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March 24, 2020

Stroock Special Bulletin

By: Loryn D. Arkow, Brian Diamond, Jeffrey R. Keitelman, Karen Scanna, Joshua Sohn, Ira K. Teicher, Phillip M. Kim, Daniel H. Lewkowicz

As a result of COVID-19 and the necessary nationwide expansion of shelter-in-place-type ordinances, buyers and sellers of commercial real estate are facing increasing uncertainty regarding whether they can close transactions. The national response to COVID-19 is erecting significant roadblocks to closing transactions as county recorder’s offices are closing their doors alongside an increasing number of restaurants, companies, courthouses and other governmental offices, begging the question of what heightened legal and practical risks these coronavirus-related complexities impose upon the parties.

I. Closing Risks

Sales of commercial properties close in one of two ways: either a deed-recordation closing or a “gap closing.” In deed-recordation closings, the recorder’s office is required to confirm that the deed has been recorded before the buyer’s funds are released to the seller and the transaction is deemed closed. In a “gap closing,” which is the more common method of closing, the parties deposit all closing deliverables, including the buyer’s funds, in escrow with the title insurance company and the title insurance company issues title insurance in favor of the buyer. Rather than being conditioned upon the recording of the deed, as in a deed-recordation closing, the closing and release of the funds to the seller are conditioned upon the satisfaction or waiver of all conditions precedent, including the title insurance company’s irrevocable commitment to insure the buyer’s ownership. This is called a “gap closing” because the title insurance company is insuring the “gap” between the date of the closing and the date of recordation of the deed. To protect themselves, title insurance companies typically require the seller to provide a “gap indemnity” to cover the risk of liens and other title defects arising between the closing date and the date of recordation of the deed.

 In the current environment, with recorder’s offices either closed or at risk of closing, both methods of closing create concerns. If the closing is contingent on recording, a buyer may be hesitant to fund the purchase price in to escrow without any assurance of when the deed will be recorded because of the costs inherent in having funds remain in escrow for a prolonged period of time. A buyer’s hesitance may be compounded by the potential unwillingness of the buyer’s lender to provide funding or to leave funds in escrow for any extended period. This uncertainty can be paralyzing. In a gap closing, title insurance companies may be wary of accepting gap indemnities and issuing title insurance when the date of recordation is a moving target because there is a greater risk of intervening liens as the gap period lengthens. Even if the title insurance company accepts the gap indemnity and is willing to issue title insurance to the buyer, there is a question as to the buyer’s willingness to close when it may have to pursue claims against its title insurance company to clear title of liens or defects following closing. And similarly, the buyer’s lender may consider the title company’s gap coverage insufficient given the possibility of needing to pursue claims against the title company to defend the lender’s lien priority.

Regardless of which type of closing the sale contract calls for, the seller typically bears the risk that the title insurance company will fail to issue title insurance and that this condition precedent remains unsatisfied. While failure of the title insurance company to remain committed to issue the title policy is not a default by the seller, the buyer will likely have the right to terminate the contract in the event that: (i) in a deed-recordation closing, the recording cessations or uncertainties mean the title company is not timely committed to issue title insurance as of the scheduled closing date; and (ii) in a gap closing, the title company will not insure the gap as noted above. After the President’s declaration of national emergency, there have been stories that title companies in various counties will not continue issuing policies. A steadfast and willing title company can be a seller’s best friend.

Buyers, on the other hand, risk default under the purchase contract. A buyer will not be in default if it deposits its funds and closing documents in escrow and authorizes closing. As noted above, however, a buyer may be unwilling or, because of its lender, unable to do so in either type of closing. Thus, a buyer’s potentially substantial deposit may be now at risk.

II.  When Time Is of the Essence

As parties to real estate transactions assess new risks presented by the COVID-19 crisis, they should consider the potential impact of issues related to the timing of closings. Specifically, parties should consider the concept of “time of the essence” as they prepare for closings,  structure their transactions and negotiate with counterparties.[1]

Whether a buyer has any leeway in the time of performance depends on whether the sale contract expressly states that “time is of the essence,” either generally or with respect to the specific obligation to close. If time is of the essence in connection with a party’s obligation, failure to perform by such party by a specific date will constitute an incurable breach.[2] Generally speaking, if “time of the essence” is not expressly stated in a contract of sale, the contract will be construed to permit a reasonable time to perform.[3] This includes a reasonable adjournment of the closing date, unless the party seeking the adjournment has acted in bad faith or the delay is inexcusable.[4]

In certain jurisdictions, including New York, where a contract does not expressly state “time of the essence,” a party can unilaterally create such an obligation by sending a “time of the essence” notice.[5] To establish “time of the essence” via notice, one party must give clear, distinct, and unequivocal notice to the other party setting a closing date that provides a reasonable time for that other party to act.[6] The notice must also state that the other party will be considered in default should it fail to perform on the date designated in the notice.[7]

What courts deem to be a “reasonable” amount of time for a party to act may be subject to change given a prolonged national emergency that results in the periodic extended closure of county recorder’s offices, local governments and businesses. Presently, courts may look to some of the following factors when determining what is “reasonable”: (i) the nature of the contract, (ii) the parties’ previous conduct, (iii) whether the parties acted in good faith, (iv) the experience of the parties, (v) the potential for prejudice or hardship for one of the parties, and (vi) the amount of time provided for performance.[8] A party to a real estate transaction seeking to use “time of the essence” notices during the COVID-19 crisis should expect courts to weigh the particular circumstances impacting the other party’s ability to close when determining the reasonableness of the amount of time provided by such notices. Further, parties seeking to use “time of the essence” notices as a way to benefit from challenges presented by the COVID-19 crisis may find their actions viewed as acting in bad faith by the courts.

