September 20, 2011
Do Attorney's Ever Litigate Good Contracts – Or Just Bad Ones?
Last year at a Real Estate Deal Making Symposium and Syndication Seminar program, the audience was treated to an extraordinary speaker who demonstrated, using real life examples, why good contracts are so critically important. Our presenter, Larry Rothstein, has put the majority of his presentation into words so that people who were not in attendance could benefit from those insights. I share it with you here and hope that you enjoy it.
"I've Never Litigated Over a Good Contract”
By Larry A. Rothstein, Esq.
Remember the old Fram Oil Filter commercial? The mechanic is finishing up a complete transmission overhaul. He looks into the camera and tells the viewer that his customer could have saved hundreds of dollars if only he’d invested in a Fram oil filter costing just a few dollars. It’s a riff on age old maxims “an ounce of prevention is worth a pound of cure” and “he’s penny-wise but pound-foolish.”
What I’m about to tell you is against my own interest. I’m a trial lawyer. I litigate and try construction, surety, real estate, and complex business disputes, many of which turn on the interpretation of agreements the parties had executed long before my involvement. Trials are always expensive and always involve uncertain outcomes. In my world the best case has a 1-in-8 chance of going wrong. Such are the vagaries and unknowns inherent in our judicial system. I’ve yet to have that best case, so even “slam dunks” come with significant risks.
Don’t get me wrong, I’m a big believer in the jury system. Jurors almost always get it right, usually more often than judges. You’d be surprised how often the collective common sense of twelve conscientious people, working collaboratively, will achieve “substantial justice.” If there’s one thing I’ve learned in 33 years of practice, it’s that jurors almost always side with the party they like better, or conversely, against the party they dislike more. Much as some of my colleagues would believe they possess magical powers of persuasion and charisma (and there are a few who do), it is the parties whose stories are to be told, not the lawyers, not the experts, who most often determine how the jury will decide their case. Often this means confronting evidence harmful to the client and addressing it honestly and plausibly at the earliest opportunity, usually in the opening statement, if not voir dire. It is far more effective to acknowledge harmful evidence before the opposition can exploit it. Effective witness preparation, reasonable explanations or justifiable excuses will often minimize any otherwise harmful impact. The last thing a trial lawyer wants is to confront harmful evidence which he or she didn’t anticipate or expect.
Most of the cases I try involve written agreements. I will summarize the three types of contracts most of us are familiar with and the types of problems which can arise from each. Next, I will discuss the three principles underlying every good contract and which, if adhered to, will minimize the chances of litigation arising from such contracts. Finally, I will offer a few examples from my own experience where failure to adhere to one or more of the three principles led to litigation. I will also discuss one particularly well-known contract – the Frank and Jamie McCourt post-nuptial agreement – where the failure to adhere to any of the three principles led a judge to rule the post-nup unenforceable and therefore to determine that Jamie held a one-half ownership interest in the Los Angeles Dodgers.
The Three Types of Contracts
Generally speaking, there are three types of contracts most of us are familiar with: the first type is what lawyers call contracts of adhesion. These contracts are drafted entirely by one side – always the one with the superior bargaining power – where the only negotiated terms are price and payment terms. Examples include home and other loan agreements with banks; the purchase or lease of a car; commercial leases and credit card agreements. The rest of the terms – and they often go on for several pages – are all boilerplate. These terms are non-negotiable and these contracts are rarely litigated. Why? Because if the bank sues you, it is because you are in default and you will lose. But if it is the bank that breaches, you are likely not to be able to afford to sue it.
The second type of contract is also on a pre-printed form prepared by one side, usually with somewhat greater bargaining power. More terms are negotiable. Examples include: most construction contracts (where I’ve tried many cases); residential leases; small to medium-size business acquisitions; syndication agreements. These contracts are more likely to find their way into litigation because there are more ways to default, but also more excuses for default. The terms are more likely to be in dispute and the conduct of both sides may be in issue. And unlike the adhesion contracts in the first group, parol evidence – oral explanations offered by either side to explain or interpret the terms of the agreement – may be admitted, in which case it often comes down to a he said/she said dispute where witness credibility becomes all the more critical.
