leasing space--whether it be an office, store, warehouse, or industrial space--always require the landlord to deliver to you a non-disturbance and attornment agreement executed by the project's lender (and ground lessor if there is one). If you don't, you may be placing your lease at the mercy of the project's lender or ground lessor.

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MEMORANDUM #1405 Guarantors

Leases are often guaranteed by an individual or by a parent company of the tenant. Such guarantees are very important to the landlord and his lender, especially if the tenant is a shell corporation or has a limited net worth.

What happens when a lease is amended without the consent of the guarantor? The general rule is that the guarantor is released. There are two exceptions: (a) when the amendment does nothing more than to extend the time the tenant has to pay a monetary obligation, or (b) when the amendment is of a sort that can only be beneficial to the guarantor.

Extension of Time. The law does not require the guarantor's consent if the only modification is to extend the time to pay money, even though the guarantor may prefer that the extension not be granted. Under the law, it's something the guarantor must accept, whether he likes it or not.

Beneficial to Guarantor. This one is slightly trickier. The basic idea is that if the amendment reduces the obligations of the tenant, the guarantor's consent is not necessary because the guarantor's contingent obligations are also reduced. However, the amendment must be of such a nature that there is nothing about it that might be construed as being worse for the tenant, and thus the guarantor.

A recent case furnishes an example. A landlord and a tenant agreed to reduce the amount of leased space in a shopping center and also agreed to a corresponding reduction in the rent. This would normally seem to be the kind of amendment that would not be of concern to a guarantor, because the amount of rent he might be called upon to pay has been reduced. However, the smaller space resulted in the loss of frontage facing a major road. When the tenant later went broke, the landlord sued the guarantor. The guarantor defended by saying that he hadn't consented to the amendment, and therefore should be released from his guarantee. There was conflicting testimony as to whether the loss of the frontage was a detriment.

The court released the guarantor because it was possible under some circumstances that the reduced frontage might be a detriment. In other words, the court held that if it is possible that the amendment could be disadvantageous under any possible set of circumstances, then the guarantor is completely released from his guarantee unless he consented to the amendment.

Other Applications. This rule is not limited to the guarantee of a lease--it applies to guarantees of virtually any kind of obligation, including promissory notes, contracts, and agreements of all kinds. Whenever the underlying contract or obligation is changed in any way, there is the possibility that the guarantor could be released. The only exception to the general rule is where the guarantor is a "compensated surety." This is generally a bonding company or insurance company which guarantees an obligation for a fee or premium. In this case, the guarantor can still be released if the guaranteed obligation is changed without his consent, but the rules are a little tougher and a little more complicated.

The Lesson. If you are a landlord (or if you are a lender to a landlord relying on his leases for security), the best rule is to always get the guarantor's consent when you agree to a lease modification, extension or renewal because you don't want to risk an inadvertent release of the

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guarantor. The courts are protective of guarantors, and will often search to find ways to release them from their obligations.

__________________ The case referred to above is Indian Village Shopping Center Inv. Co. v. The Kroger Co., 140 Ariz. Adv. Rep. 16 (May 26, 1993).

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MEMORANDUM #1406 Going Dark

Every shopping center operator wants all of his leasable space open and operating. He doesn't want any of his stores to "go dark," even if they're still paying rent, because closed shops lower the center's traffic, income and value. This is especially true for anchor tenants, which are the life blood of most retail shopping centers.

On the other hand, many major tenants insist on the right to "go dark," because the cost of paying minimum rent is often less than the cost of operating an unprofitable store.

As a result, "go dark" clauses are often one of the most critical terms in a retail lease. Clearly, if the lease expressly allows a tenant to go dark, he may. On the other hand, if the lease prohibits it, he can't (or at least if he does, he's in breach of the lease and will probably be sued). But what of the lease that neglects to mention it one way or the other? Believe it or not, such leases do occur, and when they do they often lead to litigation.

There are no Arizona cases on point. However, a body of law has developed in other states along the following lines:

1. If there's no percentage rent provision, the tenant may go dark if he chooses.

2. If there's percentage rent only (that is, no minimum guaranteed rent) the tenant may not go dark.

3. If there are percentage rent and guaranteed minimum rent provisions, the tenant may go dark only if the guaranteed minimum rent is "substantial" when compared to the percentage rent.

It is not clear exactly how much minimum rent must be in order to be considered "substantial." However, some cases have found minimum rent not to be substantial where it amounted to less than half of the percentage rent. Other cases have found minimum rent to be substantial when it is more than 90% of the percentage rent. In between is a gray area that will depend on the facts of the particular case and the predilections of the particular judge.

Remember, the above rules apply only if the lease is silent on whether the tenant can go dark. Therefore, the best course of action is to expressly provide in the lease whether the tenant has the right to go dark. Otherwise, litigation over the point is a good possibility.

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MEMORANDUM #1407 CPI Adjustments

Many real estate contracts--especially long-term leases and purchase options--are tied to the rate of inflation. For example, a lease may provide for periodic increases in rent in proportion to increases in the Consumer Price Index. This makes a lot of sense for contracts that extend over many years because inflation over time can significantly erode the purchasing power of a fixed number of dollars.

Common Problems. Unfortunately, these cost-of-living provisions have led to a lot of litigation, due mostly to sloppy draftsmanship. One recurring problem is referring to an index that doesn't exist. For example, in one case the parties referred to the Consumer Price Index published by the U.S. Bureau of Labor Statistics for the City of Phoenix. The U.S. Bureau of Labor Statistics does publish an index, but it doesn't publish one for Phoenix. In that particular case, the court rewrote the contract to substitute an index for Phoenix published by Arizona State University. In another case, however, the parties referred to a non-existent Spokane Consumer Price Index as the basis for increasing the rent payments under a lease. In the Spokane case, there was no similar index, and the court held that the original rent would apply for the entire 69-year term of the lease. This was a windfall for the tenant, but a disaster for the landlord.

Other problems abound, leading to results not intended by the parties. Oftentimes these problems are caused by adjustment formulas that are faulty or which lead to aberrational results. The cure, of course, is simply to draft the provisions with care, and refer to an index that actually exists by its correct and complete name.

Example. Here is an example of a cost-of-living adjustment provisions that you can adapt to your own use:

The rent payable under this Lease shall be adjusted as of the fifth anniversary of the commencement of the term of this Lease, and on such anniversary date every five years thereafter (the "Adjustment Date"). The rent shall be adjusted for inflation as measured by the "United States City Average (all Urban Consumers)--All Items" index of the Consumer Price Index published by the Bureau of Labor Statistics, United States Department of Labor (hereinafter "CPI").

The adjustment shall be made as follows: The original rent payable hereunder shall be multiplied by a fraction to determine the rent payable from and after the pertinent Adjustment Date. The numerator of this fraction shall be the CPI for the month four months prior to the month of the Adjustment Date (or the most recent month for which the CPI is available if the CPI for the fourth preceding month is not then available). The denominator of the fraction shall be the CPI for the month four months prior to the month in which the lease term hereunder originally commenced. The CPI in the numerator and denominator shall have the same base year. In no case, however, shall the application of this formula result in a reduction of the rent payable hereunder.

If the CPI called for by this formula is no longer published, or if the format of it has changed so that this calculation is no longer possible, then another substantially comparable index shall be substituted in the formula by agreement of the parties. If the

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parties cannot agree on the substitute index, then the substitute index shall be selected by a committee composed of three independent certified public accountants, one selected by landlord, one selected by tenant, and one selected by the other two certified public accountants.

Conclusion. Provisions in leases or contracts calling for rent or price adjustments in accordance with increases in the cost of living can be important elements of a long-term lease or other agreement. However, they must be drafted with great care and precision.

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MEMORANDUM #1408 Maximum Term

Long-term ground leases often run for a term of 99 years. Did you even wonder why such an odd number seems to appear so frequently in leases?

Why not an even 100 years?

Is there some law that limits leases to a maximum of 99 years?

Statutes. Actually, a few states have enacted statutes limiting the length of leases to 99 years. For example, Alabama limits all leases to a maximum of 99 years, and Nevada provides the same limit for all leases other than agricultural leases (which cannot exceed 25 years). California, North Dakota, and South Dakota limit leases of city lots to 99 years, and Illinois and Wisconsin limit certain leases by municipalities or governmental units to 99 years. A number of states have shorter limits for particular kinds of leases. For example, California limits agricultural leases to 51 years, Minnesota limits agricultural leases to 21 years, and Montana limits agricultural leases to 10 years and leases of city lots to 75 years. Arizona has no such statutory limit on any kind of lease.

General Rule. In the absence of a state statute to the contrary, there appears to be no limit on the permissible length of a lease. The leading case on the subject states:

"There being no statute in this state [Delaware] to the contrary, the law permitted the lease notwithstanding its length of two thousand years." (Emphasis added.)

Now that's a long lease!

This raises an interesting question: Can two parties enter into a lease that runs forever? Some courts have stated that perpetual leases are not favored and will not be enforced unless it is clear the parties actually intended the lease to run forever. However, it does not appear that any American court has ever flatly stated that perpetual leases are not enforceable if the intention of the parties is clear.

Conclusion. In most states there is no limit on the length of a lease. The parties are free to contract for whatever term they desire. In most cases, the 99-year term appears to be more of a custom than a legal requirement. If you're not sure whether there is a statutory limit in your state, be sure to check with local counsel before entering into a long term lease, because leases in excess of the legal limit may be void.

__________________ The Delaware case mentioned above is Monbar, Inc. v. Monaghan, 18 Del.Ch. 395, 398, 162 A. 50, 52 (1932).

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MEMORANDUM #1409 Special Rules Apply to Rental of House or Apartment

Arizona has adopted a set of laws known as the "Residential Landlord and Tenant Act" which govern the rental of a house or apartment for residential purposes. These laws are very different from the laws governing the rental of commercial property, and are designed primarily to protect the tenant. A summary of some of the more important provisions of this Act are set forth below.

Prohibited Actions. A landlord may not refuse to rent to a family with children except where children are prohibited by valid deed restrictions, as in a retirement community. A tenant who is wrongfully excluded for this reason can file suit for three months' rent, court costs, and attorneys' fees. A landlord can, however, enforce reasonable standards limiting the maximum number of occupants, even if families with children are incidentally excluded.

A landlord may not require a security deposit, including prepaid rent, of more than 150% of the monthly rent. Every deposit made by the tenant is refundable unless stated otherwise in writing, and the purpose of all deposits must be stated in writing. The landlord must return any refundable deposit to the tenant with an itemized list of deductions within 14 business days of demand by tenant. If the landlord fails to do so, the tenant can sue for twice the amount wrongfully withheld.

Required Actions. The landlord must furnish the tenant with a signed copy of the lease with all blank spaces completed, a move-in form which the tenant can use to list existing damage to the premises, and a written statement that the tenant has the right to be present at the move-out inspection.

The landlord must disclose to the tenant on or before the date the lease begins the name of the person authorized to manage the premises and the name of the owner or owner's agent who is authorized to receive notices and service of process. The foregoing information must be kept current. The landlord must also inform the tenant in writing that the tenant can obtain a free copy of the Residential Landlord and Tenant Act from the Secretary of State.

The landlord is required to keep the premises in good repair and to furnish running hot and cold water and heating and cooling (when the dwelling has heating and cooling facilities), except that the parties can agree otherwise in good faith and not as an attempt to evade the law.

Landlord's Rights. The landlord may adopt reasonable regulations if he notifies the tenant of them when the lease is signed or gives the tenant thirty days' notice of them thereafter, so long as they don't amount to a substantial modification of the lease.

The landlord may enter the premises at reasonable times and only after giving the tenant two days' notice, except in an emergency when no notice is required.

Termination. A lease for a term automatically terminates upon expiration of the term. A week-to-week lease can be terminated by either landlord or tenant on ten days' written notice. A month-to-month lease can be terminated by written notice given at least thirty days prior to the end of the month for which the termination is effective.

Landlord's Remedies. If the tenant fails to pay rent within five days of written notice that the rent is due and that the landlord intends to terminate the lease if the rent is not paid within five days, the landlord may terminate the lease only by filing an action for eviction. Self-help or turning off the utilities is not permitted for a residential lease. If the tenant pays the rent and any

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applicable late fee before the eviction action is filed with the court, the lease is reinstated. Or, if the tenant pays the rent, late fee, court costs and attorneys' fees after the eviction is filed but before judgment is entered, the lease is reinstated.

If the tenant causes a breach affecting health and safety, landlord may terminate the lease on five days' written notice. For other violations, the lease may be terminated only on ten days' written notice.

The landlord must hold the tenants' personal property that is left behind for 21 days after a judgment of eviction, and must furnish the tenant an inventory by certified mail, return receipt requested. However, the landlord must release clothing, the tools or books of a trade or profession, and identification, immigration, and public assistance documents. To reclaim the property the tenant need only pay costs of removal and storage. The landlord's lien for unpaid rent has been abolished; the landlord cannot hold the tenant's property to force the payment of rent. If not reclaimed, the landlord may sell the property after 21 days. He must apply the proceeds first to amounts he is owed by the tenant, and must mail the balance, if any, to the tenant. The landlord must keep a record of the sale for one year.

The tenant is considered to have abandoned the premises (a) if he is absent seven days and the rent is ten days past due, or (b) if he is absent for five days, the rent is five days past due and his personal property has been removed. In the event of abandonment, the landlord must give five days' written notice to the tenant by certified mail, return receipt requested, and post the property. At the end of five days, the landlord may retake possession of the house or apartment unless the tenant has taken possession and paid the rent in the meantime.

The landlord may not retaliate against the tenant for exercising his rights by raising the rent or curtailing services.

Tenant's Rights. The tenant has the right to have the property properly maintained. If it is not repaired after specified notices to the landlord, the tenant has certain remedies, including the right to terminate the lease, recover damages, withhold rent, and procure substitute housing at the expense of the landlord. If the landlord fails to make minor repairs costing less than the greater of $300 or half the monthly rent within ten days of written demand from the tenant (or sooner in the case of an emergency), the tenant may have the repairs done by a licensed contractor and offset the charges against the rent.

Conclusion. The rights of residential tenants have been greatly expanded in recent years. If you are renting out a house or apartment, be sure your lease and your practices comply with all aspects of the law in order to avoid exposure to damages and possible criminal sanctions.

__________________ The Arizona Residential Landlord and Tenant Act is found at A.R.S. § 33-1301, et seq.

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MEMORANDUM #1410 Should You Assign Your Lease Or Sublet Your Space?

Tenants sometimes find themselves with leased space they no longer need. When that happens, the first question is whether to assign the lease or sublease the excess space. If only a portion of the space is to be disposed of, or if the original tenant wants the space back before the expiration of the master lease, the answer is easy - the space must be subleased. This is because an assignment transfers the entire leasehold estate to the new user, leaving the original tenant with no present or future right to any part of the premises. However, if the tenant wishes to dispose of all the leased space for the entire remaining balance of the term, he has a choice - he can either assign the lease or sublease the space.

The difference between a sublease and an assignment is that under a sublease, the original tenant leases the space to the subtenant and becomes the subtenant's landlord, but under an assignment the new tenant steps into the shoes of the original tenant, creating a direct relationship with the master landlord. With an assignment, the assignee normally pays the rent directly to the master landlord. With a sublease the rent is usually paid to the sublandlord who in turn pays the master landlord.

What difference does it make?

As far as the original tenant's liability is concerned, it usually makes no difference at all. Unless the master landlord releases the original tenant (which he rarely does), the original tenant remains fully liable under the lease regardless of whether he subleases or assigns.

Considerations. However, there are some other important factors to consider. First, with an assignment the new tenant deals directly with the landlord, bypassing the original tenant. While this may relieve the original tenant of the inconvenience of being "in the middle," it does deprive the original tenant of a certain amount of knowledge and control concerning a lease for which he is liable.

Second, under an assignment the original tenant cannot evict the tenant and recover the premises in the event of a default, whereas he can under a sublease. A sublease therefore gives the original tenant a better opportunity to protect his interests by taking back the space, and possibly using it himself or subleasing it to a new user. The assignor of a lease does have a cause of action against the defaulting assignee for any rent he is forced to pay, but he has no legal means of regaining possession of the property even though he is responsible for paying the rent.

Third, under an assignment the tenant has the right to exercise any options to renew contained in the master lease, whereas under a sublease the subtenant has the right to exercise options only if he is expressly given that right in the sublease. Clearly, the original tenant would prefer to avoid the exercise of renewal rights because it extends the period of time for which he is liable under the lease, again leading one to favor a sublease.

Conclusion. In most cases, the original tenant should sublease rather than assign so that he is in a position to protect himself by taking back the premises from a defaulting subtenant. The only exception is when the master landlord agrees to release the original tenant in connection with the sublease - in that case, an assignment is usually the best option because he can then walk away with no further responsibility for the lease.

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MEMORANDUM #1411 Make Sure Your Right Of First Refusal Is Not A Watered-Down Imitation

A right of first refusal is often requested by tenants when leasing space because they want the right to take any additional space that becomes available. Most businesses expect to grow, but at the same time are often hesitant to commit to more space than they need because of the cost and difficulty of predicting future space needs. A right of first refusal can be a useful method of accommodating the tenant's uncertain need for additional space in the future without causing undue inconvenience for the landlord.

It is not unusual for a landlord to verbally agree to give the tenant the first right to lease certain additional space. However, when the actual lease document is presented, the tenant may not get exactly what it expected.

