Legal case studies in this issue:

• Challenges to short-term rental ordinance mostly dismissed by federal court
• Disgorgement of broker’s fee to buyer reversed on appeal
• Court erred in dismissing case by one co-trustee alleging other co-trustees failed to follow Trust Act in conveying property
• Contract for sale can be “documentary evidence” for some purposes but not for others

Research and analysis by Lisa Harms Hartzler,
Sorling Northrup Attorneys

Challenges to short-term rental ordinance mostly dismissed by federal court

In Stone River Lodge, LLC v. Village of North Utica, No. 20 C 3590 (N.D. Ill., Nov. 15, 2020), a group of property owners challenged an Illinois village’s ordinance regulating short-term rentals. The plaintiffs’ villas and cabins were located within a planned unit development created by Grand Bear Lodge & Resort P.U.D., LLC, which operated a hotel within the development near Starved Rock State Park. The declaration of covenants applicable to the P.U.D. provided that owners would not be prohibited from renting out their units.

The village enacted an ordinance in 2020 which made it unlawful for anyone in the village to operate a “vacation rental unit” (defined as a rental of less than 30 days, excluding establishments regulated under other rental licensing provisions) without a current valid license. However, the plaintiffs were unable to obtain rental licenses for their villas and cabins because the ordinance provided that only one license could be issued to Grand Bear Lodge & Resort P.U.D., made private rental of villas and cabins within the development ineligible for a license, and required those private owners to participate in a “rental pool” offered by Grand Bear Lodge & Resort.

The plaintiffs argued that the village ordinance violated several federal and Illinois constitutional protections and laws. The federal court dismissed all but one federal claim and declined to exercise jurisdiction over the state claims.

Procedural Due Process violation. The court first expressed skepticism that the plaintiff’s right to rent under the development’s covenants established a legitimate claim. “Nothing in the covenants entitled the plaintiffs to be forever free from regulation.”  Further, the village always retained the right to enact zoning changes, which the ordinance “most certainly” was. Even so, no procedural due process violation arose from the adoption of the ordinance. It was a legislative act by the village, which was “all the process that is due” under the Constitution. Residents unhappy with the result can only be protected by the power to vote for or against those legislators. This count was dismissed.

Substantive Due Process violation. To assert a substantive due process violation, the plaintiffs were required to allege that the ordinance was not rationally related to a legitimate governmental interest or was arbitrary. The plaintiffs failed to explicitly make that allegation—but even if they had, the court held that there was nothing arbitrary about an ordinance requiring short-term rental property to be licensed. The village’s ordinance itself provided a rational basis for the regulation:  “vacation rental units possess certain specific concerns that can cause negative impact on surrounding properties and the Village as a whole,” such as concerns about life-safety, quality of neighborhood, security, fire safety, and tax revenue. Further, the terms of the ordinance (including prohibiting rentals for less than 24 hours, barring service of food and beverages, requiring adequate parking, and posting applicable rules for guests) were rationally related to those stated governmental interests. This count was dismissed.

Fourth Amendment search warrant violation. The court handily disposed of the plaintiffs’ claim that the ordinance requiring all rental units to be subject to inspection and to maintain a guest register available to the village ran afoul of the Fourth Amendment by not requiring probable cause or reasonable suspicion prior to any inspection. Because the plaintiffs had not alleged that any of them had been subject to inspection or a request to inspect a guest register, none had standing to challenge those parts of the ordinance. Standing requires an “actual, concrete injury.”  This count was dismissed.

Anti-trust violation. The plaintiffs alleged the ordinance constituted anticompetitive restraints in violation of the Sherman Act. The court held that the Sherman Act does not apply to allegedly anticompetitive restraints imposed by a state as an act of government. The same immunity extends to actions by local governments when acting pursuant to authority conferred by a state. Local governments are clearly authorized to enact zoning and land use restrictions as appropriate for public health, safety, and welfare. This count was dismissed.

