Risk lies with buyers in real estate closings

Because buyers in residential real estate transactions have a better opportunity to protect themselves from attorney embezzlement than sellers, they should bear the risk of loss, the Supreme Court has ruled in a 5-2 decision.

The ruling aligns with the common practice of the closing attorney being chosen by and representing the buyers as well as the equitable principal that “he who first reposes the confidence or by his negligent conduct made it possible for the loss to occur, must bear the loss,” according to the majority opinion by Justice Mark Martin.

The opinion also relied on the fact that, in typical residential real estate closings, closing protection letters are issued by title insurance companies to protect buyers, including where losses are suffered by an attorney’s fraud or dishonesty.

“As a result, while insurance coverage is normally an irrelevant inquiry when allocating losses between parties, we find it significant that the market as a whole allows buyers to protect themselves through a means entirely unavailable to sellers,” Martin wrote.

Attorneys for both parties did not return phone calls seeking comment on the decision.

Bright line?

The case, Johnson v. Schultz (North Carolina Lawyers Weekly No. 10-06-0376, 20 pages), arose in Johnston County in January 2006 when buyers retained an attorney to perform the closing on a $277,500 house.

The attorney issued the sellers a trust-account check for the net sale proceeds, which was returned for insufficient funds because the attorney had embezzled the money.

The sellers sued the buyers, seeking to set aside the conveyance or, in the alternative, receive the $277,500 in damages.

The trial court granted summary judgment in favor of the buyers, but the Court of Appeals reversed that decision in a 2-1 decision in February 2009. The buyers appealed.

The case elicited wide interest, including amicus briefs from both the State Bar (arguing the risk should fall on the buyers) and the N.C. Land Title Association (contending the risk runs with the sellers).

The hope was to have a decision that established a bright-line rule, according to Charlotte attorney Robert B. McNeil, who wrote the amicus brief for the NCLTA.

“The problem with the decision, with all due respect, is that I don’t think it gives us a bright line,” McNeil told North Carolina Lawyers Weekly.

“People can differ about the role of an attorney and who the attorney represents in a residential real estate transaction.”

According to the majority opinion, the buyer alone in most transactions would be legally deemed to “repose confidence” in the closing attorney through the existence of the attorney/client relationship.

However, the majority left the door open for the risk falling either partially or entirely on the sellers in some cases.

For instance, in this case, the high court pointed to evidence that the sellers had paid the closing attorney $125 to prepare a deed to the property and had a prior relationship with him.

“Thus, a factual inquiry must be conducted to determine whether [the attorney] also represented the sellers during the closing process,” Justice Martin wrote.

McNeil said he wondered if the decision would make either buyers or sellers reluctant to choose the closing attorney.

“According to this decision, there would be an increased risk for the person who chose the attorney,” he said.

Better-positioned

McNeil said the NCLTA argued that the better course would be to apply the entitlement rule, which places losses during escrow transactions on the party who was entitled to the property at the time of the embezzlement.

However, because this was a settlement-method closing, and not an escrow closing, the entitlement rule could not apply, the majority ruled.

The majority said the case was instead controlled by a principle of equity recognized in North Carolina as early as 1875.

The principle: Where one of two innocent persons must suffer by the acts of a third party, “[H]e who has enabled such third person to occasion the loss, must sustain the loss.”

In most residential real estate closings, the opinion said, the closing attorney represents buyers and lenders and only performs limited services for sellers, such as preparing the deed.

According to the majority, the buyers also would be in better position than the sellers to protect themselves if the attorney ended up embezzling the funds.

For instance, they could recover a portion of their losses from the State Bar’s Client Security Fund, and they could recover as a result of a title insurance company’s closing-protection services.

The majority also rejected the buyers’ argument that the sellers should take the loss simply because they chose to accept payment from an attorney’s trust account rather than cash or some other form of payment.

“[W]e are unwilling to accept the consequences likely to result if the standard of practice would require lawyers to possess and disburse tens of thousands of dollars in cash at real estate closings,” Martin wrote.

Dissent

Justice Patricia Timmons-Goodson, joined by Justice Robin Hudson, dissented. In their view, the majority opinion inflicted “incalculable damage” on agency law and violated the rule that prohibits the consideration of insurance coverage in determining liability.

The equity principle the majority relied on did not apply to this case because it was generally regarded as a principle of apparent authority under the law of agency, Justice Timmons-Goodson said.

Here, she said, there was no contention that the closing attorney had acted with any real or apparent authority when he embezzled the funds.

Also, according to the dissent, the “innocence principle” had only been otherwise invoked where, in fact, one party was “less innocent” than the other party because of negligent conduct that had somehow enabled the third party to inflict harm.

Under the majority’s reasoning, she said, truly innocent, non-negligent principals would be held liable for the misconduct of their agents, even if the misconduct exceeded the scope of agency.

“This has never before been the law in North Carolina and should not be so now,” Timmons-Goodson wrote.

She also asserted that the majority’s reasoning contradicted the “nearly universal rule” that liability should not hinge on the availability of insurance coverage.

According to the dissent, the loss would need to lie “where it has fallen,” or with the sellers.

Because the sellers had failed to show that the buyers in any way contributed or enabled the embezzlement in this case, the dissent argued, the sellers could not shift their loss.

OPINION BRIEF

Case name: Johnson v. Schultz

Court: N.C. Supreme Court

Justices: Mark Martin (author); Patricia Timmons-Goodson and Robin Hudson (dissent)

Date: April 15, 2010

Platintiff-appellee’s attorneys: Gordon Woodruff and Mary McCullers Reece of Woodruff, Reece & Fortner (Smithfield)

Defendant-appellant’s attorneys: James Pendergrass of Pendergrass Law Firm (Raleigh)

Amici curiae attorneys: Katherine Jean and David Johnson of N.C. State Bar (Raleigh); Robert McNeil and Phillip Lewis of N.C. Land Title Association (Raleigh)

Issue: Did the trial court err by granting summary judgment in favor of the defendant-buyers where the plaintiff-sellers sought to set aside the conveyance of property in a residential real estate transaction, or in the alternative, monetary damages, after the closing attorney embezzled the net proceeds from the transaction?

Holding: Yes. The buyers in real property transactions bear the risk of loss because they possess practical advantages over sellers in terms of protecting themselves from attorney misconduct, including choosing the attorney who handles the closing. Under principles of equity, where one of two persons must suffer loss by the fraud or misconduct of a third person, he who first reposes the confidence or by his negligent conduct made it possible for the loss to occur, must bear the loss.

Noteworthy: The court remanded to the trial court to determine whether an attorney/client relationship existed between the closing attorney and the plaintiff-sellers.