California Supreme Court Decision Provides Framework for Real Property Purchase Agreements in California

March 25, 2010

Last week, the California Supreme Court handed down its decision in Steiner v. Thexton, ruling that a purported real property purchase contract was instead an irrevocable option and remanding the case to the trial court for further proceedings. See Steiner v. Thexton, No. S164928, slip op. at 17 (Cal. Mar. 18, 2010). In Steiner, the Supreme Court reversed the finding of the lower courts (both trial and intermediate appellate) that the option was revocable, but in the process affirmed their categorization of the contract at issue as an option, because the contract allowed the buyer to terminate the contract in his sole and absolute discretion. Id. at 1; Steiner v. Thexton, 163 Cal. App. 4th 359, 370 (2008). The contract language which the Court found to have created an option resembles numerous forms of real estate purchase contracts currently in use, thereby casting a shadow of doubt on the enforceability of those contracts going forward. Amicus Curiae Brief of California Association of Realtors at 3, Steiner v. Thexton, No. S164928 (Cal. Mar. 18, 2010). 

I. Background

The dispute in Steiner arose out of an agreement by Martin Steiner, a real estate developer, to purchase a 10-acre portion of a 12.29-acre parcel owned by Paul Thexton. Id. In negotiations with Steiner, Thexton had indicated that any potential buyer would have to be responsible for obtaining the necessary approvals to effect a legal parcel split, which would allow Thexton to sell the 10-acre parcel and continue to live on the remaining two acres. Id. at 13. In fact, Thexton had previously turned down a higher offer to purchase the 10-acre parcel because the prospective buyer had insisted that Thexton be responsible for obtaining the governmental approval of the parcel split. Id. at 1.

Steiner and Thexton entered into a written agreement for the sale of the 10-acre parcel in 2003. Id. at 1. The agreement provided that Thexton would sell the 10-acre parcel to Steiner by September 2006 if Steiner so chose, after Steiner pursued, at his own expense, the governmental approval of the parcel split. Id. Steiner was required to deposit $1,000 of earnest money in escrow, to be applied to the purchase price if Steiner chose to purchase the property, or to be returned to Steiner if he terminated the transaction in accordance with the agreement’s provisions for termination and refund. Id. at 2.

The agreement contained certain contingencies, including an absolute termination right for Steiner:

"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 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."

(Emphasis added) Id.fn. 2. [1]

Following the execution of the agreement, Steiner began pursuit of the parcel split and the governmental approvals therefor. Id. at 4. Thexton initially complied with several requests made by Steiner, including executing applications to the county planning department. Id. In October 2004, however, Thexton decided he no longer wished to sell any portion of his property, and contacted the title company to cancel escrow. Id. Shortly thereafter, and after allegedly spending nearly $60,000 in the process, Steiner obtained approval for a tentative parcel map from the county and filed suit seeking specific performance of the agreement. Id. at 5.

II. The Decisions

A.  The Lower Courts

Both the trial court and the Court of Appeal entered judgment in favor of Thexton, concluding that the agreement was unenforceable as a matter of law "because it is, in effect, an option that is not supported by any consideration." Id. at 5. The lower courts based their decision on the fact that, although Thexton was bound by the agreement to sell the property for a period of up to three years, Steiner retained "absolute and sole discretion" to cancel at any time, concluding that the unilateral nature of the agreement created an option, rather than a contract. Id. The lower courts also found that since no money was paid to Thexton, nor did he receive anything of value for the option, it was not supported by consideration and thus was unenforceable. Id. The courts rejected Steiner’s arguments that the requirement of consideration could be satisfied by the purchaser’s obligation to proceed expeditiously in obtaining the parcel split and approvals and that promissory estoppel should be applied based on the purchaser’s efforts in obtaining the parcel split and approvals. Id. at 5-6.

