April 6, 2010
JDTP Alert: California Supreme Court Rules in Case Affecting Real Estate Purchase Contracts
The California Supreme Court recently issued its decision in Steiner v. Thexton, which is a case that concerns the enforceability of a real estate purchase contract. The Supreme Court ruled that a contract with a long escrow period and a contingency that allows the buyer to terminate the contract at any time is a disguised option that must be supported by independent consideration in order to be enforceable. However, the Supreme Court also held that part performance by the buyer of its promise to seek a parcel split was sufficient consideration to render the option irrevocable. Below, we summarize the decision and discuss the implications of the ruling in structuring real estate purchase agreements.
The facts of the Steiner case are that the parties entered into a purchase agreement in which the seller agreed to sell a 10-acre parcel to the buyer if the buyer was able to obtain the necessary entitlements to obtain a parcel split and develop the property. The purchase agreement included a contingency in favor of the buyer that the buyer could choose to terminate the transaction at any time during the 3 year escrow period in its sole discretion. The buyer made a $1,000 deposit in escrow, but the deposit was refundable if the buyer terminated the escrow. The buyer then spent over a year in his effort to obtain the parcel split, and incurred $60,000 in costs in support of that effort. Prior to obtaining the necessary entitlements for the parcel split, the seller canceled the escrow, saying that he no longer wanted to sell the property, and the buyer sued for specific performance. The trial court held that the purchase agreement was a disguised option that was not supported by consideration; therefore, the contract was unenforceable. The Court of Appeal affirmed the trial court's ruling, and the Supreme Court then accepted the case for review.
The Supreme Court agreed with the lower court that the purchase agreement was in fact a disguised option, but it reversed on the issue of consideration, holding that the buyer's part performance of its promise to seek a parcel split was sufficient consideration to render the option irrevocable. (As a legal concept, "consideration" consists of a benefit conferred or a detriment suffered by one of the parties to a contract; in order to have an enforceable contract, bargained-for consideration must exist.) The case was remanded to the trial court for further proceedings (leading one to wonder whether the buyer is still interested in buying the parcel after all of these years).
As we stated when the Court of Appeal issued its decision, the first lesson of this case is that a land acquisition transaction that includes a lengthy escrow period and one or more buyer contingencies that are within the buyer's control (such as an entitlement contingency) should be structured as an option agreement with the up-front payment of non-refundable option consideration to the seller.
However, the issue of whether a real property purchase agreement that includes a typical "free look" period in favor of the buyer to perform its due diligence investigation should also be structured as an option is not clear. In a footnote to its opinion, the Supreme Court stated that bilateral contracts (i.e., those in which both seller and buyer are bound at the beginning) that are subject to one or more contingencies are not affected by this holding. But that footnote does not answer the question-most buyers want the right to conduct whatever due diligence they deem necessary during the due diligence period, but they do not want to be obligated to do anything; they want to be able to cancel the escrow at the end of the contingency period and walk away for any reason or no reason. If the buyer has no obligation to do anything, then the purchase agreement is not bilateral and an option structure should be used. On the other hand, if the buyer is at least willing to commit to conduct its due diligence investigations during the contingency period, then the transaction can be structured as a purchase agreement.
Another issue which remains unclear after the Steiner decision is what constitutes adequate consideration for the grant of an option to purchase real property. Although Steiner holds that part performance by the buyer constituted sufficient consideration, the Court in another footnote stated that it had no occasion to consider how much (or little) part performance would be sufficient consideration to make an option irrevocable. As a result, we recommend that buyers make an up-front payment of non-refundable option consideration at the time that the option is granted, so that there is no question that consideration was given for the option.
Of course, the next issue is the amount of the non-refundable option consideration. The Supreme Court does not offer much guidance on that issue either. In yet another footnote, the Court suggests that the buyer's $1,000 refundable deposit in escrow might have been sufficient consideration because the buyer had suffered a detriment by not having use of the funds, but they do not decide the issue. Therefore, we recommend that at least $100 of the initial deposit made by the buyer into escrow be designated as non-refundable option consideration and immediately released to the seller. By immediately releasing money to the seller, the consideration for the grant of the option will be clear and the option will be irrevocable.
The final issue to consider is whether a "free look" purchase agreement should include the payment of some non-refundable consideration to the seller. Without the payment of any consideration by the buyer, there is a risk that the seller could try to terminate the purchase agreement during the due diligence period, on the theory that the contract is not bilateral because the buyer is not obligated to do anything during the due diligence period. There are a few ways of dealing with this issue. First, a recital to the purchase agreement could state that that buyer has paid at least $100 to seller in consideration for the rights granted to buyer. For many years, most contracts contained a clause such as "in consideration of the payment of $1 in hand paid"; the Steiner decision may cause the revival of such clauses. However, as noted above, it is important that the consideration actually be paid and released to the seller. Second, if the buyer covenants in the purchase agreement that it will assign to the seller any reports or studies that it prepares or obtains during the due diligence period if it does not proceed with the purchase of property, that would also bolster the argument that consideration was given to the seller, if the buyer actually obtains such reports and studies. Third, a "free look" contract could be structured as an option with non-refundable option consideration in order to remove any uncertainty, although many buyers will not want to go through the trouble of having to deal with the mechanical details of an option (such as the length of the option term and the manner of exercise) in a short escrow.
In sum, the Steiner decision gives buyers some guidance on how to structure transactions in order to protect the time and money spent on due diligence and in processing entitlements, but there are open questions that remain. Finally, we note that the principles addressed in the Steiner decision are not limited to real estate contracts, but apply to all contracts. We will continue to monitor developments in this area.
For more information please contact one of the following shareholders in our Real Estate Practice Group:
Disclaimer: These materials have been prepared by Jackson DeMarco Tidus Peckenpaugh for informational purposes only and are not intended as legal advice.
