Traps for the Unwary under California Law: How Good Deals Can Go Bad

California law has the potential to produce unintended consequences in real estate transactions. Below are a few of the legal “gotchas” that deal makers should keep in mind in transactions where California law governs.

Letters of Intent

Real estate transactions often start with letters of intent, which outline material terms and establish negotiation parameters. Under California law, such letters imply a duty to negotiate in good faith.

For example, in Copeland v. Baskin Robbins, 96 Cal. App. 4th 1251, 1255 (2002), Kevin Copeland entered into a letter of intent to purchase a Baskin Robbins ice cream manufacturing plant in the City of Vernon. Copeland made clear from the outset that his agreement to purchase the plant was contingent on Baskin Robbins agreeing to purchase the ice cream that he manufactured there under a co-packaging arrangement. The parties then agreed to the price of the plant, but not the terms of the co-packaging arrangement. Terms that could not be resolved included the price of the ice cream, the flavors that would be produced, quality standards, and trademark protection. Eventually, Baskin Robbins broke off negotiations, saying that because its parent company recently made new strategic decisions, the co-packaging arrangement was not aligned with its strategy, and therefore ended negotiations. Baskin Robbins still offered to sell the plant, but not enter into the co-packaging agreement.

Copeland sued, alleging that Baskin Robbins had breached its contract by unreasonably and wrongfully refusing to enter into the co-packaging agreement. He alleged his damages were the lost profits from the sales he could have made at the plant. The trial court granted summary judgment in favor of Baskin Robbins, holding that the letter of intent was susceptible to several interpretations, but no matter how it was interpreted, it failed as a contract because the essential terms of the co-packaging deal were never agreed to and there was no reasonable basis upon which to determine them.

The Court of Appeal affirmed summary judgment, but for a different reason. It held that the letter agreement was not an unenforceable “agreement to agree” in the future, but that it was an agreement to negotiate in good faith. The court explained that failure to agree on terms would not constitute a breach, but failure to negotiate in good faith would. The court held that “Deals are rarely made in a single negotiating session. Rather, they are the product of a gradual process in which agreements are reached piecemeal on a variety of issues in a series of face-to-face meetings, telephone calls, e-mails, and letters involving corporate officers, lawyers, bankers, accountants, architects, engineers, and others. . . . These slow contracts are not only time-consuming, but costly. For these reasons, the parties should have some assurance their investments in time and money and effort will not be wiped out by the other party’s foot dragging or change of heart or taking advantage of a vulnerable position created by the negotiation.” Id. at 1262. Summary judgment was nonetheless affirmed, based on the plaintiff’s failure to plead and prove damages. Damages in such a case can include the plaintiff’s out-of-pocket costs in conducting the negotiations, but not the lost opportunity costs that were being sought without evidence.

The law in New York and other states also address the distinction between agreements to agree, and agreements to negotiate in good faith. “[I]t is rightfully well settled in the common law of contracts in [New York] that a mere agreement to agree, in which a material term is left for future negotiations, is unenforceable. This is especially true of the amount to be paid for the sale or lease of real property.”Joseph Martin, Jr., Delicatessen, Inc. v. Schumacher, 52 N.Y.2d 105, 109-110 (N.Y. 1981) (noting that Arkansas, Maine, Missouri, North Carolina, Oregon, and Rhode Island are in accord with New York on this issue, but not Arizona, California, Ohio, or Tennessee). Even New York courts, however, do not apply the doctrine of definiteness rigidly, and parties may agree to have material terms, including price, determined by later events, including by a third-party arbitrator, if the parties agree to be bound by such determinations. 166 Mamaroneck Ave. Corp. v. 151 East Post Rd. Corp., 78 N.Y.2d 88, 93 (N.Y. 1991) (upholding a contract that provided a third-party arbitrator would decide the rent if the parties could not agree). New York courts also have contemplated damages for breaches of contract provisions requiring parties to negotiate in good faith. Am. Broadcasting Cos. v. Wolf, 438 N.Y.S.2d 482 (1981) (indicating, in dicta, that damages may be available for breach of a provision in an agreement to negotiate in good faith, even though injunctive relief was not).

Damages in letter-of-intent cases can include the plaintiff’s out-of-pocket costs in conducting the negotiations. While some jurisdictions have indicated that lost opportunity costs should not be part of those damages, others have hinted that they might be included with proper evidence. See Columbia Park Gold Course v. City of Kennewick, 160 Wn. App. 66 (“It has been argued that if a party wants to avoid paying expectation damages on the basis that the final agreement was unlikely, it should offer evidence of that unlikelihood.”). While clients do not always want to start incurring legal costs at the earliest stages of a deal, it will save them in the long run to have experienced counsel with an understanding of the risks and benefits of letters of intent.

