July typically is the slowest month of the year for the Center, and this year is no exception. While we don't have much Burnham-Moores Center news to report, we did want to bring to your attention — in the form of a special report — an important court decision that will have far-reaching implications for all of those structuring real estate deals.
We asked Michael Maher, of the law firm of Hecht Solberg Robinson Goldberg & Bagley LLP, to put the May 2008 Steiner v. Thexton court decision into context for our readers, who may not have become aware of its implications yet.
We wish all of our friends a happy Fourth of July, and time to reflect on the tremendous freedoms we enjoy in this great nation. See you in August.
by Michael J. Maher
Hecht Solberg Robinson Goldberg & Bagley LLP
Michael J. Maher
Every so often a court issues a decision that affects the way an entire industry conducts its business. In late May 2008, the California Court of Appeal issued its ruling in Steiner v. Thexton, which affects the viability of a common practice in the real estate industry in California: the purchase and sale escrow in which the buyer is entitled to receive back their entire deposit if they elect to terminate the escrow at the end of its feasibility period.
If you enter into a purchase and sale agreement with a contingency that enables the buyer to decide not to proceed with the transaction, terminate the contract and receive back the deposit, then you ignore the Steiner decision at your peril.
Paul Thexton owned his family's homestead — roughly 12 acres in Sacramento County — and was a reluctant seller. When Martin Steiner approached him in September 2003 about buying 10 of the 12 acres, Thexton had already turned down a higher offer. Nevertheless, Thexton entered into an agreement with Steiner to sell him 10 acres for $500,000. Steiner deposited $1,000 in escrow, which would be applied to the price at closing. The closing was to occur upon Steiner's "successful completion of subdividing the 10 acres from the existing [12-acre] parcel" but not later than September 2006. During the term of the escrow, Steiner had the right, but not the obligation, to investigate the financial feasibility of developing the 10 acres, including obtaining the parcel split. If Steiner elected not to proceed, the entire deposit would be returned to him.
Steiner applied for the parcel split and the county approvals needed to develop the property. He proceeded to process the application, including providing Thexton with quarterly progress reports as their agreement required. Steiner spent approximately $60,000 on investigating the property and on seeking the development approvals. In October 2004, shortly before Steiner's final public hearing for the parcel split and development approvals was scheduled, Thexton instructed the escrow holder to cancel the escrow, stating that he no longer wanted to sell the property. Steiner objected to Thexton's instruction and proceeded with the final hearing, thereby obtaining the county approvals he had been seeking. Steiner brought suit against Thexton seeking the remedy of specific performance — that is, a court order compelling Thexton to sell the property to him at the agreed-upon price.
Steiner had deposited $1,000 into escrow, and he had retained the right to elect, in his sole and absolute discretion, not to purchase; if Steiner elected not to proceed, the entire $1,000 deposit was to be returned to him. The court emphasized that Steiner had no obligation to conduct any investigations and no obligation to pursue the parcel split. Even though Steiner had spent approximately $60,000 on investigations and processing his application for development approvals, he had no obligation to Thexton to do so. The court focused on the following sentence in the purchase agreement: "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." Based on that sentence, which trumped all, the court concluded that the agreement was not supported by legally sufficient consideration and was therefore unenforceable.
Legally sufficient consideration is the glue essential to a legally binding and enforceable contract — the respective benefits bargained for between the parties to the contract. For example, the buyer pays money to the seller in consideration for the seller conveying the property to the buyer; and vice versa.
Steiner mounted valiant and elaborate arguments that the agreement was supported by consideration: that the agreement required him to "move expeditiously" to obtain the parcel split, and that he had done so; that he was obligated to deliver the product of his due diligence investigations and tests to Thexton; that he had delivered the required quarterly progress reports to Thexton; that the effort he had expended and the approximately $60,000 in expenses he had incurred in pursuing the parcel split and development approvals enhanced the value of the property and therefore conferred a benefit on Thexton; that he had relied on the agreement to his detriment, so equity made the agreement enforceable; and finally, that under the implied covenant of good faith and fair dealing, he had an implied obligation to pursue the parcel split — but all to no avail.
In the court's final analysis, the plain fact remained that Steiner had reserved for himself the right to walk away from the deal in his discretion, and that made the agreement void and unenforceable. The court's decision has surprised the real estate industry because so many buyers routinely structure their purchase agreements the same way Steiner had structured his — the parties sign the contract, the buyer pays its deposit into escrow, the buyer is entitled to a discretionary review of the property, and if the buyer elects to terminate before the end of its feasibility period, the escrow terminates and the buyer's entire deposit is returned.
So what are parties to purchase and sale agreements to do? Two solutions:
First, the agreement can state that if the buyer terminates based on disapproving feasibility or some other contingency for the buyer's benefit, the deposit is returned to the buyer, except that some portion of the deposit is paid to the seller. Note that the amount paid to the seller need not be large, but should not be nominal. For example, applying the court's analysis, if the agreement had stated that upon Steiner's election to terminate, the deposit is returned to Steiner, except that the escrow holder is to first deduct $250 from the deposit and pay the $250 to Thexton, the court would have concluded that agreement was enforceable.
A second alternative is for the buyer to agree to perform specific obligations during the feasibility period, for example, being required to conduct tests, investigations and inspections, with copies of the results delivered to the seller, or being required to pursue development entitlements. The practical reality, however, is that few buyers want to obligate themselves in that respect. Moreover, the second approach may leave open for debate whether the buyer's promise to conduct tests, investigations and inspections or to pursue entitlements was really bargained for by the seller.
The agreement between Steiner and Thexton contained a so-called entitlements contingency — that is, the agreement gave Steiner the opportunity, but did not obligate him, to pursue the parcel split and the development entitlements, with the right to terminate if he did not obtain them. Consequently, some have interpreted the decision as applying only in that particular situation. The principle articulated by the court, however, applies more broadly.
The Steiner decision teaches us that "free looks" aren't really free; for a purchase and sale agreement to be a binding contract, the buyer must have an obligation that benefits the seller — for example, being obligated to perform tests, investigations and inspections during the feasibility period or being obligated to pay a portion of the deposit to the seller if the buyer terminates the escrow based on a contingency in the buyer's favor.
You can bet that Mr. Steiner will be structuring his agreements differently in the future. And you will want to as well, unless you want to wind up with your own tale of woe — how you had this great piece of property under contract, spent tens of thousands of dollars during feasibility on great consultant reports, but then the seller backed out and all you got was your $1,000 deposit back.
Mickey Maher is a real estate and business lawyer whose practice includes neighborhood and community retail and mixed-use centers; office and industrial park development, sales and leasing; purchases and sales of real property; reviewing and analyzing title-related matters; real estate financing; and advising a variety of businesses.
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