B.  The Supreme Court

On review, the Supreme Court affirmed the lower courts’ finding that the agreement between Thexton and Steiner constituted an option, rather than a bilateral contract. Id. at 6. The Court opined that "[w]hen by the terms of an agreement the owner of property binds himself to sell on specified terms, and leaves it discretionary with the other party to the contract whether he will or will not buy, it constitutes simply an optional contract." Id. quoting Johnson v. Clark, 174 Cal. 582, 586 (1917). Thus, the Court reasoned, since Thexton was obliged to hold open the offer to sell for $500,000 for three years, and since Steiner was vested with the power to accept or the power to do nothing and terminate in his sole and absolute discretion, he was not bound at all and his promise was illusory. Id. at 7. The Court also rejected the argument that Steiner was obligated to proceed expeditiously in obtaining the parcel split and approvals, noting that "Steiner’s unfettered power to withdraw at any time for any reason overrode any other obligations." Id. at 8.

On the question of consideration, however, the Supreme Court reversed the lower courts, finding that the option itself was supported by consideration and therefore was irrevocable. Id. at 10. In reaching its decision, the Court noted that for consideration to be deemed present, a promisee must confer or agree to confer a benefit, or suffer or agree to suffer a prejudice, and that such benefit or prejudice must have been bargained for as the exchange for the promise at issue. Id. at 10 quoting Bacon v. Grosse, 165 Cal. 481, 490-91 (1913); Bard v. Kent, 19 Cal. 2d 449, 452 (1942). The Court found that Thexton had bargained for the promise by Steiner to seek approvals for a parcel split, as evidenced by Thexton’s willingness to accept a lower purchase price on the basis of that promise (the prior offer rejected by Thexton was for a substantially higher price, but that buyer had refused to take on the responsibility for completing the parcel split). Id. at 12. While the Court agreed with the lower courts that the promise was illusory at the outset due to Steiner’s unfettered ability to cancel, it held that where part performance of an illusory promise has occurred, it "makes up for the initially illusory nature of [the] promise." Id. Since the parcel split constituted a benefit to Thexton and a burden on Steiner, since it was clearly bargained for, and since partial performance by Steiner had begun, the Court concluded that the option was supported by consideration and therefore became irrevocable despite the fact that Steiner initially was under no obligation to obtain the parcel split. Id. at 12-13.

III. Analysis

A.  Satisfying Steiner

Steiner v. Thexton raises several important issues regarding the enforceability of absolute termination rights for purchasers of real property. As noted by the California Association of Realtors, the decisions in Steiner cast doubt on a great number of pending real estate sale transactions in California. See Amicus Curiae Brief of California Association of Realtors at 3, Steiner v. Thexton, No. S164928 (Cal. Mar. 18, 2010). Moreover, given the prevalence of termination rights–like the one at issue in Steiner–in the majority of real estate purchase and sale contracts, the decision also creates uncertainty for future transactions. Id. In order to satisfy the requirements of Steiner going forward, and to avoid real estate purchase and sale agreements being deemed unenforceable, parties appear to have two alternatives.

1.  Ensuring the Option  Is Irrevocable

The first alternative would be to take as a given the Steiner Court’s determination that a purchase and sale contract allowing a purchaser to terminate in its sole discretion constitutes an option contract, and include in the option express language to satisfy the consideration requirement, thus causing the option to become irrevocable. The consideration requirement could be satisfied in a number of ways, but in each case, two things are clear. First, as was stressed by the Court, the consideration must be bargained for. Id. at 12-13. Accordingly, a party drafting an agreement should expressly state that the consideration, whatever it may be, was specifically bargained for and induced the promise from the other party. Second, since the adequacy of consideration is measured at the time the parties enter into the agreement, the consideration must not be illusory at the outset. Id. at 11. In Steiner, the promise was illusory when the contract was executed, and it was only Steiner’s partial performance before Thexton attempted to cancel the contract which caused the option to become irrevocable. Id. at 12. Thus, a drafting party should ensure that the consideration given survives the exercise of the termination right, thus making the consideration non-illusory, and the option irrevocable. Id. This could be accomplished, for example, by making some portion of the earnest money deposit non-refundable, or by any other consideration provided by the purchaser, so long as it was bargained for and not contingent on the termination right.

