I remember when I first got into law practice, the partner that I worked for, he was mostly a real estate transactional lawyer, he put something on my desk and he said, “This is a title commitment, and I need you to clear the exceptions from this title commitment.” I nodded, “You got it, Boss.” This was actually, I think Google existed back then, I’m not totally sure. Maybe it was Altavista, we might have gone to Altavista back in those days.
What is a title commitment and how do I clear exceptions from it? Nobody had ever told me about that in law school. A title commitment is something that you get from a title insurance company. I called up someone who worked for the title company and they told me what I needed to do. I thought if i ever really wanted to understand real estate, I would go to work for a title company. That’s what I did. I spent a number of years in-house counsel at a title agency here in Arizona.
Title insurance is something that is hard for people to see any value in. It seems like a waste to them until they need it, and then they’re really happy to have it. I won’t go into a long dissertation right now into the virtues of title insurance, but I will say this. Get title insurance. If you’re purchasing property, get an owners’ policy of title insurance. If you are lending on property, get a lender’s policy of title insurance. Your lawyer can help you make sure that you’ve got the right type of coverage. It’s not that expensive, and it can help you to avoid disasters. If you have problems with the title on property that you’re purchasing or that you’re lending on, it can truly be financially disastrous. Title insurance virtually eliminates most of that risk.
I’ll also say a quick word about escrow. An escrow agent is basically a neutral stakeholder in a transaction. When you are purchasing real property, you would have an escrow agent that was an intermediary, really, between the buyer and the seller. The purchaser would give the money to the escrow agent. The seller would give the deed to the property to the escrow agent. There are several other things that would happen in the escrow process as well, those are the big ones.
After all of the conditions have been satisfied that the parties have agreed to, then the escrow agent closes the transaction, records the deed in the name of the buyer, releases the funds to the seller. If there’s a lender involved, then there’s some things that the escrow agent will do in paying off the old loan and putting the new loan in place, as well. Escrow agents help to make a transaction run much more smoothly and escrow agents have duties to the parties to the transaction. It’s an area that can get messy because sometimes escrow agents do not perform all of the duties they were supposed to perform. Sometimes you’ll see an escrow agent that’s buddies with one side of the transaction and is delivering all of the information needed to one party of the transaction and maybe keeping other information secret to another party to the transaction.
I’m a big fan of escrow, but I also like to monitor what’s happening in escrow to make sure that the job is being done properly. In Arizona, almost always the title insurance and escrow functions are performed by the same company, but that’s not the case everywhere in the country. In some places in the country, when you have a real estate transaction, there will be a title insurance agent who is issuing title policies and then you have an escrow agent who is performing escrow functions and they’re two different companies and two different people.
Contracts in general do not need to be in writing. That is true in general. There are certain categories of contracts that must be in writing in order to be enforceable, but even though a contract may be enforceable, it’s still best if it is in writing.
The reason why is writing makes very clear in most cases what the terms of the contract are. If you have an oral agreement, that is very susceptible to people having different memories of what the agreement was exactly. There’s nothing quite like a written agreement to clarify what the terms of the contract are.
A due-on-sale clause is an agreement that usually exists in loan documents where the borrower is representing to the lender that they are going to be using the building or the real estate, whatever kind it is, for certain some purpose, and they are personally going to be using it.
They get the loan and that is one of the representations that the lender is relying on: how are you going to be using this property? Because they want to be make sure that they property is protected and used in the appropriate way, and that it’s value is being preserved. One way they so that is through this kind of a term, a due-on-sale clause.
The due-on-sale clause says if you sell this property, that is secure our loan, we can call your loan due. We can accelerate the due date on your loan and require it all to be paid when you sell. This may be the case even though you may be perfectly willing to continue to make the payments. Even though the deed of trust that the lender may have on the property is still valid and enforceable. The lender still has that provision in the loan document that says, no we can call the loan due if you sell the property.
Occasionally, lenders will use that term for some negotiating leverage where they don’t have any objection to allowing you to sell the property, or allowing the new person to take over the loan, but, they’ve got the power to extract something out of you, so sometimes they will. Say okay, we’re going to waive our due-on-sale clause here, but it’s going to cost you $5,000. Lenders can do that sometimes.
There is a statute in Arizona that calls into question the enforceability of due-on-sale clauses. There’s also some case law in Arizona that calls into question the enforceability of due-on-sale clauses. You’re going to want to look at those before you make any decisions based on some expectations you have of how the law is going to apply to your situation. It may not be as it seems in the loan documents.
Another thing you need to be aware of when it comes to due-on-sale clauses is what constitutes a sale, because sometimes you can trigger a due-on-sale clause unintentional. For instance, an individual may own property in their own name, maybe it’s a husband and wife that owns property in their own name, and then they convey that property into a living trust that’s going to benefit their family. Is that a transfer? Is that a sale? Does that trigger the due-on-sale clause? Well, it may, it may not, but it’s something that you may want to consider before you make a move on that.