Equal Protection violation on “its face.”  The court held that there was nothing on the face of the ordinance violating the Equal Protection Clause. The ordinance treated all short-term renters who obtained a license the same way. And all the Equal Protection Clause requires is that an ordinance be rationally related to a legitimate state interest. That interest and rational relationship was already determined to be adequate under the due process discussion. This count was dismissed.

Equal Protection violation “as applied.”  The only argument with any merit to survive the village’s motion to dismiss the case related to the plaintiffs’ allegation that the ordinance was unconstitutional as it was applied by the village to them. The plaintiff argued that, as villa and cabin owners, they had been precluded from obtaining licenses unless they agreed to join the Grand Bear Lodge “rental pool.”  In other words, they were being treated differently from others in the village who wanted to obtain a short-term rental license. For want of more facts on this issue to review, the court could not say, as a matter of law, that the ordinance was rationally related to a legitimate state interest. It declined to dismiss this one count.

In short, challenges to short-term rental ordinances remain challenging.

Disgorgement of broker’s fee to buyer reversed on appeal

In Falcon Properties LLC v. Bowfits 1308 LLC, 478 P.3d 134 (Ct. App. Wash. 2020), Falcon Properties was a property management company that also owned a 13‑unit apartment building in Seattle. Sokolov was Falcon’s managing member and a real estate broker. Bowfits was a group of investors looking for income producing property with a capitalization rate of approximately 5%. (A “cap rate” is a way of analyzing the current performance of a property by dividing its net income by its purchase price, which yields a percentage.)

Falcon initially listed the apartment building for a sale price of $4,250,000 with a net-operating income of $185,581 and a cap rate of 4.37%. It subsequently reduced the price to $3,747,500, which increased the cap rate to 4.9%, a number that satisfied Bowfits. Falcon and Bowfits signed a purchase and sale agreement.

Falcon was required to deliver various financial documents to Bowfits, which immediately noticed discrepancies. For example, the rent roll and the profit and loss statement did not match and pages of certain leases were missing. Bowfits requested receipts and bank statements showing the advertised $20,000 per month in rental income but Falcon refused, claiming those documents were confidential. In the end, Bowfits accepted a certified rent roll from Falcon and closed on the property. Falcon paid Sokolov a $75,000 broker’s commission for the sale.

After closing, Bowfits discovered multiple material misrepresentations on the certified rent roll along with other misleading representations. The actual cap rate turned out to be 4.27%.

Bowfits filed a complaint against Falcon and Sokolov alleging breach of contract and fraudulent and negligent misrepresentation. It also asked for Sokolov’s commission to be disgorged. The trial court found in favor of Bowfits and awarded actual damages of $13,400. It also ruled against Sokolov and ordered disgorgement of his commission to Bowfits because he violated his statutory duties as a licensed broker and, therefore, received a commission constituting unjust enrichment.

All parties appealed. The appellate court affirmed the judgment against Falcon but reversed the disgorgement of Sokolov’s commission.

The appellate court found the trial court’s decision regarding Sokolov’s commission was erroneous for two reasons. First, any statutory duty a broker has to deal honestly and in good faith and to disclose all existing material facts known is owed to the party to whom the broker renders real estate brokerage services. In this case, the agreement for brokerage services was between Sokolov and Falcon, which paid a commission to its agent after the sale. As to this contract, Bowfits was an outside third party. Consequently, there was no privity of contract between Bowfits and Sokolov that could justify disgorgement of the commission to a third party such as Bowfits.

Second, even if Sokolov did owe a duty of good faith to Bowfits, the remedy for a violation of that duty was an action for common law tort to recover damages. The trial court already awarded Bowfits actual damages proximately caused by Falcon’s fraud. Bowfits was not entitled to Sokolov’s commission in addition to damages.

Court erred in dismissing case by one co-trustee alleging other co-trustees failed to follow Trust Act in conveying property

In Ashby v. Pinnow, 2020 IL App (2d) 190765, three siblings were named co-trustees of a trust created by their parents. The trust property was to be divided equally upon their parents’ deaths. The father died in 2004 and the mother in 2006. The principle asset of the trust was a five-acre plot containing a residence. In 2010 two of the co-trustee siblings conveyed the improved part of the property, valued at $62,397, to themselves. They conveyed the unimproved portion of the property, valued at $20,000, to the third co-trustee and recorded the deed. In 2018, the plaintiff, the third co-trustee, filed a suit to quiet title and to assert a breach of fiduciary duty against his siblings. The trial court dismissed the case with prejudice and the plaintiff appealed.

