Hello everybody. This month, let’s discuss “back-up” offers as they frequently occur in connection with the sale of apartment buildings.
Real estate purchase contracts often contain a provision that the seller may receive back-up offers even though the seller has an accepted offer with the buyer and may even be in escrow. Under real estate law, it is perfectly legal for the seller to include such a provision in the agreement, and entirely proper for the seller to thereafter receive back-up offers from prospective purchasers.
What is not lawful, however, is for the seller to cancel his existing contract in order to accept a better offer from a new prospective purchaser, even if the offer is substantially higher. Not only would that constitute a breach by the seller of express covenants (i.e., obligations) under the contract, it would also constitute a breach of the seller’s “implied covenant of good faith and fair dealing.”
The Implied Covenant of Good Faith and Fair Dealing
The law implies in every contract a covenant of good faith and fair dealing. Broadly stated, that covenant provides that neither party is allowed to do anything which would deprive the other of the benefit of the agreement.
Here is an example of a seller’s breach of the implied covenant of good faith and fair dealing:
Suppose that a seller who has signed a $2,000,000 contract with an existing buyer wants to cancel the transaction so that he may accept a new buyer’s back-up offer of $3,000,000. Also suppose that the buyer’s lender requires, as most lenders do, that its appraiser conduct a physical inspection of the interior of the building structure as a condition to loan approval.
Further, assume that without that interior inspection, the lender would not make the loan. Finally, suppose that the seller refuses to allow the appraiser access to the building structure because the seller anticipates that the lender would not then make the loan and, therefore, the buyer would not be able to consummate the transaction.
Under that scenario, the seller would be in breach of the implied covenant of good faith and fair dealing.
Since the motive behind the seller’s lack of cooperation was to re-sell the property to the prospective purchaser making the back-up offer, the seller, when refusing access to the appraiser (and therefore expecting that the buyer’s loan application would be declined), would be liable to the buyer for damages for breach of the implied covenant.
Similar laws apply to prospective purchasers who submit back-up offers. It is perfectly proper for a prospective purchaser to make a back-up offer to the seller even though the prospective purchaser may know of the existence of the seller’s contract with the buyer. However, in submitting such an offer, the prospective purchaser needs to exercise caution, lest he be liable to the initial buyer for inducing the seller to breach the contract.
That would be particularly true if the prospective purchaser submitted the back-up offer with the intent to induce the seller not to sell the property to the buyer, but to instead sell it to the prospective purchaser.
There are three types of legal theories under which the prospective purchaser may be liable to the buyer. They are:
- Inducing a Breach of Contract: If the prospective purchaser has knowledge of the buyer’s contract and intends to induce its breach by submitting the back-up offer, the prospective purchaser may be liable to the buyer for any damages that the buyer suffers because of the seller’s breach.
Of course, the court would require proof that the prospective purchaser had an expectation that his submission of the back-up offer would in fact induce the seller to breach the contract.
While direct proof of a party’s state of mind may be difficult to show, our courts have endorsed a maxim of jurisprudence which assists in proving a person’s intent: “A person is presumed to intend the natural and probable consequences of his acts.” Pierce v. Nash, (126 C.A.2d 606, 613).
- Interference with the Contractual Relationship: This second theory is slightly broader in that it protects against intentional acts not necessarily resulting in a breach of the contract. If the prospective purchaser commits intentional and unjustified acts designed to interfere with or disrupt the buyer’s contract with the seller, the prospective purchaser may be liable to the buyer for damages which the buyer suffers as a result of actual interference with or disruption of the relationship.
- Interference with Prospective Economic Advantage: This third theory is still broader in that it protects against intentional acts designed to harm an economic relationship which is likely to produce an economic benefit to the buyer even though no contract had yet been formed.
It requires that (1) the buyer have an economic relationship with the seller concerning the probability of a future economic benefit, (2) the prospective purchaser had knowledge of that relationship, (3) the prospective purchaser committed an intentional and unjustified act designed to disrupt the relationship and (4) the relationship was actually disrupted, causing the buyer damages.
This type of liability arises where the buyer does not yet have a contract but instead has an economic relationship with the seller which would give rise to the probability of a future economic advantage.
While the first two theories of liability are fairly straightforward, the third is rather nebulous. Generally, it applies to parties who have an on-going business relationship with one another. It would not apply to a seller who is negotiating with a buyer with whom he has never before been involved.
For example, it is lawful for a prospective purchaser to submit his own higher offer to a seller even though he knows that the first proposed buyer has submitted an offer which the seller is about ready to accept. (In that circumstance, of course, the prospective purchaser’s offer would not be a “back-up” offer because there was no already existing contract—the first buyer had merely submitted an offer.)
Real Estate Agents
A real estate licensee who receives a back-up offer on behalf of a prospective buyer or presents a back-up offer to the seller also should be careful that he/she does not receive or submit the offer with the intent to cause the seller to breach the contract or with the intent to disrupt the contractual relationship between the seller and buyer. The broker may have similar exposure for damages to the buyer under the theories discussed above.
Indeed, real estate agents are well aware that they cannot interfere with existing contracts, particularly with respect to listing agreements. A common practice of licenses to avoid exposure for contractual interference is seen in their “direct mail” solicitations. Often, the fine print will say, “If your property is presently listed with another broker, please disregard this mailing.”
Back-up offers are generally lawful and play a significant role in the sale of real estate. But prospective purchasers, sellers and real estate agents need to be particularly circumspect about presenting or receiving back-up proposals once a contract has been entered into between the buyer and the seller.
If the back-up offer interferes with the sale of the property to the buyer, the buyer may pursue causes of action (e.g., by litigation) against the prospective purchaser or broker for inducing breach of contract or interference with contractual relations.
The buyer may also have causes of action against the seller for breach of the implied covenant of good faith and fair dealing as well as ordinary breach of contract.
Attorneys wishing to further brief themselves on the different theories of liability should review Shamblin vs. Berge, 166 C.A.3d 118. That case presents an excellent discussion of the differing elements and nuances among the theories in a real estate context.
Dale Alberstone is a prominent real estate attorney who has specialized in real property and resident manager law for 40+ years. He has been appointed to periodically serve as a judge pro tem of the Los Angeles Superior Court and is a former arbitrator for the American Arbitration Association. He also testifies as an expert witness for and against other attorneys who have been accused of legal malpractice.
Mr. Alberstone has been awarded an AV rating from Martindale-Hubbell. An AV rating reflects an attorney who has reached the heights of professional excellence and is recognized for the highest levels of skill and integrity.
The foregoing article was authored in July 2019. It is intended as a general overview of California law only and may not apply to the reader’s particular case. Readers are cautioned to consult an advisor of their own selection with respect to any particular situation.
Questions of a general nature are warmly invited. Address correspondence to Dale S. Alberstone, Esq., ALBERSTONE & ALBERSTONE, 269 S. Beverly Drive, Suite 1670, Beverly Hills, California 90212. Phone: (310) 277-7300.