ACREL Spring 2011

Illusory Contracts in California and New York (and in between)

Roger Bernhardt*

The adrenalin level of the California real estate bar rose up dramatically earlier this year when our state supreme court rendered its opinion in Steiner v Thexton, 48 Cal 4th 411, 226 P3d 359 (2010), a decision that seemingly redefined our rules concerning the enforceability of executory contracts for the purchase of property. At least a dozen law firm blogs about the case must have crossed my desk worrying about that decision.[1]

In Steiner, a putative buyer had sought specific performance of his arrangement to purchase 10 acres of land. The document had been executed in 2003, and gave the parties until 2006 to close, during which time the buyer was to obtain all the necessary entitlements for a development, and had in fact gotten many of them by the time of the seller’s withdrawal in 2004.

Too Easy to Withdraw

What killed the buyer’s case at trial (and at the intermediate court of appeal) was the a clause that entitled him, at any time, at his “absolute and sole discretion” to withdraw from the contract.  That provision, as far as the lower courts were concerned, made the buyer’s promise to purchase illusory and converted the deal into an option, unsupported by any consideration; thus entitling the seller to withdraw at any time before the buyer accepted his offer.

That particular conclusion was solidly (and unanimously) endorsed by the supreme court. The backout provision converted the agreement into an option, and no implied covenant of good faith or fair dealing, or duty to act expeditiously in getting the permits could deconvert it.   As a bilateral contract, it was – at the outset – illusory.

But Redeemed By Efforts Thereafter

But that was just Part 1 of the opinion. In Part 2, the court then ruled that the buyer’s subsequent efforts towards getting the entitlements constituted enough consideration as to render the option irrevocable, meaning that the seller could no longer withdraw.  Although the lower courts had opined that such efforts could not constitute consideration to support a contract because they had not been bargained for, the high court held that they were nevertheless sufficient as to have “cured the initial illusory nature of the promise and rendered the option irrevocable. “

So that is now the situation in California.  Professors may argue over its arguably dubious reasoning about consideration, and practitioners may have to give very uncertain advice as to part performance, but the rule of Steiner cannot be ignored, because the contract there looked so much like those commonly used throughout the state.

Different from other withdrawal provisions?

The California Association of Realtors (CAR) standard form Residential Purchase Agreement has an escape clause that gives buyers 17 days to “approve all matters affecting the property.”    That language looks like it might make an ordinary purchase agreement illusory under the first part of the Steiner opinion.  The CAR has amended that provision to add, “Any removal of contingencies or cancellation under this paragraph by either buyer or seller must be exercised in good faith and in writing”, but since the court’s opinion rejected the implied covenant of good faith as a cure for illusory obligations, it is unclear whether an express covenant of good faith can function much differently.

The supreme court did attempt to distance itself somewhat from this threatening consequence by stating that the provision it was looking at was different from what is in standard real estate contracts. In a footnote, it declared, “Thus, bilateral contracts subject to a contingency, which are widely used in real estate transactions, are not affected by our holding.”  But while it may be easy enough to distinguish a contract made contingent on obtaining financing from one giving the buyer absolute discretion to withdraw, there are an awful lot of situations that fall in between those extremes. Can lawyers always tell which contingency provisions make their contracts illusory and which don’t? More importantly, can brokers - the players who draft almost all of the residential sales contracts in California – do so?

Since the court’s opinion did ultimately validate the Steiner contract, because of the subsequent efforts by the buyer in getting the development permits, will this new interpretation of our consideration requirement  (not testing its adequacy solely as of the time the agreement  was made), save many otherwise illusory contracts?  But most conventional residential real estate contracts entail little activity by the purchaser during the escrow period that could qualify as consideration to the seller (such as what occurred in Steiner).  That should not stop counsel for buyers from trying to get their clients’ deals to fit under the first part rather than the second part of the opinion, and providing that all those activities , e.g., making the investigations, are recharacterized as being for the seller’s benefit as well as the buyers, so that the buyer’s performing of them may lock the seller in.

Adding Independent Consideration

More provocatively, the court threw into another footnote the rather gratuitous suggestion that it would not take too much original consideration by the buyer to make such a contract enforceable.  It volunteered:

“the agreement required Steiner to deposit $1000 into escrow, which he did. The trial court concluded the payment did not constitute consideration because Steiner would recover the money if he terminated the agreement; thus, the money did not confer a benefit on Thexton. However, even assuming the trial court’s interpretation of the agreement is accurate, it is not clear that its ultimate conclusion is correct.... [B]y placing the money in escrow, Steiner gave up use of the money for as much as three years. This arguably constituted prejudice to Steiner even if he ultimately got the money back. In light of our conclusion regarding plaintiff’s part performance, we need not resolve the effect of the escrow payment.”

That footnote has been richly tempting to the bar, with many of the newsletters that I mentioned suggesting inclusion of a deposit arrangement looking more favorable to the seller – e,g, paid directly to the seller, or giving him the interest it earned, or made nonrefundable -  might consitute sufficient independent consideration as to support the deal contract notwithstanding its inclusion of absolute back out rights.  Indeed, given a sufficiently sympathetic court, a token payment for an option to purchase might be all that is necessary.

(I am tempted to say that if that kind of “gimmick” is utilized, then it ought at least to be taken seriously, i.e. the $100 should actually be paid, except that even that may be unnecessary in jurisdictions that subscribe to the Restatement of Contracts (2d) position that offers can be enforced as binding option contracts if they simply recite a “purported consideration” (§ 87), even when the recitation is false!