The COVID-19 crisis may cause parties to future purchase and sale contracts to rethink the customary approach that these transactions are “time of the essence.” From now on, purchase and sale contracts may be more likely to include clauses that permit delays due to pandemic, government closures and other causes not heretofore deemed to excuse performance by either a seller or a buyer.

III.  Potential Defenses for Breaching Parties 

If a non-breaching party is able to establish that it was ready, willing and able to close, but the non-performing party is in default for failing to close — whether due to strict enforcement of timing or a general unwillingness to close — the non-performing party may be able to assert some of the potential defenses below.

Impossibility of Performance

The common law doctrine of impossibility of performance is available generally “when the destruction of the subject matter of the contract or the means of performance makes performance objectively impossible” and the “impossibility was produced by an unanticipated event that could not have been foreseen or guarded against in the contract.”[9] When performance of a contract becomes impossible, performance may be excused, but mere difficulty or inconvenience is insufficient to excuse performance.[10] Arguments that a contract was impossible to perform, even in the face of a government moratorium, will not succeed where the intervening government action was foreseeable.[11] This doctrine exists in most states.  This argument may be more beneficial to a buyer where the contract requires recordation of the deed for closing, as opposed to a gap closing, although it is unclear if buyer’s performance would be excused only due to potential delay in the recordation.

Frustration of Purpose

A party may be able to invoke the “frustration of purpose” doctrine where the purpose or “essence” of a contract is frustrated, rather than rendered impossible, by an unforeseeable event. This defense may be available even where performance of the contract is not impossible. To invoke the defense, the frustrated purpose “must be so completely the basis of the contract that, as both parties understood, without it, the transaction would have made little sense.”[12] As with impossibility, the frustrating event must not have been foreseeable by the parties.[13] A core tenet of the frustration of purpose doctrine, which warrants mention here, is that “changes in market conditions or economic hardship do not excuse performance.”[14] A party is not excused from a contract simply because it becomes more economically difficult to perform.[15] In this context, a buyer may attempt to argue that the recordation of the deed is a fundamental premise of the contract, but it is unclear whether this argument would be successful. Uncertainty or delay in recording may not be sufficient to frustrate the purpose of the contract.

Good Faith and Fair Dealing

The law of most states includes an implied covenant of good faith and fair dealing to all contracts. This means that underlying every contract is an implied covenant that neither party will act in a way that destroys or damages the right of the other party to receive the fruits of its contract.[16] Further, where the ability to bring about a condition is solely within the control of one party, the express language of a condition within a contract will give rise to an implied promise that the controlling party will make some effort to see that the condition will occur.[17] This covenant may cut both ways for buyers and sellers, possibly favoring the party willing to extend the closing. However, it is unclear whether a court would elevate in importance an implied covenant over an express time of the essence clause.

Force Majeure

Many non-performing parties to all types of contracts have begun advancing arguments based on force majeure clauses in connection with the effects of COVID-19. Force majeure, or superior force, is a defense that, under certain circumstances, may excuse performance of a contract when a party has been prevented by a force beyond its control.[18] It is not a common law doctrine, but rather a bargained-for contractual right. This means the underlying contract must contain a force majeure clause for a party to assert it as a potential defense.[19] Where a contract contains a force majeure clause the effectiveness of defense will depend on the language of the clause and whether it is broad enough to include the effects of the COVID-19 crisis.[20] Since most purchase and sale agreements do not include force majeure clauses and courts are not likely to read a force majeure clause into a contract absent the express language, claims of force majeure are unlikely to excuse a missed closing.

 III.  Resolutions

Although the COVID-19 crisis has brought unprecedented changes to the conventions of daily life and business, as of the date of publication, most recorder’s office closings have been resolved through eRecording programs and local governments have demonstrated their commitment to maintaining the functions of the property records systems they administer. If both parties to a sale transaction desire to consummate a deal, they will need to proactively and collaboratively seek creative solutions. Closing early or beginning the closing process sooner may mitigate uncertainty around the timing of recordings. Parties may also mutually agree to waive claims for failure of a condition to closing, including for title, or claims for default due to timing issues related to recordings. Parties contracting for future deals will want to account for the possibility of government shutdowns impacting their transactions. However, if one party determines not to move forward with a transaction, the buyer and seller will likely face a protracted battle over the deposit, asserting many of the claims and defenses discussed above. These legal battles may be similarly impacted by delays and face protracted schedules as courts are forced to shut down as a result of the very same national crisis that produced the underlying legal dispute.