Sometimes, a landlord will present the tenant with a provision that is more accurately called a "right of first offer." This is not the same thing as a "right of first refusal."

First Refusal. A typical right of first refusal will give the tenant the right to match any lease of additional space that the landlord intends to enter into with a third party. The landlord is required to inform the tenant of the proposed lease, and the tenant then has a specified period of time to enter into a lease of the same space on the same terms and conditions.

First Offer. However, some landlords are reluctant to enter into an agreement of this type because it is a somewhat cumbersome procedure and they fear it may discourage potential tenants. Consequently, it is not unusual for the landlord to include a right of first offer in the lease, instead of a right of first refusal. A right of first offer typically requires the landlord to offer any additional space to the tenant at a rent set by the landlord before placing it on the market. The tenant then has a specified period of time to lease the space, and if the tenant does not exercise its right to lease the landlord is completely free to lease it to third parties at whatever rent and on whatever terms it desires. Notice that it is not necessary for the landlord to have an offer from an actual third party tenant at the time it makes the offer, nor is the landlord required to offer the space at market rate.

Disadvantage of Right of First Offer. Clearly, this is not as advantageous for the tenant because the price and terms offered by the landlord may not be at market, and because it is a single opportunity to lease which might be activated at a time when the tenant does not yet need the space.

Essential Terms. A tenant who wants the advantages of a true right of first refusal should clearly specify what is wanted during the negotiation phase, and should carefully read what is offered and negotiate the most favorable provisions possible. A good tenant-oriented right of first refusal should contain at least the following terms:

1. The landlord should be required to offer the space to the tenant on the same terms and conditions offered to an actual third party prospective tenant, and should be required to disclose the name of the prospective tenant and to furnish a copy of the proposed lease.

2. The tenant should have a reasonable period of time to accept or reject the offer.

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3. If the terms are changed after being shown to the existing tenant, the existing tenant should have the opportunity take the space on the new terms.

4. The landlord should have a specified period of time to consummate the lease to the third party.

5. If the landlord does not consummate the lease to the third party within a specified period of time, the tenant's right of first refusal should be reinstated.

Conclusion. A tenant desiring a right of first refusal should make it clear exactly what it wants at the outset, and should carefully review the language of the lease to make sure that the provision meets its needs and furnishes a meaningful right to expand at market rates if and when space becomes available.

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MEMORANDUM #1501 Minor Breaches

Your tenant is three days late with his check for operating expenses. His rent is too low, and you've wanted to get rid of him for years anyway. So you immediately terminate the lease. Will the termination stand up in court?

According to a recent Arizona case, the answer probably is no. The Arizona Supreme Court has recently held that a lease may not be terminated because of a trivial or non-material breach by the tenant. This rule applies even if the lease itself specifically provides that it may be terminated as a result of any breach, or that "time is of the essence."

The Court held that it was necessary to look at the specific facts of the case in determining whether the breach was serious enough to permit termination. The factors to be considered are as follows:

1. The extent to which the landlord will be deprived of the benefit which he reasonably expected;

2. The extent to which the landlord can be adequately compensated by damages for the breach;

3. The extent to which the tenant will suffer forfeiture as a result of the termination;

4. The likelihood that the tenant will cure his default, taking into account all the circumstances of the case; and

5. The extent to which the behavior the tenant comports with standards of good faith and fair dealing.

In other words, the Arizona courts will now be required to take an equitable approach in reviewing any lease termination based on a minor or trivial breach. The courts will examine such things as the seriousness of the breach, whether it was intentional or accidental, the harm caused to the landlord, and the extent of the forfeiture to be suffered by the tenant if the lease is terminated (that is, the remaining term of the lease, the value of tenant improvements, and the other investments that will be lost if forfeiture is upheld).

Conclusion. The decision is good news for tenants who might otherwise be faced with a lease termination based on a minor breach. The lesson for landlords is that they must establish a record of acting reasonably before attempting to terminate a lease, particularly for a minor breach. This might include one or more written notices and telephone calls to allow the tenant an adequate opportunity to cure, particularly if the breach appears to be of a relatively minor nature.

__________________ The case referred to above is Foundation Development Corporation v. Loehmann's, Inc., 788 P.2d 1189 (1990).

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MEMORANDUM #1502 Termination and Damages

It's almost automatic. A tenant misses his rent payment. The landlord gives written notice demanding payment. The tenant still doesn't pay. The landlord then tells the tenant his lease is terminated, and demands that he vacate the premises.

What happens if the landlord is unable to find a new tenant, or if he does, if the rent is less than the previous tenant was paying? Often the landlord calls his lawyer and tells him he wants to sue his prior tenant for the difference.

Unfortunately, there's a problem. A landlord can't sue for any rent accruing after he "terminates" a lease, even if the termination occurs because of the tenant's default. He can sue, however, for unpaid rent accruing prior to termination and for his expenses in terminating the lease, but this is rarely adequate compensation for a landlord with an empty building.

A Solution. Happily, there is a solution if the landlord handles the situation correctly to begin with. As odd as it may seem, the landlord can evict the tenant and preserve his right to future rent if, instead of terminating the lease, he merely terminates the tenant's "right to possession." Incredibly, the landlord's choice of a few words can make the difference between no claim at all and one that may be worth thousands of dollars or more.

Of course, the landlord still has a duty to mitigate his damages even if he doesn't "terminate" the lease — that is, he must make reasonable efforts to lease the premises to someone else, and must give the old tenant credit for any rent received. But he can assert a claim for rent accruing while the building is empty, for the difference between the rent the old tenant was paying and the rent the new tenant will pay once he leases to a new tenant, for brokerage commissions, and probably for leasehold improvements and alterations paid for by the landlord in order to sign the new tenant, so long as he made reasonable efforts to re-let the building on the best terms possible. On the other hand, if the tenant (and guarantor, if there is one) is broke, it may be better to terminate the lease and be done with it.

A Caveat. There is one additional issue to consider. If you believe the tenant may file bankruptcy to avoid eviction, you may be in a better position in bankruptcy court if you have actually terminated the lease and evicted the tenant prior to the bankruptcy filing, rather than merely terminating the tenant's right to possession. This is because the bankruptcy court is supposed to honor the termination of any lease that occurs before the bankruptcy filing. As to leases that have not been terminated, the trustee or debtor in possession has 60 days to decide whether to accept or reject the lease, although rent must be paid during this period of time. However, if you have another tenant standing by, or if the space can be re-let at a higher rent, you may prefer to have the lease terminated. Under these circumstances, the issues can become quite complex and consultation with legal counsel may be advisable to best protect your position.

Conclusion. If your tenant defaults, take prompt action. But if you decide it's time to get rid of him, be very careful with your choice of words. A "termination" of the lease can cut off your right to collect future damages, but a failure to "terminate" may prejudice your rights if the tenant files bankruptcy.

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MEMORANDUM #1503 Mitigation

What happens when a tenant quits paying rent and abandons the premises? Can the landlord sit back and collect full rent for the remainder of the lease term, or does he have to try to lease the premises to someone else?

The answer is, "it depends."

It depends on two things. First, it depends on what the lease says. Second, it depends on where the property is located.

Lease Provisions. If the lease itself provides that the landlord has a duty to mitigate his damages, then he must make reasonable efforts to find a replacement tenant. He cannot sit idle and demand payment of the rent each month for the rest of the term. If the landlord re-leases the property, the former tenant is entitled to a credit for the amount of rent the new tenant pays.

Local Law. What if the lease contains no provision requiring mitigation (and most do not)? Can the landlord insist on the payment of full rent for the rest of the term without making any effort to find a new tenant?

In many states, including Arizona, the answer is no. The law in these states provides that the landlord does have to make reasonable efforts to lease the property to someone else in order to minimize the tenant's damages, regardless of what the lease says. In these states, the landlord is entitled to recover only the deficiency in rent after deducting the rent he receives from the new tenant, assuming he was reasonably diligent in trying to re-lease the property. However, if the landlord fails to make reasonable efforts to re-lease the property and the tenant is able to show that the property could have been re-leased, the tenant is responsible only for the difference between the rent under the lease and the rent the landlord could have obtained if he had leased the property.

What about the other states? Interestingly, there are a number of states where the landlord has no duty to mitigate his damages unless the lease requires it. He can choose to hold the property vacant and collect the full amount of rent from the tenant each month as it comes due, or he may sue for the full present value of the rent (subject to the duty to refund a portion of it if he later re-rents the premises even though he has no duty to do so). This somewhat harsh rule is often justified on the theory that the tenant should have no right to impose a duty to find a new tenant on the landlord as a result of the tenant's wrongful behavior.

States that appear to follow this rule include Alabama, Arkansas, California, Delaware, District of Columbia, Florida, Georgia, Kentucky, Maine, Maryland, Massachusetts, Minnesota, Mississippi, Missouri, Nebraska, Oklahoma, Oregon, Pennsylvania, Texas, Virginia, and Washington.

In a number of states the law is not clear, or there are cases which appear to have decided the issue both ways, including Ohio, New York, Illinois, and New Jersey. In other states, the courts hold that there is no duty to mitigate unless the landlord re-enters the property and takes possession.

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Conclusion. If your business requires you to enter into leases in other states, do not assume that the law of every state is the same. If possible, determine what the local law is so that you can be fully aware of your legal responsibilities under the lease. In addition, it is always a good idea to try to negotiate a provision specifically stating that the landlord has a duty to mitigate his damages if the lease is breached, or at least capping your liability in the event of a breach.

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MEMORANDUM #1504 Limitations on Landlord

Disputes between landlords and tenants over money are not uncommon. Often, the tenant under a commercial lease is required to pay various sums of money to the landlord in amounts to be determined in the future. Because the amounts to be paid are not fixed by the lease, this can easily lead to disagreements. For example, the tenant might have to pay his share of increases in taxes, insurance, or other operating expenses, or he may have to pay percentage rent based on his gross income. Sometimes the landlord and tenant disagree over the calculation of these amounts, or have disagreements over the amount of rent or other items the tenant is required to pay.

If these disputes cannot be resolved, the landlord normally tells the tenant to pay or to leave. Because the relocation of a business on short notice is risky and expensive, the tenant usually pays.

This is not necessarily the end of the matter, however. If the tenant makes it clear that he does not agree with the charge or that he is paying it under protest, the issue remains open. In that case, the tenant usually has three options: (1) he can pay what the landlord demands and forget the matter, (2) he can stay in the premises and sue to recover the amounts paid under protest and to obtain an order prohibiting the landlord from levying such charges in the future, or (3) he can vacate the premises at a future point in time when it is convenient for him to do so, and then sue the landlord for damages. This means that if the landlord has been receiving payments under protest, he may have a ticking time bomb on his premises that might cause him to lose a tenant and become involved in expensive litigation at any time.

An Example. An actual case will provide an example. The lessor of a theatre in Tucson demanded certain sums of money from his tenant for increases in operating costs. The lease was not clear on the point, but the tenant said the parties had verbally agreed that such increases would not be charged to the tenant. Nevertheless, the landlord demanded payment and threatened eviction. The tenant had no place to move his business to, and paid under protest.

Five years later, the tenant vacated the premises before the end of the term and sued the landlord for damages! The court agreed with the tenant and awarded him more than $80,000 in damages and more than $50,000 in attorneys' fees and costs.

The Law. The court said that if the landlord breaches a material term of the lease and does not cure within a reasonable period of time after being requested to do so, the tenant may terminate the lease and recover damages. In this case, threatening to evict a tenant if he does not pay amounts he does not owe is a material breach of the lease. The court also said that the above rule does not apply if the lease provides otherwise, which this particular lease did not do.

The interesting thing is that the passage of time does not appear to limit the tenant's remedies, or at least it didn't in the case described above.

Damages can be significant. They might include, for example, the amounts wrongfully paid to the landlord plus interest, any increase in rent at the new location, moving expenses, remodeling costs, lost business, and court costs and attorneys' fees.

The Lessons. If you are a tenant wrongfully threatened with eviction for not paying disputed amounts, make the payments if you feel you must, but make them under protest to reserve your rights. But before you leave early, consult legal counsel to be sure your position is valid--

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because if it isn't, you, not the landlord, will be breaching the lease and you, not the landlord, will be the one paying damages and attorneys' fees.

If you are a landlord, the best step is prevention--be sure that your leases say that the tenant's remedies are limited to the recovery of overpayments and that they expressly disallow any right of termination. A binding procedure for arbitration or for referring such monetary disputes to an accountant is often helpful in avoiding trouble. If you have leases in effect that do not contain such provisions, you should do two things: (1) be sure you are legally entitled to any amounts you demand, and (2) attempt to resolve all outstanding disputes before the potential for damages becomes large.

__________________ The case referred to above is Terry v. Gaslight Square Associates, 178 Ariz. Adv. Rep. 38 (Ariz. App. 1994).

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MEMORANDUM #1505 Tenant Bankruptcy

It happens all too often. Your tenant files bankruptcy, and the rent checks stop. You've heard about the "automatic stay" which prohibits all legal action against the debtor who's filed bankruptcy, so you know you can't sue your tenant or evict him. You wonder what, if anything, you can do to protect yourself.

The general rule is that the debtor (or the trustee if there is one) has 60 days after filing bankruptcy either to assume or reject the lease. In other words, he has the right for 60 days to decide whether he wants to terminate the lease or continue with it. The 60-day period can be extended with approval of the bankruptcy court.

Payment of Rent. In the case of non-residential leases, the bankrupt tenant is supposed to pay rent coming due after the filing on a current basis until assumption or rejection of the lease. In practice, however, the rent is often late because of the disorganization and distraction caused by the bankruptcy, or the lack of available funds. However, it should eventually be paid, although the court can for good cause extend the time for payment of rent until 60 days after filing. If rent isn't being paid on a current basis, the landlord should complain to the tenant or the trustee or its bankruptcy counsel. If this doesn't work, the only remedy is to petition the bankruptcy court for the payment; unfortunately, the landlord cannot terminate the lease or evict the tenant while the tenant is in bankruptcy. This is true even if the lease contains a provision giving the landlord the right to terminate the lease in the event of the tenant's insolvency or bankruptcy, because such provisions are unenforceable.

Pre-Filing Termination. If the lease was validly terminated prior to the bankruptcy filing, it remains terminated. A bankruptcy filing does not revive a terminated lease. It is not necessary to have evicted the tenant before the filing--it is only necessary to have terminated the lease under state law. This is normally done by written notification, usually after a grace or cure period specified by the lease. If the lease was validly terminated prior to the filing of the bankruptcy but the tenant is holding over, the landlord should be able to seek an eviction order in state court despite the automatic stay, although some attorneys will first seek bankruptcy court approval to do so.

Landlord's Duties. If the lease was in effect at the time of filing, then unless and until the lease is rejected, the landlord must perform in accordance with its terms, even though the tenant is not paying rent. One exception, however, is that the tenant must pay the landlord for services and supplies that are incidental to the lease, such as heating, cooling, janitorial service, and so forth. If the tenant does not pay for such services and supplies, the landlord may cease providing them.

Assumption and Rejection. If the tenant assumes the lease, he must bring it current and provide adequate assurance that he will be able to meet his future obligations under the lease. This might take the form of a cash deposit or letter of credit, or in some cases, it might just be the debtor's promise to pay. It is also possible for the tenant to assume the lease and simultaneously assign it to a third party, notwithstanding any restrictions on assignment in the lease.

If the tenant rejects the lease, the landlord has a claim for the breach of the lease. This claim, which covers unpaid rent which accrued prior to the bankruptcy filing and damages for the

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tenant's premature termination of the lease, is made by filing a proof of claim with the Bankruptcy Court. This claim is considered a general unsecured claim and in most cases will not be paid in full. In addition, the landlord's claim is in any event limited to a ceiling amount equal to the unpaid rent which had accrued at the time of the bankruptcy filing, plus the rent payable under the lease for the greater of one year or 15% of the remaining term of the lease but not to exceed three years. The practical result is that the landlord generally receives only a small percentage of the actual unpaid rent and damages. The landlord is, however, entitled to rent on a priority basis for the period of the post-filing occupancy (that is, for the time between filing and rejection). He is not entitled to exercise his landlord's lien rights against the property of the tenant, however.

Conclusion. In most cases, it is not necessary for the landlord to do anything. The post-filing rent should eventually be paid, and the tenant should eventually assume or reject the lease. If post-filing rent is not paid and falls into arrears, the landlord may need to petition the bankruptcy court for payment of the rent. However, if the tenant owes pre-filing rent, or if the lease is rejected, it may be necessary to file a proof of claim in order to share in the distributions to the general creditors.

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MEMORANDUM #1506 Landlord's Liens

Arizona law gives a lessor of real property the right to assert a landlord's lien against the property of a defaulting tenant. This means that a landlord can take possession of the tenant's property located on the premises and sell it to reimburse the landlord for unpaid rent or the cost of curing other breaches under the lease.

The lien applies only to the property of the tenant—any property belonging to third parties, such as leased equipment, goods on consignment, or property which has been sold by the tenant to a customer but not yet delivered—must be released to its owner upon demand. In addition, if the tenant is an individual, there is certain property which is exempt from the lien, such as tools of the trade with a value of $2,500 or less, an automobile with a value of $5,000 or less, and certain items of furniture, clothing, and other personal effects. These items are not subject to the lien and must be released to the tenant.