What specifically might qualify as consideration in this context remains an open question. The Court’s definition, as previously discussed above, is rather broad, finding consideration where a promisee confers or agrees to confer a benefit, or suffers or agrees to suffer a prejudice in exchange for the promisor’s promise. Id. at 10. Certainly, monetary consideration would satisfy the definition provided by the Court, so long as it was bargained for. Additionally, the Court found the parcel split undertaken by Steiner to qualify as consideration, since it represented a benefit to Thexton, a burden on Steiner, and was clearly bargained for. Id. at 12. Whether Steiner’s refundable earnest money deposit might constitute adequate consideration remains unclear. The Court did not answer the question of whether or not the refundable earnest money deposited in escrow by Steiner could satisfy the consideration requirement, but did observe in a footnote that "Steiner gave up use of the money for as much as three years . . . [which] arguably constituted prejudice to Steiner [. . .]." Id. fn. 13. However, a contrary argument could be made that the prejudice endured by Steiner in that scenario was not bargained for to the same extent as the parcel split was bargained for, and there was less evidence in the record that the refundable deposit had induced Thexton’s promise to sell.  Unfortunately, the Court declined to comment further on the refundable deposit and did not resolve the question. Id.

2.   Preventing the Agreement from Being an Option

The second alternative would be for parties to limit the purchaser’s termination right in some way in order to prevent its promise to purchase from being deemed illusory and, by extension, to prevent the parties’ agreement from being deemed an option.[2] As the Court explained, it was Steiner’s unfettered right to terminate which made his promise to purchase illusory, and created the option. Steiner, No. S164928 slip op. at 7, 8. If, by contrast, Steiner’s right to terminate had been tied to objective criteria, his promise to purchase would have been binding, and a bilateral contract would have existed. See id. To that end, a drafting party might consider enumerating the possible reasons the purchaser would be permitted to terminate a contract during a due diligence period. Arguably even an exhaustive list of permissible reasons to terminate would still not qualify as "unfettered" since by its very terms the right of termination would be limited to the listed reasons.

Rather than creating an express list of reasons for termination, a drafting party might also consider invoking the implied duty of good faith and fair dealing, either by stating it applies to the termination right expressly, or by limiting the language of the termination right so as to allow the implied duty to be read into the agreement. As the Court wrote in its opinion, while the duty of good faith and fair dealing applies generally to all contracts, and would have narrowed Steiner’s termination right, "[given] the broad and express language of the escape clause, Steiner’s power to withdraw was not constrained by the implied covenant of good faith and fair dealing." Id. at 9.  The Court found that the implied covenant of good faith and fair dealing had been superseded by the agreement’s express terms. Id. Thus, the Court leaves open the possibility that by limiting a termination right by expressly requiring the terminating party to act in good faith or by limiting the termination right to allow the implied duty of good faith to be read into it, a party could avoid its agreement being deemed an option.

IV. Conclusion

The decision in Steiner represents a departure from the status quo for purchasers of real estate in California. Fortunately, the Steiner decision provides a relatively clear framework for ensuring an agreement will be viewed as an enforceable obligation in California. To that end, post-Steiner buyers of real estate should take heed of the decision and either expressly lay out the bargained-for non-refundable consideration for their right to purchase, or limit their termination rights, to ensure both the enforceability of their agreement, and the fulfillment of their expectations.

Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding this decision.  Please contact the Gibson Dunn attorney with whom you work, or any of the following members of the Real Estate Practice Group:  

Jesse Sharf – Co-Chair, Los Angeles (310-552-8512, [email protected])
Fred L. Pillon – Co-Chair, San Francisco (415-393-8241, [email protected])
Alan Samson – Co-Chair, London (+44 20 7071 4222, [email protected])
Dennis B. Arnold – Los Angeles (213-229-7864, [email protected])
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Peter Decker – Munich (+49 89 189 33 115, [email protected])
Teresa J. Farrell – Orange County (949-451-3895, [email protected])
Eric M. Feuerstein – New York (212-351-2323, [email protected])
Drew C. Flowers – Los Angeles (213-229-7885, [email protected])
Amy R. Forbes – Los Angeles (213-229-7151, [email protected])
David J. Furman – New York (212-351-3992, [email protected])
Andrew A. Lance – New York (212-351-3871, [email protected])
Mary G. Murphy – San Francisco (415-393-8257, [email protected])
L. Mark Osher – Los Angeles (213-229-7694, [email protected])
Mark S. Pecheck – Los Angeles (213-229-7588, [email protected])
Erin L. Rothfuss – Singapore (+65 6507 3685, [email protected])
Michael F. Sfregola – Los Angeles (213-229-7558, [email protected])

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