United States Real Estate Investment: the Contract Process by Lee A
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Property Group | 2003 United States Real Estate Investment: The Contract Process By Lee A. Kuntz* large measure, a reflection of the essential laissez faire * Introduction spirit of the United States economic system. For foreign investors, one of the most important but least In most other countries either by law (primarily statutory understood aspects of an investment in United States real law) or custom, the areas of potential controversy in a real property is the negotiation of a contract of sale and, once estate transaction are largely limited to price and the contract is completed, the closing of the acquisition. payment terms. In a fundamental sense, the basic Because this process differs greatly from the contract question of the merchantability of the property is not at process in most other countries, it is a difficult and often issue, because, as a result of the applicable statutory confusing period for foreign investors. Yet, if they are to provisions, the seller is usually obliged to sell the property protect their interests, they must not only understand the in a merchantable condition and the purchaser is process but join actively in it. This paper will explain the generally assured as to its ownership by registration of its United States contract process to help foreign investors to title. The question of merchantability really becomes participate in it more effectively. important only after the conveyance of the property if the To begin at the beginning, a contract of sale provides the purchaser discovers that the property’s condition does not terms and conditions of the transaction. It is the basic comply with applicable law. means of setting forth the parties’ agreement as to the The situation in the United States is different. As will be purchase price and terms of payment. If this were all that discussed more fully below, there is no implied warranty were required, contracts of sale would be about a page of merchantability in commercial real estate transactions. long, and there would be no need for this paper. Rather, As a consequence, a contract of sale must deal with the as a result of the complexities of United States law and condition of seller’s real property, how this will be custom, contracts of sale in commercial transactions are ascertained and what steps, if any, the purchaser must often fifty or more pages plus about an equal number of take to assure that it will receive the real property in the pages of supplementary schedules and exhibits. It is the condition bargained for in the contract. Moreover, the preparation and negotiation of all this material which sets United States does not have a general system of the contract process in the United States apart from that government registrations of land titles. As a in most other countries. The differences arise not only consequence, a contract of sale must also deal with the because of our common law legal system but also because nature of the seller’s title, how this will be ascertained and of our particular approach to our legal system. It is, in what steps, if any, the seller must take to assure the purchaser that it will receive the quality of title bargained * This article is an update of an article originally written in 1986 and revised in for in the contract. 1993 and 1998. Mr. Kuntz is head of the Property Practice Group of Shearman & Sterling LLP. He was assisted in this and prior updates by Alfred There are many statutes applicable to real estate Groff, a member of the Tax Practice Group. If you have any questions concerning this article, please contact Mr. Kuntz at 212.848.7392 or ownership and operation in the United States. However, [email protected]. very few apply to the actual process and terms of the sale NYDOCS02/769797.2 2 of commercial real estate, particularly if one excludes the parties seek greater certainty by negotiating specific federal and state tax laws. In addition, all but a few of the and detailed contractual provisions rather than rely on applicable non tax statutes are waivable by the parties general principles of law. and are generally waived in commercial transactions. For In addition, in our federal system, except for tax and instance, most states have adopted a law known as the environmental matters, almost all relevant real property Uniform Vendor and Purchaser Risk Act, which governs law is state law. There is essentially no Federal real the rights and obligations of the parties to a contract for property law. This alone substantially differentiates the sale or exchange of real estate in the event of United States real estate transactions from those in other destruction of the property or a taking by eminent countries which generally have a national real property domain. The Act provides that it is applicable “unless the law. Even though our real property law, except for the contract expressly provides otherwise... ”, and most state of Louisiana, is derived from the English common commercial contracts do expressly provide otherwise. As law, state laws differ widely. Customs and procedures the parties to a commercial real estate contract of sale also differ, not only among the states but also within contract out of most statutory restraints, they possess a particular states. For example, there are substantial flexibility in structuring a real estate transaction to satisfy differences in substantive laws and closing procedures their mutual needs that may not be available in other between California and New York as well as differences in countries. While flexibility has its benefits, it also may closing procedures between northern and southern hold risks for a party not used to dealing with such California. flexibility. For these and other reasons, the practice has arisen in the Moreover, most of the real property law in the United United States of using very detailed contracts which States which governs the rights and obligations of a seller attempt to cover all potential disputes between the and purchaser is common law. This is a body of law parties. This approach is essentially self justifying. As based upon decisions of courts, which decisions act as lawyers draft ever more detailed agreements, the courts precedents for future decisions in cases involving similar are forced to ever finer distinctions, which drive counsel facts. Thus, principles of the common law are determined to cover the issues in ever greater detail in order to by inductive reasoning from court decisions rather than, anticipate such ever finer distinctions by the courts. This as in the code system, by deductive reasoning from approach in drafting and interpreting legal documents statutory provisions. The common law system has several naturally creates substantial issues for the inexperienced direct effects on drafting contracts. First, it places a foreign investor, making legal advice for the protection of premium on the particular facts of each case. Second, its interests essential. Although the process is although the basic principles of common law are clear, cumbersome, expensive, and perhaps frustrating for their application to particular fact situations is often those investors from different legal and business systems, uncertain. Third, the legal principles in real estate are investors who understand and accommodate the process largely derived from the early English common law and will be at an advantage. have changed remarkably little over time. Thus, in many respects, one is applying 400 year old law to modem To focus on the contract process in the United States is to transactions. Last, the common law evolves after the fact focus both on some broad general themes and on many because final court decisions often are rendered several detailed provisions. However, the intent of this paper is years after the dispute actually arose. Thus, in areas to deal with broad themes that affect the basic process of where the basic real estate law is changing, it may be entering into a contract rather than specific contract difficult to predict the course the courts will take. Thus, provisions, which will be discussed only to explain how they affect the negotiations. 3 In order to simplify the discussion, this paper will focus deliberate lies or fraudulent conduct, our law does not on an all cash sale of a major commercial office building impose any liability on sellers for undisclosed defects (the “Property”) by a domestic seller (“Seller”) to a foreign or liabilities in respect of sales of commercial real investor (“Purchaser”). In addition, annexed as Appendix property. As indicated above, for commercial sale A is a summary checklist of matters pertinent to such a transactions, there is no implied warranty of fitness or transaction. merchantability but rather a basic rule of caveat I. Initial Contact emptor — let the buyer beware. This is an important issue at the initial stage of the There are, of course, many ways in which the contract process: Purchaser must be prepared to transaction may be initiated. These include an offering undertake its business, legal and physical review (often by Seller or Seller’s broker, an auction by Seller, a called due diligence review) of the Property at this contact by Seller’s or Purchaser’s broker and a contact time. Although it may be preferable to obtain a post between the parties themselves. contract period in which to perform the due diligence The sales brochure is a common method used today in review, in many cases such a “due diligence review major commercial transactions. The brochure contingency” is unacceptable to a seller. generally provides substantial information about the Again, contrast the United States approach to the civil Property, its income and expenses, its location law system which does imply a warranty of (including statistical information for its metropolitan merchantability and discourages a purchaser from area) and, often, projections for the Property’s conducting a due diligence review as the implied performance over a given investment period (generally, warranty does not extend to matters as to which the 10 years).