When faced with litigation stemming from real estate deals gone wrong, oftentimes disputes focus on three key issues: enforceability of liquidated damage provisions, letters of intent and whether representations and warranties survive the close of escrow and can be used to limit the time within which claims may be made. This article briefly discusses each.

Liquidated Damages

Liquidated damages can provide parties added incentive to perform all types of contracts, including commercial real estate contracts. But are they enforceable in California? The short answer is that they’re presumed to be enforceable as long as they’re not a penalty.

A liquidated damages provision is not invalid merely because it’s intended to encourage a party to perform so long as it represents a reasonable attempt to anticipate the losses to be suffered. If, however, the sole purpose of a liquidated damages provision is to coerce compliance with the contract and not to compensate the innocent party for damages resulting from the breach, the provision is a penalty and not enforceable. No matter what you call it, the court will analyze such provisions based upon their impact on the parties, and not necessarily on their headings.

A liquidated damages clause will generally be considered “unreasonable,” and, therefore, unenforceable, if it bears no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach. The amount set as liquidated damages must represent the result of a reasonable endeavor by the parties to estimate a fair average compensation for any loss that may be sustained. When reviewing liquidated damages provisions, courts generally examine all the circumstances existing at the time of the making of the contract.

What about specific performance? A liquidated damages provision does not necessarily preclude the remedy of specific performance. Parties should be careful as to whether they wish to have the liquidated damages be the “sole remedy” or just the substitute for damages.

Letters of Intent

Business people like to use LOIs to tie up a deal. On the other hand, they don’t want to be bound by them if they want to walk away. As one court explained, “Not infrequently, the negotiations that follow the execution of [a letter of intent] break down, prompting the disappointed party to sue on the theory that the preliminary document is binding.”

How do the courts decide whether LOIs are enforceable? First, subjective belief doesn’t mean anything. Instead, look at the language of the LOI. Does the LOI state that there will be no binding contract unless and until the parties sign a formal written contract? That type of provision has a better chance of allowing the parties to walk away than an LOI that says the parties intend to “reduce the informal writing to a more formal one.” In the latter case, the court may find that there was still an enforceable agreement, even though the parties wanted to make it prettier and longer later on. If you want to avoid enforcement, use protection, like a disclaimer.

What if the parties want some of the LOI to be enforceable, even if there is no final overall agreement? That is generally allowable; the parties may agree that there is no enforceable purchase and sale agreement or lease agreement until they have executed a formal, written agreement, but still use the LOI to enforce certain rights and duties that flow from their negotiation process, such as: confidentiality/non-disclosure; non-circumvention; and exclusive negotiation.

Real estate parties must be careful in drafting LOIs if they want to avoid having a judge later hold that instead of a precursor to an agreement, the LOI became an enforceable agreement.

Representations and Warranties

Representations and warranties serve as a safety net for the seller and buyer. If, prior to closing, either the seller or buyer discovers that a representation or warranty made by the other party is not true, they can back out of the deal.

In real estate transactions, the usual approach is for the seller to agree to no representations and warranties, and sell the Property “as is.” However, as one court held, “[i]t is well settled that where a principal is under a positive duty to make a disclosure, he cannot escape liability for his failure to do so by relying on a provision in the agreement of sale that there are no other representations except those therein expressed.”

How long do the reps and warranties live? Absent a “survival clause,” they have no independent existence. Unless the parties agree to a survival clause — extending the representations and warranties past the closing date — the breaching party cannot be sued for damages post-closing for their later discovered breaches.

Language stating only that the representations and warranties “shall survive” for a specified duration operates solely to extend their life past the closing date. Here, again, drafters must be careful to add language if they wish to shorten or lengthen the time within which a claim can be made based upon breaches of the representations and warranties.

Jeff Brown is a Partner with Thompson Coburn LLP.

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