The Interstate Land Sales Full Disclosure Act: Residential Developers Beware!

Needless to say, residential real estate developers experienced a rough 2008. By all accounts, 2009 does not promise to be much better. As if it weren’t difficult enough to attract new purchasers in the midst of plummeting demand for new construction and the tightening of credit markets, developers are struggling to hold on to their existing purchasers. Many purchasers who signed contracts eighteen to twenty-four months ago are now incapable of closing due to the lack of financing or an inability to sell an existing residence. Other purchasers are unwilling to close on the purchase of their units due to a fear of declining market values. In those cases, the purchasers are simply walking away from their earnest money. While developers typically retain earnest money in all of these purchaser-default situations, the developer’s inability to resell these previously sold units is an increasingly significant problem.

To make matters worse, many of these non-defaulting contract purchasers are now exploring ways to terminate their pending purchase contracts in an attempt to preserve their earnest money deposits. Since new construction contracts are one-sided, take-it-or-leave-it agreements, purchasers typically do not have termination options and rarely have the right to terminate their purchase contracts based upon a developer’s default. In response, aggressive purchasers are now closely scrutinizing applicable state and federal law to determine whether they have any legal rights to terminate their contracts. Developers are now discovering that their failure to observe simple statutory formalities during the robust market of two to three years ago, can lead to an increasing numbers of purchasers who have rights to terminate their contracts.

One statute which is drawing renewed attention from contract purchasers is the Interstate Land Sales Full Disclosure Act (“ILSFDA” or the “Act”). Passed by Congress in 1968, ILSFDA is intended to protect purchasers of newly constructed residential property from insufficient disclosures and developer misrepresentations. In general, the statute requires the developer of projects containing in excess of one hundred units to register the project with the Department of Housing and Urban Development (“HUD”) and to provide all prospective purchasers of units with a federal property report which contains detailed disclosures regarding the developer and the property. The statute also imposes separate anti-fraud provisions on developments containing in excess of twenty-five units.

Although the statute has been in effect for some forty years, developers have routinely ignored the ILSFDA. In robust residential real estate markets, this lack of compliance has not presented too many problems for developers because purchasers are usually looking to keep their purchase contracts in effect. In the event a purchaser were to default or found a means to terminate his or her purchase contract, developers typically did not have much trouble finding a replacement purchaser. As such, developers were not always willing to incur the time and expense involved in registering with HUD and preparing and maintaining the required HUD disclosures.

Now that demand for new construction has fallen dramatically, developers are finding that non-compliance can be expensive. Failure to register a project and to furnish a property report to a prospective purchaser at the time of contract signing could permit that purchaser to revoke his or her contract for a period of two years after contract signing. Purchasers are also permitted to terminate purchase contracts under the Act for a period of two years after contract signing in the event the purchase contract does not provide (i) the purchaser with notices of the purchaser’s default, (ii) the purchaser with at least a twenty day cure period to cure such defaults, and (iii) that a defaulting purchaser may recover the portion of the purchaser’s forfeited earnest money which exceeds fifteen percent (15%) of the purchase price. Moreover, ILSFDA may permit purchasers who have closed on the purchase of a unit to revoke the contract for up to two years from the date of contract signing. In such cases, the purchaser may be entitled to tender title to the unit back to the developer and to receive a return of all amounts paid under the contract. Additionally, purchasers can also recover damages, including attorneys’ fees, from developers for violations of the disclosure requirements and anti-fraud provisions of ILSFDA. Violations of ILSFDA may also subject a developer to civil and criminal penalties, the latter of which may include up to five years’ imprisonment.

The scope of ILSFDA is intended to be inclusive, especially with respect to large developments consisting of one hundred or more units. While there are over twenty statutory and regulatory exemptions available under the Act and related HUD regulations, the exemptions tend to be narrow in scope and are not applicable to most developments. For example, there are eight statutory exemptions which exempt a project from the entire statute (i.e., both the anti-fraud and registration/reporting requirements). Six of the eight apply to special sale situations such as the sale of debt instruments, sale of real estate investment trust stock, sale of lots to governmental entities, sale of cemetery lots and the sale of lots to other developers (who presumably would have to comply with ILSFDA themselves when marketing units). The seventh exemption is for projects of under twenty-five units. While it is clearly intended to exclude small projects, ISLFDA and the related HUD regulations provide elaborate rules regarding the aggregation of units which are part of a common promotional plan. As such, a developer cannot fit within this exemption merely by splitting a project into different phases or dividing ownership of lots among different “developer” entities.

The “easiest” exemption of which developers may avail themselves is the exemption for the sale of improved land under a contract obligating a developer to build the unit within a period of two years from contract signing. The problem with using this exemption is that standard industry practice is for developers to limit their liability for failure to timely delivery units. In fact, most developers are reluctant to contractually obligate themselves to deliver a unit within a specific time frame. HUD and the courts have consistently held that for the two-year delivery exemption to apply, developers may not limit a purchaser’s legal and equitable rights in any fashion. To qualify for the exemption, a developer would need to agree that a purchaser may bring a claim for full monetary damages (including consequential damages) in the event the unit is not delivered within two years. In many respects, the realities of qualifying for this exemption may not be much better than the realities of complying with the statute.

Prevailing thought seems to be that the residential housing markets will not recover until some time in 2010. During the upcoming year, the strain on residential developers will continue as an increasing number of purchasers seeking to terminate their purchase contracts. Unfortunately for the developers of large residential developments, their disregard of ILSFDA in years past may yet prove to be very costly.

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