The third type of contract is one drafted by the parties over a few drinks on the back of a cocktail napkin. Seriously, these are contracts made specifically between the parties and often without benefit of counsel. We see them all the time. These contracts are often made by legally unsophisticated parties with roughly equal bargaining power. Here, terms, conditions and the intent of the parties is not clearly expressed, leaving it to the court to divine the parties’ actual meaning. It is also important to recognize that in these types of situations, courts, not juries, are empowered to interpret the terms of a written agreement.
The Three Principles of a Good Contract
So what makes a good contract? I think there are three principles: First, the contract should be fair to both sides. This sounds intuitive and it is. When a contract is fair, it motivates both sides to achieve their respective goals and encourages mutual performance. Also, at the time the agreement is made, both sides believe they are each capable of performing its terms.
Second, the terms must be clear and definite. This also sounds intuitive, but you can well imagine how often ambiguities give rise to litigation.
The third principle of a good contract is that foreseeable risks to both sides must be foreseen and reasonably allocated. Often the parties and sometimes even lawyers fail to consider risks that may occur: What if the market turns around? What if we get divorced? What if a third party, whose cooperation or consent is needed, refuses to cooperate? We will be looking at contracts which violated one or more of these principles and the parties wound up paying dearly as a result.
The McCourt Post-Nuptial Agreement
As many of you know, Frank and Jamie McCourt announced in 2004 that they were buying the Los Angeles Dodgers from News Corp. In 2009, they separated and last year completed one of the most expensive divorce trials in history, with each side spending millions on attorneys’ fees.
At issue was the interpretation of the McCourt Post-Nuptial Agreement which they executed in 2004 in anticipation of their acquisition of the Dodgers. There are at least six different versions of the agreement, drafted by a Boston lawyer with a large national law firm who represented both Frank and Jamie and who apparently knew nothing about California community property law. Even if you are entering into an agreement with your spouse, make sure the agreement is reviewed by a lawyer for each side. This is always true. If one party has his or her lawyer prepare the agreement, have your own lawyer review the document. That’s the Fram Oil Filter. Otherwise, you’ll be paying a litigator like me to rebuild your transmission.
On its face, the agreement purported to give Frank ownership of the Dodgers and Jamie ownership of the couple’s real and other property. Jamie, a University of Maryland-educated lawyer who also holds an MBA from MIT, claimed the couple’s intent was to give her sole title to the real property in order to shield it from the Dodgers’ creditors if the team continued to lose money, but that there was no intent to actually divide any of the couple’s assets between them. Why would Jamie agree to receive assets worth maybe $20,000,000, in exchange for giving up her interest in a team they were buying for $471,000,000?
This case stands as the poster child for why bad contracts lead to litigation. It managed to violate all three principles underlying every good contract.
- It is highly unlikely that the couple really intended to split their property by giving Jamie assets worth $20,000,000 and Frank an asset worth at least twenty times that. Thus, it was inherently unfair to one side.
- Sometime after the agreement was drafted, the lawyer switched the original word “exclusive” (referring to Frank’s interest in the Dodgers), in the addendum to “inclusive” without bothering to tell either party. There are three signed versions of each agreement. The lawyer drafting an agreement never wants to testify later in a trial over the agreement’s meaning. This lawyer did, claiming he changed the words to comply with the intent of the parties. Given that the terms “exclusive” and “inclusive” are opposites, could the switch in terms have been be any less clear and definite? It would not have been difficult at the time for the lawyer to advise both sides that he believed he made a drafting error and to have each side acknowledge that the second version reflected their true intent (assuming it did). It is always better to make any required modifications to an agreement before an issue arises over its meaning.
- The lawyer who drafted it was not well-versed in the area of law to which the post-nuptial most related, namely California community property law. This was because he was a transactional/business lawyer who failed to properly allocate a foreseeable risk – the risk that the couple might later divorce. (Incidentally, if the intent of the property division in the post-nup was to shield the couple’s homes from creditors of the Dodgers without intending the assets to become their respective separate property, then the agreement could constitute a violation of the Uniform Fraudulent Transfer Act.)