After the property is seized, the tenant has 60 days to pay any amounts necessary to satisfy the landlord's claim. If the tenant fails to do so, the property may be sold and the proceeds applied first to the expenses of sale, then to satisfy the landlord's claim, and the balance, if any, must be paid to the tenant.

Conflicting Claims. A conflict often arises between a landlord claiming a lien and a lender who claims a security interest in inventory or equipment located on the premises. The lender could be a bank which takes a security interest in the tenant's equipment and inventory to secure a loan, or it could be a seller who takes a security interest in equipment or inventory sold to the tenant to secure the unpaid balance of the purchase price. The law resolves this conflict by providing that the landlord's lien is superior to the lender's lien, unless the lender's lien was perfected before the property was brought onto the premises. This means that the lender must have received a signed security agreement and must have recorded a financing statement (also known as a UCC-1) before the property is taken to the tenant's premises if the lender wishes to preserve his priority.

Bankruptcy. A landlord's lien does not survive the bankruptcy of the tenant. Therefore, when the tenant files bankruptcy the landlord is required to release the tenant's property to the trustee so that it can be sold to satisfy the tenant's general creditors.

How To Protect Yourself. If you are a tenant and believe you may need bank financing at some time in the future, attempt to negotiate in your lease a provision that the landlord will subordinate its lien to any future lenders. The time to do this, of course, is when you are negotiating the lease. It is always difficult to get a landlord to release an existing right after the lease has been signed. A provision of this type will make it much easier to obtain financing in the future should it ever become necessary or desirable.

If you are a landlord and are concerned about the financial stability of your tenant, obtain a separate security agreement from the tenant to secure his obligations under the lease, and perfect it by filing a financing statement. This will normally survive a bankruptcy filing by the tenant, even though the landlord's lien standing alone will not.

__________________ A.R.S. Sec. 33-361 and -362; Ex-Cell-O Corp. v. Lincor Properties of Arizona, 158 Ariz. 307, 762 P.2d 594 (Ariz. App 1988).

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MEMORANDUM #1507 What To Do If Your Tenant Doesn't Pay His Rent

The owner of a commercial property has a number of options available if a tenant doesn't pay his rent when due.

Notice. When the rent is late, the first thing the landlord must do is to read the lease. This may sound obvious, but it is critically important. Leases usually contain lengthy provisions governing defaults by the tenant. It is important to determine whether any particular type of notice is required before the landlord can exercise his remedies. Often, leases provide that the tenant must be given five or ten days notice before the landlord can take action, and many times the notice must be given in a particular manner (such as by certified mail), and to multiple parties. If the lease contains such provisions, the required notice must be given, and if the tenant cures the default within the specified time, the lease is again in good standing and no action can be taken.

It is interesting to note that commercial leases, which are normally drafted by the landlord to be as tough as possible, often provide more protection for the tenant than if they were completely silent on the subject of defaults. This is because the Arizona Landlord Tenant Act does not require any notice at all when the tenant is in default of his rent. Once the tenant is five days in arrears, the landlord can either retake possession by self-help or commence an eviction action without advance notice to the tenant. However, if the lease provides that a certain notice is required, then the specified notice must be given before the landlord can take action. This is a situation where the law sometimes provides a tougher remedy than the one specifically put into the lease by the landlord.

It should always be remembered when giving notice of default to a tenant, the tenant should be clearly informed that even though the tenant's right to possession is being terminated, the lease itself is not being terminated. This preserves the landlord's right to damages for unpaid future rent. If the lease is terminated, the landlord is considered to have waived all future rent.

Remedies. Assuming any required notice is given and that the tenant has not cured, the landlord may do one of three things—he may demand that the tenant vacate the premises, he may exercise self-help and take back the premises himself (usually known as a "lockout"), or he may start an eviction action (legally known as a "forcible entry and detainer"). If the landlord simply gives notice and the tenant does not vacate, then of course the landlord must either resort to a lockout or an eviction proceeding.

A lockout is the easiest and quickest remedy. However, it is available only if it can be carried out without a "breach of the peace." The law does not want landlords to physically eject persons from the premises because of the risk of escalating violence. Therefore, the lockout remedy usually works only when the landlord takes possession of the premises during non-business hours when no one is inside. The lockout is accomplished by changing the locks on the premises and leaving conspicuous notices that the landlord has retaken possession. Depending on the tenant and the value of the property inside, it may be advisable to post a security guard to prevent unauthorized re-entry.

Any landlord contemplating a lockout must be absolutely sure that he is entitled to eject the tenant, and that all required notices have been given. If there is any doubt, the landlord should avoid a lockout because if it later turns out that the eviction was not justified, the landlord can

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become liable for damages for wrongful eviction which may include lost profits suffered by the closure of the tenant's business.

The remaining means of recovering possession is by an action for forcible entry and detainer. This is a simplified and accelerated procedure for obtaining a court order of eviction. After the tenant is served with the summons and complaint, he will have to appear before a judge within several days to plead guilty or innocent. If he pleads guilty or fails to show up, an order of eviction is immediately entered. If he pleads innocent, the matter is set for trial within 30 days after the day the action was commenced. If the tenant does not promptly vacate the premises after being ordered to do so, the landlord can have the sheriff physically evict him. Although a forcible entry and detainer action is slower and more expensive than a lockout, it does have the advantage of protecting the landlord from a claim of wrongful eviction in nearly all cases.

Landlord's Lien. In addition to removing the tenant from the premises, the landlord is entitled to a judgment for unpaid rent. To enforce his claim for rent, the landlord is given a statutory landlord's lien on the tenant's property located on the premises. Property belonging to others, such as inventory on consignment or leased equipment, must be released to the rightful owner upon request. If the tenant does not pay the rent within 60 days, the landlord may sell the property at public auction and apply the proceeds to the back rent. The tenant must be given at least five days written notice of the auction if he can be found, and if not, the landlord must publish notice of the auction in a local newspaper twice before the auction is held.

Residential Properties. It must be remembered that the foregoing applies only to commercial properties. For residential properties, there is an entirely different set of rules which provide the tenant much more protection against eviction.

Conclusion. Care should be taken in drafting leases to provide the landlord with workable remedies in the event of the tenant's default. In some cases, it might be preferable for the lease to simply provide that the landlord shall have the remedies available at law, which can be tougher than the provisions typically found in a lease. When a default occurs, the first step must always be to read the lease. After any required notices have been given, the landlord should carefully consider whether to lock out the tenant or begin eviction proceedings, and whether to exercise its right to a landlord's lien. The landlord should avoid saying that the lease is "terminated" if he intends to seek damages for unpaid future rents.

__________________ The relevant statutory citations are A.R.S. Secs. 33-361, 33-1023, 33-1368, and 12-1178.

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MEMORANDUM #1601 Mechanics' Liens Caused By Tenant

Most people involved in the real estate industry have a basic knowledge of mechanics' and materialmen's liens. However, many property owners do not know whether construction carried on by their tenant can create a lien against their property.

First, a little background. Arizona law provides that every person who labors or furnishes professional services, materials, machinery, fixtures, or tools in the construction, alteration, or repair of any building may assert a lien against the property if not paid. This means, for example, that if a lumberyard delivers lumber to a building site for incorporation into a building but is not paid when the bill comes due, the lumberyard may record a lien against the property. It may then foreclose on that lien in a manner similar to foreclosing on a mortgage. The sheriff would sell the property at the completion of the foreclosure and the proceeds would be used to pay lienholders, including the holder of any mechanics' and materialmen's liens against the property, in the order of their priority. The balance, if any, would be paid over to the owner.

Building owners often lease space to a tenant--be it an office, shopping center, or industrial building--knowing that the tenant is going to make improvements to the leased space. Usually, the lease will expressly give the tenant permission to make certain improvements, or may require the tenant to obtain the landlord's approval of the plans before beginning any improvements or alterations. As a result, landlords are often concerned about the exposure of their property to liens if the tenant encounters financial difficulties and fails to pay his suppliers, contractors, and laborers.

In most cases, the landlord has little to worry about if he is aware of the law and handles the situation properly. Here are the ground rules:

1. The general rule is that the landlord's property is not subject to liens for improvements done by the tenant, even if the landlord knew of or consented to the work.

2. The first exception is when the lease requires the tenant to make improvements. In this case, the landlord's property becomes subject to mechanics' and materialmen's liens if the tenant doesn't pay for the work.

3. The second exception is when the tenant is the landlord's agent in having the work done, provided that the agency can be proven by clear and convincing evidence. If an actual agency relationship can be proven, the landlord's property may be subject to liens.

4. Even if the landlord's property is not liable for liens, the tenant's leasehold estate will be if the tenant doesn't pay his bills. Any lien claimant foreclosing on the tenant's leasehold estate would, of course, have to pay the landlord his rent and comply with the other terms of the lease, so this remedy is of limited value and is rarely exercised.

Conclusion. If you are a landlord, be very careful before you sign a lease requiring your tenant to make improvements, because this can subject your property to liens. And if you do require such improvements, either require the tenant to file a bond against liens or take steps to insure that all contractors, professionals, workers and suppliers are paid and lien waivers obtained as the job progresses.

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MEMORANDUM #1602 Landlord Liability For Nuisance

Suppose you own a house, and you lease it to a family on a month-to-month basis. A few months later, the next door neighbor comes to you and says that your tenant is repairing cars on the property and has automobile gas tanks and other flammable materials strewn about the yard. Even worse, he tells you that your tenant's children have been seen playing with a cigarette lighter, and he is concerned about the fire danger to his own property.

After his visit, you think it over and conclude it's not your problem. You figure it's not your job to police the activities of your tenant or his children. All you're doing is leasing a house. Besides, you need the rent.

You can guess what happens next. The children start a fire, several explosions follow, the neighbor is badly burned, and his house is destroyed. Then he sues you. And he wins.

This story is true — except that you're not the landlord, of course.

Does this mean that every landlord is responsible for the acts of his tenants? Not at all. In fact, the general rule is that a landlord is not responsible for the acts of his tenants, including nuisances, dangers, or annoyances created on the property itself. As the above case illustrates, however, there are exceptions.

In order for a landlord to be liable for nuisances created by his tenant, and for the harm that results, three factors must be present:

(1) The nuisance must be one for which the landlord would be liable had he created it himself,

(2) At the time the landlord enters into the lease, he must consent to the activity creating the nuisance or must know or have reason to know that the activity will be carried on at the property, and

(3) At the time the landlord enters into the lease, he then knows or should know that the activity will cause a nuisance.

Why, then, was the landlord found liable in the above case, since he learned of the nuisance after he had entered into the lease? The answer is because a month-to-month lease is treated as new lease every month. The landlord is under no obligation to continue the arrangement, and may terminate it at virtually any time. Therefore, once the landlord was informed of the fire danger, he had a duty either to see that it was corrected or to refuse to allow the lease to be renewed for another month.

Conclusion. If you, as a landlord, learn of a nuisance or dangerous condition on your property, you have an obligation to correct it as soon as you have the legal power to do so by refusing to renew or extend the lease. You may also be liable if you know or should know, at the time you lease the property, that your tenant will be creating a nuisance or danger to others.

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MEMORANDUM #1603 Estoppel Certificates

If you're a tenant, you've undoubtedly been asked to sign those annoying little forms that say "Estoppel Certificate" at the top. And if you've ever purchased commercial property or lent money on commercial property, you've probably asked tenants to sign them.

In general, an estoppel certificate is a statement by the tenant that the lease is in force, that there are no defaults, that the rent has not been paid more than one month in advance, and so forth. The purpose, of course, is to provide verification to the purchaser or lender that the leases are as represented and that the cash flow upon which he is relying is likely to continue.

These certificates are based on the legal doctrine of estoppel, which holds that someone should not be allowed to take inconsistent positions to the detriment of another. The requirements for estoppel are: (1) the party to be estopped must know the true facts, (2) the party to be estopped must intend or have reason to know that his acts will be relied upon by another, (3) the party relying must be ignorant of the true facts, and (4) the party relying must have done so to his detriment.

Therefore, when a tenant signs an estoppel certificate knowing that a purchaser or lender is relying on the representations in the certificate, the idea is that the tenant will be estopped, or legally prevented, from later taking a contrary position. For example, if the tenant represents in the certificate that the lease expires on a certain date, and later tells the new owner that he has a side letter extending the lease, the new owner can take the position that the tenant is estopped from claiming that the extension letter is valid and refuse to recognize it.

This means that as a tenant, you should read carefully any estoppel certificate you sign and should be absolutely sure anything stated in the certificate is correct. If you are engaged in a dispute or disagreement with the landlord, or if you believe the landlord may be in default under the lease, be sure to disclose this in the estoppel certificate. And if you are not sure whether a particular representation is true, insert the words "to the best of tenant's actual knowledge" at the beginning of that statement.

What if you sign an estoppel certificate not knowing that a representation in the certificate is untrue? For example, suppose the landlord was in breach of the lease by overcharging for common area expenses, but you were not yet aware of that breach? If you had no reason to know the statement was untrue, you shouldn't be estopped from later taking a contrary position because one of the requirements of estoppel is that the party to be estopped must know, or at least have reason to know, the true facts. Nevertheless, great care should still be exercised in signing estoppel certificates because it is not always easy to prove what one did or did not know months or even years after the fact. A carelessly signed certificate can amount to a relinquishment of valuable rights.

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MEMORANDUM #1604 Lease/Option Agreements

Tenants sometimes negotiate an option to purchase as part of a lease. Occasionally they are even able to negotiate a provision that all or a portion of the rent payments will apply to the purchase price. Options of this kind are most commonly found in leases of single-user improved property, such as restaurants or manufacturing plants, or in leases of single-family residential properties. An option can be an important and valuable provision for the tenant, especially if he has a special need for the particular property.

Remedies. If the landlord fails to honor the option, the tenant has to look to his legal remedies. Generally, the tenant has two kinds of remedies available where the landlord breaches an option: (1) damages, and (2) specific performance. Unless the tenant has one or both of these remedies available, the option is nothing more than an illusion which depends solely on the good faith and cooperation of the landlord.

Damages. If the tenant seeks to recover damages, he is entitled to recover the difference between the option price and the fair market value of the property at the time the option is exercised. In some cases, this is an adequate remedy. In other cases, however, this is totally inadequate, particularly if the tenant has a special need for the property not reflected in its market price. Damages are also inadequate where the option price is the same or higher than the market price because in the eyes of the law there are no damages. Therefore, it is critical for the tenant to have specific performance available as one of his remedies.

Specific Performance. Specific performance means that the court orders the breaching party to perform the contract as written. If he doesn't, the court can enforce its order by the contempt power-—that is, the court can put the party in jail until he complies with the court's order. This is usually enough to persuade a reluctant landlord that he should comply with the terms of the option.

Unfortunately, the tenant's efforts to obtain specific performance to enforce his option can be easily frustrated. The reason for this is usually that the option is not detailed enough. In order to qualify for specific performance, an option must contain all the essential terms of the deal. The courts like to say that they will not write a contract for the parties, which means that they will not order a party to perform a contract unless all the material terms of the contract are specified.

This kind of legal deficiency is usually not a problem when the parties enter into a contract for sale, as opposed to a lease. The parties to a sale normally go to great lengths to write out all sorts of detailed provisions--who pays the closing costs, how any deferred balance of the purchase price is to be structured, whether there are any warranties and what they are, who is responsible for risk of loss prior to the closing, what the status of title is to be, and so on. As a result, specific performance is usually available to enforce a sales contract. On the other hand, when the parties insert an option in a lease, there is a tendency to specify little more than the price, payment terms, means of exercise, and closing date. For whatever reason, the parties to a lease/option contract often seem to leave out many of the important details found in a real estate purchase contract.

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The failure to specify all the details does not necessarily mean the option is unenforceable, however. If the major terms are specified, there might be enough to sustain an action for damages, even though there may not be enough for specific performance.

To make sure your option qualifies for specific performance, include all of the things a purchaser and seller would normally put in a real estate purchase. Clearly the price, payment, terms, and the closing date must be specified. But this is not nearly enough. The contract should also specify the condition of title, type of deed, closing costs, warranties, indemnifications, title insurance, prorations, and other typical terms found in a sales contract. A good approach is just to do a separate purchase contract and attach it to the lease as an exhibit, stating that if the option is exercised, the terms of the purchase contract will govern the sale.

Conclusion. If you are negotiating an option to purchase as part of your lease, be certain to include all the terms you would have in a purchase contract. Do not simply insert a short paragraph specifying the price, terms, and closing date, or you risk losing the important remedy of specific performance, perhaps leaving you with an illusory option.

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MEMORANDUM #1605 Rent Tax

Many states and local jurisdictions levy a tax on gross rents received from leasing real property. This tax is really a form of excise or sales tax, and is based on the gross rent received by the landlord.

In Arizona, the state rent tax on commercial property has been phased out, but a number of cities and counties still impose the tax.

The tax is levied against the landlord, not the tenant, but the landlord can pass it along to the tenant, just as most retailers pass the sales tax along to their customers.

What's Included. Landlords should be aware that the tax is based on more than just monetary rent. If the tenant pays a cost or expense on behalf of the landlord, this amount is treated as additional rent and tax must be paid on it. For example, if the tenant pays the property taxes on the building, as is the case with a net lease, this is considered part of the rent. It doesn't matter whether the tenant reimburses the landlord or pays the property tax directly to the assessor, it's still part of the rent and the landlord has to pay tax on it just the same as if he had received the money in cash.

