Due Diligence Periods and the Enforceability of Purchase Contracts

May 14, 2010 Stephen Aron Benson Real Estate Law

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

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 consideration.

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.