On March 18, 2010, the California Supreme Court issued one of its most significant rulings in recent years impacting commercial real estate transactions.  The Court reversed the holding in Steiner v. Thexton[1], which previously held that a contract giving a buyer the right to terminate for any reason in its sole discretion was an unenforceable option agreement that lacked consideration.

The Contract

In 2003, Steiner (Buyer) entered into a purchase and sale agreement titled “Real Estate Purchase Contract” with Thexton (Seller) for the sale of 10 acres of land for $500,000.  The agreement required Buyer to pay a $1,000 refundable deposit into escrow once the agreement was executed, which deposit would be applied toward the purchase price at the closing of the sale.  The agreement contained a three-year escrow period to allow Buyer at its sole cost to obtain various county approvals and permits necessary to develop the property into several residences.  The parties agreed that if Buyer could not obtain the necessary approvals, Buyer could terminate the agreement.  The agreement, however, contained a much broader “Contingencies” section that included a provision that stated in part, “It is expressly understood that the Buyer may, at its absolute and sole discretion during this period, elect not to continue in this transaction and this purchase contract will become null and void.”  The agreement did not provide that Buyer could only terminate if Buyer failed to obtain the necessary approvals.

The Lawsuit

A year after Buyer spent $60,000 to obtain approvals, Seller advised Buyer it would no longer sell the property.  Buyer filed suit seeking specific performance.  Seller argued the agreement was not enforceable because it constituted an option agreement that lacked consideration.  Specifically, Seller claimed that because the agreement allowed Buyer to terminate at anytime, for any reason in Buyer’s sole and absolute discretion, the agreement was an option.  The trial court agreed and stated, “The unilateral nature of this agreement is the classic feature of an option.”[2]  Further, since the Seller did not receive any money or other benefit for the “option,” the trial court held that the agreement was unenforceable.  The trial court rejected Buyer’s argument that the work Buyer did and money it spent on the approvals constituted consideration.  The trial court reasoned that the adequacy of consideration is measured at the time the contract is entered into.  Because Buyer was not obligated to do anything at the time it signed the contract, Buyer’s later decision to seek approvals could not satisfy the consideration requirement.  Notably, the trial court also concluded that the $1,000 deposit did not constitute consideration.  The Court of Appeals affirmed for the same reasons given by the trial court.  The Supreme Court, however, rejected the lower courts’ holdings.  Although the Supreme Court agreed with the lower courts that the purchase and sale agreement was in fact an option agreement, it held that there was sufficient consideration to make it enforceable.  In reaching its decision, the Court laid out several important real estate legal principals.

Bilateral Contracts vs. Option Agreements

The Court explained that because the Buyer could terminate for any reason, even if all contingencies had been satisfied (including as the Court pointed out, if Buyer found a better deal), the Court rejected Buyer’s assertion that the agreement should be construed as a bilateral contract subject to a contingency (i.e., an agreement that is enforceable because the Buyer’s obligation to purchase satisfies the consideration requirement).  The Court explained that if an agreement allows a buyer to terminate because of a failure of a contingency, such as a loan or inspection contingency, termination is permitted “only” if the contingency fails.  Such types of agreements do not require separate consideration since the buyer is obligated to perform from the outset.  The Court concluded, “Thus, bilateral contracts subject to a contingency, which are widely used in real estate transactions, are not affected by our holding.”[3]

The Court also rejected Buyer’s argument that the Buyer was subject to the implied covenant of good faith and fair dealing, thereby, giving Buyer only a limited right to terminate based on good faith reasons.  The Court stated, “…theimplied covenant does not trump an agreement’s express language.”[4]  The Court commented that provisions granting a party broad rights to act in its sole and absolute discretion will not be subject to the covenant of good faith and fair dealing.

Consideration

After establishing the contract was an option agreement, the Court next tackled the issue of consideration.  The Court explained, “Thus, there are two requirements in order to find consideration.  The promise must confer (or agree to confer) a benefit or must suffer (or agree to suffer) prejudice.  We emphasize either alone is sufficient to constitute consideration…”[5]  Further, “…the second requirement is that the benefit or prejudice must actually be bargained for as the exchange for the promise.”[6]  In other words, it is not enough for a party to suffer a burden, rather the burden must be one which the other side bargained for.

The lower courts concluded it was immaterial that the Buyer had begun to seek the parcel split since the Buyer had no obligation to do so.  But the Supreme Court rejected these conclusions holding, “To the contrary, we conclude as a matter of law that [Buyer’s] part performance of the bargained-for promise to seek a parcel split created sufficient consideration to render the option irrevocable.”[7]

Having established that consideration existed, the Court added a meaningful opinion as dicta about the effect of Buyer’s $1,000 deposit in escrow.  The Court suggested the deposit would have also satisfied the consideration test, stating, “By placing money in escrow, [Buyer] gave up use of the money for as much as three years.  This arguably constituted prejudice to [Buyer] even if he ultimately got the money back.  In light of our conclusion regarding [Buyer’s] part performance, we need not resolve the effect of the escrow payment.”[8]

Practice Pointers:

1.  When drafting purchase and sale agreements, the parties should tie the buyer’s right to terminate to specific contingencies such as title, environmental, physical inspection, permits, financing, etc.  The question remains, however, whether it makes a difference if the buyer’s right to terminate for a specific contingency is based on a buyer’s reasonable discretion or sole and absolute discretion.  It is safe to say that an agreement with a contingency tied to reasonable discretion will be enforceable as a bilateral contract but it remains unclear whether a contingency tied to absolute discretion would be analyzed more closely with a bilateral contract or an option agreement.

2.  Most buyers expect to have a “free look” due diligence period where they can back out for any reason.  Typically, sellers accept a buyer termination letter without requiring more.  But it is certainly possible for a seller to reject a buyer’s attempt to terminate based on a specific contingency.  To protect against this possibility, buyers should include many contingencies and establish easy to satisfy reasonable grounds to terminate if the property does not meet the buyer’s expectations.

3.  To avoid any question, buyers may desire to pay some nominal amount of consideration.  As the court suggested, it may be enough for a buyer to pay into escrow (not even to the seller) a $1,000 refundable deposit.

4.  While a refundable deposit to escrow may be sufficient consideration, it is well established that buyer payments of non-refundable deposits to sellers (which still could be applied to the purchase price if the deal closes) would satisfy the consideration test.  In light of the above recommendations, however, it is unnecessary to structure transactions this way unless the buyer wants to retain the right to terminate in its sole and absolute discretion.  Beware, however, of agreements in which buyers agree to pay a nominal amount to sellers without actually following through and paying the amount.

5.  An alarming lesson from this case is that both the trial court and the Appellate Court got it wrong.  Most real estate experts were very surprised by the lower courts’ rulings which questioned the enforceability of many real estate contracts.  The irony is that the Buyer may have achieved a Pyrrhic victory given the current state of the real estate market.