Court Rules an Entitlements Contingency Renders Land Contract Unenforceable

by:
Joseph S. Stuart
Luce, Forward, Hamilton & Scripps LLP - Irvine Office

Robert D. Buell
Luce, Forward, Hamilton & Scripps LLP - San Diego Office

David B. Franklin
Luce, Forward, Hamilton & Scripps LLP - San Francisco Office

George C. Rudolph
Luce, Forward, Hamilton & Scripps LLP - Irvine Office

Benjamin Allan Hirasawa
Luce, Forward, Hamilton & Scripps LLP - San Diego Office

July 9, 2008

Previously published on June 10, 2008

In the recent case of Steiner v. Thexton (May 2008), the California Court of Appeal ruled that a particular purchase agreement containing a discretionary, unilateral “entitlements” contingency, is void. Specifically, the court indicated that a buyer cannot enforce this purchase agreement, and that the seller may walk away from it even if the buyer has made significant progress in obtaining the entitlements. The court characterized the purchase agreement as an “unsuccessful attempt” to create a “disguised option agreement.” This new case sends a caution signal to all real estate professionals, especially drafters of real estate purchase and sale agreements.

The facts of Steiner v. Thexton are not complicated. The buyer was willing to pay the purchase price and acquire the property only after the buyer was successful in getting the local municipality to approve legally subdividing the parcel. The parties signed a purchase agreement incorporating these terms, and also wisely included an outside date when the escrow and the agreement would automatically terminate if buyer was ultimately unsuccessful in obtaining the parcel subdivision approval. The agreement included language providing for buyer’s delivery of a refundable earnest money deposit that is typically found in real property purchase and sale agreements; this language did not characterize the earnest money as an option-like payment of consideration.

The court highlighted the following fatal language in the agreement: “It is the intent of buyer that the time period from execution of this contract until the closing of escrow is the time that will be needed in order to be successful in developing this project. 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.” It is common for land purchase agreements to have a relatively short, discretionary “contingency period” permitting a buyer to cease pursuing the purchase of the property for any reason, such as problems with potential entitlement approvals. It is also common for land purchase agreements to have a “closing contingency” permitting the buyer to terminate the agreement if some agreed-upon contingency is not satisfied, such as obtaining entitlement approvals. In Steiner, these common buyer contingencies were addressed by flatly stating the buyer could “elect not to continue this transaction.” The court ruled: (a) since the buyer could terminate the agreement and escrow at any time without forfeiture of earnest money, the buyer never had any substantive obligation under the agreement, (b) thus the agreement was merely a unilateral option agreement, and (c) since no option consideration was paid, buyer’s option to purchase was unenforceable.

To counter the lack of consideration argument, the buyer argued: (a) buyer did have an implied obligation to pursue the entitlements in good faith, (b) the agreement expressly required buyer to “move expeditiously with the parcel split,” (c) buyer incurred significant amounts in the pursuit of the parcel split, (d) buyer was obligated to deliver costly and valuable due diligence and other materials to seller, (e) buyer’s efforts and progress in pursuing the entitlements benefitted the seller, and (f) the equities of the situation made the agreement enforceable given the degree of buyer’s reliance on it. Point by point, the court rejected all of these counter-arguments.

It’s interesting to note the court’s view of each party’s motivations. The court’s written opinion alone does not reveal whether an unscrupulous seller tried to get out of a deal and take advantage of buyer’s entitlements work, or an unscrupulous buyer tried to take advantage of an unsophisticated seller with an arguably one-sided agreement. The court’s ruling essentially dismissed the notion of unfair seller motivations or conduct, and repeatedly described what happened as a “disguised” and “attempted” option. Perhaps the court felt the buyer was culpable in some way when it summarily concluded “the equities do not support compelling [the seller] to sell the property.”

The Steiner case means buyers, sellers and attorneys need to give very specific thought to the “legal consideration” issue in all purchase and sale contracts.

The views expressed in this document are solely the views of the author and not Martindale-Hubbell. This document is intended for informational purposes only and is not legal advice or a substitute for consultation with a licensed legal professional in a particular case or circumstance.