What is Fraud in the Execution of a Real Estate Agreement?
Unfortunately, there are many examples of fraud in California real estate transactions, and one form was the subject of the recent decision in Munoz v. PL Hotel Group.
I am presently handling a case that involves a form of fraud in the execution whereby my Spanish speaking client was presented with a Spanish version of an agreement, and then induced into signing an English version that was different, and resulted in a change in ownership of the real property.
The appeal in Munoz involved a form of fraud rarely seen in day-to-day litigation. It goes by various names—fraud in the factum, fraud in the execution, fraud in the inception—but they all describe the same genre of deceit.
It occurs where, after parties have agreed upon certain contract terms, one of them surreptitiously substitutes a document for signature that looks the same as the earlier draft but contains materially different terms.
Fraud in the execution is distinct from promissory fraud, which involves false representations that induce one to enter into a contract containing agreed-upon terms.
The case, on appeal after a demurrer was sustained without leave to amend, involved the purchase and leaseback of a vacant hotel and restaurant.
The nub of the lawsuit was the buyers’/plaintiffs’ claim that the sellers/defendants surreptitiously substituted altered versions of the lease and financing instruments containing terms extremely adverse to the buyers, and which they alleged were neither bargained for nor agreed to.
The allegations stated, quite literally, a textbook cause of action for fraud in the execution, as this illustration from the Restatement Second of Contracts demonstrates: “A and B reach an understanding that they will execute a written contract containing terms on which they have agreed. It is properly prepared and is read by B, but A substitutes a writing containing essential terms that are different from those agreed upon and thereby induces B to sign it in the belief that it is the one he has read. B’s apparent manifestation of assent is not effective.” (Rest.2d, Contracts (1981) § 163, illus. 2.)
But acting under the misapprehension that plaintiffs’ theory was promissory fraud, the superior court sustained a demurrer brought by defendants Inn Lending LLC (Inn Lending) and Rajesh Patel (Rajesh) on the grounds that insufficient facts were alleged showing they made promises upon which plaintiffs relied. The court also determined that related causes of action for breach of contract, breach of the implied covenant of good faith and fair dealing, and financial elder abuse also failed.
Shivam Patel and his son, Rajesh (collectively, the Patels), owned a hotel and restaurant (Hotel). The Hotel had been closed for years and the property needed substantial repairs. When renovations were about half completed, the Patels determined the project was not viable because there was no way to get conventional financing with a half-finished Hotel that had no financial history.
The Patels formed PL Hotel Group, LLC (PL) to hold title and listed the property for sale. They structured the transaction so they would remain in possession after the sale. Toward that end, the sale included a leaseback to the Patels under a triple net lease.
A triple net lease (sometimes designated as NNN) is one in which the lessee/tenant pays taxes, insurance, and utilities.
From the buyer/landlord’s perspective, the difference between the monthly rent under the lease and cost of financing would be the return on investment.
Luis Munoz was an 80-year-old real estate investor and sole owner of LR Munoz Real Estate Holdings, LLC (collectively, Munoz). In June 2018, the Patels’ agent, Steven Davis, sent an offering memorandum to Munoz’s agent, Ryan Cassidy.
Among other terms, it stated the transaction would include a new 20-year absolute NNN lease to start at close of escrow.
In early July, the parties agreed on a $2.8 million purchase price. Cassidy drafted the purchase agreement, under which the Patels were to provide Munoz a fully executed lease that should include an "annual rent payment of $230,000 NNN paid monthly".
On July 17, the Patels (via Davis) sent a proposed but unexecuted triple net lease to Cassidy. In an accompanying e-mail, Davis reserved the Patels’ right to make further edits in case there was an error or oversight.
This lease, which the parties refer to as the “July 17 lease,” was circulated “multiple times” during the 60-day escrow. It was the only lease agreement ever circulated before close of escrow. It contained the agreed lease terms, and at no time before escrow closed did the Patels ever contend there was an error or oversight in it.
The July 17 lease was for a 20-year term, with specified options to renew, rent began at $19,167 per month, and periodically increased over the 20 year term, and the tenants (Patels) were solely responsible for (1) maintenance and repairs; (2) insurance; (3) utilities; and (4) taxes.
On August 29, Davis sent an e-mail to Cassidy attaching the July 17 lease, indicating it is the version that would be signed at closing.
On September 13 (two days after escrow closed), Shivam sent an e-mail to Cassidy stating, “Attached is the lease,” thus making it appear he had signed the July 17 lease. But the September 13 lease attached to Shivam’s e-mail was materially different.
Unfortunately for Munoz, the differences between the two leases were not so numerous to be obvious. For instance, the provision a landlord might be expected to check—rent payments—was unchanged. Munoz signed the September 13 lease after only a cursory review, believing it was the same triple-net lease the parties had circulated and approved numerous times.
But as Munoz would soon learn, the September 13 lease was anything but a triple net lease. For example:
Maintenance and Repair: Under the July 17 lease, the landlord (Munoz) has no obligation to maintain or repair the premises. But the September 13 lease provides the landlord “shall have the duty to repair” everything beyond normal wear and tear.
