State of Faith: Making Sense of California Real Estate Good Faith Negotiation Agreements

• Publication year: 2015
• Author: Delmar G. Williams

State of Faith: Making Sense of California Real Estate Good Faith Negotiation Agreements

Delmar G. Williams

Delmar Williams is a real estate transactional attorney in San Diego. His practice encompasses all aspects of real estate use, development, and financing. He has negotiated real estate transactions throughout California. Delmar can be reached by e-mail at delmar.williams@williamslaw.us.

I. Introduction

Real estate purchasing and leasing transactions often require the purchaser or tenant to expend significant amounts of time and money determining the feasibility of the transaction before entering into a binding contract for the purchase or lease of the subject real estate. A landowner failing to act in good faith when negotiating the prospective purchase contract or lease agreement can impose considerable costs on a prospective purchaser or tenant due to the time and financial investment made by the purchaser or tenant in due diligence activities and contract negotiation. To protect their investments, prospective purchasers or tenants often request that landowners forego other economic opportunities for the property during the due diligence and contract negotiation time periods. Alternatively, a prospective purchaser or tenant failing to act in good faith while negotiating a purchase contract or lease agreement can cost a landowner significant contract negotiation expenses and lost opportunities for the sale or lease of the property to someone else during the contract negotiation process.

In an attempt to ensure that the other party negotiates the terms of the purchase contract or lease agreement in good faith, a prospective purchaser, tenant, or landowner might request that the parties enter into a written agreement obligating the parties to negotiate in good faith. These good faith negotiation agreements have various labels, including "negotiation agreement," "exclusive negotiation agreement," "exclusive right to negotiate," "letter of intent," "term sheet," or other similar names. For the purposes of this article, these good faith negotiation agreements are referred to as "negotiation agreements."

This article addresses the use of negotiation agreements in the real property purchase and sale context, but the analysis in this article applies equally to any type of negotiation agreement subject to California law. Section II of this article discusses how the obligation to negotiate in good faith arises in California. Section III addresses how California courts and academic commentators have struggled to define the obligation to negotiate in good faith. Section IV discusses the prevailing approach to damages for breach of the obligation to negotiate in good faith. Section V addresses the key elements to consider when preparing a negotiation agreement in order to reduce or limit risks associated with negotiation agreements.

II. Establishing the Obligation to Negotiate in Good Faith

In California, all contracts have an implied covenant of good faith and fair dealing.¹ This covenant requires that

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the parties to a written contract subject to California law must not do anything that will injure the right of any other party to receive the benefits of their contract. Each party has the obligation to take every action that the contract presupposes they will take to accomplish the purpose of the contract.²

Generally, though, parties negotiating a contract for the purchase and sale of real estate do not have an existing contract into which a covenant of good faith and fair dealing can be implied.³ Entering into a negotiation agreement before entering into a final purchase and sale agreement creates a contract into which the good faith negotiation requirement can be implied, thereby establishing the obligation to negotiate in good faith regarding the terms of the ultimate purchase and sale agreement.⁴

Before 2002, California law was not settled on whether negotiation agreements were enforceable contracts or unenforceable "agreements to agree."⁵ In 2002, the court in Copeland v. Baskin Robbins⁶ determined that an agreement to negotiate the terms of a future contract is enforceable in its own right. Copeland distinguished between the enforceability of the ultimate agreement that the parties intended to negotiate in the future and the enforceability of the written agreement to negotiate that ultimate agreement.

Initially, we see no reason why in principle parties could not enter into a valid, enforceable contract to negotiate the terms of a co-packing agreement. A contract, after all is "an agreement to do or not to do a certain thing." [Citations omitted.] Persons are free to contract to do just about anything that is not illegal or immoral. [Citations omitted.] Conducting negotiations to buy and sell ice cream is neither.⁷

Copeland relied on the covenant of good faith and fair dealing implicit in every contract subject to California law⁸ to find that a written agreement to negotiate regarding a future contract created an obligation to negotiate the terms of that future contract in good faith.

When two parties, under no compulsion to do so, engage in negotiations to form or modify a contract, neither party has any obligation to continue negotiating nor to negotiate in good faith. Only when the parties are under a contractual compulsion to negotiate does the covenant of good faith and fair dealing attach, as it does in every contract.⁹

After Copeland, the parties to a written negotiation agreement in California cannot walk away from negotiation of the anticipated future contract, without good cause. Further, Copeland can also be interpreted as implying a good faith negotiation obligation into a letter of intent (a "LOI") for a real property purchase and sale, unless the good faith negotiation obligation is expressly disclaimed in the LOI.

III. Defining the Scope of Good Faith Negotiation

The obligation to negotiate in "good faith," as a practical matter, is often defined in terms of what constitutes "bad faith" in negotiation.¹⁰ The reason for this approach is that what constitutes "good faith" is only an issue when a dispute arises and one party alleges that another party acted in "bad faith." Failure to agree on the anticipated future agreement is not, in and of itself, a breach of a negotiation agreement.¹¹ Failure to perform an express, material term of a negotiation agreement, however, constitutes a breach of that agreement.¹²

Professor E. Allan Farnsworth has identified seven possible types of "bad faith" negotiation: (a) refusal to negotiate; (b) employing improper negotiation tactics; (c) making unreasonable proposals; (d) failing to disclose facts material to the negotiation; (e) negotiating with third parties about the same subject matter; (f) reneging on previous agreements or proposals during negotiation; or (g) terminating negotiations without cause.¹³

As the requisite standard of conduct under a negotiation agreement, Professor Farnsworth proposes: (a) actual negotiations with no imposition of improper conditions, such as inflexibility in negotiation designed to result in failure of the negotiations or unreasonable proposals that put the other party in a worse position than before, without any change in circumstance justifying the change in position; (b) disclosure of sufficient information about parallel negotiations (negotiations with third parties) to provide the other party with a reasonable opportunity to make competing proposals; and (c) continued negotiation until an impasse is reached, unless another justification exists for terminating the negotiations.¹⁴

Professor Farnsworth further contends that a party to a negotiation agreement does not breach its duty of good faith and fair dealing by concluding a separate deal with a third person on the subject matter covered by the negotiation agreement when the existence and material terms of the prospective separate deal are disclosed to the other party during the negotiations.¹⁵ If a party has agreed not to negotiate with others, though, that party would breach the negotiation agreement by conducting parallel negotiations. Even without a contractual obligation not to negotiate with

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others, a seller increases the probability of being sued for bad faith negotiation when the seller enters into a separate transaction with a third person for the purchase and sale of its real property, while negotiating for the purchase and sale of the same property under a negotiation agreement or immediately after terminating those negotiations. From these circumstances, it is not difficult for a finder of fact to infer that the seller breached its obligation to negotiate in good faith by terminating negotiations because a better offer came along, which makes it easy for the jilted buyer to allege seller bad faith in negotiation.

IV. Damages for Breach of a Negotiation Agreement

Damages for breach of a negotiation agreement are measured by the injury that the plaintiff suffered in relying on the defendant to negotiate in good faith. A plaintiff will have difficulty proving damages for lost expectations due to the parties' failure to complete the ultimate agreement under negotiation or lost opportunities from failed negotiations.¹⁶ As the appellate court stated in Copeland, "[t]he plaintiff cannot recover for lost expectations (profits) because there is no way of knowing what the ultimate terms of the agreement would have been or even if there would have been an ultimate agreement."¹⁷ Therefore, damages for breach of a negotiation agreement will typically not include lost profits.¹⁸

Judge Richard...