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Selling Encumbered Property at Absolute Auction

Is it Really Absolute, and What are the Legal and Ethical Considerations?

· Absolute Auction,Encumbrance

Encumbered property (whether real or personal) is, typically, property that is subject to a lien although there may be other types of encumbrances. Liens may arise from a variety of circumstances, and may include, without being limited to, mortgage liens (for real property), security interests (for personal property), judgment liens, tax liens, utility liens, and mechanic’s liens. Selling property at absolute auction means that the seller must have a legitimate intent to sell the property to the highest bidder regardless of price.

Without delving into the psychology of offering property without reserve, with reserve, or subject to seller’s confirmation, or debating which method – all things being equal – might yield the highest hammer price, selling encumbered property absolute raises certain practical, legal, and ethical concerns.

From a practical perspective, if the hammer price of encumbered property sold without reserve is less than the amount of the lien, there is a hole (a shortfall referred to as a deficiency) that must be filled in order for the seller to deliver good title. For example, if real property subject to a $325,000 mortgage lien is struck off for $275,000, there is a $50,000 deficiency that must be resolved. And, that’s not all – not only must the seller come up with the amount of the deficiency, he or she also needs to come up with the auctioneer’s commission out-of-pocket on top of the deficiency. Talk about salt in the wound!

When dealing with encumbered property, and discussing whether it will be sold with or without reserve, the auctioneer needs to have a serious conversation with the seller identifying both the possible benefits and the significant risks of an absolute auction. A very important point, and this is a very important point, is that an optimistic seller’s assurance that a shortfall can be resolved (i.e., the seller has the means to fill the gap or can rely on someone to fill the gap, or will be able to work it out with the lien holder once the amount of the deficiency is known) is really not enough comfort or protection for the auctioneer. Keep in mind that the seller may not have enough money (or may not have access to enough money) to fill the gap, and, even if the seller does have the means at the time he or she enters into the seller’s contract, he or she may not have that money at the time of closing (unless a significant amount of money is being held in escrow). Moreover, it is always possible for a seller with the means to fill the gap to decide not to do so. So where does that leave the auctioneer?

I have drafted a lot of auction real estate purchase and sales agreements, and seen a lot more. Typically, such agreements (drafted by the auctioneer, the seller, or one of their lawyers) will attempt to limit the seller’s obligations (or opportunities for breach) to the delivery of good title and the truthfulness of representations made in a seller’s disclosure statement. Also, typically, such agreements will attempt to limit the buyer’s rights on the seller’s breach to a return of the deposit, specifically excluding incidental damages, consequential damages, or specific performance. So, there you have it, if the seller can’t, or chooses not to, resolve the deficiency when property put up at absolute auction is struck off for less than the lien amount, the deposit is returned, and that’s that, right? Well, not so fast.

Under those circumstances, the ability of the seller to walk away from the sale by simply returning the deposit makes the auction look like one subject to seller’s confirmation or one with – effectively – a backdoor reserve. In either case, the question can be raised as to whether it was truly an auction without reserve. This exposes the seller to potential litigation, and the auctioneer as well. Additionally, various licensing states take a serious approach to the use of the term "absolute" in advertising an auction. If it turns out that – as a practical matter – the auction was not truly an absolute auction, the auctioneer may have some explaining to do with state licensing authorities.

If we are talking about personal property, even if the buyer takes possession, an unsatisfied lien will follow the property into the buyer’s hands, resulting in, potentially, a very unhappy buyer. And, there is also at least one court decision (from Pennsylvania) in which a lender sued the auctioneer for conversion and recovered the entire hammer price from the auctioneer after the auctioneer sold encumbered property and distributed the proceeds to sellers who, as the court described it, took the money and "promptly disappeared." There is also the possibility of criminal violations if the auctioneer, in selling encumbered personal property, intentionally interferes with a creditor’s security interest.

Sometimes decisions can appear remarkably simple, until you discover that you have been looking at only a small part of the entire picture. While the possibility of encouraging bidding by selling encumbered property without reserve is one consideration, ethically and legally the auctioneer must be aware of the various consequences of that decision, and include those possibilities in his or her discussions with the seller up front.

This post is for information and discussion purposes only and does not constitute, and is not intended to constitute, legal advice. No attorney client relationship is created.