As a trial attorney specializing in real estate litigation, I have been inundated in what I refer to as my “up-market cases.” It seems that every seller that has recently contacted me has wanted to cancel its purchase contracts, and every buyer has wanted to maintain its position no matter how many times it has defaulted or missed deadlines. This is all the result of Arizona’s spectacular recent real estate boom where the price fluctuation of even a typical house may now justify litigation.

In the environment of meteoric price increases, many have understandably sought to capture as much of the market’s upside as possible. In purchase contracts with lengthy escrow periods or delayed closings, such as in the context of new home construction, many disputes over the increased value of the property have arisen.

Two basic patterns have emerged in these up-market cases. First, there are the cases where sellers want out of their sales contracts by asserting that a buyer has breached, and buyers want to close sales contracts no matter how egregious their breaches have been. Second, there is a similar, albeit more one-sided, phenomenon in the case of sellers who have contracts that on their face permit them to cancel at essentially their discretion upon merely refunding the buyer’s earnest money. I will refer to the first phenomenon as the “Up-Market Breach Cases” and the second as the “Up-Market Cancellation Cases.”

I. The Up-Market Breach Case, or When is a Breach Really a Breach?

At their core, most of the Up-Market Breach cases turn on one issue: Was the alleged breach material? Under the law, only “material” breaches justify the cancellation of a contract. Alleged breaches on the part of buyers have included claims such as a failure to provide qualified loan commitments, failure to lock in interest rates, modification of the house prior to closing, and a myriad of other claims. In each instance, the sellers claim that the buyer’s failure to do something, or the buyer’s affirmative action constitutes a breach of the contract, which gives the seller the right to cancel. The question for the lawyers is whether these alleged breaches were material.

The law has given a legal definition of what constitute a “material” breach. The basic rule announced by the courts is that a material breach occurs when a party fails to do something required by the contract which is so important to the contract that the breach defeats the very purpose of the contract. Obviously, there can be and often are disputes on (1) whether a contract requires some act, (2) whether that act is so important to the contract that its failure defeats the purpose of the contract, and (3) whether there actually was a breach.

Because the number and kind of alleged breaches are so varied and numerous, in most cases there are few hard-and-fast rules for courts, juries, or arbitrators on these issues. This means that the application of the rules can be can be unpredictable, and juries and arbitrators, for example, may rely on their “gut” to determine whether a breach is material.

Arizona courts have attempted to set forth a series of factors that juries should consider in determining if there has been a material breach of the contract. In legal terms, these factors are stated as: (1) the extent to which the injured party will be deprived of the benefit which he reasonably expected; (2) the extent to which the injured party can be adequately compensated for the part of that benefit of which he will be deprived; (3) the extent to which the party failing to perform or to offer to perform will suffer forfeiture; (4) the likelihood that the party failing to perform or to offer to perform will cure his failure, taking account of all the circumstances including any reasonable assurances; and (5) the extent to which the behavior of the party failing to perform or to offer to perform comports with standards of good faith and fair dealing.

These factors all constitute legalese for asking the question of just how bad was seller hurt by the buyer’s failure to do something, and how bad will the buyer be hurt if the sale does not go through. More practical questions are such things as: (1) has the Seller always enforced this condition; (2) has the seller closed other sales with the same issues (3) will the buyer be losing a home to live in, or is it just an investment where money from the opportunity will be lost; or (4) what are other sellers requiring or expecting. Answers to these questions go a long way to persuading a jury or arbitrator that a breach was or was not material.

It is generally not possible to predict how a court or jury will decide the materiality issue. Conventional wisdom is that a monetary default, meaning the buyer was required to pay some money and did not, is material. Timing, on the other hand, is usually only material if the contract contains a clearly worded time-is-of-the-essence clause. Non-monetary defaults, especially in the context of lease/purchase agreements, often end up with courts, juries and arbitrators all over the map. Whether a non-monetary default is found to be material can be and often is simply a crap shoot.