Other items included as part of the rent for tax purposes, to the extent paid by the tenant, are insurance, promotional expenses, common area maintenance charges, utility connection charges, and improvements made on behalf of the landlord. Any of these items paid by the tenant must be included by the landlord in his tax return.

What's not Included. Actual utility charges paid by the tenant or reimbursed to the landlord are generally not considered part of the rent for tax purposes. The same is true of other actual operating expenses of the tenant not related to the ownership or maintenance of the building.

Landlord's Risk. The landlord needs to be vigilant in collecting taxes for these expenses from the tenant, if the lease allows him to do so. Otherwise, the tax collector may later discover that back taxes and penalties are owing, long after the tenant has gone, leaving the landlord holding the bag.

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MEMORANDUM #1606 Subleases When Master Lease Terminated

It is not unusual for a landlord and his tenant to mutually agree to terminate their lease. The reasons are many. The tenant may no longer be able to afford the lease payments, or he may need to move his business location elsewhere. Sometimes the tenant agrees to pay a termination fee or settlement to the landlord in order to avoid litigation, and sometimes they just agree to terminate the lease without a payment of any kind.

Subtenants. What happens if a portion of the property has been subleased by the tenant to a third party? An example might be an office tenant who has subleased a few office suites, or a retailer who has subleased a little extra space to a small merchant or service provider. Another example might be the subleases under an "office suite" leasing arrangement where individual offices are leased out to those needing an office and support services.

You might think that a mutual agreement to terminate the master lease automatically terminates the sublease, since the subtenant is claiming through the terminated master lease. You might also think that the subtenant would be left only with a claim for damages against the tenant (his sublessor). If you had such a thought (even though it is quite logical), you would be dead wrong!

The courts analyze the situation a little differently. They say that when a tenant subleases a portion of his space, he grants a portion of his leasehold estate to a third party. Therefore, he cannot agree to terminate an estate he no longer has. The result is that while a mutual agreement by the landlord and tenant terminates the master lease, it does not terminate the sublease. The subtenant may remain on the premises for the duration of his sublease. This can be difficult for the landlord if the subleased space is in the middle of a large suite or in some other inconvenient location.

The Shocker. This is not the worst of it. Some courts have held that the subtenant no longer has to pay rent! This is based on an ancient theory of real property law that the unqualified surrender of the remaining term of the master lease, coupled with acceptance by the landlord, merges the leasehold estate into the fee, subject to the estate held by the subtenant. The result is that the subtenant retains his subleasehold estate, and any claim for rent by the landlord or the sublessor is extinguished along with the termination of the master lease. Other courts have adopted the more reasonable rule that the duty to pay rent is impliedly assigned to the landlord under this circumstance, or have developed a rule requiring the subtenant to pay rent on grounds of fairness and equity. Since most courts have yet to address this issue, in many jurisdictions the result could go either way.

(Keep in mind that the above discussion refers only to terminations by mutual agreement; unilateral terminations by the landlord resulting from the tenant's breach do operate to terminate all subleases).

The Lessons. What does this mean if you are a landlord? Fortunately, there are a few helpful lessons we may derive from this scenario:

1. When Leasing. As a landlord, attempt to negotiate a provision in your lease that you may withhold consent to a sublease in your sole and absolute discretion, without any requirement of reasonableness. If you can't get that, attempt to negotiate a provision that says any sublease must state that it terminates upon the termination of the master lease, whether the termination is by mutual agreement of the landlord and tenant or otherwise.

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2. When Consenting. If you are consenting to a sublease, remember that you may be stuck with it if the master lease is terminated. Try to make sure it is in a location that will not prove troublesome if the master lease is terminated, or negotiate a provision that you have the right to relocate the subtenant upon termination of the master lease.

3. When Terminating. If you are negotiating the termination of a lease, make sure there are no subleases; but if there are, (a) try to make their termination a condition of the termination of the master lease, or (b) at least have your tenant assign the subleases to you (together with an express assignment of the right to collect rent) before you agree to the termination so that you can collect rent even though you must honor the subleases.

4. The Last Resort. Finally, if the sublease is a serious problem, don't agree to a mutual termination. Wait for the tenant to default, and then terminate the lease (or at least the tenant's right to continued possession) for non-performance, which also terminates the sublease.

__________________ Cases providing that no rent is payable include Byrd v. Peterson, 66 Ariz. 253, 186 P.2d 955 (1947); Bailey v. Richardson, 66 Cal. 416, 5 P. 910 (1885). Cases requiring the subtenant to pay rent include Hessel v. Johnson, 129 Pa. 173, 18 Atl. 754 (1889); Shaw v. Creedon, 133 N.J. Eq. 397, 32 A.2d 721 (1943).

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MEMORANDUM #1607 Ground Leases

Why A Ground Lease? A ground lease is rarely the developer's first choice when searching for a site. A leased site generally requires lengthy negotiations and complex documentation, and can make financing more difficult. It creates a depreciating asset as the lease winds down. Finally, a ground lease does not provide the sense of security and permanence that an owner has with fee title. Why, then, does anyone ever lease a building site?

The answer is usually that it's the only way to make the deal. Typically, the developer begins by looking for a site to purchase. After finding the site he wants, he discovers that the landowner will not sell it--he will only lease it. This is especially common where the land is a pad on the edge of a large shopping center or mall. At that point the developer must decide whether he wants the site enough to enter into a long-term ground lease. If the site is good enough, and the rent reasonable enough, the answer is frequently "yes," and the parties proceed to negotiate that lengthy document we all know as a ground lease.

Developer Advantages. Of course, there are a few advantages to leasing, rather than purchasing a site. Chief among them is that a lease can provide more leverage, because the land does not have to be purchased. This means that less capital will have to be invested in the project. This is especially true if the landowner is willing to subordinate his fee to the developer's mortgage. The ground lease, in other words, can be used as a financing device for the developer, constituting something roughly equivalent to a second mortgage. Some developers believe a properly-drafted subordinated ground lease is as good as, or better than, fee title. Another advantage is that the entire lease payment is tax-deductible, as opposed to mortgage financing, where only the interest payment is deductible.

Landowner Advantages. The landowner normally sees a number of important advantages to a ground lease. They include some or all of the following:

First, the owner can achieve a steady flow of trouble-free income. Ground leases are typically net leases and produce a dependable monthly income over a long period of time. It is not unusual to see a landowner enter into a ground lease to provide himself a retirement income. Sometimes leases are assigned a trust to provide a stable long-term income for the landowner and his heirs.

Second, the landowner can avoid capital gains taxes. If he were to sell the land and invest the proceeds, he would be able to invest only the value left after paying taxes on his gain. By leasing the land itself, he can realize income on the full pre-tax value of the asset and earn a higher cash flow.

Third, he can usually negotiate for rent increases over time, an advantage not normally available with other forms of debt investment, such as bonds and mortgages.

Fourth, the landowner may desire to speculate on the potential increase in the value of the land. Sometimes the long term of the ground lease makes this difficult. However, for certain uses it is sometimes possible for the landowner to retain termination rights (usually with a substantial penalty), if he should later desire to redevelop the land for a higher and more profitable use.

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Fifth, the landowner may have an emotional attachment to the land. An example might be a family farm or homestead that has become ripe for development. In such a case, a ground lease can allow the landowner to turn his asset into something economically productive while still satisfying his psychic need to retain title to the property.

Sixth, the landowner may feel like he retains more control over the use of the land with a ground lease, which is particularly important when dealing with a shopping center pad.

In most cases the landowner has already decided that he wants a ground lease before he is ever approached by the developer. In other situations, the landowner is approached about selling his land and refuses. He may have no interest in selling for any of a number of reasons. In this situation, a ground lease is sometimes suggested by the broker or developer as a means of gaining a good site from an owner who does not want to sell. An awareness of the possibility of a ground lease as an alternative to a sale can sometimes enable a developer to obtain a site that might otherwise be unavailable.

Subordination--The Big Issue. Every ground lessee would like the right to subordinate the landlord's fee to his financing. On the other hand, every landowner wants to avoid subordination because it creates a risk to his fee title. Many landowners simply refuse to consider subordination at all.

To convince an owner to subordinate, the lessee will usually have to make the landowner very comfortable that his risk is minimal. In addition, the lessee usually will have to offer the landowner a financial incentive. This may take the form of a higher rent, some sort of equity or cash flow participation, or both.

Comfort to the landowner is usually furnished in two ways. First, the lessee must demonstrate financial strength and a track record of successful real estate development, and perhaps provide a guarantee by a financially strong individual or company.

Second, the lease will have to contain certain restrictions on the type of financing to which the fee may be subordinated. Typical subordination provisions include the following restrictions on financing:

(A) Amortization. The loan will probably have to be fully-amortizing over a specified long period of time. For example, the lease may provide that the loan must amortize over no less than 25 years, and may not have balloon payments.

(B) Interest Rate. There may be limitations on the rate of interest that may be paid. The lease may provide that the interest rate shall not exceed a certain rate, that it must be fixed for the entire term of the loan, and that there can be no negative amortization.

(C) Use of Proceeds. Usually, the loan proceeds must be used only to improve the property. There may be enforcement mechanisms similar to those required by construction loans.

(D) Approval of Plans. The landowner may require approval rights over the plans and specifications for the improvements.

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(E) Refinancing. There may be restrictions on refinancing. Typically, many of the same restrictions will apply to refinancing that applied to the original loan. However, it is not unusual for the landowner also to prohibit refinancing for an amount greater than the current unpaid balance of the original loan. The landowner, in other words, may not want his land to be used as security for a loan where the lessee will be pulling money out of the project, fearing that this may increase his risk. While this furnishes valuable protection to the landowner, it is obviously a great disadvantage for the lessee, because it may require the lessee to tie up capital in a real asset that he might have better uses elsewhere.

(F) Default. The lease will probably provide that a default on the loan is a default under the lease. In addition, the subordination may be conditioned on the lender agreeing to give the landowner certain notices and opportunities to cure in the event of a default on the loan.

Non-Subordinated Leases. If the lessee is not able to negotiate a right to subordinate the landowner's fee to his financing, he should attempt to negotiate provisions in the lease that will permit him to obtain non-subordinated financing secured by the leasehold estate. This is a good idea even if the lessee has no present intention of obtaining financing for the project, because these provisions will give the lessee added flexibility and will make the leasehold estate more valuable if the lessee ever wants to sell it.

Obviously, any lender will be concerned about lending on a leasehold estate, because if the lease is terminated, the lender's security evaporates. The lender will therefore insist on a number of protections to make sure that this risk is minimized.

The best procedure is for the lessee to bring his lender to the table at the time he is negotiating the lease so that the lender can specify exactly what sort of provisions will be required in order to make the project financeable. This is important, because even if the lessee attempts to anticipate his lender's needs and desires, there is no standard set of lender protection provisions that every lender will automatically accept. Lenders may have their own specific requirements for leasehold mortgages, and if the lessee doesn't have them in his lease he may be in the uncomfortable position of having to later renegotiate his lease to get them.

If a lender is not available when the lease is being negotiated, the developer should attempt to negotiate the following kinds of provisions, which are required by most lenders before they will lend on a non-subordinated leasehold estate:

(A) Notice and Cure. Any lender will require notice of any default under the lease and an ample opportunity to cure. These provisions can be extensive and may give the lender a considerable period of time to cure. It is not unusual for the lender to require more than one notice before the lease may be terminated, and the notices might have to contain certain specified information to make sure the recipient is aware that its security is in jeopardy.

(B) Time To Obtain Possession. The lender may require sufficient time to be able to take possession of the property before the lease can be terminated as the result of a non-monetary default. That is, the lender will want sufficient time to foreclose on its

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mortgage before the landowner may terminate the lease based on a non-monetary default. Normally, the lender will agree to pay the rent in the meantime, but this provision does allow the lender to obtain possession so that it is in a position to cure a default that can only be cured by one in possession, such as the duty to maintain or repair the property.

(C) Foreclosure Not Default. The lender will want provisions stating that the foreclosure of its lien and the subsequent sale of the leasehold estate to a third party will not be considered a default under the lease and will not require the consent of the landowner.

(D) No Liability. The lender may ask for a provision that it has no personal liability under the lease, even after becoming the lessee as the result of foreclosure or deed in lieu.

(E) Cancellation or Amendment. The lender will probably want a provision in the lease that the lease cannot be canceled or amended without the consent of the lender.

(F) New Lease on Termination. The lender may require a provision that if the lease is terminated as a result of the lessee's bankruptcy (pursuant to the trustee's power to reject leases), the landowner will, upon the request of the lender, enter into an identical lease with the lender.

(G) Estoppels. If the building is to be leased out to tenants, the lender may want a provision requiring the lessee to furnish estoppel certificates from the tenants from time to time.

From the developer's perspective, if he intends to lease his building out to others he should be sure to negotiate a provision in his lease that the landowner will enter into attornment and non-disturbance agreements with his subtenants upon request. This will allow the lessee a better opportunity to enter into leases with large sophisticated tenants, who will want protection against the risk of termination of the ground lease as a result of the lessee's (their landlord's) default. The landowner will usually agree to such a request, but only if the subleases meet certain qualifications, such as being at no less than market rates with limitations on the amount of rent that can be paid in advance, possible limitations on the duration of the leases, a disclaimer of any duty by the landowner to make tenant improvements, and so on, so that the landowner is not stuck with onerous or unprofitable leases should his lessee default on the ground lease.

Conclusion. A long-term ground lease is rarely the developer's first choice when acquiring property, but in some cases it is the only way to gain development rights to prime property. If properly structured, a ground lease can provide a satisfactory way to acquire a good site for development, and provide advantages to both the landowner and the developer. Often a broker or developer can suggest a ground lease in order to make a deal where the parties cannot agree on a sale.

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MEMORANDUM #1608 Sublease Space or Not?

Subleases are quite common, especially for commercial property. Subleased space often costs substantially less than similar space leased directly from the landlord. This is partly because there are some extra risks, inconveniences and disadvantages associated with subleased space, and partly because many tenants are just not comfortable with subleased space.

Risks. What are the risks? The main one is that the sublandlord—that is, the tenant under the primary lease—will default. If this occurs, the landlord under the primary lease could terminate the primary lease, which automatically terminates the sublease. Fortunately, it is often possible to eliminate this risk by having the primary landlord agree in writing to (a) notify the subtenant of any default by the sublandlord under the primary lease, (b) allow the subtenant to cure the default, and (c) agree to honor the sublease if the primary lease is terminated.

Another risk is that there are undisclosed problems with the primary lease, or an amendment to the lease the subtenant has not been informed about. For this reason it is critical to have the primary landlord execute an estoppel certificate acknowledging that the primary lease is in full force and effect, has not been amended, and that there are no existing defaults. This helps to eliminate the risk that the subtenant is buying into an existing problem or undisclosed lease terms.

Inconveniences. What are the inconveniences? For the most part, the inconveniences arise out of the fact that the subtenant has to deal with two landlords, instead of one; or, he might have to deal with the primary landlord through the sublandlord. For example, two consents will probably have to be obtained for alterations, further subleases, or amendments to the sublease, and if disputes arise there is one additional party that must be dealt with. This can lead to delays, complications, and misunderstandings, especially if all communications with the primary landlord have to be filtered through the sublandlord. If the sublandlord files bankruptcy, lawyers may have to be hired to protect the sublease. All of this can take time and attention and generate expenses that are not normally required when you have a direct lease with the landlord.

Disadvantages. What are the disadvantages? Other than those listed above, one of the not common disadvantages is that the sublease can be no longer than the remaining term of the primary lease, which may be shorter than the subtenant would like. Often, the primary lease will not allow the subtenant to take advantage of any option to renew that the sublandlord may have; or, the sublandlord may not agree to exercise its option, in either case placing the subtenant in the position of having no right to stay beyond the end of the current term. Where the primary term is fairly short, this can be a real disadvantage. To cure this problem, the subtenant might try to negotiate a direct lease with the landlord if the sublandlord does not renew, but this is often difficult to do in advance, perhaps leaving the subtenant in a precarious position.

Another disadvantage of a sublease is that the subtenant has to accept all the terms and conditions of the primary lease, usually without an opportunity to negotiate changes that may be desired by the subtenant. In other words, it's usually a "take it or leave it" proposition. For this reason, a subtenant should always carefully review the primary lease.

Conclusion. Subleases often offer attractive below-market rates. For a tenant who is willing to make the effort to protect himself legally at the outset, or who is satisfied with the shorter term and other potential inconveniences, a sublease can be quite advantageous. However, the documentation is critical, and it is important to obtain experienced legal assistance.

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MEMORANDUM #1609 Amending Your Lease? If You Miss This Small Detail, You May Be Out Of Luck

In today's economy, many tenants require a rent reduction just to stay in business. Not surprisingly, many landlords are accommodating them, because a tenant at a reduced rent is preferable to an empty space with no rent at all.

Most landlords have lenders. Whether it is an office building, a retail center, or an industrial property, it is not unusual for the landlord to have a loan secured by a mortgage against the property.

Non-Disturbance Agreement. Most experienced tenants know that they need a subordination, non-disturbance and attornment agreement (usually referred to as an "SNDA") from the landlord's lender when they rent space. This requires the lender (and anyone who purchases at the foreclosure sale) to honor the lease if it forecloses on the landlord's property. Unless the tenant has an SNDA, a lender whose mortgage pre-dates the lease can, if it chooses, terminate the lease or threaten to do so unless the lease provisions are changed as demanded by the lender or purchaser at the foreclosure sale.

