Michael J. Rooney | 312-401-3454 | E-mail Michael J. Rooney
Seventh Circuit and Illinois Commercial Real Estate Sales Contracts: Great Reading
As an old-fashioned (and, in fact, old) dirt lawyer, it does my heart good when a lawsuit is decided based on the substantive law and not some procedural quirk or mistake. Litigators, I’m sure, are just as interested in cases decided on procedural motions, defective service of summons, statutes of limitation or repose, and the like. If I were a litigator, I would find those matters of interest, too. But none of those issues affect negotiating transactions or drafting contracts like the substantive law of real property. It’s a plus when a federal court correctly applies Illinois law and at the same time does an outstanding job of explaining why the state law of real property leads the court to conclude which side is victorious. So it is with Smart Oil, LLC v. DW Mazel, LLC, No. 19-2542, 2020 WL 4745068 (7th Cir. Aug. 17, 2020).
Smart Oil was the seller of 30 parcels of land improved by gas stations and convenience stores in a “flip” transaction to DW Mazel. That Smart Oil did not currently own the parcels was disclosed in the contract, and Smart Oil obligated itself to negotiate with the owners to purchase those properties so it could, in turn, “flip” them to DW Mazel. The purchase price was $67 million. DW Mazel was to pay total earnest money of $750,000 in two payments. The contract provided Smart Oil was to receive the earnest money as liquidated damages in the event of default in the performance of its obligations by DW Mazel.
The first installment of $300,000 in earnest money was to be made during a due diligence period. At the close of the due diligence period DW Mazel was to pay the second installment of $450,000. The buyer, however, paid no earnest money whatsoever. Although the first deposit was not made, the parties continued to negotiate concerning due diligence matters and the buyer argued it was also negotiating to extend the due diligence period. In fact, the contract required the buyer to provide Smart Oil with written notice after its investigations if the buyer disapproved the purchase after the due diligence period, and, if such notice had been given, the contract would have been terminated and the buyer would have been entitled to the return of its earnest money.
However, the contract also provided that the buyer’s failure to timely deliver written notice of its disapproval “shall be deemed Buyer’s approval of such investigations” and would entitle the seller, Smart Oil, to keep the earnest money as liquidated damages. 2020 WL 4745068 at *1. The buyer did not dispute that it had not given written notice of its disapproval of the deal at all, much less done so in a timely manner. Nonetheless, the buyer argued several excuses or theories on which it relied to justify the failure of written notice. The federal district court rejected them all, as did the Seventh Circuit, which affirmed summary judgment in favor of the seller.
The buyer contended that Smart Oil did not satisfy all its obligations under the contract as it did not have all the properties under contract in order to be able to flip them to the buyer. Also, the buyer contended that the seller’s list of properties, provided during due diligence, was 9 properties short of the 30 that the buyer agreed to purchase. In addition, the buyer argued that the liquidated damages portion of the contract was unenforceable under Illinois law. The buyer also argued that the seller was not entitled to the entire amount of proposed earnest money but was entitled only to that portion that had been actually deposited: none. Finally, the buyer argued that the seller had fraudulently induced the buyer to enter into the agreement.
Both the trial and appellate courts rejected all the buyer’s arguments. First, the courts upheld the parties’ choice-of-law provision specifying that Illinois law applied. Both courts, sitting in diversity jurisdiction, applied Illinois substantive law. Second, both courts rejected the buyer’s contention that the seller had breached the contract because the seller did not have all 30 properties under contract in order to flip them to the buyer. Both courts found that such a requirement was not a condition precedent to the buyer’s obligation to deposit earnest money. The seller did have sworn statements from 21 of the 30 property owners that they were ready and willing to sell their properties to the seller so the seller could flip those properties to the buyer. 2020 WL 4745068 at *3. But the contract did not require the seller to submit the specific material requested by the buyer: statements from all 30 parcel owners.