Here, there was plenty of blame to go around. First of all, the lawyer had a non-waivable conflict of interest. There is no way he should have been representing both sides of this transaction, particularly if the intent was to divide marital property as disproportionately as this agreement purported to. Also, stated earlier, the lawyer was not sufficiently well-versed in the law applicable to the agreement (California community property law). Don’t hire a workers’ comp lawyer, even if he’s your brother-in-law, to review a real estate syndication agreement. See a specialist. Let me repeat: see a specialist.
Jamie, the Maryland lawyer and MIT MBA, claims she didn’t bother reading the agreement because she trusted her husband. The lawyer claims that he went over every paragraph with both of them. My advice: trust, but verify. The McCourts should have hired two separate lawyers to review the agreement. Think how much they would have saved later.
Here are two examples of bad contracts which I’ve litigated:
The Skilled Nursing Home Sale
This case involved a Letter of Intent (LOI) to purchase two skilled nursing homes for $4,000,000. The LOI was a classic type 3 agreement typed up by the buyer with several bullet points. First of all, wouldn’t you hire a lawyer if you were buying (or selling) a $4,000,000 business? The LOI was signed by the buyer individually, not by the corporations he intended the sale to transfer the facilities to. There were three equal shareholders of two separate corporations who were the sellers. It was unclear if the shareholders (who were feuding with each other) were signing in their individual capacities or on behalf of the corporations or both.
Incidentally, LOI’s are generally enforceable as long as its terms are reasonably clear and specific and doesn’t require subsequent ratification or approval. It is common in business to agree to deal points with the understanding that a more formal agreement will be executed at a later date. If you don’t intend to be bound by an LOI or “deal points memorandum,” be sure to include escape language in the document such as: “This is for purposes of reaching a binding agreement at a later date and is not intended to be binding on either party hereto.”
The real problem here was that a condition of the sale required the landlord “to execute a new lease with interim approval of the existing lease for 30 days.” The landlord owned the real estate (land and improvements) on both facilities but was not a party to the LOI.
Under California law, a commercial landlord may not unreasonably withhold consent to an assignment or sublease of an existing lease. A commercial landlord is not required to consent to a new lease. After the LOI’s were executed, but before obtaining the landlord’s consent, the buyer and sellers entered into temporary operating agreements for both facilities (this is standard practice in the sale of nursing homes to allow the new operator to obtain licensing). The buyer then took possession of both facilities and began operations.
During this time, the buyer had entered into what appeared to be good faith negotiations with the landlord to execute a new lease or an extension of the existing lease (obviously the buyer needed a long-term leasehold to secure his investment) when, quite unexpectedly, the landlord refused to consent – even to an assignment or sublease of the existing lease. Immediately the sellers, aided and abetted by the landlord, entered into new LOI’s with a third party buyer for $4,100,000.
The buyer sued for breach of contract, interference with contract and other serious business torts, claiming damages of $20,000,000. All defendants demurred. The buyer argued that “new lease” was susceptible to meaning either a transfer or sublease of the existing lease, in which case the landlord’s consent could not be unreasonably withheld. The court sustained the demurrers without leave to amend on the grounds that the “new lease” was not susceptible to the interpretation urged by the buyer and therefore the landlord had the right to unreasonably refuse his consent to a new lease.
There are at least three lessons here: First, understand that lay people often use words or phrases that mean something other than what they intended or use them in a way that can be misinterpreted. Thus, principle two – that the terms be clear and definite – was violated. Had the buyer spent $1,000 to have a lawyer review the LOI before it was executed, it would have saved him millions. Second, there was no “savings” provision in the LOI in the event the landlord refused to consent to a new lease or an extension of the existing lease. Assuming both sides were otherwise acting in good faith (and the underlying facts suggested that neither the sellers, landlord, or subsequent buyers were), the foreseeable risk that the landlord might refuse to consent should have been allocated to both parties, not just the buyer. Thus, the third principle is violated.
Third, and this is just common sense, if the deal is dependent on the consent or affirmation of a third party, try to ensure that such consent or affirmation is obtained before the contract is executed. Elimination of foreseeable risk at the outset is always better than attempting to allocate it as a future possibility. Of course this is not always possible. Better a future allocation than not providing for it at all.
