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Do REALTORS Have A Duty to Report A Client's Fraud?

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Had a most interesting discussion with a REALTOR friend last night over dinner about professional ethics, and came across an interesting question. We didn’t know the answer, so I figured I’d blog about it and ask you all.

The question is whether a REALTOR has a duty to disclose bad acts by a client, or more importantly, by an ex-client, if she knows that what the client is planning on doing is (a) illegal, (b) unethical, and/or (c) fraudulent.

Scenarios

For example, let’s say that a REALTOR takes a listing and starts walking through it with the client. She notices obvious structural problems — say a cracked foundation or something like that. She mentions it to the client, and the client instructs her to say nothing about it, that he plans on covering up the problem, and tells the REALTOR more or less in straightforward terms that he plans on committing fraud.

Our REALTOR immediately tells the client that what he’s planning on doing is illegal, unethical, and advises him not to do so. The client responds by firing the REALTOR: “If you’re not going to help me and work for my interests, then I can’t trust you.”

Does our REALTOR have any responsibility to tell someone that this house has a major structural defect, and that the seller is planning on defrauding the buyer as to the defect?

Keep in mind that she is no longer the REALTOR on the deal. She’s been fired. The client has gone and found another REALTOR who is ostensibly more flexible as it comes to morals and ethics.

My REALTOR friend thought that she had no duty to disclose, because she is no longer party to the contract. Can that be right?

Further Scenarios and Questions

Same situation as above, but our REALTOR heroine believes that the new listing agent who has come in after her does not know about the major defect, because the client has already covered it up. Does she have either a legal obligation or an ethical responsibility under the Code of Ethics to inform the new listing agent?

Suppose that a buyer enters into contract on this house. The buyer is represented by one of the agents in our REALTOR heroine’s brokerage. So legally, the buyer client is represented by the same broker. Does our friend have either (a) the responsibility to tell her broker/the buyer’s agent in her same office, or (b) the right to tell her broker/buyer’s agent? If the buyer is represented by another brokerage, can the REALTOR call the buyer’s agent to inform her of the problem with the property? Is she obligated to do so?

Suppose that the new listing agent is in the same office/brokerage. In conversation with the new listing agent, our heroine learns that he knows about the problem, and is willing to go along with the client’s plan to cover it up and commit fraud. Does our heroine have (a) duty to report the listing agent to the Association or to the State Board; or (b) a duty to report the agent to her broker; or (c) if no obligation to report, does she have the right to report him to either the authorities or to her broker?

What about issues and problems not related to the property at all? For example, in walking through the listing, the REALTOR notices a large stash of drugs, assault weapons, and cash suggesting that the client is a major drug dealer. This has nothing to do with the property, of course, but is clearly an illegal activity. Does she have an obligation to report the client to the authorities?

Matter of Degrees

However you answer the above hypotheticals, any duty or right to divulge client information learned in the course of professional representation will be fraught with judgment calls. A situation where the client is explicitly planning on committing fraud might be an easy call. One can imagine a range of more difficult choices.

Something minor — like say, a window that gets stuck often — is probably not going to warrant any duty to disclose or major ethical issues. But one can easily imagine a host of situations between stuck window and cracked foundation. With so many grey areas, one can imagine a host of ethical dilemmas arising from the client’s understandable desire to maximize the value of his property and the REALTOR’s duty to work for the client’s best interests, counterbalanced by some sort of duty to the public.

Is there any guidance out there, either at the state regulatory level, or at the Association level, as to how REALTORS should conduct themselves in such ethical situations?

I’m asking these hypotheticals because I don’t know the answer. My friend and I spent a pleasant hour or so over wine and Thai food discussing these dilemmas, and didn’t come to many conclusions.

So what do you say? Obligations? Rights to disclose?

-rsh

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Rob Hahn
Managing Partner of 7DS Associates, and the grand poobah of this here blog. Once called "a revolutionary in a really nice suit", people often wonder what I do for a living because I have the temerity to not talk about my clients and my work for clients. Suffice to say that I do strategy work for some of the largest organizations and companies in real estate, as well as some of the smallest startups and agent teams, but usually only on projects that interest me with big implications for reforming this wonderful, crazy, lovable yet frustrating real estate industry of ours.

15 COMMENTS

  1. Great topic & it’s a complicated what if’er stuff that makes my head spin since what’s legal, is not always right and what’s right may be illegal (for example, contract interference). Don’t forget that E&O insurance may kick in when dealing with same office and talking to broker would be needed to verify additional issues.