Of course, at any closing, the seller would have been required to convey good title to all 30 parcels. However, there was no closing because of the buyer’s default of making the earnest money deposits. Further, in the absence of the availability of all 30 parcels, the buyer could have, should have, given its written notice to the seller, disapproving the terms of the contract. Had that notice been given as the contract required, the buyer would have been entitled to the return of all the earnest money and the contract would have terminated. As earlier noted, the contract specifically said that failure to give such notice was deemed to be the buyer’s approval of the terms of the sale. Regardless of negotiations, if any, about extending the due diligence period, the requirements of the contract did not change, and the buyer failed to provide written notice of disapproval.
Both courts likewise upheld the seller’s entitlement to the earnest money under the liquidated damages provision. Such a provision is valid under Illinois law, and the contract specifically mentioned the difficulty in precisely measuring the seller’s damages in the event of breach by the buyer. The courts found that the $750,000 earnest money deposit required for a $67 million sale (just over 1 percent of the purchase price) was not unreasonable. Here again, the federal courts recognized the need to apply Illinois law. The appellate court specifically said it was not the province of the court to decide if Illinois law was wise policy. The court’s role was limited to applying the law, and, citing cases approving liquidated damages in the range of 15 percent – 20 percent of the purchase price in a real estate contract, the Seventh Circuit decided that 1 percent was not clearly disproportionate.
Interestingly, the buyer also argued that although the contract provided that the seller was entitled to retain the earnest money, with interest, because there was never any deposit, there was no money on which interest could be paid! Not surprisingly, the court rejected the buyer’s argument summarily. Beyond that, the contract said the seller “shall receive” the earnest money and all accrued interest and the court interpreted the word “shall” to be mandatory. 2020 WL 4745068 at *6.
Both the trial and appellate courts also rejected the buyer’s suggestion that the seller had fraudulently induced the buyer to enter into the flip contract. Noting that both parties were sophisticated commercial enterprises that had engaged in extensive arm’s-length commercial negotiations, each aided by advice of counsel to reach an agreement, the court held the parties to their bargained-for transactional terms.
PRACTICE POINTERS: First, counsel for each side must be sure to read thoroughly, then reread, the contract terms the client is agreeing to by signing a contract. The fact is that all the buyer would had to have done to avoid the problems here was to have given written notice in a timely fashion of the buyer’s disapproval of the contract during the due diligence period. Perhaps even doing so within a reasonable time after the expiration of the due diligence period would have sufficed. Here, though, the buyer did nothing to avail itself of the simple remedy to avoid the terms of a contract that it disapproved.
Second, counsel for each side should make sure that the client understands the terms of the contract and, equally as important, understands the deadlines for actions the client is required or permitted to take. It does counsel no good to understand these matters if the client does not understand them and the importance of adhering to contractual deadlines.
Third, not all flip deals are illegal and, as we all learned in law school, the seller of real estate needs only to be able to provide good and merchantable title at the closing, not before. Of course, the buyer could have insisted on a clause requiring something more than this contract required. But then the seller would likely have required an even greater earnest money deposit in order to cover all potential damages for the buyer’s breach.
Fourth, liquidated damages are permitted in Illinois and actual damages need not be proven. Read the opinion thoroughly for a good primer on Illinois liquidated damages law in real estate transactions.
Fifth and finally, the last paragraph of the opinion is also of interest, though it raises more questions than it answers. The contract contained a provision shifting to the loser the attorneys’ fees and costs of the prevailing party. This provision, too, is enforceable, and the court gave the seller 14 days to submit its request for fees and costs and then gave the loser another 14 days to respond. I trust counsel for the seller was observant, noted the appellate court opinion, read it all the way through to the very end and submitted the fees and costs request before going out to celebrate!
Be careful out there, boys and girls!
For more information about real estate, see TITLE INSURANCE: LAW & PRACTICE (IICLE®, 2019). Online Library subscribers can view it for free by clicking here. If you don’t currently subscribe to the Online Library, visit www.iicle.com/subscriptions.