One Small Detail. What many tenants forget, even if they are experienced, is that nearly every SNDA contains a provision that says any amendment to the lease must be approved by the lender. If the amendment isn't approved in advance by the lender, the lender is not bound by it. This means that if the lender should ever foreclose, it would not have to honor the amendment, making the SNDA nearly worthless as a protection for the tenant.

In this market, a foreclosure by a lender is not unusual, and while most lenders will want to keep tenants, even at reduced rents, they are not required to do so. In addition, the purchaser at the foreclosure sale may demand a higher rent or other prejudicial changes in the lease, or may have other plans for the space that do not involve the tenant.

Conclusion. When renegotiating your lease, always try to obtain the consent of the lender if you have an SNDA. Otherwise, the amendments you so painfully and carefully negotiate may disappear if the landlord's lender should ever foreclose.

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MEMORANDUM #1701 Innocent Purchaser Defense

By now, everyone is well aware of the enormous liabilities that can result from owning or operating contaminated real property. It doesn't matter who caused the problem--if you owned or operated the property while it was in a contaminated condition, you can be fully liable for the cost of the clean-up. Lessees can also be liable for the clean-up of property they occupy as a tenant, unless they are physically excluded from the area of the contamination. This is especially true of long-term lessees.

Clean-up costs can easily run to the tens or hundreds of thousands of dollars, and sometimes into the millions. Don't think the government won't pursue you if you're not the guilty party--because it will. The government is not interested in fairness, it is interested in getting the money from somebody--anybody--to clean up the contamination.

There is a defense to this potential liability that many purchasers of real property have relied upon. It is called the "innocent purchaser" defense, and it provides that if a purchaser is "innocent" he isn't liable for contamination he didn't cause. To be innocent under the law, it's not enough to be innocent of causing the contamination. One must also have made a reasonable investigation of the property before purchasing it, and the investigation must have indicated that the property was clean. This, of course, is one of the reasons everyone has a phase one environmental assessment done when purchasing property.

So what's wrong with this defense? Plenty.

First of all, it only applies as a defense against the Federal Superfund law and the State counterpart (the Water Quality Assurance Revolving Fund). There are many other laws where the "innocent purchaser" defense does not apply at all, and many of these laws can impose liabilities as great as Superfund. The innocent purchaser defense is also no defense against tort claims by private parties.

Second, even if you do establish a good innocent purchaser defense, it cannot be used by others once the problem becomes known. Therefore, you will probably never be able to sell the property or borrow money against it.

Third, the defense is limited. For example, if your investigation turned up only a small trace of a contaminant which could be easily removed, and it later turns out there was a lot more that was missed, the defense is of no benefit.

Fourth, if the company doing the environmental assessment misses something it should have found, you lose your innocent purchaser status. In other words, the negligence of the company performing the assessment can be attributed to the owner.

Arizona has passed a law expanding this defense under certain circumstances. This law provides that an owner or lessee of property is not liable under the Arizona Superfund law if underground contamination seeps under his property from adjacent property, as long as he had no part in causing the contamination. However, this law affords no protection from federal statutes or from many types of state claims and claims by private persons. As a result, while this expansion of the defense is helpful, it is of limited usefulness.

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Conclusion. What this means is that a buyer or lessee should never assume he is protected just because his environmental assessment comes up clean. He can still have catastrophic legal exposure if contamination is later found on or under the property. To minimize that exposure the buyer or lessee must have a thorough phase one assessment done by a competent firm, and must follow up with a phase two assessment if there are any indications at all of potential contamination. If there is a problem, have the seller cure it before you buy or lease the property. Even then, there is always the risk of liability if contamination should later be discovered.

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MEMORANDUM #1702 Disclosure Requirements

As a general rule, the seller of real property is not required to volunteer adverse information about the physical condition of his property. Although he cannot actively mislead the buyer or stand silent when he should speak, he has no duty to come forward on his own to point out defects.

In fact, it is not uncommon for the buyer and seller to specifically agree that the buyer is making his own investigation and that the buyer releases the seller from all responsibility for the physical condition of the property. In other cases, where the buyer desires representations and warranties, he usually must negotiate for them. The general rule is that the buyer and seller are free to negotiate a mutually acceptable contract on whatever terms they find acceptable, and if the seller refuses to make representations about the condition of the property, the buyer is free to walk away.

Exception. The Arizona Legislature, however, has placed a limit on the seller's right to refuse to make any representation or warranty concerning the condition of his property. Under Arizona law, anyone selling real property knowing that it has been the subject of prior environmental remediation must disclose this fact to the buyer in writing. He cannot remain silent, even if the buyer is willing to purchase the property "as is." This means that if an old service station site has been cleaned up and the seller knows about it, he must disclose it to the buyer in writing even if the property is now in full compliance with law. The same is true for other kinds of contamination that may have been remediated, such as underground storage tank leaks, contaminated dry wells, buried chemicals, asbestos, oil or chemical spills, or other kinds of environmental contamination that constitute a violation of Arizona law. (It is interesting that the wording of the statute only requires disclosure of remediated contamination, leaving one to wonder whether the seller is required to disclose unremediated contamination, which is a worse problem.)

Two Standards. Under Arizona law, contaminated sites must be cleaned up to satisfy one of two standards. If the site is to be used for non-residential uses, one standard applies. If the site is to be used for residential uses (and certain similar uses, such as schools and day-care centers), a higher standard applies.

Because the residential standard is so high, the law has provided an exception to the mandatory disclosure requirement. If contaminated property has been cleaned up so that it meets the residential standard, the statutory disclosure need not be made. Under this circumstance, the seller may remain silent about the remediation, so long as he has not made other statements or representations that may mislead the buyer about this issue.

Conclusion. If you are a seller of remediated property, you must disclose the prior remediation to the buyer, even if you are selling the property "as is" (unless it has been cleaned up to the residential standard). If you are the buyer and are informed of a prior remediation on the property, hire your own consultant to double-check the results. Environmental liabilities are potentially so severe that you will want to have your own experts check out the remediation to make sure it has been done correctly and in full compliance with law before you proceed with the purchase.

__________________ The statute referred to above is A.R.S. § 33-434.01.

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MEMORANDUM #1703 Mortgagee Liability

In recent years commercial lenders and anyone else holding a note secured by real property have been justifiably concerned about the possibility of environmental contamination on the property that is their collateral.

The concern is well-founded, and is two-fold: (1) the value of the collateral is diminished by the existence of contamination, and (2) there is the possibility of the lender becoming personally liable for clean-up costs, particularly if it forecloses on the property but in some cases even if it doesn't.

Value of Collateral. Once the loan is made, there is little that can be done to solve this problem, aside from requiring the borrower to clean it up. This suggests two things — one, the lender should always have an environmental assessment done on the collateral before making the loan or acquiring the mortgage, and two, the loan documents should always contain a provision requiring the borrower to immediately cure any environmental problems.

Personal Liability. If the lender or mortgage holder can be held personally liable for the costs of clean-up, the consequences can go far beyond the loss of collateral value. The property which the lender took as security can suddenly become less than worthless — it can turn into a large liability, or what might be called "negative security."

This can occur either before or after foreclosure.

Before foreclosure — that is, before the lender takes title to the property — the lender's liability depends largely on the extent to which the lender can control the property or its owner. Until recently, there were conflicting court decisions on when a lender could be held liable. The most far-reaching of these decisions held that a lender could be held liable if it had the ability to influence decisions regarding the contamination, whether it did so or not. Because many loan agreements give the lender broad powers of control over the borrower, it was often possible to argue that the lender was liable even if it never foreclosed or took any other action with respect to the contaminated property.

However, EPA regulations now impose personal liability before foreclosure only if the lender actually (1) exercises decision-making control over the borrower's environmental compliance, or (2) exercises control over environmental compliance at a level comparable to a facility manager. It is specifically provided the lender does not incur liability by inspecting the property or by requiring clean-up before making or acquiring the loan. It can also enforce the terms of the loan documents without liability; for example, it can enforce a loan provision requiring the borrower to cure environmental violations without risking liability.

After foreclosure — that is, after the lender has acquired title to the property — the rules are a little different. Originally, the lender simply became liable as an owner. However, the EPA regulations now provide that the lender will not become personally liable as a result of foreclosing as long as the lender disposes of the property in a reasonably expeditious manner by commercially reasonable means. What does reasonably expeditious mean? Initially, there is a six-month grace period. Thereafter, the lender must accept any reasonable offer for the property. Finally, within a year it must attempt to auction off the property or otherwise dispose of it in a

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public manner, and may not reject any offer received. The problem, of course, is that the buyer of the property will probably become personally liable, so that in the worst cases it will simply be impossible to dispose of the property at any price, but at least the lender won't have personal liability. Apparently, the lender will be required to own the property in perpetuity in its contaminated state, hoping someone will eventually come along to take it off its hands.

Conclusion. The EPA regulations provide some relief, but are no substitute for the exercise of due care, both before lending and before foreclosing. In addition, the EPA regulations are being challenged in court, and it is possible that they may be modified or found invalid.

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MEMORANDUM #1704 Wetlands

It is often assumed that federal laws dealing with wetlands and waterways have little application in the desert valleys of Arizona. Nothing could be further from the truth. Land does not have to be wet to be considered a waterway or wetland by the federal government--the definitions include even dry washes and certain vegetated lowlands. It may even include artificial lakes and the runoff from them.

One of the important laws governing wetlands and waterways is set up by Section 404 of the Clean Water Act, which is enforced primarily by the Army Corps of Engineers. This is actually a statute designed to control water pollution, but its reach extends to many ordinary construction and development activities.

The Corps is stepping up its enforcement of the Section 404 "dredge and fill" permit program in Arizona. This program requires people who do development work that affects dry wash beds, such as road construction or grading and leveling of construction sites, to obtain a formal permit or to fit into one of the permit exemptions. Those who have filled or disturbed more than one acre of wash bed in any single project since about the end of 1984, when the requirements tightened up, may have serious exposure for those earlier activities.

Two examples:

--The developer of a mesquite bosque area was forced to get a Section 404 permit under the theory that the bosque was a wetland, even though it was not wet.

--The Corps notified a major resort that its wash bed development activities extending back into the late 1970s have been illegal under the Section 404 program. The Corps claimed that not only were their grading activities illegal, but they have now created an artificial wetland subject to the Section 404 permit program because discharges from their artificial lakes are allowing cattails to grow in a wash below the lakes. The Corps demanded that they cease all development activities until they get a permit, threatening fines up to $50,000 per day and a 3-year jail sentence.

Section 404 issues should be included in the due diligence investigation for real estate purchases, and should be carefully considered before undertaking any real estate development project.

There are two especially frightening things about the 404 program. First, if illegal filling has occurred, the Corps can order complete restoration of the property to its former condition. It has done this in other states. Second, the Corps is becoming more active in asserting jurisdiction over artificially created wetlands and other manmade bodies of water. As absurd as it may seem, the Corps can claim that even a manmade lake is subject to its permitting program, so that any dredge and fill activities on such a lake would require a Corps permit (even on private property). The 9th Circuit Court of Appeals has upheld the Corps' jurisdiction over an artificial wetland, and the Supreme Court has denied review.

Conclusion. Federal water pollution laws can apply to the filling or altering of dry desert washes, doing site work on lowland vegetated areas, and altering artificial lakes and streams. The penalties for violating the laws can be severe, and might include restoring land that was filled years ago to its original condition. A thorough investigation should be made before acquiring any land that may be classified as a waterway or wetland, and proper permits should be obtained before doing any work on land that may be considered a waterway or wetland.

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MEMORANDUM #1801 Basics of Community Property

Arizona is one of several states that recognize the unusual system of ownership known as "community property." Because the community property laws have special application to real estate and certain other kinds of transactions, it is prudent to understand how community property works and how it can affect your business and personal dealings.

What is Community Property? The general rule is that all property acquired during marriage is community property, except property which is inherited or which is received as a gift. Property owned before marriage ordinarily remains sole and separate property. Property acquired during marriage while the couple resides in a non-community property state is separate property and retains its separate character when the couple moves to Arizona.

Property which starts out as separate property can be converted into community property by gift (that is, the spouse owning the property can give it to the community) or by becoming so commingled with community property that its identity is lost. Conversely, community property can be converted into sole and separate property if one spouse makes a gift of his or her community interest to the other.

Control. In Arizona, each spouse has the full right to manage and control community property and to bind the community to debts and obligations. This means that either spouse, without the consent or even the knowledge of the other, can buy or sell community personal property, enter into contracts, borrow money, or engage in other business dealings on behalf of the community.

There are two important exceptions:

1. Both spouses must join in the acquisition, disposition, or encumbrance of real property (including leases of a year or more).

2. Both spouses must join in the execution of a guarantee or indemnity agreement.

What happens if only one spouse signs an agreement that requires the signature of both?

First of all, if it is done fraudulently, it is a felony. Arizona law provides that any person who represents that he or she is authorized to sell or mortgage community real estate, knowing that his or her spouse has not consented, can be prosecuted and sentenced to jail.

More commonly, it simply creates title problems or results in an unenforceable agreement. If community real property is conveyed or leased without the consent of both spouses, the conveyance or lease is void. This is true even if the public records indicate that title is held as the sole and separate property of the spouse who signed. For this reason, it is prudent to learn something about the seller, and if he or she is married, the spouse should be required to either sign the deed or lease or execute a disclaimer deed giving up any community property rights in the real estate. The rule is that community property is community property regardless of how title is held. Don't blindly rely on the public records when it comes to this issue.

If a guarantee or indemnity is executed without the joinder of a spouse, the result is a little different--the instrument is enforceable, but only against the sole and separate property of the

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signer, but not the community property or the sole and separate property of the other spouse. If one spouse enters into a contract to buy, sell, or lease real property (for a year or more) on behalf of the community--the sole and separate property of the spouse who signed the contract is liable in the event of a breach, but not the community property or the sole and separate property of the other spouse.

Debts and Obligations. Suppose one spouse borrows money or executes some other contract not involving real estate or a guarantee. Clearly, this binds the community, but that's not all. Arizona law provides that any valid claim based on the agreement of one spouse must be satisfied first out of community property, and then out of the sole and separate property of the spouse who entered into the agreement. The sole and separate property of the other spouse, however, is insulated from liability for such claims.

Finally, what about the debts and obligations of a spouse before marriage? Is the community property of the marriage liable? The answer is that the community property is liable, but only up to the value of the sole and separate property of the debtor spouse which he or she contributed to the community. This prohibits unmarried people from escaping their debts and obligations by getting married and contributing all their assets to the community, and it also protects newly-married people from the full impact of the pre-existing debts of the other spouse.

Conclusion. If you are purchasing real property or entering into a lease of a year or more, be sure to determine whether the other party is married and if so, to obtain the consent or disclaimer of his or her spouse. If you or your spouse has sole and separate property, do your best to keep it separate if you desire to protect it from the claims of creditors of the community or the other spouse. And if you accept a guarantee from a married person, be sure to get the signatures of both spouses.

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MEMORANDUM #1802 Effect on Real Estate Transactions

Arizona is a community property state. This means that most property acquired during marriage is owned jointly by the husband and wife, regardless of who actually earned or produced it. The only exceptions are property acquired by gift or inheritance, or income derived from property that is sole and separate property. And even if property is sole and separate property when acquired, it can become community property if it is commingled, or mixed up, with community property. This often happens, so that after a long marriage there is usually very little sole and separate property.

With a few exceptions, each spouse has full right of control over community property, meaning that if one spouse signs a contract, borrows money, or sells community property, all of the community property owned by the marital community is subject to any liability created by such act. This gives each spouse life-or-death control over the community property, because either spouse alone can bind the entire marital community.

Exceptions. There are a couple of important statutory exceptions:

1. Both spouses must join to purchase, sell or encumber an interest in real property (including leases of a year or more), and

2. Both spouses must join in the execution of a guarantee.

If only one spouse signs for these kinds of obligations, only his or her own sole and separate property is liable. None of the community property is liable.

Partnerships. Suppose one spouse is in a general partnership, and the partnership signs a note secured by a deed of trust. Is the partner's community property liable for a deficiency if the note is not paid?

Until recently, it was generally thought that the partner's community property was liable. The reasoning was that the marital community hadn't encumbered real estate, the partnership had. The liability of the marital community was considered to have been a liability arising out of a partnership interest, not out of an interest in real estate; and since an interest in a partnership is personal property, the obligation was not covered by the statutory exception requiring the spouse's signature. The result was that the community property of both spouses was thought to be liable for the obligation even though one spouse didn't sign, and even though it arose out of an encumbrance of real property.

Two recent Arizona cases have turned that theory on its head. In one case, the Federal District Court for the District of Arizona held that the community property of a partner was not liable for a deficiency judgment against the partnership. In the other case, the Arizona Court of Appeals held that a guarantee executed by a partnership did not bind the community property of the partners. Although the decisions dealt only with encumbrances and guarantees, not purchases, sales or conveyances of real property, the same theory would seem to apply in either case. This would mean that the spouses of all partners would have to sign whenever a partnership bought, sold, leased or conveyed real property.

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The Lesson. Most people have very little sole and separate property. Therefore, if you are relying on the assets of the general partners when doing a real estate deal with a partnership, be sure to require the spouses of the partners to sign. The same is true if you buy property from a partnership or accept a secured note or guarantee from a partnership. Otherwise you may be left with an empty remedy; or worse, with defective title to your real property.

