August 19, 2002

On July 15, 2002, the California Court of Appeals for the First Appellate District held that a real estate construction lender had no duty to act in good faith but was required to be objectively reasonable in determining whether a condition precedent to funding had been satisfied. Storek & Storek, Inc. v. Citicorp Real Estate, Inc.

FACTS
The lender’s obligation to make disbursements under a construction loan agreement was conditioned upon the fulfillment of a condition precedent: the lender’s determination that the project budget was “in balance”. Having determined that the project budget was out-of-balance, the lender suspended further disbursements. As a result, the borrower defaulted on various loan obligations, filed for bankruptcy and the bankruptcy trustee (which later sold its claims to the plaintiffs) sued the lender for breach of the express terms of the contract (a claim that plaintiffs subsequently withdrew), fraud (a claim that is not addressed in this update) and breach of the implied covenant of good faith and fair dealing in connection with the lender’s determination that the loan was out-of-balance. On this last claim, the jury found for the plaintiffs and awarded 0,001 (the total amount of the construction loan withheld).

COURT OF APPEALS
The appellate court reversed. The court stated that the implied covenant of good faith and fair dealing applies both to a grant of unfettered discretion, and to a performing party’s determination of satisfaction of a condition precedent, only when necessary to avoid an illusory promise by creating mutuality. In this case, the court found mutuality by supplying a “reasonableness” standard for the lender’s determination as to whether the loan was in balance. The court stated that (1) where a contract provides that the satisfaction of one of the parties is a condition precedent to that party’s performance, then either an objective reasonableness test or a subjective good faith test should be applied, (2) the parties to a contract may specify which test applies, (3) if the contract is silent, then the courts will tend to apply the objective reasonableness test (unless the matter involves aesthetics or personal taste), and (4) here, the lender’s determination involved financial calculations and therefore the proper test was objective reasonableness.

Most lenders would be disappointed to find themselves bound to an objective reasonableness test as opposed to a subjective good faith test. However, under the procedural circumstances of this case, this was a lender’s dream and a borrower’s nightmare. By finding that the implied covenant of good faith and fair dealing did not apply, the plaintiffs lost their remaining contract claim. The net result was that neither a subjective good faith test nor an objective reasonableness test would be applied.

SIGNIFICANCE
Although there are problems with the reasoning of the Storek case (which are beyond the scope of this update), the case does suggest some important drafting considerations:

1. To avoid the imposition of a limitation on the exercise of a contractual grant of unfettered discretion, a party should make the grant clear and unambiguous and support it with separate consideration. For example, in a purchase agreement providing for a “free-look” period with unfettered discretion to terminate, is it clear the buyer can terminate for any reason or no reason? Is there separate consideration? Is the consideration adequate to support an action for specific performance?

2. For any grant of less than unfettered discretion, the parties may wish to consider spelling out a standard to avoid the judicial imposition of a less favorable standard.

For more information or to arrange an interview, please contact Leeza Hoyt, The Hoyt Organization, 310-373-0103 or the following attorney at Pircher, Nichols & Meeks Los Angeles: Stevens A. Carey 310-201-8904 or Chicago: Ajay Gupta 312-915-3112.

Founded in 1983, Pircher, Nichols & Meeks is a national real estate law firm with a diversified real estate practice that includes litigation, bankruptcy, corporate, tax and public finance matters. Based in Los Angeles, the 45-attorney firm also maintains a full-service office in Chicago. The Los Angeles office is located at 1925 Century Park East, Suite 1700, Los Angeles, CA 90067; phone: (310) 201-8900.