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Contracts with “Free Look” Period May Create an Unenforceable Option Under California Law

December 8, 2010

A common, if not standard, component of real estate purchase contracts is a provision allowing the buyer a period of time to conduct due diligence with an unrestricted right to terminate the contract in its sole discretion, sometimes referred to as a “free look” period (a “Free Look Provision”). Free Look Provisions have recently come under scrutiny by California courts, calling into question the nature and enforceability of contracts containing such provisions.

On May 18, 2010, the Supreme Court of California reversed Steiner v. Thexton [1], a 2008 decision by the California Court of Appeal for the Third District. In Steiner v. Thexton, a property owner entered into a purchase contract with a real estate developer on the condition that his parcel be split so that he could sell a portion to the developer and retain the remaining portion. The purchase contract obligated the seller to hold open an offer to sell the property at a fixed price for three years, during which time the buyer was to conduct all necessary investigations and studies and obtain all necessary permits and authorizations for the parcel split. The purchase contract granted the buyer the absolute and sole discretion to terminate the transaction at any time. The buyer brought a claim for specific performance after the seller decided he no longer wanted to sell the property.

Both the trial court and the Court of Appeal held that the contract was actually an option to purchase because the Free Look Provision contained in the agreement gave the buyer an unrestricted right to terminate the contract, and was revoked by the property owner due to lack of consideration. Accordingly, the real estate developer had no enforceable right to purchase the property and, therefore, was not entitled to specific performance. While the Supreme Court agreed with the lower courts, finding that the unilateral right to withdraw from the purchase contract meant that the agreement was an option, in reversing the decision of the Court of Appeal, the Supreme Court held that the option was supported by sufficient consideration and, therefore, irrevocable.

According to the Supreme Court, in order for consideration to be sufficient to render the option irrevocable, (a) the promisee must confer (or agree to confer) a benefit on the promisor or the promisee must suffer a prejudice and (b) such benefit or prejudice must induce the promisor to enter into the contract. The Supreme Court found that the buyer’s agreement to obtain the permits and approvals for the parcel split would confer a benefit upon seller (and actually resulted in a prejudice to the buyer) which had induced the seller to enter into the purchase contract. To support the conclusion that the benefit actually induced the seller to enter into the purchase contract, the Supreme Court noted that the seller had rejected an earlier offer from another potential purchaser for 50% more money because that purchaser required the seller to obtain the necessary approvals and permits. Moreover, the Supreme Court emphasized that the bargained-for benefit to seller also resulted in a prejudice to buyer because the buyer undertook substantial steps toward obtaining the parcel split, including expending “thousands of dollars” in pursuit of the necessary permits and approvals (alleged by the seller to be $60,000) and spent months pursuing the parcel split (acknowledged by the Supreme Court to be 75-90% of the necessary work). As such, the Supreme Court found that there was sufficient consideration to render the option irrevocable [2].

Based upon this decision, parties drafting purchase contracts that include Free Look Provisions should be careful to avoid inadvertently creating unenforceable options. If the buyer desires to retain an absolute right to terminate the contract during the free look period, then the parties should consider specifically documenting the adequacy of consideration by requiring either some payment by buyer or some sort of service be performed for the benefit of the seller or the property in exchange for such termination right. A large non-refundable deposit relative to the purchase price more likely will be considered satisfactory consideration, although California courts in the past generally have followed the legal maxim that a single peppercorn can constitute adequate consideration. In Steiner, the $1000 deposit equaled merely .2% of the purchase price. While the court chose not to specifically address the sufficiency of the deposit (basing its holding on other evidence of adequate consideration conferred to seller), the Supreme Court highlighted in a footnote that the buyer, upon making such deposit, lost the use of such money for up to 3 years. The court’s emphasis on this point suggests it was less interested with the magnitude of the deposit and more concerned with the resulting prejudice suffered by the buyer [3]. If the parties to a purchase contract with a Free Look Provision do not intend to require a relatively large cash deposit or that it be potentially tied up in escrow for a long period, the parties alternatively should take caution to include a commitment by buyer to perform actual services that would result in a benefit to seller or would cause the buyer to expend money and/or time in pursuit thereof, such as obtaining necessary permits, changes to zoning or land use regulations or similar regulatory approvals. Such performance by buyer may be adequate consideration to render the agreement irrevocable.

[1] Steiner v. Thexton, 226 P.3d 359 (Cal. Mar. 2010).
[2] Note that the Supreme Court specifically stated that they had “no occasion to consider whether any act, no matter how small, would be sufficient part performance to make an option irrevocable.”
[3] The Supreme Court noted that such loss of the use of the money for up to three years may be a sufficient bargained-for prejudice suffered by buyer to render the option irrevocable.