__________________ The cases cited above are Meritor Savings Bank v. Camelback Canyon Investors, No. CIV 91-843 PHX WPC (Filed Nov. 13, 1991, reconsideration denied Jan. 29, 1992); and First Interstate Bank v. Tatum and Bell Center Associates, 98 Ariz. Adv. Rp. 38 (Filed Oct. 22, 1991).

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MEMORANDUM #1901 Tax-Deferred Exchanges

Most real estate investors are generally aware of the tax-free exchange provisions contained in Sec. 1031 of the Internal Revenue Code. These provisions allow you to exchange one piece of investment or business real estate for another without the payment of income taxes.

Normally, a seller of real estate will consider an exchange so that he won't have to pay taxes on the property he is about to sell. However, even if you are about to become a buyer of real estate you might want to consider Sec. 1031 before you sign the contract.

How can a buyer benefit from Sec. 1031? Oftentimes a buyer owns other property he is planning to sell eventually. For example, a company buying a new factory or distribution center might plan on selling its old facility after moving to the new one, or an investor may simply have some other property in his portfolio that he is planning on selling at some time in the future. If so, the buyer should consider accelerating the sale so that the purchase and sale can be tied together in a tax-free exchange.

Three-Way Deferred Exchange. The words "tax-free exchange" connote a trade of properties between two parties, each of which trades the property he owns for the property of the other. It almost never happens that way. Obviously, it is next to impossible to find someone who wants to acquire your property and who also has property you want to acquire. Fortunately, the Internal Revenue Code authorizes what is known as a deferred three-way exchange. Under this arrangement, you sell your property and have the money placed directly in a trust, normally with the title company. When you find the property you want to buy, you have the title company use this money to buy the property for you "in exchange" for the property you gave up. Even though the procedure bears little resemblance to an actual trade of two properties between two parties, the end result is the same and you are allowed to treat it as an exchange for tax purposes.

Basic Requirements. The basic requirements of a deferred three-way exchange are as follows:

First, the properties must be of "like kind." Fortunately, almost any kind of real estate is considered to be like kind with any other, so long as they are both held for investment or for business purposes. Land may be exchanged for income property, or an office may be exchanged for a factory. However, real estate may not be exchanged for stocks, bonds, or personal property, and a partnership interest (even in a land partnership) may not be exchanged for real estate, although there are sometimes ways around the latter if properly structured.

Second, the replacement property (the property you are acquiring) must be designated in writing within 45 days of the closing of the sale of the property you are selling. You can designate more than one property, and don't have to actually purchase each and every property you designate, but there are limits. You can always designate up to three properties (the "three property rule"); or you can designate more than three if their total value does not exceed 200% of the value of the property you sold (the "200% rule"). If you designate too many properties and break both of these rules, you will lose your tax-free exchange.

Third, you must close the purchase within 180 days of the closing of the sale.

Fourth, you cannot receive or have access to the money in the trust until the 180 days elapses.

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Partial Trade. What happens if you have some money left over? If you don't spend all of the money you received from the sale of the property on the acquisition of replacement property, you are deemed to have received "boot" and will have to pay tax on your gain up to the amount of "boot" you received. For example, if you receive $10,000 cash out of the exchange, you will have to pay tax on your gain up to $10,000.

Mortgages. If the property you sell is subject to a mortgage which the buyer assumed or took subject to, this is treated the same as additional cash or "boot" and is subject to tax. However, you may offset this "boot" by the amount of any mortgages you assume or take subject to on the property you acquire. If you realize cash on the exchange sale and also sell property subject to a mortgage, the amount of taxable boot can become quite large. Therefore, it is a good idea to try to purchase a property with a mortgage on it that is at least as large as the mortgage on the property you are selling. In some cases the seller of the property you are acquiring can be persuaded to refinance his property with a larger mortgage in order to help you achieve that objective. That way he gets his cash out and you avoid income taxes.

Conclusion. Deferred tax-free exchanges can postpone the payment of taxes indefinitely, a considerable benefit in these times of high and rising capital gains taxes. Whenever you are selling, or even when you are buying, real estate, at least consider an exchange. However, the rules are exacting and complex, and professional help is strongly advised. A small mistake can render the entire transaction taxable.

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MEMORANDUM #1902 Renegotiation of Debt

The depression in Arizona real estate has caused many debtors to seek a renegotiation of their debts, particularly debts secured by real property. Often debtors seek a modification that will (a) accrue but defer the payment of all or a portion of the interest, (b) reduce the rate of interest, or (c) reduce the principal balance of the note. Each of these modifications can have unexpected tax consequences for one or both parties to the transaction.

Deferral of Interest. The deferral of the payment of interest generally is not a problem for the debtor. The creditor or note holder, however, will probably have to recognize the accruing interest as income, at least if the creditor is an accrual basis taxpayer. This can come as an unpleasant surprise because no one likes to pay income taxes on income he has not yet received. An exception is available, however, if the creditor can show that the future payment of the interest is reasonably uncertain.

Reduction of Interest Rate. If the interest rate is reduced below the applicable federal rate, the modification can create cancellation of indebtedness income for the debtor and a loss (usually a capital loss) for the creditor. The applicable federal rate is a floating rate tied to U.S. Treasury securities of varying maturities which is used as a standard for judging whether the parties to a transaction have provided for a reasonable rate of interest. The applicable federal rate changes from month to month to reflect changes in market rates of interest.

Cancellation of indebtedness income results from a reduction in the interest rate below the then applicable federal rate because the Internal Revenue Service recharacterizes some of the principal payments as interest payments in order to bring the stated rate up to the required rate. As a result, the principal balance of the note is treated as having been reduced, since principal payments which are to be treated as interest cannot also be treated as principal. This can create cancellation of indebtedness income for the debtor and capital loss for the creditor. Again, this can be an unpleasant surprise for the debtor who is treated as having income for tax purposes when he has received no money.

Reduction of Principal. An agreement to reduce the principal amount of a debt will generally result in debt cancellation income to the debtor and capital loss to the creditor. An exception is available, however, for purchase money indebtedness if (a) the reduction is the result of an agreement between the seller and buyer of the property, (b) the parties to the agreement are the original seller and original buyer of the property, and (c) the reduction does not occur in a bankruptcy or when the debtor is insolvent.

Conclusion. The tax rules governing the modification of debt instruments are extremely complex and are well understood only by experts in the field. Those involved in debt renegotiations should be aware of the general types of modifications that can create tax consequences, and before finalizing any modification agreement, should consult with a competent tax advisor to be sure they understand all the costs and benefits of the transaction.

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MEMORANDUM #2001 Builder Liability

You buy a house and three years later the stucco starts falling off the walls. So you call the Registrar of Contractors to complain. The Registrar says he can't help you because the house is more than two years old. Are you out of luck? Not necessarily.

It is true that the Registrar of Contractors can't help if the defective work was done more than two years before. However, this does not mean that the homeowner is without a remedy. In some cases he may still have the right to sue for as long as nine years after the work was done.

But first, a word about the Registrar of Contractors. If the two year limitation has not expired, a complaint to the Registrar is often the cheapest and most effective way of forcing a contractor to correct improper construction. This is true regardless of whether the defect is in a residential or commercial structure--the procedure is the same for both. The Registrar, at its own expense, will investigate and attempt to resolve the matter. However, if the complaint is not filed within two years, the Registrar has no authority to take action and the owner is left only with his other remedies.

Residential Property. The law treats the owners of homes differently than the owners of commercial structures (for this purpose, apartments are apparently consider commercial). A recent Arizona case is a good illustration. This case allowed a homeowner to recover from the contractor for defective stucco twelve years and two owners after the stucco had been applied. The court held that the length of the warranty depended only on how long the particular component ordinarily would last if properly constructed. In the case of stucco, the court extended the warranty to at least twelve years because it found that stucco should ordinarily last from 30 to 50 years in Arizona. And it made no difference that the house had been sold twice since the stucco was applied; the homeowner could sue a contractor he had never dealt with. In the case of a subsequent owner, the only additional qualification is that the defect must not have been apparent from a reasonable inspection at the time the home was purchased. For this purpose, a reasonable inspection is an inspection by a lay person--it is not necessary that an expert be hired to inspect the home.

After that case, the Arizona legislature enacted a statute limiting the liability of contractors and builders to eight years (which may be extended for up to nine years if the defect is discovered during the eighth year). A.R.S. § 12-552.

Therefore, for residential construction, the rules can be summarized as follows:

1. A complaint may be filed within the Registrar of Contractors within two years of the time the work was done.

2. Suit may be filed until the shorter of (a) eight years (nine if the defect is discovered during the eighth year), or (b) the expected life of the defective component. This time limitation may be extended by an express warranty for a longer period.

3. Subsequent owners may sue the builder or contractor, but only if the defect was not apparent from a reasonable inspection at the time the property was acquired.

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Non-Residential Property. The remedies available to the owners of non-residential structures are not quite so broad. Rules 1 and 2 above are the same for commercial structures as they are for houses. But rule 3 is not. This is because the courts have not extended the implied warranty of good workmanship to subsequent owners. That is, if the owner hired the contractor himself, or bought a new building from a developer, he has all the same rights as the purchaser of a home. However, if he bought the building used, the rule today (at least in the absence of outright fraud) is caveat emptor--let the buyer beware. The Arizona courts have not established an implied warranty for used commercial buildings. It is always possible, of course, that future decisions may extend such protections to the owners of commercial structures, as they have for residential buildings, and the trend is clearly in that direction. However, it hasn't happened yet.

So, if you are buying an existing commercial building, have it thoroughly inspected by a professional, and get whatever warranties you need from the seller in writing.

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MEMORANDUM #2002 Joint Checks

Everyone involved in construction--whether owner, developer, or contractor--is concerned about mechanics' and materialmen's liens, and for good reason.

If a subcontractor or supplier is not paid, he will usually file a lien, often after the project has been completed and everyone is supposedly paid. The result is that someone--usually the owner or general contractor--gets stuck and must pay off the lien, thereby paying twice for the same work or materials. This can result in a large loss or even bankruptcy.

Joint Checks. To protect themselves, many owners, developers and contractors issue joint checks. That is, they make their checks payable to all contractors, subcontractors, and materialmen who are to be paid from the draw. Most contractors assume that this protects them from liens by anyone named on the check, even if they don't get lien waivers. A decision of the Arizona Supreme Court holds that this assumption is correct--sometimes. (Brown Wholesale Electric Co. v. Beztak of Scottsdale, Inc., 163 Ariz. 340, 788 P.2d 73 (1990)).

Until this decision, no one really knew for sure whether a joint check furnished any protection at all against a mechanics' lien. The good news is that this decision does adopt the "joint check rule" in Arizona, which means that in most cases the owner or contractor is protected against liens by anyone named on a joint check, up to the amount of that check, even if they didn't get lien waivers. The bad news is that the decision creates a pitfall for those who ironically, try to be the most scrupulous.

Trap for the Unwary. The pitfall created by this decision is that the builder or contractor who specifies how much of each draw is to go to each subcontractor or supplier increases his risk of being liened. For example, the builder may note on a $10,000.00 check that $5,000.00 is allocated to XYZ Lumber Company. Under the Beztak decision, this builder takes on more risk than the builder who doesn't allocate, even though the purpose of the allocation is to insure that everyone gets paid. The same problem results if the owner has an agreement with the general contractor specifying how each draw is to be disbursed, or tells the general contractor how to distribute the check, and the subcontractor or materialman is aware of the agreement or instruction. Ironically, the less conscientious builder or developer who simply issues the joint check without specifying any allocation among the payees is entitled to full protection against liens from those named on the check, up to the amount of the check, while the builder who specifies the allocation on the check or by separate agreement does not always receive that protection.

This result is reached because the Court held that the subcontractor or materialman who has a check presented to him for endorsement must insure that he collects all the money he is then owed, or he loses his lien rights for the uncollected amount. However, if the check specifies his share or if he is aware of an agreement or instruction that only a specified portion of the check is his, he is required to take only that portion. He retains his lien rights as to the balance of his claim.

The problem this creates for the builder or contractor who makes specific allocations is that the builder thereby assumes the risk that the specified amount is wrong. For example, if clerical

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errors, change orders, price increases, mistakes as to the amount of work completed, or other reasons cause the amount allocated to a supplier or subcontractor to be in error, the issuer of the check will be exposed to liens for the shortage. On the other hand, the builder or contractor who simply issues joint checks without specific allocations is entitled to lien protection for all amounts then owed the subcontractor or supplier, up to the amount of the check.

Lesson of the Decision. The lesson of this decision for all Arizona owners, developers, and contractors is as follows: do issue joint checks whenever possible, but don't specify or agree how the check is to be allocated among the payees.

If you're the one being paid by joint check, do collect all money you are then owed (up to the greater of the amount of the check or the amount allocated to you) before signing and releasing the check.

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MEMORANDUM #2003 Discovery of Hazardous Substances

Arizona law gives licensed contractors the right to terminate work and collect damages from the owner upon the discovery of hazardous substances during the performance of the contractor's work. A.R.S. § 32-1129.01.

Applicability. The law applies when a contractor discovers unknown hazardous materials, such as asbestos, which by law must be removed or contained, and

(a) the contractor does not have the license required to remove the hazardous material himself, or

(b) the removal or containment of the hazardous material cannot be accomplished without the contractor ceasing work.

The law provides that the contractor may cease work only in the area affected by the hazardous materials. In other words, the contractor may not shut down the whole job because of a problem in only one area.

Damages. When the contractor ceases work for this reason, he may collect damages from the owner for any additional expense caused by the delay. These damages could be substantial if men and equipment are required to sit idle for several months while the owner arranges the removal of the hazardous materials.

The owner, on the other hand, may terminate the contract upon the interruption of the work, provided that he pays the contractor for all services and materials furnished to the time of termination, plus the damages caused by termination.

The law does not apply if the hazardous materials are disclosed to the contractor before the contract is signed.

The law is also a little unclear when it refers to the contractor being able to interrupt work if he does not have the license necessary to remove the hazardous materials. This is because in most cases the contractor himself need not be licensed under Arizona law to remove such materials, although his employees may have to be certified. However, in all likelihood the law was intended to apply to situations where employee certification is required, regardless of whether the contractor himself must be licensed.

Effect of the Law. The effect of this law is to place the economic burden of unknown hazardous materials on the owner, rather than the contractor. In order to avoid interruption of the job and the payment of damages, owners should have an environmental audit performed before contracting for any work which may lead to the discovery of hazardous materials. If such materials are found, they should be disclosed to the contractor in writing. This is particularly true in the case of remodels or demolition, which frequently expose asbestos, PCB's, and other such substances, or new construction, which may disclose leaking underground storage tanks or other soil contamination.

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MEMORANDUM #2004 How to Recover When You Don't Have a Lien

Subcontractors have the right to file a mechanics' and materialmen's lien against property they improve in order to enforce payment. The same remedy is available to suppliers, laborers, and others who improve real property. This allows those who increase the value of real property to enforce payment against the owner of that property, even though they have no contract with the owner. Their contract is with the general contractor or other middlemen, not the property owner. The owner has to pay in order to remove the lien and protect his equity in the property.

What if the unpaid subcontractor has no lien rights? This can happen in a number of ways. Certain properties, such as owner-occupied homes, may be exempt from mechanics' liens by subcontractors. In other cases procedural requirements, such as the giving of a 20-day notice, have not been followed, or perhaps the time limit for filing the lien has elapsed.

The subcontractor can always sue the general contractor for payment, of course. But if the general is in financial difficulty this may be a useless remedy. Does this mean the unpaid subcontractor or supplier is out of luck?

Not necessarily. In some cases the legal doctrine of "unjust enrichment" can come to the rescue.

Under this doctrine, the subcontractor or supplier can sue the property owner for payment if the owner has not paid the general contractor for the particular work or materials. The theory is that the owner would be "unjustly enriched" if he were allowed to reap the benefit of the work or materials without paying. So even though he has no contract with the subcontractor or supplier, and even though the subcontractor or supplier has no lien rights, the owner must pay.

Conclusion. If you are a subcontractor or supplier without lien rights, don't give up if your general contractor goes under. First determine whether he has been paid by the owner for your work--and if he hasn't, you can go after the owner.

__________________ See Flooring Systems v. Radisson, 160 Ariz. 224, 772 P.2d 578 (1989).

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MEMORANDUM #2005 What Is A Pre-Lien Notice And What Should You Do When You Get One?

Anyone hiring a contractor for a commercial construction job will usually receive a number of mailings from subcontractors and suppliers entitled "Notice to Property Owner." These notices contain scary-sounding language warning that a mechanics' lien could be placed against the recipient's property if bills are not paid and that his property could be lost through foreclosure proceedings.

The result is often a concerned call to the owner's lawyer asking what the document means and what he should do about it.

Before dealing with that question, let's begin with a little background.

Mechanics' and Materialmen's Liens. Arizona, like most states, has a statutory scheme that allows contractors, subcontractors, suppliers, and others to file a lien against real property they work on or supply materials to if they are not paid. They can then foreclose the lien, have the property sold, and be paid out of the proceeds. The theory behind the legislation is that those who improve another's property should have a lien against the property if they are not paid, because the owners get the benefit of the improvement while the workers and suppliers get nothing.

The danger for the property owner is that parties the owner has never dealt with, such as subcontractors, tradesmen and suppliers, might not be paid by the general contractor even if the owner has paid the general contractor. This often happens when the general contractor is in financial trouble. The owner may find his property liened and either has to pay twice or risk the loss of his property through foreclosure.