Also, you may have an individual, or a husband and wife that own property personally, and they decide hey, this really ought to be owned by the business, it’s our business that’s owning this property. Let’s convey it into the name of our business. You have a similar situation there. The use of the property may not have changed but the actual ownership of the property has changed and there is a risk that you have triggered a due-on-sale clause in that instance. It’s something that you want to be aware of so you can make the best decision possible.
In commercial leases you will usually see, unless the tenant is really well established and an excellent credit risk for the landlord, you will usually see the landlord requiring the individuals who own the business to personally guarantee the lease.
You need both members of the marital community to sign. If you don’t you’re gonna have a really big problem from the lender or landlord’s side, and this is another area in which mistakes are frequently made, because you’ll have a lot of landlords, in fact, you’ll probably see it here more than anywhere. You’ll have landlords who have significant commercial holdings all over the country and they have a building or two here in Arizona, and it’s just not enough for them to have gotten the familiarity with Arizona law. When they signed the lease, they didn’t involve their counsel. They said, “Ah, we know what we’re doing here. We’ve done this a hundred times on a hundred other buildings. And we’ve got all of our forms and they use the same forms that they use everywhere else”.
The problem is that guarantee form that they’ve got, it doesn’t have a place for the husband and wife to sign. It’s only got a place for the husband to sign. It comes time to enforce that guarantee and they are very disappointed to find out my guarantee is not worth the paper it’s printed on.
So go back and watch my video regarding the importance of both members of the marital community sign any personal guarantee.
What else can you do to secure your money? You want as many people as you can get guaranteeing that repayment. You may be loaning money to a business. Businesses come and go. People generally survive longer than businesses. You want to get personal guarantees from the people who are going to be benefiting from that business.
Let’s use the example of the lawn mowing service. Lawn mowing services come and go. It doesn’t do you a lot of good usually to have a promissory note from Chip’s Lawn Mowing Service because Chip’s Lawn Mowing Service can come and go, but Chip is going to hopefully be around for a while. Chip is going to be earning wages. You want to get a personal guarantee from Chip. If Chip is married, you want to get a personal guarantee from Chip’s wife as well.
This is a trap really. I see people walking into this trap so often. It’s terrible. In Arizona, guarantees are virtually worthless if they are not signed by both members of the marital community. I will often times see out of state lenders, or any kind of company that is based out of state, that is requesting a guarantee for anything, they’ll send a guarantee to be signed by an individual, but they won’t insist that the guarantee be signed by the individual’s spouse.
If it comes right down to enforcing that guarantee at some point in time, the guarantee is only enforceable against the sole and separate property of the spouse who signed the guarantee. In Arizona, if you have a couple that has been married for any length of time at all, you will usually find that there is no sole and separate property. Everything is marital property, so the guarantee becomes virtually worthless.
I’ve encountered the problem many times. I’ve encountered it also many times in the context of litigation, where I represent a client who is being sued on a guarantee. Husband signed the guarantee. The wife didn’t sign the guarantee. They’re freaked out. They’ve been sued. It’s for a large amount of money. They think there is no way out.
If the spouse did not sign the guarantee, it’s almost a get out of jail free card. That’s something to be very careful about. If you are investing into businesses or if you’re making any kind of investment or loan in which you are requiring the borrower or the affiliates of your borrower to sign the guarantee. Make sure that you get both members of the marital community to sign that guarantee.
When I’m talking about private equity here, I’m really not talking about Mitt Romney private equity. I’m talking about local wealthy investor private equity. From the standpoint of a local wealthy investor that’s going to be investing in local companies or local real estate opportunities, there’s a great need to protect that investment. It’s really sad to see, sometimes, people that have worked very hard to amass a substantial amount of wealth invest it into some enterprise that they, obviously, believe is going to be successful, but it’s not managed properly. Their investment is not protected properly, and the investment can disappear rapidly.
There are some things that an investor can do to protect that investment. First thing I want to talk about is operationally protecting the investment. One of the things that I believe investors needs to do to protect their investment, beyond just securing the investment with liens or with financing statements that may get recorded with the Secretary of State, I’m not talking about that sort of protection, I’m talking about monitoring what’s going on in the company that they’ve invested in, or what’s going on in the real estate that they have invested in.
This can actually be quite a difficult thing to do because you can have a situation where you think you know what’s going on, but really you’re just being shined on by somebody who’s telling you what they want you to hear. You need to have some levers in place so that you have the right to get in and see what’s happening. Look at the books. Tour the facility. Actually get a sense for what’s going on.
