No More Free Look PSAs

Steiner v. Thexton

On January 27, 2010, I attended the oral arguments to the California Supreme Court in the real estate case of Steiner v. Thexton. This case places in doubt the entire structure of real estate purchase and sale transactions as they have been structured for many years. The trial judge, all three appellate justices, and from the questioning it appears a majority of the Supreme Court justices, agree that if the buyer has the complete and unlimited right to cancel the contract and get all of the deposit back, then the contract is not a bilateral, mutually enforceable contract, but instead is a unilateral option contract. It always has been the law that an option contract can be canceled by the seller at any time before the option is exercised, unless the buyer pays consideration for the option. So if there is no consideration, the seller can terminate at will, until the option is exercised.

The consideration does not have be large, but it must exist. The consideration need not benefit the seller, as long as it is a detriment or expense to the buyer. In this case, the trial court and the Court of Appeal found that the deposit into escrow was not consideration, because the buyer had the right to get all of it back if the buyer canceled the contract. They also held that the promise by the buyer to do the land use permitting to subdivide the subject property was not consideration, because the buyer had the right to cancel the contract before the buyer even started any of that land use planning and application processing. So the trial court and Court of Appeal both held that the seller was within his rights to cancel the contract, even after the buyer had spent $65,000.00 processing the subdivision application.

Chief Justice George did not ask any question. All six of the other justices asked multiple questions and appeared very interested and engaged in the arguments. Several read passages from the trial transcript and the contract. Justices Kennard, Baxter, Werdegar and Moreno all appeared to feel that the contract at issue was an option and not a bilateral, mutually enforceable contract. Only Justice Chin asked anything that could support the contract being a mutually enforceable agreement.

For the same reason, the majority appeared headed towards agreeing with the lower courts that the buyer's unconditional and unlimited right to cancel the contract and get all of his deposit back meant that there was no consideration for the option when the option was made. The buyer's counsel appeared to concede that the test for consideration was made at the time the contract was signed. There was no discussion by counsel or the Court about an option becoming binding on the seller as soon as the buyer actually began spending money and effort on obtaining the required subdivision approval. Such a holding would have its own problems. How does the seller know when the buyer has done enough that the seller's right to cancel and sell to someone else has been terminated? How much performance is required in order to cancel the seller's right to cancel and make the option binding on the seller? In order to terminate the buyer's right to cancel, does the buyer need to know how much the seller has performed? If so, how? Such questions go on and on, and none of them were asked or raised in oral argument. So the Court probably is not headed towards that kind of a decision.

There was discussion of the related theory of promissory estoppel, the equitable theory that the buyer was changing its position by incurring the detriment of having expended the effort and money on the subdivision application process, in reliance on the seller's option promise and with the seller's actual knowledge of such efforts and expenditures, and therefore should not be allowed to exercise the right to cancel the option promise. The facts are very favorable to the buyer on such a theory. The buyer had spent more than $65,000.00 and nearly completed the subdivision process, and the seller agreed that the subdivision would increase the value of the subject property at least $250,000.00. The lower courts rejected this argument on different legal grounds. The Supreme Court could affirm or reverse the lower court decision on this theory and leave the real estate industry with the same problem discussed above, that the most common real estate sale structure is actually an option without consideration that either side can terminate at will until the buyer exercises the option and waives all contingencies, at which time the contract becomes binding on both sides, but until then, either side can terminate unilaterally and with no justification required for doing so. Unfortunately, from the questioning by the Supreme Court, it appears that is the most likely outcome.

It was interesting that there was no consideration or discussion of broader public interests or the impact on common practice and standard operating procedure in the real estate industry. Neither the buyer's attorney nor any of the justices mentioned these issues. The California Association of Realtors submitted a brief alerting the Court to the potential problems raised by the characterization of this kind of contract as an option without supporting consideration, in the retail home sales market. No mention was made of any of these problems or issues. The entire discussion was about existing law and how it applied to the contract terms and facts determined by the trial court in this particular case, with no consideration of broader impacts and implications or the impact on other real estate sales contracts.

One of the scary parts of this lawsuit is that all of the legal arguments are based on already existing legal principles and cases. This is not a new rule of law. Therefore, it applies to all current and future contracts, regardless of when the final decision is released. This option without consideration right of the seller to cancel and applies now to sellers under current contracts and future contracts where that same transaction structure is employed. The only exception would be if the Court announced some new rule, such as that an option to sell real property that is in writing and signed by the seller is binding on the seller, even if there is no consideration for the option. Any other decision is going to leave buyers who do not pay for the option at risk that the seller has the right to cancel until the buyer exercises the option and cancels the buyer's unconditional right to cancel.

The Supreme Court will issue its decision within 90 days. It is possible that the decision might announce a new rule that would not treat customary "free look" contingency periods for real estate purchase and sale agreements as options not supported by consideration and therefore subject to unilateral cancellation by the seller until the buyer waives its free look. From the questioning by the justices, it appears more likely that, regardless of the outcome of that particular lawsuit, that the Supreme Court is going to uphold the option-not-supported-by-consideration characterization of the purchase and sale agreement That means that if the buyer really wants to lock up the property and bind the seller, then the buyer needs to provide the seller with some consideration for the option.

Option money would be simplest, but how much raises an issue that the courts have not addressed in a very long time. In the right case, a court might not consider a very small amount to be sufficient in a case with sufficiently unattractive facts and equities. A mutual agreement to buy and sell with the buyer allowed to cancel only in the event of objectively testable contingencies, would work. Such contingencies could include confirmation of gross revenues from rent and CAM reimbursements, a cap on the cost of repairs required, and acceptable terms for debt financing (e.g. 70% LTV, maximum interest rate and monthly payment, minimum term).

Should you have any questions regarding how to deal with this issue in any real estate purchase and sale agreement you have outstanding or are negotiating, please ask your attorney how to deal with Steiner v. Thexton, or call me.