In order to help the owner protect himself from this, the statutes require anyone who might wish to claim a lien to notify the owner within twenty days after beginning work. This notification is called a "preliminary 20-day notice," or simply a "pre-lien." The notice can be given more than twenty days after work begins, but in that case the lien can cover only work done or materials supplied beginning with the date twenty days prior to the giving of the notice.

The pre-lien has to contain certain specified information, including the name of the subcontractor or supplier and the amount of the lien he could claim if not paid.

What To Do. If you receive a pre-lien notice, the law requires several things. First, you should correct any erroneous information and notify the sender. Second, you must furnish any missing information requested by the person giving the notice which is necessary for a valid notice. Third, you must furnish a copy of the payment bond if you have one, and give the name and address of the bonding company and agent. Fourth, you must execute the acknowledgment of receipt enclosed with the notice and return it to the sender.

How To Protect Yourself. Then, you should consider how to protect yourself against a lien. If there is a construction lender (such as a bank) which is making progress payments to the general contractor as construction proceeds, you might decide to rely on the lender. Normally, the construction lender will establish procedures to make sure all subcontractors and suppliers are paid and require that they waive their lien rights for the work done through the prior draw period.

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Relying on the lender is usually a safe way to go, but you should be aware that if the lender fails to adequately insure that all potential lien claimants have been paid, the owner remains responsible. Before taking this route, you should make sure the bank's procedures for obtaining lien waivers are adequate.

If the owner does not wish to rely on the lender, or if there is no lender, the owner has several options:

1. Do Nothing. The owner can essentially do nothing and rely on the character and financial capability of the general contractor to make sure that all subcontractors and suppliers are paid. This, obviously, is the easiest thing to do, but it does expose the owner to risk as many owners have learned to their sorrow.

2. Conditional Waiver. The owner can require the general contractor to deliver conditional lien waivers from each subcontractor and supplier who sent a pre-lien whenever the owner makes a progress payment. This is a statutory form of waiver executed in advance of payment to the subcontractor or supplier, which says the subcontractor or supplier waives his lien rights upon receipt of payment. Obviously, this leaves something to be desired because if the general contractor does not pay, the lien waiver never becomes effective. Note that Arizona statutes set out the language for lien waivers, which must be followed in order for the waiver to be valid.

3. Unconditional Waiver. The owner can require the general contractor to deliver an unconditional lien waiver from each subcontractor and supplier who sent a pre-lien at the time the owner makes a progress payment. This requires the general contractor to pay the subcontractors and suppliers before he is paid by the owner, which is not always acceptable to the general contractor. The alternative is to require the general contractor to deliver unconditional lien waivers after each payment to the general contractor, but before the next progress payment is made. Although the owner still has some exposure to liens, at least it is limited to the amount of work done or materials supplied during the preceding draw period.

4. Joint Checks. The owner can issue joint checks to the general contractor and each subcontractor and supplier who worked on the project during the preceding draw period, which is sufficient to protect the owner from liens by the payees of the check. This can be inconvenient for both the owner and the general contractor, and is usually not done unless there is reason to believe there is a problem.

5. Check with Subs and Suppliers. The owner can check with the subcontractors and suppliers periodically to make sure they have been paid current. Although this is not binding, as a lien waiver would be, it can give the owner early warning if a problem is developing.

Regardless of the procedure chosen by the owner, he should keep informed as to who is working on the project or supplying materials during the period covered by the draw, and take reasonable steps to insure that those persons are paid. After the project has been completed, the owner should get final unconditional lien waivers from all subcontractors and suppliers waiving any and all lien rights against the property to foreclose any possibility that the owner could be hit

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with a lien at a future time. (Note that it is not legally possible to get blanket lien waivers from all subcontractors and suppliers at the beginning of the job.)

Conclusion. A preliminary 20-day notice should not normally be a cause for concern. It is an informational notice only, but it does give the property owner an opportunity to protect himself from the possibility of liens by persons with whom he has no direct contact.

__________________ The Arizona statutes governing mechanics' and materialmen's liens begin at A.R.S. Sec. 33-981. This memo does not attempt to describe or summarize all the details of this statutory scheme, which is quite detailed and lengthy. Consult with your attorney for more information.

The foregoing procedures are usually not necessary for an owner-occupied dwelling as no lien can be claimed unless the claimant has a contract directly with the owner.

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MEMORANDUM #2101 Commission Rules

It doesn't matter what you call it--a finder's fee, a success fee, a performance bonus, or just a plain commission, it can involve big dollars and sometimes leads to serious misunderstandings. For that reason, it is important to understand the governing principles before proceeding with any transaction that might result in a claim for a commission.

Types of Listings. There are three basic types of commission agreements: (a) exclusive, (b) exclusive agency, and (c) open. Under an exclusive listing, which is the most common kind, a commission is payable if a buyer is found, regardless of who is responsible, even if it's the owner himself. Under an exclusive agency agreement, a commission is payable regardless of who finds the buyer, except that no commission is payable if the owner finds the buyer. Finally, under an open listing, a commission is payable only if the broker with the listing finds the buyer. Another kind of open listing, the single party listing, is sometimes used where the owner agrees to pay the broker a commission only if a certain specified party is the purchaser.

When Is It Earned? The general rule for any kind of a commission, real estate or otherwise, is that it is earned when the broker produces a ready, willing and able purchaser at the designated price. Notice that the transaction does not have to close--it is enough if a qualified and willing buyer is produced. Therefore, if the seller changes his mind at the last minute, or raises the price, or refuses to close after signing the contract, he is still liable for the commission. From the broker's perspective, this is a reasonable outcome--after all, he has done what he was hired to do and should be paid. However, this principle leads to many disputes and makes some sellers uncomfortable, and therefore it is not uncommon for a seller to insist on a provision in the listing that a commission is earned only when the transaction actually closes.

Another fact that every owner should be aware of is that most listing agreements and escrow instructions provide that the broker is entitled to half of any earnest money deposit forfeited by the buyer, so long as this amount does not exceed the amount of the full commission which would have been earned if the sale had closed. There is nothing inherently wrong with this provision; however, it often comes as a surprise to the owner when he has to give up half of a forfeited deposit. If he doesn't like it, he should negotiate with the broker to have it deleted from the listing agreement and escrow instructions before he signs them.

Real Estate. If the property being sold involves an interest in real property, including a leasehold estate, any claim for a commission will be governed by the statutes and regulations which regulate the real estate brokerage industry. In Arizona, these regulations are promulgated and enforced by the Arizona Department of Real Estate. However, they may also be enforced by private parties in the course of litigation where they often have a decisive role in determining the outcome. For example, if a party is not properly licensed, he may lose his lawsuit to collect a commission.

Who Must Be Licensed? In general, anyone receiving compensation for selling or leasing, or offering to sell or lease, an interest in real estate must be licensed. This also includes a business broker who is selling a business if the buyer will be purchasing or assuming the lease of the business premises, even if it's only incidental to the larger transaction. It does not include the officers of a corporation or the partners of a partnership who are selling corporate or partnership

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property, so long as they don't receive any special compensation or bonus for the successful completion of the transaction.

In addition, it is not necessary to have an Arizona license to sell Arizona real estate, as long as the sale is not made in Arizona. Although the law is not totally clear on the point, if the primary sales activities are carried out elsewhere, and the sales (not listing) contract is not executed in Arizona, normally the broker is not required to be licensed in Arizona. It may, however, be necessary to be licensed in the state where the sales activities are being carried out or where the contract is entered into.

Requirements. Under Arizona law, certain specific requirements must be satisfied in order to have a valid listing for real estate. They are (a) the broker must be licensed, (b) the listing must be in writing and must be signed by the parties, (c) the listing must contain all the material terms, such as the names of the owner and broker, etc., (d) the listing must have a specific commencement and expiration date and cannot be automatically renewable without action by the owner, and (e) the listing must have a specific price at which the property will be sold or leased. If the listing agreement does not meet each one of these requirements, the broker cannot recover a commission, even if he procures a purchaser, and even if the transaction closes. The law is strict on this point, and there are no exceptions. Even though every broker is taught these rules in real estate school, it is not uncommon for commission claims to fail because the listing does not meet one or more of these requirements.

Conclusion. Brokers provide a valuable service and have every right to be paid for the services they provide. If you are an owner, be sure you understand the ground rules governing the payment of commissions, and be sure you read the listing agreement carefully. If you don't like something in the listing, try to negotiate a different provision before you sign. If you are a broker, be sure you check your listing agreement each and every time to make sure it contains all of the required information so you don't find yourself trying to enforce an invalid listing.

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MEMORANDUM #2102 Does An Out-Of-State Broker Have To Comply With Arizona's Brokerage Laws?

In today's mobile world, and especially with the availability of information over the Internet, out-of-state investors, developers, and users of real property are increasingly crossing state lines to purchase or sell Arizona real estate. This frequently raises questions about the permissible activities of the brokers involved in these transactions when some or all of them are licensed in states other than Arizona.

Arizona Statutes. Fortunately, Arizona law clearly sets forth the rules which govern such situations. The operative principles are as follows:

First, the general rule is that a person not licensed in Arizona cannot engage in any activity in Arizona that requires a license, even if that person is licensed in another state. For example, an unlicensed person may not accept a listing for Arizona real property, take prospective purchasers to inspect an Arizona property, place his or her signs on an Arizona property, or advertise or offer an Arizona property for sale in Arizona. There are some limited exceptions to this general rule, which are discussed below.

Second, the statute expressly authorizes an Arizona broker to pay compensation to and to receive compensation from a broker licensed in another state. Therefore, an Arizona broker may pay a referral fee to an out-of-state broker for referring a prospect who purchases or sells Arizona real estate, or may receive a fee for referring a prospect to the out-of-state broker. However, if the activities go beyond the simple payment of a referral fee or the split of a commission, the two brokers are required to enter into a written cooperation agreement before undertaking any activity otherwise requiring an Arizona license. The cooperation agreement must include the following terms:

(a) A list of the activities that are to be conducted by the out-of-state broker.

(b) A statement that the out-of-state broker agrees to comply with the laws and regulations of the State of Arizona, and to submit to the jurisdiction of the Arizona Department of Real Estate.

(c) A statement that the Arizona broker accepts responsibility for the acts of the out-of-state broker.

Third, regardless of what the cooperation agreement provides, the statutes require that all negotiations in Arizona or with people who own property in Arizona must be conducted through the Arizona broker, and that all funds handled by either broker must be handled in the manner required by Arizona law. In addition, the out-of-state broker may not take listings on Arizona property, market Arizona real property in Arizona, or use the cooperation agreement as a means of selling Arizona real estate to an Arizona resident. Although a cooperation agreement does allow a limited amount of participation by the out-of-state broker, is not a blanket license for an out-of-state broker to set up a real estate brokerage business in Arizona.

Advertising. The Arizona statutes expressly prohibit out-of-state brokers from using the Internet to offer real estate brokerage services in Arizona. In addition, the statutes also prohibit an out-of-state broker from advertising (in Arizona) Arizona real estate for sale or lease. As a

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practical matter such laws may be difficult to enforce against a broker physically located in another state. Nevertheless, it is the law.

Conclusion. Although Arizona law allows Arizona brokers to split commissions with out-of-state brokers, any brokerage activity taking place within the State of Arizona requires a cooperation agreement between the Arizona and out-of-state brokers. Even then, the activities of the out-of-state broker are quite limited and a licensed Arizona broker will have to remain closely involved in the transaction.

__________________ A.R.S. § 32-2163

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MEMORANDUM #2201 Subrogation

If you are involved in any aspect of the real estate business, sooner or later you will come across the term, "subrogation." Most often it appears in leases, but you may also find it in mortgages, insurance policies, guarantees, and other agreements. The phrase may appear in a document where a party agrees to "waive his right of subrogation," or where it is stated that one party is "subrogated to the claims of another."

What is the right of subrogation, anyway, and what does it mean to waive it?

Simply stated, the right of subrogation is the right to pursue someone else's claim. If you are subrogated to someone's claim, it sounds as though you are somehow subordinated to it--but that's not what it means. It means that you may pursue it as though it were your own. It can arise by the express agreement of the parties, or automatically by operation of law.

Let's look a few examples.

1. Insurance. Suppose you own a building which burns down due to the negligence of a third party. Normally you could sue the negligent third party for causing your building to burn down. If your fire insurance company pays off your claim, however, the insurance company is then subrogated to your claim against the negligent third party. This means your claim against the negligent third party is treated as having been assigned to the insurance company, which may sue him to recover the amount it paid you on account of the fire loss.

2. Guarantees. Suppose you guarantee your brother-in-law's loan so that he can buy an apartment building. If you are forced to make good on the loan, you are subrogated to the lender's claim against your brother-in-law. This means that you may foreclose on the apartment building to the same extent the lender could do so, or you may sue on the lender's note. You are in essentially the same position as if you purchased the lender's note.

3. Interest in Real Property. Suppose you hold an interest in someone else's real property. It might be an easement, a leasehold estate, or a lien or encumbrance of some sort. If the fee owner allows the property taxes to go into default, you might decide to pay the taxes in order to protect your own interest from a tax foreclosure. By doing so, however, you also protect the interest of the fee owner by paying off an obligation the owner should be paying. In this situation, you are subrogated to the rights of the taxing authority and may proceed against the fee owner in order to obtain reimbursement for the taxes you paid.

4. Assumptions. Suppose you sell some property, and the buyer assumes the existing note and mortgage; however, in typical fashion, you are not released and remain liable along with the buyer. If the buyer defaults and you pay off the note to avoid being sued, you are subrogated to the rights of the noteholder and may recover from the buyer who assumed the note.

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From the above examples it becomes apparent that subrogation most often arises when someone reimburses another's loss or pays another's obligation. To achieve fairness, the law assigns the claim to the party who made the payment so that he can pursue it in order to make himself whole.

Waiver of Subrogation. There are certain situations where it makes sense to waive the right of subrogation. Leases, for example, frequently contain a provision stating that the landlord and tenant waive rights of recovery against one another to the extent the loss is covered by insurance, or agree to obtain insurance policies in which the insurance company waives any rights of subrogation it may have against either the landlord or the tenant. These are two ways to reach the same result--namely, to make sure the insurance company doesn't have a right of subrogation with respect to either the landlord or the tenant.

These are useful provisions and normally should be contained in all leases. To see why, assume the landlord's building burns down due to the negligence of one of the tenant's employees. Without a waiver of the right of subrogation, the insurance company could pay the landlord for the value of the building, and then sue the tenant to recover the amount it paid because (a) it would be subrogated to the landlord's claim against the negligent employee of the tenant, and (b) the tenant becomes responsible for its employee's negligent acts under the doctrine of respondeat superior. The net result is that the tenant is not protected by the insurance policy and ends up having to pay the insurance company for the fire loss, which is not what the parties intended.

A similar situation can arise under liability insurance policies where someone suffers a personal injury due to someone's negligent acts. The parties intend the policy to protect both the landlord and tenant, but unless the right of subrogation is precluded, the result might be quite different. Consequently, most leases should contain provisions precluding the insurance company's rights of subrogation for claims arising under either liability or hazard insurance policies.

Conclusion. Once you understand the meaning of the "right of subrogation" and become familiar with the situations in which it is normally applied, it becomes much easier to intelligently analyze and understand documents containing the term and to decide when it is in your best interests to provide for the waiver of these rights.

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MEMORANDUM #2202 Fixtures

We have all used the word "fixture" to describe something that has become attached to a building, or which has become something of a permanent item.

Under the law of real property, however, it has a more precise meaning - it is an item of personal property that has become real property, yet retains its separate identity. A perfect example is a water heater that has been installed in a house. It has become a part of the house, yet retains its identity as a water heater. This could be distinguished from a piece of lumber, for example, because even though the lumber becomes part of the house during construction, it does not retain its separate identity. It is just a part of the house. Therefore, it is not a fixture.

The Test. The law establishes a three part test to determine when an item of personal property has become a fixture. First, there must be an intention that it become a fixture. A water heater which is temporarily installed while the old unit is being repaired does not become a fixture, because the owner does not intend to make it a part of the realty.

Second, the item must be reasonably adapted to the use to which the property is put. A water heater installed in a house is adapted to the use of the property as a residential dwelling and becomes a fixture. However, if the same water heater is stored unused in a barn, even if it is bolted down, it does not become a fixture because it is not adapted to the uses made of a barn.

Third, the item must be "annexed," or fastened to the property in some manner. A water heater that is hooked up to the power source and the water pipes in a home is "annexed," and becomes a fixture. A water heater sitting loose in a garage does not.

Of these three factors, intention is the most important. If the person installing the item intends for it to become a fixture, it normally does, and vice versa.

Trade Fixtures. There is a special kind of fixture known as a "trade fixture." A trade fixture is property that meets the definition of a fixture, but which is attached to the property by a tenant for the tenant's business purposes. A common example is the shelving placed in a store by a tenant to display merchandise. A trade fixture can also consist of such items as built-in furniture, a special cooling system for computers or food storage, and machinery. Trade fixtures are treated differently than other kinds of fixtures by the law, which is explained in more detail below.

The Consequences. If an item of personal property becomes a fixture, it ceases being governed by the law of personal property and starts being governed by the law of real property. This has a number of consequences.

First, fixtures go with the realty when the realty is sold. If you sell a building, it automatically includes the fixtures unless the parties explicitly agree otherwise. A sale does not normally include personal property located on the property.

