Most sophisticated real estate investors are wise enough to know that they should abide by the terms of their investment entity’s governing agreement — the partnership agreement or LLC operating agreement.  When times are good and investments are profitable, it is easy to envision the “lost profits” damages that might result from a breach.

During a downturn, however, investors often feel they have nothing to lose by breaching the agreement because the enterprise’s investments are failing anyway.  That’s where “reliance damages” come into play.  Even where the investments are failing and there are no profits to be had, a partner who breaches the entity’s agreement might be on the hook to reimburse his partners for the amounts they spent “on the faith of the contract.”

An opinion published by the California Court of Appeal (Sixth District in San Jose) earlier this year — Agam v. Gavra — illustrates how reliance damages work.

The facts: partnership makes a big real estate bet just before the Great Recession…

In April 2007, Isaac Agam, Eran Cohen, Eliyahu Gavra, and Yifah Gavra formed a real estate partnership.  The partnership agreement stated that the purpose of the entity was to purchase a parcel of land in Los Altos Hills, subdivide it, build two or three houses, and then sell the lots.

Agam and Cohen purchased the property for $4.6 million, financed by a seller carryback loan of $3.8 million due in November 2008.  Agam and Cohen transferred title to the partners in proportion to their partnership interests.  The partners discussed building either 6,000 square foot homes priced in the $6 million range, or 9,000 square foot homes priced in the $9 million range.

By October 2007, the partnership became plagued by infighting, “friction,” and “personality and style differences.”

The partners paid off the seller carryback loan using a combination of a new bank loan, partner capital contributions, and a hard money loan.

The Gavras refuse to pursue construction

The Gavras’ attorney wrote to Agam, stating that due to the “worsening economy and real estate market” and the partners’ “dire financial situation,” the Gavras contended that the “partnership cannot proceed to the construction phase and the partners should focus their efforts on selling the lots.”

Agam and Cohen retained an attorney, who proposed that the Gavras withdraw from the partnership, take any one of the three lots, and accept (or make) true-up payments depending on which lot they selected.  The Gavras rejected the offer.

Agam and Cohen pursue construction on their own, but fail

Agam and Cohen pursued construction of the envisioned new homes on the parcels, and first sought a construction loan.  Agam and Cohen viewed the construction loan as the “only alternative” to default and foreclosure.

Agam prepared a joint application on behalf of all the partners for an approximate $5 million construction loan for one of the three parcels.  But the Gavras reiterated their refusal to proceed with construction several times.  As such, Agam did not submit the joint application and instead applied for the construction loan as an individual.  The bank declined the loan, citing the loan-to-value ratio.  The bank told Agam that the most it could lend was $3,775,000.

The partnership sells the lots

With construction unable to proceed due to the Gavras’ refusal to participate, the partnership sold all three lots.  The partnership had spent a total of $6,441,519 to purchase and improve the lots, and received $5,164,405 when it sold the lots, resulting in a loss of $1,277,114.  Agam also spent $157,500 in making payments to the hard money lender, and incurred additional partnership expenses of $4,255.74.

The trial court awards Agam reliance damages

After a nine-day court trial, the trial court concluded that the Gavras had breached the partnership agreement by refusing to proceed to construction or pay for any partnership expenses other than those associated with the sale of the undeveloped lots.  The Gavras’ refusal to cooperate with the construction effort, the court held, “effectively prevented Agam from pursuing the chief aims of the Partnership Agreement” which was to obtain a construction loan, build homes, and sell at a profit.  (Cohen settled out, and was not a part of the judgment.)

The trial court held that Agam failed to prove lost profits or opportunity losses, but did prove $732,201 in out of pocket losses (Agam’s percentage share of the overall partnership losses plus the hard money loan payments that he paid himself) and $4,255.74 in additional partnership expenses.  The court awarded those sums to Agam as reliance damages.

The court held that the Gavras had the burden to show the reliance damages should be reduced on the grounds that the “contract was a losing one for Agam,” and the Gavras failed to show any projected loss with reasonable certainty.

The Gavras appealed.

The court of appeal affirms, and clarifies the shifting burden of proof governing reliance damages

On appeal, the Gavras did not dispute that they breached the partnership agreement.  Instead, they disputed the trial court’s award of reliance damages.  The Gavras argued that the trial court erred by placing the burden on them to show that Agam would have suffered a loss even if they had proceeded to construction.

The court of appeal affirmed the trial court’s judgment, and described the “shifting burden” governing awards of reliance damages as follows:

Accordingly, we hold that, in the context of reliance damages, the plaintiff bears the burden to establish the amount he or she expended in reliance on the contract.  The burden then shifts to the defendant to show (1) the amount of plaintiff’s expenses that were unnecessary and/or (2) how much the plaintiff would have lost had the defendant fully performed (i.e., absent the breach).  The plaintiff’s recovery must be reduced by those amounts.

The court held that Agam met his initial burden by showing the amounts he expended in reliance on the contract, and that the Gavras’ breach caused the damages.  “The Gavras’ refusal to participate in construction prevented the partnership from attaining its goal.”

The court further held that the Gavras failed to prove that any reduction of Agam’s reliance damages was warranted.  The Gavras did not offer any clear evidence that Agam would have lost a particular sum of money had the contract been fully performed.  “To the contrary,” the court held, “what might have happened had the parties attempted to proceed with construction is speculative[.]”  The court rejected the Gavras argument that the partnership would not have obtained a construction loan, noting the evidence showed the partnership could have obtained a smaller loan and built smaller homes than originally planned.

Lesson

The absence of profits is not a justification for breaching a partnership agreement.  Even when a breach causes no “lost profits,” your partners can still recover “reliance damages” to compensate them for sums expended performing the agreement.