One of the most common questions I get from listing agents relates to the loan contingency and, specifically, when or if the buyer is exercising it in bad faith. In many instances, the seller is skeptical about claims that the loan application was rejected or that the buyer really tried to get approval. As a result, the seller wants to know if they can keep the deposit even though the loan contingency was exercised. Since there is often no simple answer to this question, I thought it worth discussing with you. The first thing to remember is that, according to California law, every contract must be performed in “good faith.” It doesn’t matter whether the subject contract actually has a good faith clause in it. According to case law, that clause is implied in every contract.
With regard to the loan contingency in the RPA, there is actually some language that helps define the good faith use of the contingency. In paragraph 3K, “Buyer Stated Financing,” the contract states as follows: “Seller is relying on Buyer’s representation of the type of financing specified…. The seller has agreed to a specific closing date, purchase price and to sell to Buyer in reliance on Buyer’s covenant concerning financing. The buyer shall pursue the financing specified in the Agreement. The seller has no obligation to cooperate with Buyer’s efforts to obtain any financing other than specified in the Agreement and the availability of any such alternate financing does not excuse Buyer from the obligation to purchase the Property….” In other words, in order to exercise your loan contingency in good faith, the buyer’s application for the loan specified in 3A-D must be denied. Those numbers define “good faith” for that contract. As a result, in order to protect their cancellation rights, the buyer must always apply for the loan in the contract. Trying to use the loan contingency when they did not apply for the specified loan would be bad faith, even if they still had the loan contingency. And the seller would probably be within their rights to keep the deposit (if the liquidated damages clause is initialed).
Additionally, when the buyer has waived their appraisal contingency but the property doesn’t appraise, the contract tells us that using the loan contingency to cancel would be a bad faith act. In paragraph 3J (2), the RPA provides as follows: “If there is no appraisal contingency or the appraisal contingency has been waived or removed, then failure of the Property to appraise at the purchase price does not entitle Buyer to exercise the cancellation right pursuant to the loan contingency if Buyer is otherwise qualified for the specified loan.” In other words, if you have waived the appraisal contingency, and the only reason the loan is denied is the appraisal, you cannot use the loan contingency to get out.
While the scenarios above are easy, there are others that come up often and are not so clear. For example, it is not uncommon for me to hear about sellers who do not believe that the buyer has been diligent in their loan application. The lender has asked for simple documents that the buyer has not provided, or that they have unreasonably delayed in providing. Or perhaps a simple condition was placed on funding that is totally within the buyer’s control and they don’t take the simple steps necessary to satisfy it. It each of these cases, if those facts are proven, the seller would have a reasonable argument that the buyer’s conduct constituted bad faith. Of course, these scenarios are less clear and more fact-specific than the situations above and we would need to recommend that the seller talks to an attorney if they want to make that claim. After all, “good faith” is a subjective standard, and a legal one, so we cannot assure the seller that she has a winning claim in that regard. But, if the evidence of the buyer’s failure to take easy steps is clear, the seller has a good claim to the deposit.
In short, the good faith requirement is often central to the use of the buyer’s loan contingency. When representing either side in this situation, make sure they understand what the contract says about their situation. If your facts are not directly covered by the RPA, be sure to remind your client about the good faith requirement and, if a question arises, refer them to a lawyer. That way, everyone is protected.
As always, if you have any questions about this issue, please contact your manager.
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