Legal Blog

Frustration (2)

The COVID pandemic has spawned a number of cases in which one of the parties to a contract claims that the contract has been frustrated so that the party is no longer bound by its contractual obligations. From what we have read, this argument has not had much success. One such case is FSC (Annex) LP v. Adi 64 Prince Arthur LP 2020 ONSC 5055.

Buy-Sell

A developer and a private equity investor firm entered into a joint venture to rezone and redevelop a Toronto property into condominiums. The developer had a 20% interest; the investor had an 80% interest. The deal was not unusual for the developer; it tended to take minority positions in projects in which it was also able to receive a management and development fee.

The relationship between the parties soured. Consequently, the investor exercised a buy/sell provision in the governing agreement. It was the usual type of provision; one party triggers it and sets a price and the other party has the choice either to buy or sell at that price. In this case, the price was $12.7 million for the whole development and, on January 9, 2020, the developer elected to purchase the investor’s 80% interest in it. The closing date was set for April 8, 2020.

As we all know, COVID hit in mid-March 2020. The developer advised on March 25, 2020 that it would not be able to close the transaction due to the “unforeseeable delay” that the pandemic caused. In response, the investor brought an application for specific performance.

The developer resisted that application on three grounds: (i) the investor did not come to court with clean hands; (ii) the pandemic had frustrated performance of the agreement; and (iii) equitable principles militated against specific performance.

Clean Hands

The developer claimed that the investor had failed to pay the development management fee that it owed the developer and therefore had no right to force the developer to purchase its interest. The judge gave short shrift to the argument because, when the developer received the buy/sell notice in December 2019, it knew of the alleged default and never raised it as a basis for invalidating the shotgun offer; instead, it unreservedly agreed to purchase the investor’s interest. Having agreed to do so, the developer was not able to raise the alleged default as a basis to prohibit the investor from exercising its rights under the agreement.

COVID

The developer claimed that the contract had been frustrated because the new contractual performance was radically different from what the developer had undertaken. It contended that, when it entered into the purchase agreement, market conditions were favourable, but that the pandemic was an extraordinary event and therefore completely unforeseeable.

The judge dismantled this contention, asserting the following

• The developer had from January 9, 2020, when it chose to purchase, until March 17, 2020, when Ontario declared a state of emergency, to obtain its financing. It had not managed to do so – mostly because it made a “somewhat relaxed” search to obtain that financing. It had only approached a limited number of financing sources and had actually attempted to obtain more financing than was needed to close the purchase. The limited scope of financing sources had nothing to do with COVID; it was a deliberate choice that the developer made.
• The developer’s view of the pandemic as an event that had never before taken place “in human history” was not tenable. Although we may not have experienced a pandemic of this proportion in our lifetimes, restrictions on the availability of credit are common and regularly occur as part of the ebb and flow of economic cycles. Even if there had been a general freezing of liquidity, which was never proven, it is a risk against which a purchaser can protect itself by making the transaction conditional upon financing. That condition was not available under the buy/sell provision, but it was a risk that should have been contemplated at the time the developer made its election to purchase. Every purchase has an inherent risk – from which a purchaser should not be protected by the doctrine of frustration.
• Courts have noted that “a shotgun buy-sell is strong medicine. One takes it strictly in accordance with the prescription or not at all.” Further, a decline in the value of real estate does not “radically” change a defendant’s obligations under an agreement to pay a specific amount on closing.

Damages

The developer argued that specific performance was not appropriate because damages would be an adequate remedy. It submitted that there was nothing unique about the purchase agreement and that the investor’s interest in the property was solely to realise a financial return.

The judge was not impressed by this argument. The damages that the developer suggested the investor would have to pursue would arise when the investor sold its interest to a third party purchaser. The investor would then have to sue the developer for the difference between the buy/sell price and the sale price to the third party. This would embroil the parties in a further lawsuit, with potential allegations that the investor failed to properly market its interest and therefore mitigate its damages.

A sale would be additionally complicated because any purchaser of the investor’s interest would have to become a party to multiple agreements that governed the project and would have to comply with a provision that gave the developer the right to approve the sale. This would result in the investor having to find someone willing to acquire an interest in the development subject to the developer’s right to continue to manage it. If the developer refused to approve the sale and the potential purchaser, a further dispute would arise about the refusal and the possible bad faith reasons for it.

The judge was not comforted by these scenarios and noted that “specific performance had much to recommend it.”

Equities

As in every application for specific performance or other equitable relief, one has to balance the equities. The developer claimed that it was inequitable for the court to allocate to it 100% of the risk arising from an unprecedented health pandemic. The judge disagreed.

• A decline in real estate markets or a contraction in available financing is not unprecedented. They are normal risks.
• Relieving the developer of those risks means that a purchaser could obtain all of the benefit of a decision to purchase and leave the vendor with risks that arise to the date of closing.
• Although contractual provisions are often available to shift risk, they were not used in this case.

The judge held that the developer had to take the bitter with the sweet. Enjoy what it thought would be the benefits of purchasing rather than selling, but assume the downside risks of doing so.

The judge ordered specific performance and, in effect, directed the developer to widen its scope for financing.

Image courtesy of campbellstogether.

Written by Jonathan Speigel, the founding partner of Speigel Nichols Fox LLP, leads the litigation and construction practices.