    Thankfully, our Realtor Code of Ethics in the Preamble says “REALTORS® having direct personal knowledge of conduct that may violate the Code of Ethics involving misappropriation of client or customer funds or property, willful discrimination, or fraud resulting in substantial economic harm, bring such matters to the attention of the appropriate Board or Association of REALTORS®. (Amended 1/00)” Thus we are obligated to inform the member’s board of the issue.

    When dealing with same office (buyer or seller sides) and trying to conceal a material fact, we also have at least a moral obligation to notify our broker of the issue too.

    When there are two other agents involved from different offices (no dual agency/limited rep issues) and I’m a 3rd party agent, it’s very unlikely I would even know who the buyer agent is. In the rare case that I did, I see the above Realtor Preamble at least requiring me to inform them that I knew of a board reported issue involving that agent & property.

    From a guy who has only been to the Ethics classes.

    • Without question yes! Not to mention as licencees, we have an obligation to protect the general public. So even if I am fired by my seller/client, protecting the general public goes for whatever buyer from another agent may be affected by refusal to disclose this known defect. By all means, notifying your broker/manager would be a must upon somone defiantly telling you they intend to lie and committ fraud!

  2. The E & O factor — I seriously doubt if that insurance would kick in once it was learned fraud was knowingly not disclosed. Pretty sure anything to do with fraud lets the carrier off the hook.

    • If the covered party (agent/broker) engaged in fraud, yeah, I can’t imagine any E&O covering that. But if the Client or ex-Client perpetrated the fraud, and the agent/broker did not know or actually tried to mitigated, I’d imagine E&O would defend that.

  3. Your topic brings to light a whole bunch of issues regarding non-disclosure and where the real estate agents duties and obligations lay.

    I suspect if you ask 10 lawyers you would get 8 different responses, or maybe 12. That being said, I am not a lawyer. I am a licensed real estate broker in the state of California. (Disclaimer).

    The first thing I always tell my Associates and Clients if you have to ask about disclosing something, the answer is disclose it.

    Second I want to bring to the table the importance of all Clients having representation for themselves. Too many times a listing agent is under pressure to not disclose material issues, or do a pretty poor job of any visual inspections. Dual agency is always risky, while having your own advocate is almost always best to look after your interests, not the other sides interests.

    Why hire the person that is obligated to get the highest and best offer for the Seller?

    In the case of your “cracked slab” scenario I think it is pretty speculative in nature. In California cracks in slabs are pretty common and take an appropriate professional to determine how much it would affect the condition of the property. As agents, in California, we are legally required to do a visual inspection and note areas of concern on the Real Estate Transfer Disclosure Statement. The buyer also does the same and hires home inspectors, pool inspectors, and other appropriate experts.

    I would advise the Client to note the crack(s) on the Real Estate Transfer Disclosure Statement and have any potential buyers investigate to satisfy themselves during their inspection period. If the Seller refused to disclose then I would not list the property without my being able to note it on the Real Estate Transfer Disclosure Statement.

    Since the disclosure is speculative in nature I do not feel I would have the legal or ethical duty to broadcast it to the world or report it to my local board. Likely I would have a conversation with the subsequent listing agent so he or she knows there may be an issue – again it is not up to us to decide. Certainly, what no one should want is a coverup of an important material fact

    In live in San Diego and do business in Rancho Santa Fe which has extremely large estates with most of them being built on concrete slabs. Several years ago an agent that was passed up for listing the property took it upon themselves to spread the news to any agent that would listen about the “catastrophic cracked slab”. In fact it was such common knowledge that it took the Seller over $30,000 to bring in experts to determine the cracks were not serious. If I were the Seller I would be looking at the first agent for some financial damages of false and speculative claims.

    Interesting enough in California if both the first and second agent work for the same Broker, they would be assumed to have material knowledge and would need to disclose to any future buyers. This of course is a complete nightmare for big box brokerages who should be passing through previous disclosures and material facts in their possession.

    I think one of the best things that organized real estates and REALTORS® do is their best to bring everything out into the light of day. I rarely find a Seller that wants to be as honest as they should be, thinking it will sour the deal.

    There is almost no material fact that cannot be overcome with early disclosure, and very few deals that can be saved when disclosure is not made. This simply opens the door for what else is the Seller hiding or not disclosing.

    Rob we are not the police charged with the duty of turning everyone in. We are real estate agents who’s job should be to get Clients through the process with the least amount of risk and non-disclosure that is possible and obviously advising them to seek legal council or appropriate experts.