Renovations: Under the July 17 lease, the tenant (Patels) were obligated to complete renovations. Under the September 13 lease, the landlord is.
Taxes: The July 17 lease provides the tenant pays taxes relating to the premises. The September 13 lease limits that obligation to taxes “attributable solely to any business property or personal property of the Tenant” on the premises.
Assignment and Subletting: The July 17 lease allows the tenant to sublease to a nonaffiliated entity only with the landlord’s consent. The September 13 lease allows a sublease “without Landlord’s consent at any time.”
Tenant’s Continuing Liability: Under the July 17 lease, an assignment or sublease does not release tenant’s liability, including for rent. But under the September 13 lease, a permitted assignment or sublease “eliminate[s]” tenants’ liability.
· Landlord’s Remedy: The September 13 lease adds a new provision that makes retaking possession the landlord’s sole remedy on tenant’s default.
Meanwhile, as the Patels’ plan with regard to the altered lease was put in place, Munoz was unable to obtain financing from a conventional lender because the Hotel had been closed for two years. Expecting this, the Patels initiated the second phase of their plan. Not only would they be the seller/tenant in the transaction, but also the secured lender.
On the Patels’ behalf, Davis contacted Cassidy (Munoz’s agent) and recommend he hire David Hamilton of Pacific Southwest Realty Services (collectively, Hamilton) as loan broker. But this was all an illusion for Munoz’s consumption. Hamilton had no intention of shopping around for a loan. Instead, he placed the loan with Inn Lending—an alter ego entity of the Patels created just for that purpose.
On July 25, Hamilton told Munoz that a private lender, Inn Lending, would finance the purchase at six percent per annum interest, secured by a deed of trust only on the Hotel (plus an unsecured personal guarantee by Munoz). These terms were presented in an August 6 “letter of intent” Munoz signed.
Munoz paid Hamilton a $7,500 “administrative” fee to have loan documents drawn on those terms. During this whole time, Inn Lending did not even exist. It was “simply Rajesh and Shivam.”
Inn Lending did not come into existence until August 23. The next day, Hamilton sent loan documents to Munoz. In a sense, it was deja vu.
Like the leaseback, the loan was another bait and switch. The approximately 300 pages of loan documents materially varied from the letter of intent:
The interest rate was “disguised” and was actually 7.3 percent per annum;
The payoff amount was $300,000 more than it should have been;
· The loan was secured not only by the Hotel, but also by Munoz’s other real estate holdings “worth several millions of dollars” and a security interest in his personal property.
On September 4, Munoz signed the loan documents, unaware of these changes. For the Patels, everything was now in place.
They always intended to surreptitiously alter the lease knowing that the real estate agents would cooperate and/or would not be diligent enough to catch the fraud. The transaction was manipulated to make sure it would be so burdensome and unfair that Munoz would quickly default on his loan, allowing the Patels, through Inn Lending, to foreclose on not only the Hotel, but also Munoz’s other real property.
It took less than a month for the other shoe to drop. On October 1, Munoz asked the Patels for the first rent check. In response, Shivam claimed no rent was due, stating, “The landlord is supposed to reimburse the Tenant for all renovation costs.”
Three weeks later, PL’s attorney demanded Munoz reimburse for all renovation expenses. Not surprisingly, the litigation ensued.
In December 2019, Munoz filed the operative Complaint against Rajesh and/or Inn Lending, Munoz alleged causes of action for: breach of contract; elder financial abuse; “promissory fraud”; and breach of the implied covenant of good faith and fair dealing.
Rajesh and Inn Lending demurred, asserting they were in no way involved in the underlying transaction and/or in negotiating the terms of the sale/lease.
They claimed the fraud cause of action failed because as to Rajesh, there are zero allegations that he even spoke to Munoz, let alone make any representations to him. And they asserted there was no authority to support the proposition that revisions to documents by one party can equate to affirmative misrepresentations that could give rise to liability for fraud.
Opposing the demurrer, Munoz’s attorney argued, among other theories, that the defendants misconstrued the allegations, and the Complaint alleged the Patels tricked Munoz into executing an altered lease.
Citing among other authorities, California Trust Co. v. Cohn (1932), they maintained that Munoz’s failure to read the lease before signing, if induced by fraud or trickery, does not preclude relief.
After conducting a hearing, the court sustained the demurrer without leave to amend, and entered a judgment of dismissal in favor of Rajesh and Inn Lending. Postjudgment, the court awarded them $92,505 in attorney’s fees plus costs.
In sustaining the demurrer to the seventh cause of action, the trial court understood it to involve promissory fraud. This was probably in no small part because Munoz’s attorney labeled it “Promissory Fraud.”
The court explained the Complaint was insufficient because there were no allegations that Rajesh or Inn lending made promises, nor allegations as to the element of reliance.
However, the nature and character of a pleading is to be determined from the facts alleged, not the name given by the pleader to the cause of action.
The gravamen of the fraud claim is not fraud in the inducement, but rather fraud in the execution.