A purchase contract that identifies certain types of breaches as “material” breaches may give a seller more ammunition. On the other hand, if such a list of “material defaults” exists, anything not on the list will likely be argued as non-material, and a clause that says that everything is material loses its effectiveness. In the end, it still comes back to a judge, jury, or arbitrator deciding whether or not a breach was material.

When contemplating a lawsuit, either as a buyer or seller, in addition to contacting a lawyer, it can sometimes be of use to get some perspective on the breach by simply asking your friends or family how significant they think the breach is – they are not necessarily different than the jury who may ultimately decide that very same question.

Another question is one of leverage. When a lawsuit over a purchase contract is filed, a lis pendens is also typically filed. As a practical matter, this means that the seller can no longer sell the property because the new buyer will not be able to get title insurance. If there is interest and carrying costs running on the property during the pendency of a lawsuit, which if fully litigated will likely last 1-3 years (depending on appeals), this can create significant pressure on the seller to settle. On the other hand, a buyer may not have the resources to fight a litigation battle for that length of time. As such, the length of time can cut both ways.

Also, mandatory arbitration clauses in contracts may affect the parties’ leverage during the litigation. If the seller can quickly resolve the matter and keep the property out of court, it may reduce the buyer’s leverage. On the other hand, arbitrators are also known to “split-the-baby.” In recent up-market cases, experience has shown that arbitrators often find creative ways to give some of the increased equity to both parties. Accordingly, if either party is seeking an all or nothing proposition, arbitration is less appealing.

II. The Up-Market Cancellation and The Duty Of Good Faith And Fair Dealing

It is not uncommon for builder/sellers to include in their sales contract the discretion to cancel the contract, with the buyer’s remedy limited to a refund of the earnest money payment. In a hot market, the builder/sellers’ incentives are clear: (i) cancel the contract; (ii) return the buyer’s nominal earnest money; and (iii) sell the newly constructed home to a new buyer at the current, much higher, market rate. The potential of a low-cost upside makes this an attractive option, but it is not without its risks, and it should not be pursued without first consulting a lawyer. The crux of the risk may be a doctrine called “the duty of good faith and fair dealing” which is implied into every contract, and cannot be excluded. The duty of good faith requires that neither party do anything that prevents the other party from receiving the benefits of their agreement and their reasonable expectations.

This duty should be kept firmly in mind when canceling a contract for the sole purpose of capturing equity in a home. Courts and arbitrators have proven sensitive to the difference in bargaining power between residential home buyers and builder/sellers, and have concluded in some cases that exercising the clear contract right of cancellation violates the duty of good faith. In addition to being liable for attorneys’ fees, a party that breaches the duty of good faith and fair dealing may also be liable for consequential damages (such as the cost of the buyer’s temporary lodgings). By taking these steps on a systematic basis, a builder may even open itself up to class-action liability. Ultimately, where the seller can point to no breaches by the buyer as the basis for canceling the sales contract, the builder/seller is taking a calculated risk when it relies upon its discretionary cancellation clause.

Dovetailing with the duty of good faith and fair dealing is the courts’ general skepticism of form contracts that contain limitations of damages. It is entirely possible that the imbalance of power between the two parties could lead a court to allow the buyer its common law remedies, including specific performance, which would allow the buyer to force the seller to convey the property. Alternately, a court may not allow the buyer to force the sale, but may permit the buyer to recover damages in the amount of the lost equity, thereby erasing the entire upside for the canceling seller.

III. Conclusion: Canceling Contracts Depends On Materiality and Good Faith.

The recent up-market has created some fantastic opportunities. What I have seen is that litigation often follows when fluctuations become so dramatic. Sellers who rely solely on technical provisions to cancel purchase contract do so at the risk of litigation. The amount of equity at issue in such a cancellation for even a modest home may now all of a sudden be worth pursuing in litigation or arbitration. Sellers who can show a consistent treatment of all buyers and the importance of the provisions that they claim to have been breached fair much better than sellers who cancel contracts solely to capture the increased equity. In all markets, parties to a contract are under a duty to act in good faith with each other, however, in an up-market, there may be enough at issue so that parties actually litigate that obligation.