    Sorry for the long response – but great questions!

    • Never apologize for length, Jeffrey. 🙂 Words to live by.

      Let me zero in on one thing:

      I would advise the Client to note the crack(s) on the Real Estate Transfer Disclosure Statement and have any potential buyers investigate to satisfy themselves during their inspection period. If the Seller refused to disclose then I would not list the property without my being able to note it on the Real Estate Transfer Disclosure Statement.

      Since the disclosure is speculative in nature I do not feel I would have the legal or ethical duty to broadcast it to the world or report it to my local board. Likely I would have a conversation with the subsequent listing agent so he or she knows there may be an issue – again it is not up to us to decide. Certainly, what no one should want is a coverup of an important material fact.

      The specific issue is that your Client not only refused to disclose, but told you that he intends to cover it up, thereby committing fraud. You refused to list the property (or, as in my hypo, he fired you). Since you are no longer working on the deal, can you still note it on the Disclosure Statement? I’m thinking not, since you have nothing to do with that Client or that Property.

      That being the case, is the answer that you have no affirmative legal duty to report the defect and/or the Client’s apparently willingness to commit fraud? (Affirmative duty means that failing to do so results in penalties/sanctions for you.) If the answer is yes, that you have no duty to report, do you have the right to report, or can the ex-Client then come after you for some sort of tortious interference claim?

      Take your second paragraph. So after this unpleasant exchange, you go and have a conversation with the subsequent listing agent. The ex-Client learns about it when said listing agent calls him up and says, “I’m dropping you, because you’re a fraudster.” Can he bring either a lawsuit for breach of confidentiality/fiduciary duty, a disciplinary action with the Real Estate Board/Commission for the same, or a complaint to the Association for breach of confidentiality?

      Or does the fraud element take all of those out of play?

      -rsh

  4. This is not a legal opinion as I am not an Attorney. It would be interesting if any of your readers were a real estate attorney that could weigh in on these questions. From a legal standpoint it has been my experience that little is black and white, and what is legal is not always ethical or moral.

    Having worked for the largest brokerage in San Diego with two full time Attorneys on staff I knew when I picked up the phone my answer would likely be, well Jeff, it depends…..

    I personally don’t believe that I have an affirmative legal duty to disclose the Sellers willingness to commit fraud since my agency agency relationship has been terminated. Again, I go back to we have not established if this is a structural problem or not – it is speculative in nature. If the knowledge was factual and supported by experts, the answer would be more black and white.

    Certainly an attorney could make the argument that I would have an affirmative duty, I personally don’t believe they would prevail.

    Unlike the example I gave where an agent told everyone in the agent community about “the cracked slab”, having a conversation with the subsequent listing agent is the “ethical & moral” thing to do. How that agent decides to react to the situation will likely determine the future relationship with the Seller. I don’t believe a court of law or arbitrator would rule against me in this situation since my only goal is to protect a future buyer from fraudulent actions by the Seller.

    Even if I had a fiduciary agency with the Seller this would not allow me to leave off my visual disclosure on the Real Estate Transfer Disclosure Statement of what I have seen so the buyer has the right to further inspection. This is intentional fraud on the Sellers part and my agency relationship was terminated when they fired me.

    Likely if the Seller finds out that they will again want the new listing agent to not disclose. Unfortunately some agents that will do this in exchange for the listing.

    It is vital to get your own REALTOR® to represent you!

    Let me give you another example of a problem in Southern California, particularly in the coastal areas, Since land is very expensive and permits to enlarge homes don’t come cheap, many Sellers choose to add living square footage that they never permit. While this is certainly illegal, as agents, we cannot go down to the County of City agency and report them since our purchase contract will not allow us to. What we can and should do, is fully disclosure this situation to the buyer who again, without the permission of the Seller, cannot go down and report to the permit departments.

    It is up to the Buyer if they want to purchase the property anyway in present condition, or to negotiate the transaction and have the illegal space permitted. This of course will not become a disclosure issue for the new buyer when it comes time to sell.

    Rob, each state could be different and this is written from a California perspective. California tends to be very consumer friendly and the contract is balance slightly towards the buyer’s rights of inspection and termination. Other states may vary.

    • Jeff – that SoCal problem is a wonderful illustration!

      The seller has clearly committed an illegal act. I assume they wouldn’t bother trying to defend themselves should the County bring a lawsuit for illegally enlarging their homes, thereby defrauding the municipality of tax revenues and contaminating the land registry system. They know they broke the law, and did it intentionally.