In the classic case of fraud in the execution, some limitation—such as blindness, illness, or illiteracy—prevents the plaintiff from reading and understanding the contract that he or she is about to sign.
For example, in Rosenthal v. Great Western Fin. Securities Corp. (1996), defendants omitted portions of the contract when reading it aloud to plaintiff, who could not read English.
In Jones v. Adams Financial Services (1999), defendants tricked an elderly legally blind woman into a reverse mortgage by telling her she was authorizing them to learn the payoff on her mortgage.
Closer to the facts alleged here, fraud in the execution may also occur where a contract is surreptitiously modified.
In Hotels Nevada v. L.A. Pacific Center, Inc. (2006), the owner of commercial property signed an agreement to sell the properties for $70 million in cash and another $5 million a year later. He alleged that after he signed the agreement, the buyers covertly substituted a provision entitling them to hold back the last $5 million for five years instead of one. The court held those allegations sufficed for fraud in the execution.
Another variation is typified by California Trust Co.: when the plaintiff sued to quiet title to certain real property, the defendants cross-complained alleging fraud in concise language.
According to the cross-complaint, the plaintiff represented that if defendants paid $7,500, he would hold title to the property, improve and sell it within a year, and pay the defendants $17,500 of the proceeds. The plaintiff prepared a written agreement and stated it contained these provisions, which defendants signed without reading it.
When the plaintiff demanded further payment, they read it for the first time and discovered it contained provisions significantly different from the prior oral agreement. The California Supreme Court determined the cross-complaint alleged sufficient facts to warrant reformation, commenting, a party to an instrument who by fraud leads the other party to sign without reading it is in no position to urge the latter’s negligence.
These cases reflect society’s understandable desire to repress this pernicious form of fraud. Yet at the same time, there has always been a sharp struggle between that policy upon the one hand, and on the other to discourage negligence and the opportunity and invitation to commit perjury.
The California Supreme Court stated in picturesque (if somewhat dated) language, “No rogue should enjoy his ill- gotten plunder for the simple reason that his victim is by chance a fool." (Seeger v. Odell (1941)
The countervailing policy is often expressed as a duty to read a contract before signing.
Generally, one who accepts or signs an instrument, which on its face is a contract, is deemed to assent to all its terms, and cannot escape liability on the ground that he or she has not read it. If he or she cannot read, he or she should have it read or explained to him or her. (Ramos v. Westlake Services LLC (2015)
In balancing these competing interests, courts have required the plaintiff to have acted in an objectively reasonable manner in failing to become acquainted with the contents of the written agreement.
The plaintiff must not only have been ignorant of the surreptitiously inserted terms, but must also have had no reasonable opportunity to learn that the document contains them.
In short, the standard is one of excusable ignorance. In making that determination in the context of fraud in the execution of a negotiable instrument, the Uniform Commercial Code explains the relevant factors include: (1) the party’s intelligence, education, business experience, and ability to read or understand English; (2) the nature of the representations that were made; (3) whether the party reasonably relied on the representations or justifiably had confidence in the person making them;(4) the presence or absence of any third person who might read or explain the instrument to the signer; (5) any other possibility of obtaining independent information about the document’s terms; and (6) the apparent necessity, or lack of it, for acting quickly. (Cal. U. Com. Code, § 3305, subd. (a)(1)(C) & com. 1, ¶ 5.)
Rosenthal is a good illustration of how courts apply these principles. There, plaintiffs brought fraud claims in connection with investments they made, and the defendants sought to compel arbitration based on client agreements containing an arbitration clause. The Supreme Court found the arbitration agreement unenforceable as to two of the plaintiffs, Giovanna Greco, an 81-year-old Italian immigrant who spoke only “ ‘a few words of English’ and "cannot read English at all,” and her daughter Rosalba Kasbarian, a 45-year-old Italian immigrant who was “able to speak and understand simple English, but cannot read English very well at all," and had difficulty reading "complicated words or legal terms.”
The court held these plaintiffs reasonably failed to read the agreement because they had a previous relationship with the defendant; they had a limited ability to understand English; Greco explained she could not understand what the representative was saying; the representative told them he would read the documents to them while Kasbarian translated for Greco; and when the representative read the documents, he did not mention the contract included an arbitration agreement or that the plaintiffs were giving up their legal rights.
In contrast, another plaintiff, Raul Pupo had no prior relationship with the defendant or its representative, and the representative did not purport to read the contract to him or orally explain its contents. The court concluded, “Under these circumstances, Pupo's failure to take measures to learn the contents of the document they signed is attributable to his own negligence, rather than to fraud on the part of defendant or its representatives.”
In this decision, the appellate court reversed the judgment of dismissal, and Appellants were awarded their costs on appeal, jointly and severally, against Rajesh Patel and Inn Lending, LLC.
LESSONS:
1. If misrepresentations are used to cause entry into an agreement, it may be fraud in the inducement.
2. If the agreement is changed without the knowledge of a party, it may be fraud by execution.
3. For all real estate transactions, written agreements should be used and carefully reviewed before execution, and legal counsel should be obtained to ensure the parties understand the agreement.