CLIENT ALERT: NEW RULING AFFECTS REAL ESTATE PURCHASE CONTRACTS
by Andrew Bernstein & Andrew Schutz
We thought you should be aware of a recent ruling by the California Court of Appeals that appears to require changes in long-standing customary practices used by the development and investment communities in entering into contracts for the purchase and sale of real estate.
The case is Steiner v. Thexton, a May 2008 ruling from the California Court of Appeals. The facts of the case are that the parties entered into a purchase agreement pursuant to which the buyer had a due diligence period to determine the feasibility of obtaining a lot split. The buyer had the explicit right during the escrow period to terminate the transaction at any time before the closing at the buyer's "absolute and sole discretion." The buyer made an initial $1000 deposit in escrow (and an assignee of buyer subsequently made a second $1000 deposit in escrow), but the deposits were refundable in the event the buyer terminated the agreement. The seller cancelled the escrow, saying that he no longer wanted to sell the property, and the buyer sued for specific performance. The court held that the purchase agreement was a disguised option agreement, and the option failed for lack of consideration; therefore, the contract was unenforceable. The court reached this conclusion even though the buyer, a real estate developer, spent considerable time, effort and money in processing development approvals for the property. The fact that the period from the signing of the purchase contract until the closing could have been as long as three years appeared to be an important consideration for the court.
The first lesson of this decision 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, this ruling also brings into question whether a real property purchase contact that includes a typical "free look" period in favor of the buyer to perform its due diligence investigations is enforceable. This risk is particularly high during the "free look" period if the seller changes its mind and decides it does not want to sell under the contract terms. If this decision is widely applied, the customary form contracts for the purchase of real estate, including the pre-printed forms widely used in the real estate industry, may not be enforceable by the buyer - at least before some portion of the deposit becomes non-refundable.
This ruling suggests that, in order for a real estate purchase agreement with a typical due diligence period to be enforceable by the buyer, some amount of up-front consideration must be paid to the seller, or some portion of the initial deposit made by the buyer must be at-risk and paid to the seller upon termination. The payment can either be characterized as either as an option payment or as a non-refundable deposit, depending on the circumstances.
Unless the Steiner case is either de-published or overruled, we recommend that a buyer entering into an agreement to purchase real property structure the agreement either as an option agreement with an up-front, non-refundable option payment to the seller, or as a traditional purchase agreement with a provision for the payment of a meaningful non-refundable amount that is paid to the seller in consideration for entering into the purchase contract.
We believe that the decision as to whether to document the transaction as an option or as a purchase agreement should be made on the specific circumstances of the deal. In the typical developer deal for the purchase of land that must be entitled over a lengthy period (i.e., facts similar to the Steiner case), we recommend an option agreement structure with the payment of a meaningful amount to the seller as a non-refundable option consideration. In the typical deal for the purchase of an improved property with a relatively short "free look" period, the transaction can be documented as a purchase agreement provided that some meaningful amount is paid to the seller either up front or at the end of the due diligence period if the buyer elects to withdraw from the transaction.
In any event, a buyer of real property should consult with legal counsel to avoid the unfortunate result that faced the buyer in the Steiner case where the buyer could not enforce the "agreement" even though the buyer spent considerable time and effort in processing entitlements and in other pre-development activities in reliance on what the buyer thought was a binding obligation of the seller to sell the property.
