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Ron Gitter

Ron Gitter

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Repairing New Construction: Five Fixes for Sponsor Deals

Posted: 04/20/11 03:52 PM ET

Springtime for Developers

Ahhh, the air is electric again with multiple bids and irrational signing deadlines. Let's face it, New York is not a happy place unless the real estate market is happy... and it's getting happier. As the metropolitan area emerges from the transactional big sleep of the past two years, developers are dusting off their promotional materials and contracts are getting signed. But sponsor transactions are in need of a serious spring cleaning. With a view towards increased transparency and greater fairness to the consumer, here are five suggestions for improving the process by which new construction apartments are offered to the public.

Offering Plan Distribution

It's time to bring the dissemination of offering documentation into the 21st century. At the moment, things probably haven't changed in New York since the first prospectus was sent to a purchaser's attorney in the late 1880s. In today's world, the sales office of the developer delivers the offering plan to the purchaser's counsel once an offer is accepted (sometimes at a cost of $100 or more). In the aftermarket, brokers and attorneys are dependent on sellers, managing agents and the few service providers that maintain offering plan libraries to get copies when a deal is about to happen. The cost of obtaining a complete set of documents can run as much as $300.00 from some managing agents. When brokers maintain copies, the offering plans are often missing pages, or the latest amendment and frequently are not in acceptable condition for completing due diligence. On the other hand, although the attorney general's office has extensive materials online, offering plans and amendments are nowhere to be found. Only through a Freedom of Information Law request will the AG's office permit a purchaser's representative (or anyone else for that matter), laboriously, to copy what hasn't been thrown out (they only save materials for 12 years). That appointment, however, can take two or three weeks to occur. Not exactly time-sensitive when parties are trying to get due diligence completed. It should not be this difficult to obtain the required documentation and there is an easy way to improve the process.

Solution: Developers should be required to maintain copies of all offering materials online either through their own website, through the AG's website, through an industry website, such as REBNY, or through an acceptable third-party provider. As soon as an offering plan or amendment is approved by the Attorney General's office it should be posted online for all to review. Active developers should be required to maintain all offering documents online for at least the past ten years. Finding out the history of a project should not be like going on an archeological dig. Just put the stuff online.

Disclosure of Defects and Other Problems

As every offering plan states in great detail, construction is a complicated process. Even when the sponsor is enthusiastic about completing the project on time and with the best of intentions, things can go wrong. Once units start getting sold, sponsors can be reluctant about disclosing problems with construction impacting the development as a whole or individual units. In one recent situation, finding out about a heating problem from the managing agent and sponsor's attorney was like pulling teeth. Further, until a sponsor loses control of the board of managers, there are rarely minutes of board meetings reflecting actions taken on behalf of the condominium. Nobody likes a paper trail.

Solution: Developers should be required to disclose by amendment post-completion construction problems, potential threats to life, health or safety (such as bedbug infestation), significant litigation with unit owners or third parties or any other issue that could have an adverse impact on the condominium, unit owners or potential purchasers. Developers will argue that they are already overburdened with current disclosure obligations and that additional requirements will only open up a can of worms. Perhaps so. But the public is entitled to greater transparency, and potential purchasers should not be buying into a project with known problems that may not have been disclosed because the sponsor believes the issue is not "material."

The Punch List Problem

One of the unique features of buying new construction is that the sponsor is not required to deliver a completed apartment at the time of closing. The purchaser does a "walk through" prior to closing and delivers an agreed-upon inspection statement, in which the sponsor promises to make certain repairs or replacements within either a "reasonable" period of time, "promptly" or "within 30 days." There are other iterations, but you get the idea. Finishing a punch list ranges from the sublime to the absurd. In one recent high profile purchase, the sponsor had not completed the punch list more than five months after the closing. When I called the sponsor's attorney and asked why the sponsor would act with indifference on such a high profile transaction, the curious response was "I can't explain it." Although many developers take the punch list seriously and view it as a marketing tool and good will generator, others do a horrible job of completing the items in a timely fashion. Something has to be done to change the cycle of neglect.

Solution: Purchasers should be entitled to an escrow at closing equal to or exceeding the cost of completing the punch list items. If needed repairs and replacements are not completed properly and within a specified period of time, the escrow should be released to the purchaser. I can hear the howls about how this will slow down the closing process as purchasers will use negotiations over the punch list escrow to delay the obligation to close. To some extent, that concern may be true. It's time for the pendulum to swing the other way, however, as sponsors have been getting a pass on this issue for years.

Paying Sponsor Closing Costs

I'm not sure how this feature originated, but built into every new construction deal is the purchaser's obligation to pay the sponsor's transfer taxes and attorney's fees at closing. On a $1,000,000.00 purchase, that adds as much as $21,000.00 to the purchaser's closing costs. When the market crashed several years ago, sponsors started giving in on this issue to get deals closed. Now that the market is improving, I'm seeing many deals where this item is back in play.

Solution: It's time for developers to rethink this issue, as it simply makes no sense for a purchaser to pay another party's closing costs. I realize it's a business point that can't be regulated, but in the world we live in today, it's not helping the real estate economy to require purchasers to pay the other party's closing costs. Purchasers, this one's a long shot.

The Private Right of Action

If I could pick one issue that would surprise almost every new construction condo purchaser, it's the fact that neither sponsors nor their principals are directly liable to the purchaser for material omissions or misrepresentations in the offering documents. The sale of a condominium apartment is similar to the sale of a security and is governed by the "Martin Act" in New York. When a material omission or misrepresentation does occur, it is the responsibility of the New York attorney general's office to prosecute the violators. When the attorney general does pursue a sponsor, the remedies may require rescission being offered to a purchaser or group of purchasers or barring the developer from future sales of apartments.

Is the Purchaser Really Protected?

Even when a sponsor is prosecuted by the Attorney General, that may not resolve the underlying problem that gave rise to the complaint, like shoddy construction or the failure to deliver amenities or other features. Although there may be a limited ability to pursue a sponsor on a common law fraud claim arising outside of the offering documents, in many cases, purchasers are left without an effective remedy. In any event, most sponsor purchase agreements and offering plans greatly limit the right of a purchaser to seek damages or to rescind the agreement and get the deposit back. Further, the sponsor entity is usually formed solely for the purpose of the offering and has no assets. When things do go wrong, it's basically a horror show for the purchasers who are impacted by the material omissions or misrepresentations.

Solution: The liability fire wall between the sponsor and the purchaser needs to come down. It simply makes no sense for the principals of the sponsor not to be directly liable to the purchasers of the units for material omissions and misrepresentations in the offering documents. Maybe creating a "private right of action" in the litigious world we live in will generate unnecessary lawsuits and will serve as a chilling effect on future development. But to rely solely on the attorney general's office to police the hundreds of new offerings made each year and the thousands of ongoing offerings, is not an achievable goal. The regulators and the developers have to come up with a solution that better protects the consumer. The principals of the sponsor have to stand behind their product, not hide behind the Attorney General.

Residential Reality: If You Don't Ask, You Don't Get

I realize some of these suggestions may never happen, but it's time to improve the process by which developers have the privilege of selling apartments to the public. To the extent that disclosure can be improved and expedited, the consumer will be in a better position to make a decision on whether a purchase in a particular condominium makes sense. At the end of the day, isn't protecting the consumer what it's all about?

 

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