__________________________________________

For more information:

Loryn D. Arkow

Brian Diamond

Jeff Keitelman

Karen Scanna

Joshua Sohn

Ira K. Teicher

Phillip M. Kim

Daniel H. Lewkowicz

[1] For brevity, the case law referenced in Sections II and III focuses on the law of the State of New York.  Most states have similar common law doctrines as described herein.

[2] See Ward Capital Mgmt. LLC v. New Pelham Parkway N. LLC, 165 A.D.3d 477, 478, 86 N.Y.S.3d 437, 438–39 (1st Dep’t 2018) (“Since the real estate contract provided that the time of closing is of the essence, performance on the specified date was a material element and plaintiff's failure to perform on that date constituted material breach”).

[3] See ADC Orange, Inc. v. Coyote Acres, Inc., 7 N.Y.3d 484, 489, 857 N.E.2d 513, 516 (2006).

[4] See Baltic v. Rossi, 289 A.D.2d 430, 430, 735 N.Y.S.2d 148, 149 (2d Dep’t 2001) (holding that “[w]hen a contract for the sale of real property does not state that time is of the essence, either party is entitled to a reasonable adjournment of the closing date.”).

[5] See ADC Orange, Inc., 7 N.Y.3d at 489, 857 N.E.2d at 516.

[6] See Somma v. Richardt, 52 A.D.3d 813, 813-14, 861 N.Y.S.2d 720, 721 (2d Dep't 2008).

[7] See ADC Orange, Inc., 7 N.Y.3d at 489, 857 N.E.2d at 516.

[8] See Hegeman v. Bedford, 5 A.D.3d 632, 774 N.Y.S.2d 769 (2d Dep't 2004) (citing Zev v. Merman, 73 N.Y.2d 781, 783 533 N.E.2d 669, 669, 536 N.Y.S.2d 739, 739 (1988)); Miller v. Almquist, 241 A.D.2d 181, 183, 671 N.Y.S.2d 746, 748 (1st Dep't 1998) (citing Zev, 73 N.Y.2d at 783, 533 N.E.2d at 669, 536 N.Y.S.2d at 739).

[9] Kel Kim Corp. v. Cent. Markets, Inc., 70 N.Y.2d 900, 902 (1987).

[10] See Stasyszyn v. Sutton E. Assocs., 161 A.D.2d 269, 271 (1st Dep’t 1990) (“[E]conomic inability to perform contractual obligations, even to the extent of insolvency or bankruptcy, is simply not a valid basis for excusing compliance.”).

[11] See RW Holdings, LLC v. Mayer, 131 A.D.3d 1228, 1230 (2d Dep’t 2015).

[12] See Crown IT Servs.,  Inc. v. Koval-Olsen, 782 N.Y.S.2d 708, 711 (1st Dep’t 2004).

[13] See Metro Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504, 1523 (S.D.N.Y. 1989).

[14] See Bierer v. Glaze, Inc., No. CV-05-2459 (CPS), 2006 WL 2882569, at *9 (E.D.N.Y. Oct. 6, 2006).

[15] See, e.g, Clarix Ltd. v. Natixis Sec. Americas LLC, No. 1:12-CV-7908-GHW, 2014 WL 4276481, at *11-12 (S.D.N.Y. Aug. 29, 2014); see also Bank of New York v. Tri Polyta Finance B.V., No. 01 Civ. 9105 (LTS) (DFE), 2003 WL 1960587 (S.D.N.Y. 2003) (finding that a party’s inability to generate sufficient cash flow due to the catastrophic collapse of the Asian markets was did not justify permitting them to avoid contractual obligations).

[16] ABN AMRO Bank, N.V. v. MBIA Inc., 17 N.Y.3d 208, 228, 952 N.E.2d 463, 475 (2011) (“[T]he implied covenant of good faith and fair dealing ‘embraces a pledge that neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract’”) (citation omitted).

[17] See Rachmani Corp. v. 9 E. 96th St. Apartment Corp., 211 A.D.2d 262, 270, 629 N.Y.S.2d 382, 387 (1st Dep’t 1995) (“[T]the failure of the condition may not be set up as a defense to the underlying obligation under the contract where the party charged with the duty to fulfill the condition has failed to make a good-faith effort to bring it about”).

[18] See Phillips Puerto Rico Core, Inc. v. Tradax Petroleum Ltd., 782 F.2d 314, 319 (2d Cir. 1985).

[19] See General Elec. Co. v. Metals Resources Group, Ltd., 293 A.D.3d 417 (1st Dep’t 2002) (declining to reach a force majeure claim in the absence of a clause).

[20] See Kel Kim Corp., 70 N.Y.2d at 902–03 (“Ordinarily, only if the force majeure clause specifically includes the event that actually prevents a party's performance will that party be excused.”).

This Stroock publication offers general information and should not be taken or used as legal advice for specific situations, which depend on the evaluation of precise factual circumstances. Please note that Stroock does not undertake to update its publications after their publication date to reflect subsequent developments. This Stroock publication may contain attorney advertising. Prior results do not guarantee a similar outcome.