An action to quiet title is an equitable proceeding in which a party seeks to settle a dispute over ownership of property or to remove a cloud upon title to the property. Generally, when the plaintiff is not in possession of improved property, the proper remedy is an action for ejectment; however, an action to quiet title can be maintained if the plaintiff can establish fraud or some other equitable claim. In this case, the plaintiff claimed that the defendants conveyed the property out of the trust without giving him written notice and did not convey it in equal shares. The court held that the Trust Code authorized a majority of co-trustees to act without unanimous consent, but only if written notice was given to the other co-trustees. Recording the deed was adequate public notice, but not adequate notice to a co-trustee under the Trust Code. Consequently, whether the plaintiff was actually given proper notice was a question of fact that the trial court would need to determine. The dismissal of this count was reversed.

On the other hand, the appellate court agreed with the trial court’s holding that recording the deed in 2010 was adequate to dismiss the claim for breach of fiduciary duty. An action for breach of fiduciary duty may be commenced at any time within five years after the person entitled to bring it discovers that he or she has such cause of action. The property was conveyed in 2010 but plaintiff did not file his claim until 2018, well beyond the five-year statute of limitations.

The plaintiff argued that he did not learn of the transfer until 2018 because he had been homeless from 2008 to 2012 and did not have access to the internet. He filed his suit as soon as he discovered the conveyance through an attorney. However, unlike the Trust Code’s requirement of written notice to a co-trustee, breach of fiduciary duty requires as one of its elements only that “the other party could not have discovered the truth through reasonable inquiry.”  Recording a deed is notice to the public and available to anyone through reasonable inquiry. Because they recorded the deed, the defendants committed no act of fraudulent concealment and the plaintiff could have discovered the conveyance within the statute of limitations. The appellate court affirmed dismissal of this count.

Contract for sale can be “documentary evidence” for some purposes but not for others

In McDonald v. O’Connor, 189 A.D.3d 1208 (N.Y. App. Ct 2020), the plaintiff signed a contract to purchase real property in Brooklyn, New York. Plaintiff sued the defendants, who were executors and trustees of an estate, for specific performance and damages for fraud regarding the property’s landmark status. The defendants presented the purchase contract and a rider as “documentary evidence” in their motion to dismiss the case, which the trial court granted.

On appeal, the court explained that a motion to dismiss based upon documentary evidence “must utterly refute the plaintiff’s factual allegations, conclusively establishing a defense as a matter of law.”  Contracts can constitute documentary evidence, depending on what they are being offered to prove.

In this case, the plaintiff alleged that the defendants did not have and were unable to convey the entire interest in the property. The presentation of an executed contract for sale between the parties in this situation was inadequate to constitute documentary evidence. Its existence was not proof of the defendant’s title and, therefore, it could not “utterly refute” the plaintiff’s allegation of lack of complete title. The trial court erred in granting dismissal of the case based on the contract alone.

On the issue of fraud, however, the contract did constitute documentary evidence supporting the defendants’ motion to dismiss the case. To succeed on a claim of fraud arising out of a real estate transaction, a plaintiff must show, among other things, how the seller misled the buyer. Disclaimers in a written agreement can preclude a claim of fraud by showing that any reliance on the seller was unjustified.

The contract in this case did just that. Not only did it provide explicitly that the plaintiff was buying the property subject to all present and future landmark restrictions and that the sellers made no representations or warranty as to any matter affecting the property, but a rider to the contract gave the plaintiff five days to procure a “landmark search” and to cancel the contract if the plaintiff was not satisfied with the results. Consequently, the contract and rider conclusively established that the plaintiff was responsible for determining the landmark status of the property. Dismissal of the fraud claim was affirmed.