Periods and the Enforceability of Purchase Contracts
A California ruling that a purchase agreement may be illusory, and thus unenforceable, during a contingency period may influence the Arizona courts in future cases
Related Article: Due Diligence in Buying Commercial Real Estate: Acreage, Apartments or a Building
There has long been
debate among real estate attorneys as to whether a purchase contract is
enforceable prior to the expiration of any due diligence or other contingency
periods, since prior to that time the buyer has (arguably) no real obligation to
move forward with the transaction and can obtain a return of its earnest money.
The California Supreme Court, in Steiner v. Thexton, recently addressed
this matter directly, holding that a purchase agreement may be illusory (for
lack of legal consideration), and thus unenforceable, during such a contingency
period. 2010 WL 960418 (Cal. March 18, 2010). This decision could have
significant implications for those of us in the real estate business –
especially how we structure purchase agreements – and is thus worth discussing.
The underlying facts of
the case were as follows. The buyer and seller entered into a purchase contract,
the closing of which was expressly contingent upon the buyer obtaining a lot
split of the seller’s property. The buyer was allowed an “investigation period”
during which he could, but was not obligated to, attempt to obtain approval for
a lot split. As well, the buyer could terminate the transaction at any time
prior to close in his “absolute and sole discretion.” Under the contract, the
initial escrow deposit of $1,000 was to be applied against the purchase price
(if the deal closed) or returned to the buyer in the event he cancelled; the
contract did not provide for any circumstance in which the seller would receive
the earnest money (absent a closing). The buyer had devoted a great deal of
resources towards obtaining approval of a lot split when the seller cancelled
the purchase contract, prompting the buyer to sue for specific performance.
The trial court found
that the purchase contract was a revocable option (i.e. the seller could revoke
the option at any time prior to the buyer’s exercise) due to lack of
consideration and the appellate court affirmed. 77 Cal. Rptr. 3d 632 (App. Ct.
2008). The appellate court found that the escrow deposit did not constitute
consideration, since it was to be applied to the purchase price, would revert to
the buyer if he cancelled, and would never go directly to the seller (absent a
closing). The buyer argued that his efforts towards obtaining a lot split and
his contractual obligation to give all property reports to the seller
constituted adequate consideration. However, the appellate court pointed out
that, under the purchase contract, the buyer had no obligation to conduct any
such efforts; thus, that “obligation” was purely discretionary and illusory.
The buyer appealed this
decision to the California Supreme Court, which reversed the appellate court.
The Court agreed that the circumstances of Steiner gave rise to an
“option” to purchase real property, not a bilateral purchase contract, since the
contract at issue (i) had an investigation period of three years, during which time
the seller had to hold the property off the market, (ii) gave the buyer absolute
discretion as to whether to perform the contingencies or not; and (iii) allowed
the buyer to terminate even if all contingencies had satisfied. Nevertheless,
the Court held that there was sufficient consideration to establish an
irrevocable, enforceable option. The Court found that the lot split contingency
in and of itself was inadequate consideration because the buyer was not
obligated to take any action; but, since the buyer had taken action (i.e.
partially performed), sufficient consideration existed in the form of prejudice
to the buyer (expense) and benefit to the seller (the lot split, which made a
portion of his property transferable). The Court further noted that, for the
consideration to be sufficient, it must be specifically bargained for by the
parties when they entered into the agreement. Incidental benefits or prejudice,
not included in the agreement or discussed by the parties, will not constitute
In 1984, the Arizona
Court of Appeals decided a similar case in Horizon Corp. v. Westcor, Inc., 142 Ariz. 129, 688 P.2d 1021 (App. 1984). Westcor had entered into a
purchase agreement with Horizon, which was contingent upon satisfaction of a
number of conditions including site plan approval, zoning and financing. The
trial court found that the contract was illusory due to lack of consideration,
since Westcor had discretion as to whether to perform the conditions, the
satisfaction of which were in Westcor’s sole and absolute discretion. However,
the appellate court reversed the trial court, holding that Westcor had an
implicit duty to make a good faith effort to fulfill the conditions and Westcor
was obligated to exercise its approval or disapproval of the conditions in good
faith. See also A.R. Mack v. Coker, 523 P.2d 1342 (Ariz. App. 1974)
(finding that the buyer’s efforts towards obtaining financing constituted
sufficient consideration for enforcing an option agreement); compare Steiner
v. Thexton, 2010 WL 960418, *3 (“[T]he implied covenant [of good faith and
fair dealing] does not trump an agreement’s express language.”).
Horizon Corp. v.
Westcor, Inc. remains the leading authority in Arizona on the matter.
However, Arizona courts have a tendency to follow California decisions. While
the purchase agreement at issue in Steiner was obviously not standard (for
instance, a 3 year investigation period), if you are a buyer and want to take
every measure towards the contract being enforceable, you may consider including
provisions that the buyer can cancel during the contingency period in its
“reasonable” discretion, instead of sole and absolute, and that the buyer must
pursue its investigations during the contingency period “diligently.”
Alternatively, you may consider having the seller receive some amount of
consideration even if buyer elects to cancel, i.e. for money to actually change
hands (not just a bare recital that there is adequate consideration). While
there is no bright line authority as to what sum would be sufficient to
constitute legal consideration, it is likely that anything less than $1,000
would be considered nominal and not affect a court’s decision.