      Why then, as a real estate agent duly licensed by the State of California, are you not permitted to disclose what is a flagrantly illegal act by the Client/Seller? Given the government grant of license, shouldn’t you be required to report illegal activities? In what sense is the real estate agent acting to protect the public by becoming party to a conspiracy to perpetrate fraud on the County Assessor and the Land Registry system?

      [Very much tongue-in-cheek there, since as a side matter, I believe that too many laws and regs make criminals out of otherwise law-abiding citizens… but that’s another issue altogether.]

      • Rob, We in fact are required to disclose any known illegal additions by the Seller. What we are not allowed to do, without the Seller’s permission, is report it to a Government Agency per the Residential Purchase Agreement.

        As real estate agent we are not permit inspectors, law enforcement, or experts in any defects of the property. Our duty lies is in advising the Seller to fully disclose any known material facts and advise the Buyers to do their due diligence in inspections and investigations to satisfy themselves.

        Code violations, non-permitted living space, structural defects should be clearly identified and disclosed to the Buyers during the inspection period. It is up to the Buyers as to what issues are important to them and what they want to do about them.

        Most court cases come about as a result of non-disclosure. The more buyers and sellers, and real estate agent realize this, and fully disclosure everything so that the buyer can make an informed decision, the better off everyone will be. To mandate the licensed real estate agent to become a permit inspector, investigator, guarantor of disclosures is well beyond the scope of a business that is already much too complicated.

        In regards to your last comment, I believe that the California real estate purchase process and the standard contracts really pull everything out into the light of day. Smart sellers should realize it is always best to fully disclose material facts, but there will always be dishonest, unethical, and illegal behavior – GET GOOD REPRESENTATION!

  5. Long time reader – first comment here. I am an attorney, state association staff member, and member of the NAR Professional Standards Committee.

    Wearing these hats, I try my best to bring these sorts of questions back to the source – the Code and state law – before getting into gut reactions or a broader sense of morality or personal ethics. The question of whether there’s an obligation to report is not clearly addressed for all circumstances, but the Code does indicate an ability to report in the scenarios you pose, and in certain circumstances one might be able to extend that to say that failure to report it would be a violation.

    Standard of Practice 1-9 specifically states states that a Realtor’s obligation to “preserve confidential information (as defined by state law)” extends after termination of a relationship except in 4 specific circumstances:
    (a) the client consents;
    (b) a court order requires disclosure;
    (c) the client intends to commit a crime and the information is necessary to prevent the crime;
    (d) it is necessary to defend the Realtor against a claim of wrongful conduct.

    It then goes on to state that “Information concerning latent material defects is not considered confidential information under this Code of Ethics.”

    Assuming that what the agent has observed is, in fact, a material defect (which may be something defined under your state law), the agent certainly has the right to speak to others about it, because it isn’t considered to be confidential information. Lest there be any confusion about that, NAR also case a Case Interpretation (Case #1-25) in which they address this very issue. In that case interpretation they find no ethical violation where Listing Agent #1 reports to listing agent #2 about a prior home inspection that showed the furnace that was defective.

    If the agent walks away from the listing and never hears about the property again it would be my opinion that they probably would not have breached the Code by failing to keep the issue alive. That is, they don’t have an affirmative obligation to track down any future listing agent or possible buyer to tell them what they’ve learned. But it would also seem that they’re not breaching the Code if they DO choose to call every future listing agent or known buyer to tell them about the defect, since it is defined as a non-confidential issue. Further, if they become aware that their brokerage ends up representing a potential buyer, one could argue that they now have an affirmative duty (through their brokerage agency relationship) to inform the buyer/buyer’s agent of the condition – though again, that may depend on how state law defines that relationship.

    Of course every agent would have to check their own state law to see if it is more restrictive than the Code. If your state law says that even a material defect is confidential then it couldn’t be disclosed, and you’d be obligated to disclose in all circumstances if that’s what the law says. I also would agree with the earlier comment that one would want to consider consulting with the E&O carrier to determine any parameters in which disclosure, or lack thereof, would affect coverage. And of course, run it by the broker before doing anything.

    • Hank, thank you so much for the clarification. It is nice to see someone with the facts and while I knew where to get them, I was remiss at digging for them and flying by the seat of my pants. You should comment MORE often!

  6. Great ethics post by @RobHahn

  7. As a Real estate broker, when we come across those kind of things we advice them if they proceed to fake things and cover up without truly fixing it.
    They can be held laible by the buyer upon the inspection, but if the buyer wants to buy as is that’s all at the risk of the buyer.

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