Consent Withheld / Assignability

California law espouses a very strong public policy favoring the free assignability of contracts. Thus, a covenant not to unreasonably withhold consent to an assignment generally means that there must be a very solid reason for withholding consent, such as the assignee’s financial inability to perform the assignor’s obligations under the contract. SeeFarmland Irrigation Co., Inc. v Dopplmaier, 113 USPQ 88 (Cal. Sup. Ct 1957) and Jack Kendall v. Ernest Pastana, 40 Cal. 3rd 488 (Cal. Sup. Ct 1985).

In real estate law, this issue arises most frequently with respect to lease provisions prohibiting a lessee from subletting without the lessor’s consent. If consent is unreasonably withheld—even where the lease does not expressly require the lessor to be reasonable—the lessor can be liable for consequential damages suffered by the lessee resulting from such withheld consent. See Jack Kendall v. Ernest Pastana, supra. This includes withholding consent based on the idea that the lessor could collect higher rents from someone else.

As a result, these types of lease provisions can be very dangerous for lessors. The solution is to spell out the lessor’s foreseeable reasons for withholding consent and identify those that would qualify as reasonable and those that would qualify as unreasonable. For example, a lessor can insist on expressly providing that withheld consent on the basis that the lessor could, as an alternative to granting consent, sublease to a third party for more money, be conclusively deemed to be a reasonable withholding of consent.

Sandbagging

“Sandbagging” occurs when a buyer closes a deal despite pre-closing knowledge that one or more seller representations or warranties are untrue, and subsequently makes claims for breach of warranty or representation. The term is used in golf to refer to a player who pretends to be less skilled in order to gain an advantage in the game; it is also used in connection with 19th century gangs that used sand-filled socks as a weapon that may have appeared innocuous, but which in fact was very effective.

Under California law, a buyer cannot sue for a seller’s breach of an express warranty—except in connection with a sale under the Uniform Commercial Code—unless the buyer proves that they relied on the specific information conveyed in the warranties and representations to their detriment. Absent a “pro-sandbagging” or “knowledge savings” clause in the agreement, if a buyer knew that the warranty was false when made, they will not be able to satisfy the “reliance” standard. So, buyers will seek the incorporation of such clauses in the agreement. Sellers will want to add an “anti-sandbagging” clause that reinforces the “reliance” requirement under California law. Below are examples of both clauses:

• Pro-sandbagging clause:

“No investigation made by or on behalf of the buyer with respect to the seller shall be deemed to affect the buyer’s reliance on the representations, warranties, covenants, or agreements made by the seller in this agreement.”

• Anti-sandbagging clause:

“The buyer hereby represents that it has no knowledge that any of the seller’s representations contained in this agreement are false, but if the buyer has such knowledge, the seller shall not be liable for the breach of such representation.”

Choice of Law / Forum

What if you do not like California law on a given issue? Can you provide that another state’s law will apply? We see this often in contracts that say they are governed by the laws of a certain state. In the absence of such a “choice of law” provision, the California Civil Code provides that “[a] contract is to be interpreted according to the law and usage of the place where it is to be performed; or, if it does not indicate a place of performance, according to the law and usage of the place where it is made.” Cal. Civil Code § 1646.

If the parties identify the applicable law in the contract, then “California courts ordinarily will enforce the parties’ stated intention unless 1) the chosen state has no substantial relationship to the parties or their transaction, and there is no other reasonable basis for the parties’ choice, or 2) the chosen state’s law is contrary to a fundamental policy of the state whose law otherwise would apply, and the latter state has a materially greater interest in the matter than does the chosen state.” Nedlloyd Lines B.V. v. Superior Court, 3 Cal. 4th 459 (1992).

The exceptions, though, can swallow the rule, if, as is alluded to by the Nedlloyd Lines court, “fundamental policies” are involved. For example, non-compete clauses, non-solicitation clauses, class action arbitration waivers, and even jury waivers may violate California policy. In some cases, merely including such clauses in the contract may be a violation of California’s unfair competition law.

Jury Waivers

The California Supreme Court has decided that pre-dispute jury trial waivers are invalid. Grafton Partners L.P. v. Superior Court, 36 Cal. 4th 944, 958-61 (2005).

A possible solution—one that may provide some additional protection from a “runaway jury”—is to include a clause in the contract at hand that requires the appointment of a referee in the event a lawsuit is filed by one of the parties, who will try the issues and make a decision that will be entered as a binding judgment. Under Section 638 of the Code of Civil Procedure, the parties can agree to appoint a retired judge to try an entire lawsuit and render a judgment, which is subject to California appellate practice and required to be in conformity with California law. See Woodside Homes of California, Inc. v. Superior Court, 142 Cal. App. 4th 99, 103-104 (2006) (pre-dispute referee agreement unambiguously results in a jury trial waiver and is enforceable).

Conclusion

Any agreement that is governed by California law should be reviewed carefully by your attorney to avoid unintended consequences and ensure that it will withstand scrutiny.