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Free Look Can Prove Costly to California Buyers

Prepared by John H. Irons, Esq.
March 25, 2010

On March 18, 2010, the California Supreme Court held that a real estate purchase agreement that gave the buyer a right to terminate in its “absolute and sole discretion” was an option in favor of the buyer, which became irrevocable once the buyer gave bargained-for consideration for the option. Steiner v. Thexton. In Steiner, such consideration consisted of the buyer’s partial performance of its obligations under the purchase agreement.

Background of Steiner

In September 2003, Steiner, a developer, entered into a contract to purchase 10 acres of land from Thexton for $500,000 if Steiner decided to purchase the property after pursuing certain county approvals for a parcel split. The contract provided for a three-year escrow period during which the buyer was to perform its due diligence and pay for the parcel split. The contract further provided that the buyer had the right to cancel the transaction at his “absolute and sole discretion.” The buyer then allegedly spent approximately $60,000 in an effort to obtain the parcel split approvals. After about a year, the seller decided he no longer wanted to sell, and sought to terminate the contract. The seller argued that (a) the contract was a mere option because of the buyer's “free look” right, and (b) the seller could revoke the option because the buyer provided no consideration -- the buyer’s agreement to pay for the parcel split was illusory because the buyer could freely terminate at any time. The trial court and appellate court agreed with the seller that the contract was an option not supported by consideration because of the “free look”. Consequently, the seller was permitted to terminate. Steiner appealed to the California Supreme Court.

California Supreme Court Holding

The California Supreme Court agreed that the contract was an option, and that there was initially no consideration for the option. The bargained-for promise to pay for the parcel split may have been illusory in light of the buyer’s unfettered right to terminate However, because the buyer actually completed some work in connection with the parcel split, the Court found that the option became irrevocable. The Court also noted that the exercise of a “free look” termination right was not restricted by the implied covenant of good faith and fair dealing.

Significance

“Free looks” in purchase contracts remain risky for buyers in California. A contract with a “free look” may be a revocable option. Therefore, buyers should insist that a modest portion of the deposit be nonrefundable so as to provide consideration for the option and thereby render it irrevocable. It may also be advisable to contractually obligate the buyer to perform certain diligence (i.e., suffer a prejudice) or to deliver the buyer’s third party reports to the seller (i.e., confer a benefit on seller). Lastly, in drafting “free look” provisions, buyers should ensure that the termination right may be exercised in the buyer’s “sole and absolute discretion” (or using similar language) so that the express termination right is not limited by the implied covenant of good faith and fair dealing.

If you have any questions concerning this Legal Update, please feel free to contact any member of our Real Estate Group in Los Angeles at:

Pircher, Nichols & Meeks
1925 Century Park East
Suite 1700
Los Angeles, California 90067
(Tel.) 310-201-8900
www.pircher.com

The PN&M Legal Update is published as a service to our clients and friends. It is intended to provide general information and should not be acted upon without first obtaining professional advice appropriately tailored to your individual needs.