Well, maybe you don’t want to spend your time doing that. Maybe you’ve got too many of those irons in the fire for it to be practical for you to attempt to do all of that yourself. That’s fine, and, in fact, that’s great. That means you’ve amassed a lot of wealth if there’s that much that’s out there in those different enterprises, but it can’t be ignored. It’s very important that if you’re not going to do it yourself that you have trusted counsel or somebody on your staff that can go in and monitor what’s happening.
Interview these people. Let’s put some structure to this. Let’s make sure that there’s some accountability for what’s going on with your investment. Some of that needs to be bargained for at the beginning of the investment. Some of it can be written into an operating agreement if you’re investing into an LLC. It doesn’t necessarily mean that you are going to try to micro-manage this business. That’s probably not what you want to do, but, still, everybody will be better served if there’s accountability to the investment that you’ve made in a business. That’s the first thing to do. Get some operational control over that business, or if not control, operational oversight over that business so you can really see what’s happening.
I have seen people, who are very cautious people and very loathed to spend money, research and be very careful, do a lot of due diligence, in deciding which camera they’re going to purchase because it’s a big investment. The thing’s going to cost $2,000, maybe. It’s a really nice camera, and they don’t want to just spend that money without making sure that it’s the best camera, that it’s going to be reliable. They’ll see what the warranty is on this. It’s really not unusual for people to spend a significant amount of time and effort vetting that sort of purchase, and, yet, investing a million dollar with somebody that they know and trust, usually, and do very little in terms of oversight. Very little monitoring “What’s happening with my money?”
What’s going to happen if a couple of these different possibilities play out? It happens all the time. It’s mind-boggling, but it’s not unusual. I see it. I don’t want to say it’s the norm, but it’s close to being the norm.
A friend of mine who’s a very successful investor, really successful investor, most of his investments are in the real estate arena, he had a great saying. I don’t even know if he made it up, but I hadn’t heard it before. He says, “You don’t get what you expect. You get what you inspect.”
I talked about practical oversight, and that’s very, very important. The legalities are also important. You want to make sure that you are securing your investment to the greatest degree possible.
How you can secure that investment will depend, to some extent, on what is the nature of your investment. Is it an investment, or is it actually a loan? In either, case there are things that you can do to protect that investment and/or loan. I’m just going to quickly go through some of the most important devices that are used to secure the source of investments.
One thing that often makes sense to have, I won’t say always, but often, is a promissory note. A promissory note is a promise to pay, and you want to make sure that you have a promissory note and that it has been reviewed by your counsel.
You don’t want to draft your own agreements. I have seen some of the ugliest agreements that you just can’t even imagine. I recall going into one contract review in the context of a partnership dispute where there was a nasty falling out. Guys were once friends and they’re no longer friends. They were once looking at making gazillions of dollars together in this enterprise, and everything had gone terribly.
They were not dumb guys, but they also weren’t lawyers. Drafting contracts is not what they did. Except it is what they did; they drafted their own contract. The one guy who was my client came to me and said, “Okay, here’s our agreement. What do I do? How do I solve this problem that I’ve got?” He said, “I drafted this thing, and I think it’s got all the important terms in here.”
He handed it to me and it was a page and a half long, and this was a significant investment. I thought, “Oh, it can’t have all the important terms in here because there’s just not enough room for the important terms in this page and a half.”
As I looked at the agreement, the heading on the agreement is something that I don’t think I’ll ever forget. It said in big, bold letters at the top “Contractural Agreement,” misspelling the word contractual, had an “r” in there. Anyways, that’s an indication that your contract may have problems. You want to put the protections in place, get a promissory note.
If there is any real property that can be used to secure your investment, secure it. The way you do that is by recording a deed of trust against that real property. A deed of trust gives you a lien on the property. You need to make sure that deed of trust is legally compliant with the laws governing deeds of trust. You need to make sure that the deed of trust is recorded in the proper county, that it includes an accurate legal description. You need to make sure that the deed of trust is in the priority that you expect it to be in.
This is a mistake that’s pretty easy to make and people make this mistake. They think that they are secured because they have a deed of trust, in other states it’s usually referred to as a mortgage. In Arizona, we don’t use mortgages usually, we use deeds of trust but they perform a similar function.
Somebody might think that they are secured because they have a deed of trust. What they may not know is there’s two or three other people that also think they’re secured because they have a deed of trust, and their deed of trust may be recorded before your deed of trust. There’s a saying, “first to file, first to smile.” You want to be there first. If you’re not, you’re going to be at a lower priority than somebody that was there before you.
How do you find out what your priority is? You involve a title insurance company in that process. I spent a number of years as in-house counsel at a title company, and I oversaw the underwriting operations within this title agency. One of the things that you do is you investigate the condition of title of real property. Are there other liens on this property that are going to take priority over your lien? Title policies are really not that expensive. They are well worth it in most cases and your attorney can help you get a title insurance policy that will insure your position on the property that you think is securing your money.