When in Doubt- Disclose it out!
The Significance of Disclosure Reports and Filing Accuracy
By: Marc Santos, Disclosure Manager of DPFG Disclosure Services, Inc.
The importance of good disclosure in buying and selling real estate in this country cannot be overemphasized. It’s just good business practice to fully disclose the impacts and obligations that will affect the prospective buyer of property. Simply put, if a seller of property is lax in adequate disclosure then that company will run the risk of being sued. Courts, across the nation, have a natural bias towards disclosing an impact and/or financial obligation to a prospective purchaser versus remaining silent.
Disclosure notices, such as Natural Hazards Reports attempt to identify all possible impacts that that could affect the property being acquired. This could range from disclosure about earthquake faults, to flood zones, to lead paint, and to mold-- just to name a few. It’s amazing how far reaching this type of disclosure goes when the reality is that most of the items disclosed have an extremely low probability of ever occurring, as well as having a low probability of economic consequences to the seller of the property when it has been disclosed adequately. Nevertheless, these Natural Hazards Reports are a good example of disclosure overkill, but as a matter of practice this is a good thing.
The Securities Exchange Commission requires that Continuing Disclosure Notices be prepared in connection with tax exempt bond issuances of “special financing districts,” such as Community Facilities Districts (California, Arizona, Hawaii, and Washington), Special Improvement Districts (Nevada), Metropolitan Districts (Colorado), Municipal Utility Districts (Texas), Public Improvement Districts (Texas), and Community Development Districts (Florida). Essentially, the purpose of this disclosure is to provide bondholders with annual updates on the real estate development project’s progress, as well as any material events that have transpired during the reporting period. This allows bondholders to be better informed as to the status and value of their investments. In the “great recession” many land developers and/or obligated homebuilders failed to complete these Continuing Disclosure Notices. The problem created by this failure to comply, is that on future special financing district bond issuances, the land developer and/or obligated homebuilders will be required to disclose in the bond offering document that they failed to complete their Continuing Disclosure obligations in past special district financing transactions and this will typically cost them higher interest rates on new bond issues because fewer bondholders will have an interest in investing with a company that has a history of being noncompliant. Oftentimes, the land developer and/or obligated homebuilder will go back and complete those delinquent Continuing Disclosure Notices to make their disclosure story in an upcoming bond issuance more credible.
Many of the special financing districts identified in the paragraph above, including many more that were not mentioned herein, have different forms of disclosure pursuant to state law for each new home that the builder sells to a new home buyer. Most of these notices are generally referred to as a “Notice of Special Taxes” or “Notice of Assessments.” These notices can vary in complexity and the methods of apportionment can be extremely complex which increases the probability of drafting mistakes.
One area where disclosure Notices of Special Taxes or Assessments often fail is in properly disclosing the maximum annual tax or assessment that would apply to a prospective home buyer. Some apportionment methods yield maximum annual taxes or assessments that are extremely high under a worst case development scenario. In this case, some preparers of disclosure documents make the assumption that the worst case development scenario will never occur and “roll the dice” by disclosing lower maximum annual taxes or assessments than technically required. Our preference is to describe what the annual taxes or assessments are expected to be if development builds as planned, but also show the maximum annual taxes or assessments if development fails to build as planned.
Another area where disclosure Notices of Special Taxes or Assessments mistakes occur is related to the term of the tax or assessment. Some preparers of disclosure documents assume that the final bond term is the last year in which a tax or assessment can be collected. There are plenty of examples where this is not true. A special financing district could be set up to issue parity bond which could expand the term, the collection of delinquent taxes or assessments could expand beyond the bond term or a special tax could be set to a specific fiscal year which exceeds the bond term by several years.
The cost of a bad disclosure related to Notices of Special Taxes or Assessments can be financially significant, not to mention the cost of litigating the matter. For example, let’s assume that a 1,000 residential unit project that’s built-out has failed to properly disclose a maximum annual CFD special tax and the homebuyer signed a disclosure document at closing that their annual maximum tax would be $2,000 per unit per year; however, the actual tax that has been and needs to continue to be levied on the tax bill is $2,300 per unit per year. Further, assume the term of the CFD tax is for 35 years. The approximate cost of this bad disclosure is a follows, not counting litigation fees and other damages that could apply:
Actual Special Tax to Levy $2,300
Special Tax Disclosed to Homebuyer $2,000
Under-Disclosed Amount per Unit $ 300
Number of Affected Units 1,000
Under-Disclosed Amount per Year $300,000
Total Years Applicable to Homeowner (*) _32
Total Cost of Bad Disclosure $9,600,000
(*) Assumes residential units closed escrow evenly over the first 6 years of the CFD bond issue.
In the above example, the CFD bond amount could typically range from $20,000,000 to $30,000,000 for a project of this size and magnitude. In this case, the cost of bad disclosure represented roughly one-half to one-third of the project’s gross CFD bond potential which is very significant.
Preparing disclosure notices is a necessary part of land developing and homebuilding. Oftentimes, these notices are rushed in their preparation and mistakes can occur. As shown in the above example, the cost of mistakes can be financially significant. Therefore, it behooves the land developer and homebuilder to have an experienced professional either prepare the notices or, at a minimum, have the professional review the notices, so as to bring in a second pair of eyes, in order to minimize the possibility of mistakes.