The Billboard Lease
If any of you know the San Fernando Valley, the biggest, ugliest billboard you will ever see is located at the southeast corner of White Oak and Sherman Way. It is vertical rather than horizontal. My clients, the fee owners, have owned the property on which the billboard now sits since the 1950's. In early 2001, a tenant who then operated a rent-a-car agency located on part of the property, proposed leasing the entire property from my clients. In addition to the rent-a-car agency, the clients had been collecting rents from two or three auto mechanic garages and some miscellaneous parking. Oh, and also from the billboard company. The billboard was located directly above the rent-a-car agency. During the negotiations, the tenant sent the fee owner a letter totaling all of the rents which the owners had been receiving, including the agency, the garages and the parking, but not the billboard rent. The tenant offered to pay the fee owners $1,000 a month more than the sum of the described rents in the proposal and the clients agreed.
They drew up a new ground lease modeled after the ages-old rent-a-car agency lease and each side had their own counsel review it. You can guess that there was no mention of the billboard lease in the ground lease and neither lawyer thought to ask their respective clients whether or not the description of the premises included all of the rents, issues and profits relating thereto.
For several years thereafter, the fee owners continued to collect the rent from the ground lessee and also from the billboard company. The value of the billboard income, over its life, including renewals, was more than a half million dollars.
In 2005, the ground lessee sold his interest to another individual. By now, the rent-a-car agency had been replaced with a Wendy’s Restaurant located underneath the billboard. When the new lessee looked up at the billboard, he asked his predecessor who was collecting the rent on the billboard. When the new lessee learned it was the fee owners, he sued.
The lease, of course, made no mention of the billboard. The new lessee claimed that because the billboard was physically attached to the demised premises, it should be deemed part of the leasehold transfer. At trial, the ground lessee called an expert witness on drafting commercial leases who testified that unless expressly excluded, all rents, issues and profits from the leasehold are deemed transferred to the lessee.
Over a ten-day trial, we presented overwhelming evidence that the conduct of the parties, both before and during the original ground lease tenancy, demonstrated that there was never any intent manifested by the lessee that the income from the billboard lease belonged to anyone other than the fee owners.
The court ruled in our favor but ignored the evidence we presented. The court reasoned that it could not add a new term to the agreement, that is, the court could not add the billboard income to the ground lease as part of the demised premises. Lessee appealed. The Court of Appeal affirmed, but on different grounds. The Court of Appeal specifically relied on the evidence we presented showing that the intent of the parties was never to transfer the billboard lease as part of the ground lease. Fee owners were ultimately vindicated and recovered all of their attorneys’ fees – well in excess of $300,000 from the lessee.
Although based on different reasoning, both the trial court and the Court of Appeal reached the same result because it would have been manifestly unfair to award the billboard income to the ground lessee. The pre- and post-contract formation conduct of the parties established that the ground lease was never intended to transfer the billboard income. In determining the intent of the parties, courts will often – and they should – consider which side’s interpretation is more commercially reasonable, that is, which interpretation is more fair. Here, the fairness principle proved essential to our success. But the second principle could have done us in. By making no mention of the billboard, the terms of the ground lease were not clear and definite. Although this was a type 2 contract (roughly equal bargaining power and lots of boilerplate language), it was reviewed by lawyers on both sides (who later testified during the trial). Neither lawyer was an expert in commercial leases. Both missed the billboard income which the fee owners had been receiving. The lawyers should have asked, “has all of the income you’re receiving from the property been accounted for?” “Is there any income you want to ‘carve out’ of the lease?” Successful lawyers make their living asking the right questions.
These are but a few examples of the difficulties clients face when their agreements violate one or more of the three “golden” principles described in this article.
Larry A. Rothstein, Esq.
Law Offices of Larry A. Rothstein
21550 Oxnard Street, Suite 690
Woodland Hills, CA 91367
Telephone: (818) 348-7000
Facsimile: (818) 348-0700
This article was adopted from a presentation made to the Real Estate Deal Making Symposium and Syndication Seminar in Reno, Nevada in November 2010.
Mr. Rothstein specializes in construction, surety, real estate and complex business litigation and trials.
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