Second, fixtures installed by a tenant belong to the landlord at the end of the lease, without payment. An exception is made for trade fixtures, which may be removed by the Tenant prior to the expiration of the lease, but not after.

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Third, fixtures and personal property are mortgaged in different ways. A fixture is mortgaged by recording a mortgage, deed of trust, or fixture filing with the county recorder of the county in which the property is located. Personal property is encumbered by filing a financing statement with the secretary of state in the state of the debtor's residence (or if the debtor is a registered entity such as a corporation, in the state where it is chartered). If the wrong method is used for the type of property being encumbered, the intended lien may be lost or subordinated to another claim against the property.

Fourth, the rules governing the priority of liens are different. Under some circumstances, a lien against personal property may become junior to a mortgage against the real property when the personal property becomes a fixture.

Fifth, fixtures can be lost to a secured creditor when a mortgage, deed of trust, tax lien, or other encumbrance against real property is foreclosed. However, personal property located on the foreclosed property is not taken by the foreclosure and may be removed by the owner who is being foreclosed upon.

Sixth, the government has to pay for fixtures when condemning real property (as for a freeway right-of-way), but does not have to pay for personal property, which may be removed by the owner.

Conclusion. A fixture is an item of personal property which has become a part of the realty, yet retains its separate identity. The classification of such property as a fixture or as personal property has a number of important legal consequences. Consult legal counsel when accepting a lien on personal property which may become a fixture to insure that your position is protected.

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MEMORANDUM #2203 Annexation Pros and Cons

The population growth in Arizona has led many cities and towns to increase their boundaries by annexing additional territory. Some property owners actively seek annexation, while others bitterly oppose it.

Pros and Cons. The decision to favor or oppose annexation can be difficult. The primary advantage of annexation is the access to city services such as water and sewer, garbage collection, and fire and police protection. Some property owners also favor the stricter zoning standards and enforcement usually found in incorporated cities and towns, and may look forward to better street improvements such as paving, sidewalks and lighting. If water and sewer service is not already available to the property, annexing to a city or town is a huge advantage because land without water and sewer service is all but impossible to develop.

Now, let's look at the disadvantages. The big negative is the imposition of additional taxes. Taxes vary from city to city, but there will usually be some additional property and sales taxes to pay for the increased services. On the other hand, these tax increases are often offset by reductions in insurance rates and the fact that it may no longer be necessary to pay for private fire protection or garbage collection services. This is something the property owner will have to carefully study in order to make a good decision.

City zoning is considered an advantage by some, while others adamantly oppose it. County zoning ordinances usually allow a wider range of uses and may have less strict building codes and fewer design review requirements. Very often horse owners and other agricultural users fear annexation because they believe the city may interfere with their ability to keep livestock on their premises, which may or may not be the case, depending on the type of zoning that the city applies to the property.

A careful analysis of all the factors is required to make a decision that is truly in the best interests of the property owner when considering whether to accept or fight annexation.

Procedure. The annexation procedure is fairly simple. It begins when the city files a map with the County Recorder showing the boundaries of the proposed annexation. Notice of the annexation is given by advertising, posting, and by mail to each affected property owner. A public hearing is then held by the city council to determine whether to go forward. After the hearing, the city has one year to obtain the signatures of at least half of the property owners in the area to be annexed, both by (a) number of owners and (b) assessed value. If the necessary signatures are obtained, the city council may then pass a resolution annexing the territory. The annexation becomes final and unchallengeable thirty days after the passage of the resolution.

Limitations. There are certain limitations on the authority of a municipality to annex additional territory, however. The land to be annexed must be contiguous to the municipality for at least 300 feet. It must be at least 200 feet wide at all points, and in most cases it cannot extend from the existing municipality a distance of more than twice its width at its widest point. The annexation cannot landlock unannexed property. (This means that "strip annexations" are no longer legal). Finally, and most importantly, the city cannot annex new territory unless it has

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adopted a plan to serve the area with infrastructure adequate to serve projected growth within the following ten years.

Zoning. State law provides that a municipality must adopt zoning in the new area that permits densities and uses no greater than those permitted by the county immediately prior to annexation. This means that the new city zoning can be more restrictive, but not less restrictive, than the previous county zoning. Thereafter, the municipality may change the zoning by following its normal rezoning procedure.

State law also provides that a municipality may adopt an ordinance authorizing county zoning to automatically continue in effect after annexation until new city zoning is adopted for the property, but no longer than six months. Some cities and towns have passed such an ordinance, but Phoenix has not. Without such an ordinance, the municipality is required to adopt new zoning for the property immediately upon annexation. Normally, the annexing municipality will adopt zoning most closely resembling the existing county zoning.

Of course, if property already has been developed or otherwise put to use, that use is considered a legal non-conforming use and cannot be made illegal by the annexation of the property into the city, even if the use is not allowed under the city zoning. However, this protection does not apply to unused vacant land, which can be downzoned to a lesser density or more restrictive use than was allowed in the county.

How To Fight Annexation. If you are opposed to annexation, the first step is to voice your opposition at the public hearing. If there are enough objectors, it may be possible to convince the city to drop the idea before it goes any further. If the city decides to proceed with annexation at the conclusion of the public hearing, the next step is to wage a campaign to persuade as many of the property owners as possible to refuse to sign the annexation petition. It can be useful to review the assessed valuations of the properties, because it may be possible to defeat the annexation if a small number of properties with high assessed values can be convinced to refuse to sign because the city would be unable to obtain the consent of at least half of the property by value. Finally, if the city obtains the necessary signatures and adopts an ordinance approving the annexation, you can file suit to block it if you can find some requirement of law that was not correctly followed. However, you have only thirty days from the adoption of the resolution approving the annexation to file suit. If you don't file within thirty days, the annexation is final and you have no further recourse to the courts.

After the annexation has become final, state law provides no way to ever de-annex and again become part of the unincorporated area of the county. At best, there is a procedure for de-annexing from one municipality and concurrently becoming part of another, but only if both municipalities agree. Under the law as it exists today, annexation is forever.

Conclusion. Annexation can have many advantages to the property owner. However, there can also be disadvantages, such as higher taxes and more restrictive zoning. A careful analysis is usually advisable when deciding whether to fight or support annexation.

__________________ The governing statutes are A.R.S. § 9-471, et seq., and A.R.S. § 9-462.04(E).

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MEMORANDUM #2204 What is a Judgment Lien?

A lien is a legal device to provide security for the payment of a debt or the performance of an obligation by means of a claim against certain specified property. If the obligation is not timely satisfied, the holder of the lien can force the property to be sold. The proceeds are then applied in satisfaction of the obligation.

A judgment lien is a special type of lien. It is known as a "non-consensual" lien; that is, it can be created without the consent of the owner of the property. A consensual lien, such as a mortgage, can only be created with the consent and cooperation of the owner.

How Created. A judgment lien first requires, as you might expect, a judgment. In most cases, a judgment is a final court order directing someone (the debtor) to pay someone else (the creditor) a certain amount of money. However, a judgment does not by itself create a judgment lien. In order to create a judgment lien, a certified copy of the judgment and certain additional information must be recorded with the County Recorder. A.R.S. § 33-961. When recorded, it automatically creates a judgment lien on all real property, then owned or later acquired by the debtor in that county. If the creditor wants to create a lien in other counties, he must file in those counties also. If he wishes to create a judgment lien in another state, he must take the Arizona judgment to the other state and have it "domesticated," which means it becomes recognized as a judgment in that other state. After domestication a judgment lien can then be created in the additional state by making the appropriate filings.

After the lien has attached to a particular parcel of real property, the judgment creditor can file suit to foreclose his lien, just as if it were a mortgage. It is as if the judgment debtor gave the judgment creditor a mortgage on every piece of real property he owns in every county where the lien is recorded. Clearly, judgment liens are a great aid in collecting judgments, at least from people who own property.

As mentioned above, the judgment lien attaches to real property of the debtor, even if acquired at a later time. It attaches automatically at the instant the debtor takes title, and it remains attached to the property even after the debtor conveys it to someone else. This is one reason title searches and title insurance are necessary whenever real property is purchased. Someone purchasing property which is subject to a judgment lien could be forced to pay a judgment against a third party to protect his property even if he had no knowledge of the lien.

Priority. The lien is subordinate to all previously existing liens. That means that if the property is foreclosed, the prior liens would be paid first out of the proceeds. By the same token, a judgment lien is superior to any lien that attaches at a later time. The only possible exception to this rule of priority is where a judgment debtor obtains a mortgage to finance the purchase of property. In this case, the law says that the holder of the purchase money mortgage or deed of trust has priority over the judgment creditor even if the purchase money mortgage is recorded later. A.R.S. § 33-705.

How Long Does It Last? A judgment (and therefore a judgment lien) lasts for only five years (the exception being a judgment lien for spousal support, which lasts until the support obligation is completely satisfied). A.R.S. §33-964. At the end of five years the judgment and the

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judgment lien automatically expire. However, both can be renewed for any number of additional five year periods by filing certain documents with the clerk of the court and the county recorder. A.R.S. § 12-1613. This must be done no earlier than 90 days before the expiration date of the existing judgment. Therefore, if you hold an unsatisfied judgment, be sure to docket the renewal date so your judgment and judgment lien don't inadvertently expire. In many cases an unpaid judgment is satisfied years later when the judgment debtor attempts to purchase, sell or obtain a loan against real property. A title search discloses the lien, and the judgment debtor is forced to pay the judgment if he wants to conclude the transaction.

Conclusion. The judgment lien statute is an important aid to creditors who are trying to collect a judgment against uncooperative debtors, because it automatically creates a lien on all real property. However, it can also pose a great danger to those purchasing or lending against real property unless proper title searches are performed and title insurance is purchased.

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MEMORANDUM #2205 What is an Opinion Letter and Why is it Required?

Lenders making commercial real estate loans often require the borrower's legal counsel to furnish an opinion letter. Borrowers sometimes wonder why their own lawyer has to give legal advice to the lender, which is an expert in the business of making loans. It can be particularly irritating for a borrower to have to pay his own lawyer to tell the lender that the lender's documents are enforceable. After all, the lender's own lawyers drafted the documents--so why does the borrower's lawyer have to vouch for their enforceability?

Part of the answer is simply because the lender requires it. If you want the money, you have to play by the lender's rules. The rest of the answer, however, is that opinions are supposed to address concerns that are within the particular knowledge and expertise of the borrower and his legal counsel. To that extent, the request for an opinion is reasonable. The lender, after all, does have a legitimate interest in knowing that there are no hidden legal problems which may affect the repayment of the loan.

The opinions most often requested by a lender making a secured commercial loan are as follows:

Existence and Good Standing. If the borrower is a corporation, limited liability company or limited partnership, the lender wants to know that the entity has been properly formed and is in good standing in the state of its formation. Legal counsel typically obtains a certificate of good standing from the state in order to give this opinion.

Power and Authority. The lender wants to know that the borrower has the power under its governing documents to enter into the loan agreement and to repay the loan, and that it has taken all necessary action to properly authorize the loan. This normally requires a review of the articles of incorporation or formation, the bylaws or operating agreement, and the corporate resolutions or other documentation authorizing the transaction. This is clearly an appropriate opinion to request of the borrower's counsel, since he is responsible for seeing that the borrower is legally empowered to obtain the loan and to repay it.

Enforceability. The lender generally requests an opinion from borrower's counsel that the promissory note, deed of trust, and other loan documents are valid and enforceable. While this might seem to be something the lender should be responsible for since the lender drafted the documents, it is still frequently required. It is used as a catch-all by the lender to uncover any problems with the enforceability of the loan that it might not otherwise be aware of. This is often the most difficult part of the opinion for legal counsel, since there are many things that might affect the enforceability of the loan. Missing any one of them could make the loan uncollectible and thereby expose the borrower's counsel to liability.

Creation of Lien. Borrower's counsel is frequently asked to give an opinion that the deed of trust or security agreement is in proper form for recording, that it will create the lien intended to be created against the collateral, and that it is recorded in the proper location. This kind of opinion is appropriate, particularly when the lender is from another state and wants assurances that the loan is properly secured in the state where the collateral is located. It is not a difficult opinion to give and one that is generally not the matter of much discussion.

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Consents Not Required. Lenders will typically ask the borrower's counsel to state that no consents or approvals are required in connection with the loan. To the extent the consents are required by law from governmental agencies, the borrower's counsel is normally in a position to give this opinion because this is a matter of law; however, to the extent the consents are required from private parties pursuant to contracts or other arrangements to which the borrower is a party, the most the borrower's counsel can do is to state that no such consents are necessary "to the best of his knowledge." Obviously, the latter issue is partly a matter of law and partly a matter of fact, and if the borrower's counsel does not know about a particular contract he cannot give an opinion as to what it may or may not require.

No Violations of Laws. Borrower's counsel is often asked to state that the execution and performance of the loan documents do not violate any laws, including any usury laws. This is strictly a matter of law, and lender's counsel usually has no problem giving such an opinion.

Taxes and Fees. Lenders, particularly those from out of state, often request opinions that there are no mortgage recording taxes or fees, documentary stamp taxes, or other significant charges that may be levied in connection with the loan. This is an appropriate subject for an opinion, and borrower's counsel generally give such opinions without hesitation, especially in Arizona where there are no such taxes or charges.

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Assumptions and Limitations. All opinions are subject to an express list of assumptions and limitations by the lawyer giving the opinion. For example, the opinion will probably state that it is limited to matters of Arizona law (if given in Arizona), that any opinion on enforceability is subject to the effect of bankruptcy laws, that the loan documents are enforceable against the lender, that the persons executing the documents are legally competent to do so, and so on. A legal opinion can expose the lawyer to significant liability and therefore the utmost care must be given to the issuance of legal opinions. Most law firms, in fact, have a committee that must review all opinions before they are released.

It is not unusual for the borrower's counsel to engage in detailed negotiations with the lender's counsel over the wording of the opinion. Sometimes lender's counsel may overreach in their requests for opinions, either by asking for opinions which the borrower's counsel should not give, or requesting the elimination of certain of the assumptions and limitations.

Conclusion. For these reasons, the opinion can sometimes be an expensive and time-consuming part of the loan transaction. However, as long as lender's counsel continue to require opinions this appears likely to continue as an expensive fact of life.

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MEMORANDUM #2206 What Is A Construction Bond And Who Can Collect On It?

Construction projects are often "bonded." The purpose of a bond is to protect the owner if the contractor suffers financial difficulties which interferes with the completion of the project or if the contractor is otherwise unable to carry out the terms of its contract.

Types of Bonds. There are basically two types of construction bonds--performance bonds and payment bonds. Both are generally purchased before construction starts, but they cover distinctly different risks.

A performance bond, sometimes referred to as a completion bond, insures that the contractor will complete the project, and will do so for the amount set forth in the contract. Thus, if the contractor defaults the bonding company will either hire another contractor to complete the contract or will provide the money necessary to cure the default. This protects the owner against a contractor who goes bankrupt or otherwise abandons a project in mid-stream, leaving the owner with a very expensive and messy problem. A performance bond clearly provides a great deal of protection to the owner, but such bonds are expensive, adding to the cost of the project. In addition, not every contractor is bondable, because bonding companies generally will bond only companies with a strong financial statement and a proven operating history.

A payment bond insures that that the subcontractors and suppliers of material and equipment will be paid, thereby providing protection against mechanics' and materialmen's liens. Thus, if the general contractor fails to pay one of his subcontractors, the bonding company will make the payment so that the subcontractor does not file a lien against the project. This prevents the project from grinding to a halt when liens start to pile up because the general contractor is not paying his subcontractors and suppliers. It also protects the owner's equity in the project which can be lost if the liens are not paid.

There is a variant of the payment bond which can be obtained after a lien has been filed. Under Arizona law, a mechanics' and materialmen's lien can be discharged by filing a bond equal to one and one-half the amount claimed by the lien. This allows the property to be cleared of the lien while the parties sort out any disagreements relating to the lien, such as whether the work was properly performed and whether the amount claimed is proper. This type of bond does not protect the property from all liens, only from the particular lien that is bonded against.

Wording of the Bond. The courts have made it clear that the language of the bond itself governs the coverage offered by the bond, regardless of what the bond is called. One must carefully read the language of the bond, which is really nothing more than a contract between the owner and the bonding company, to determine the types of claims that are covered and the type of protection the owner is to receive.

For example, in one Arizona case, the language in a payment bond stated that it covered only those who had a "direct contract" with a particular air conditioning subcontractor. When the general contractor hired another subcontractor to complete the air conditioning work after the original subcontractor was unable to, the court held that the new subcontractor was not covered by the language of the bond and that the general contractor was not entitled to coverage against the claims of the new subcontractor. This was because the new subcontractor did not have a

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"direct contract" with the original air conditioning subcontractor; instead, its contract was with the general contractor. Therefore, it is necessary to carefully read the language of the bond to be sure the necessary coverage is provided.

Conclusion. Bonds can furnish considerable protection to anyone hiring a contractor for a construction project. However, they do increase the cost, and it is necessary to carefully review the language of the bond to determine exactly what protection is offered. All bonds are not the same, and it is important to obtain the precise protection that is needed for the particular project. In cases where a bond is appropriate, it may be advisable to obtain both payment and performance bonds, or a single bond which covers both types of claims.

__________________ A.R.S. Sec. 33-1003, -1004; American Casualty Co. v. D.S. Withers Constr. Co., 204 Ariz. 282, 64 P.3d, 210 (Ariz. App. 2003).