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January/February 2014, Vol. 56, No. 1

Ethics

How real estate’s ‘gross ups’ affect lawyers and Rules of Professional Conduct

By Richard Rifkin, Special Counsel
The Professional Ethics Committee recently issued its third opinion on the subject of “gross ups” — a technical but highly controversial topic in the world of residential real estate transactions. 

The opinions represent an effort to resolve the tensions between a common and well-understood practice by those regularly involved in real estate matters and the obligation of lawyers to comply with the Rules of Professional Conduct.

The first opinion, No. 817, was issued in November 2007. It caused quite a stir among real property lawyers, with the result being the issuance of two later opinions refining the original. All three are reviewed here in the hope that it helps to bring clarification after six years of extensive discussion.

Opinion 817

In Opinion 817, the committee faced the following basic facts: After a buyer and seller had entered into an agreement, the buyer asked that the stated selling price, to be reflected in the written documents, be increased by 3 percent with the understanding that the seller would offer a concession at the closing in the same amount. 

This “gross up” enabled the buyer to obtain a mortgage loan based on the higher amount, although the actual amount received by the seller at the closing would be the agreed-upon price. The committee was told that this was a common practice, authorized in the lender’s underwriting manual and acceptable to the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). 

The question for the committee was whether a lawyer’s knowing participation in this arrangement was consistent with the then-applicable Code of Professional Responsibility.

The committee was concerned with DR 1-102(A)(4)  (now Rule 8.4(c)), which prohibits a lawyer from engaging in “conduct involving dishonesty…deceit or misrepresentation.” It looked to prior opinions of North Carolina (Opinion 12) and New Jersey (Opinion 710), both of which found violations of similar provisions in those states because the higher price set forth in the written documents did not reflect the actual price that the seller would receive after the concession at the closing. 

The North Carolina opinion focused on the true price being concealed from subsequent purchasers of nearby lots, and the New Jersey opinion focused on its being concealed from subsequent purchasers of mortgage-backed bonds in the secondary market (which, as we now know, had many other significant problems not yet identified in 2007).

After considering these opinions, the committee said that “while we recognize the evidence that the practice of grossing up the price post-contract has become common, we find the concerns expressed in North Carolina Op. 12 and New Jersey Op. 710 of considerable weight.” 

The committee was not able to define specifically when deception would result in a violation of New York’s ethical standards, but said that “a lawyer may not ethically participate in such a ‘gross up’ …unless there is neither deception nor misrepresentation at work in the transaction and its predictable consequences.” It concluded that in this situation “reporting a seller’s concession, without more, is misleading.”

This opinion troubled many lawyers whose practices include residential real estate transactions. The committee was asked to re-examine the issue. In 2011, it undertook the requested re-examination and invited lawyers from the State Bar’s Real Property Law Section to attend a meeting and explain the problems caused by the opinion. The result of this process was Opinion 882. 

With the additional knowledge, the committee was able to be more specific. It concluded that where a lawyer, whether for the buyer, seller or lender, knows (or should know) that the transaction documents set forth the grossed up price without disclosing the seller’s concession and the actual sales price, the lawyer’s participation violates Rule 8.4(c) (successor to DR 1-102(A)(4)). 

The committee was explicit in stating that it being a widespread practice or that lenders participate does not change the conclusion. The committee noted that some lenders are unable or unwilling to participate where the full facts are disclosed. That, said the committee, does not permit lawyers to engage “in conduct involving misrepresentation.”

Since failure to disclose was the basis of the violation in such situations, the committee held that lawyers could 
participate ��where the sales contract, the HUD-1 Settlement Statement, the transfer tax return and any other documents that contain the sales price each contain the following statement (or a substantially similar statement: ‘The sales price has been increased by a sum equal to the seller’s concession.” With such disclosure, lawyers would not violate their ethical responsibilities. Thus, the committee, although not changing its view, gave definition to when a lawyer could or could not participate.

Insufficient definition

However, this definition proved to be insufficient. Earlier this year, the committee was informed that a local bar association and local association of realtors, in an attempt to comply with the previous opinions, inserted a disclosure clause in the standard real property contract to cover every transaction in which there was a seller’s concession. 

They read the prior opinions to require this disclosure and said that it was causing problems with lenders, including delays, the striking of the clause and even the rejection of mortgage loans. Thus, the committee, once again, reconsidered the issue.

On Nov. 13, 2013, the committee issued its response in Opinion 993. It again recognized that the disclosure required by its prior opinions was causing difficulties, including resistance by mortgage lenders, but it said that the reasoning of these opinions “continued to be sound.” 

However, it said the recent inquiry “is based on a misunderstanding of our prior opinions.” These opinions did not require disclosure of every seller’s concession, as the request for reconsideration had presumed.  

The committee concluded that “the mere existence of a seller’s concession does not require a statement that the purchase price has been increased.”

However, when the price is grossed up and combined with a seller’s concession, “the lawyer who participates in the transaction is required to ensure that the grossing up of the price is disclosed.”