If a recorded document gives notice of an option to purchase, the option will expire of record six months after the expiration date shown in the document. If no expiration date is shown, then the option will expire of record six months after the recording date. This amendment to the California Marketable Record Title statute, effective January 1, 2013, was enacted to allow third parties to rely on the public record to determine the effect of an outstanding option.
The amendment creates a trap for the unwary option holder who records a notice of an option to preserve its priority. The priority may be lost before the option exercise date if the date is extended and the parties don't record a document giving notice of the extension. This could result in a very unwelcome surprise for the option holder (the "Buyer") if the Seller further encumbers or conveys the property while the Buyer is spending time and money determining development feasibility or pursuing entitlements.
Recording notice of an option gives constructive notice of the option to lenders and potential Buyers, but will not make an otherwise defective option enforceable. The Buyer also needs to be sure to satisfy the requirements of an enforceable option.
An option to purchase is a contract. It must identify the parties, clearly describe the property, set forth the purchase price and provide consideration to each party in order to satisfy the most basic requirements of a binding contract.
Satisfaction of these elements is occasionally disputed by the parties, but far more frequently disputed are the period during which the option may be exercised and whether the Seller received adequate consideration for granting the option. The consideration issue was a subject of great uncertainty in California for nearly 2 years when the Martin A. Steiner v. Paul Thexton case ("Steiner") was working its way to the California Supreme Court.
The purchase agreement in Steiner provided that the Buyer would pay for the required civil engineering and surveying for a new parcel map. Performance of these obligations by the Buyer would usually be found to provide the consideration necessary for a binding contract. But the trial Court in Steiner (affirmed in the Third Appellate District) found that these actions by the Buyer would not serve as consideration supporting the purchase option. The Court's decision turned on the rule that consideration for any agreement must be measured at the time the agreement is entered into, so the Court did not allow part performance by the Buyer to serve as consideration. The Court reasoned that at the time the purchase agreement was entered into, the Buyer was not obligated to perform the civil engineering and surveying, so the Buyer had not bound himself to do anything that would potentially benefit the Seller. The Court also concluded that the Buyer's deposit to escrow was not consideration to the Seller because the deposit was to be applied to the purchase price upon closing.
In a real estate purchase contract, the consideration to the Buyer is the Seller's promise to convey the property to the Buyer. The consideration to the Seller is the Buyer's promise to pay the purchase price to the Seller. These promises create mutual obligations that bind both parties to the agreement. At the time a typical purchase agreement is signed, the Seller becomes bound to convey the property to the Buyer but in most real estate purchase contracts the Buyer's promise to pay the purchase price to the Seller is contingent upon the Buyer's approval of the condition, title and other aspects of the property. So when a typical real estate purchase agreement is signed, the Seller is bound but the Buyer is not.
This issue has been discussed in legal journals for many years. California Courts normally find consideration during the Buyer's contingency period from the Buyer's due diligence investigation. After the contingency period there is a mutuality of obligation (a promise by the Buyer to buy and by the Seller to sell) so no further consideration is necessary. An obligation by the Buyer to assign to the Seller rights to entitlements (if the Buyer elects not to proceed with the purchase) can also be consideration to the Seller.
California courts have historically treated purchase agreements differently from options, but in the Steiner purchase agreement only the Seller was bound to perform during the entire 3 year escrow period - the Buyer could, in his "absolute and sole discretion" cancel the purchase at any time. So, the agreement just looked like an extended offer by the Seller to sell - which is actually an option. Options that are not supported by adequate consideration are revocable by the Seller at any time. The Buyer could have avoided this revocability by drafting the agreement as an option and providing for consideration at the outset.
The California Supreme Court ultimately overturned the trial Court and Third Appellate District decisions in Steiner, based on part performance by the Buyer, so real estate investors can breathe a sigh of relief that the enforceability of real estate purchase agreements and agreements such as leases and financing commitments have not been thrown into the uncertainty that could have resulted from a different holding by the California Supreme Court.
For any purchase in which the Buyer needs a long period of time to satisfy purchase conditions, it is generally best to use an option to purchase supported by a payment to the Seller for the option right. If notice of an option lasting more than 6 months is recorded in the public record, the Buyer also needs to assure that the recorded notice includes the expiration date of the option.
The Steiner decisions remind us that a purchase agreement may be found to be merely a revocable offer to sell. So it is advisable to include in any real estate purchase agreement that includes a Buyer's contingency period a payment of cash to the Seller as consideration for the Seller entering into the agreement, in order to avoid a finding that the agreement is actually just an open offer by the Seller that can be revoked at any time.
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This article is merely a brief comment regarding its subject matter, for informational purposes only. It is not intended to be comprehensive, create an attorney-client relationship with the reader, or serve as a substitute for legal advice.