Living With Free Looks

Whether or not it has gotten the drafting job right, our real estate industry has decided to tolerate revocable contracts to purchase houses, thereby giving purchasers a cooling off period, much like they have with regard to the loans that they apply for to complete their purchases (although 17 days is much longer than 3 days, and the counterparty is a private seller, who may have time concerns different from those of institutional lenders with thousands of loans in process at all times anyway).  Isn’t there some better alternative?

Several states include in their forms clauses making the deals subject to the review and approval of their parties’ attorneys. These have been the subject of two good law review articles: Attorney Approval Clauses In Residential Real Estate Contracts—Is Half A Loaf Better Than None?,  48 U. Kan. L. Rev. 339, by  Alice M. Noble-Allgire, a Law Professor at Southern Illinois University School of Law. written in 2000; and Navigating Residential Attorney Approvals : Finding A Better Judicial North Star, 39 J Marshall Law Review 171, 2006, by  Debra Pogrund Stark, a Law Professor at John Marshall.  Both authors survey the various clauses in use around the country and the reported decisions that have dealt with them.   Both like the clauses but also believe that a requirement of good faith should be read into them.[2] Noble-Allgire thought that a good faith requirement should be incorporated in order to keep the contracts including them from being held illusory, whereas Stark wanted attorneys to have to exercise their disapprovals in good faith to avoid letting clients use this to extricate themselves from obligations they have simply changed their minds about.

Is Good Faith Essential?

These demands for good faith have not, however, been wholeheartedly accepted by the courts.  With regard to keeping a contract from being illusory, in 2008 the Wisconjsin Court of Appeals held that an attorney approval provision did not hurt a real estate sales contract so long as the right to cancel was limited “even in a slight way”, such as having to  consult with an attorney and provide notice within in five days. “In our view, these obligations, though not onerous, are enough to save the deal from being illusory.”  Devine v Notter, 753 NW2d 557 (2008). Having to pay an attorney a one time consultation fee may be a cheap price for getting out.

Even more violent in its opposition to a requirement that attorneys opine only in good faith is the decision by the New York Court of Appeals in Moran v Erk, 901 NE2d 187, also in 2008. The high court there was considering a form contract that is used by the Buffalo Association of Realtors and includes a standard three-business-day attorney approval clause.  According to the court:

“After signing the contract, the Erks developed qualms about purchasing the Morans’ house. They discussed their misgivings with their friends and family, and ultimately decided to buy a different residence. As a result, they instructed their attorney to disapprove the contract, and she did so on October 28, 1995, which was within the three-day period for invoking the attorney approval contingency.”

In rejecting the sellers’ claim for damages, the court of appeal held: “An attorney for either party may timely disapprove the contract for any reason or for no stated reason”

With regard to the claim that the implied covenant of good faith and fair dealing should limit the buyers’ attorney's ability to disapprove, for the court said:

“clarity, predictability, and professional responsibility” lead in the opposite direction.  Outcomes would become “dependent on the subjective equitable variations of different Judges and courts instead of the objective, reliable, predictable and relatively definitive rules” of plain-text contractual language.”

Even worse, the inquiry as to bad faith would:

“likely require factual examination of communications between the disapproving attorney and that attorney's client… That is, the disapproving attorney will be subpoenaed to testify about communications the disclosure of which might be detrimental to that attorney's client-a direct conflict with an attorney's duty to preserve a client's confidences and secrets… Moreover, the threat to attorney-client confidentiality under a bad faith regime could harm the attorney-client relationship itself in the context of real estate transactions. A diligent attorney, cognizant of the risk of being subpoenaed to testify as to the basis for a disapproval, would face a perverse incentive to avoid candid communications with his or her client regarding a transaction in which the attorney is supposed to represent the client's legal interest.”

That means that in New York, a buyer can back out in 3 or 5 days after her offer was accepted, so long as she does it through an attorney, which may be easier than what she has to go through in California, where she has 17 days to do so, but must hope that a judge will agree that she did so in good faith.[3] The letter that New York counsel must write should not cost much, since no reason need be given.[4] If the brokers want to give the public quasi-illusory real estate arrangements, why not let the lawyers profit from them.



* Roger Bernhardt, a professor of law at Golden Gate University in San Francisco is a member of ACREL and Editor of the California CEB Real Property Law Reporter.  His columns may be found at RogerBernhardt.com.

[1] And there were probably a good many more blogs that went out, except that I am, unfortunately, not on their mailing lists. Please henceforth add me: .).

[2] Noble-Allgire also believes that such clauses should to be required wherever brokers rather than lawyers draft residential sales contracts, a proposal that should appeal to underemployed attorneys. Stark also wants to require a specification of the attorney’s reasons for disapproving (but was careful to not require reasonableness, because not all attorneys are at the same level of competence).

[3] It is unclear to whether the seller can do the same during those 17 days, and whether the contract really becomes nonillusory after that if the buyer put in no efforts in the interim.

[4] And it is certainly cheaper than the practice in New York City of displacing broker generated forms with contracts drafted in their entirety by two attorneys, after the brokers have put the basic deal together.  During the weeks that follow, while the attorneys are bickering over their rival favored form clauses, both parties are free to seek better deals elsewhere, thereby “gazumping” the other.  It is a miracle that deals there ever close at all!