Falling Prices Don’t Permit A Breach In Contracts

It’s pretty clear that Elon Musk wishes he could have a mulligan on his acquisition of Twitter. Earlier this year the company accepted his offer to acquire the company for $54.20 a share (a figure chosen partly because of a marijuana joke).

While that price represented a modest premium over the stock price at the time, in the ensuing months the stock market tumbled, as did Twitter’s stock price. By summer it became clear that Musk would pay much more for the company than it was worth.

Realizing his mistake, Musk made a vigorous attempt to extricate himself from the deal; he first asserted his intent to withdraw because the company was not fully transparent about the presence of bots operating on the website, and then he appeared to take steps to undo his financing arrangement for the deal, which he—incorrectly—thought might extricate him.

However, the Delaware Court of Chancery, where Twitter is incorporated and the transaction occurred, made it abundantly clear that the contract he signed when he agreed to acquire Twitter clearly delineated the predicates for canceling the deal, and a steep fall in the stock price was not one of them.

Despite his lawyers’ best efforts to meet one of those predicates, they failed to do so and the deal went through. Today, Elon Musk—no doubt to his regret—is the owner of a company for which he paid significantly more than its market price.

Elon Musk is not the only investor who’s made a deal to purchase an asset and seen its value plummet before closing the deal.

Around the same time Musk was arranging to acquire Twitter, an entity called Java Capital LLC —an Affiliate of a New York investment company called Emerald Empire Inc—entered into an agreement to purchase a multifamily residential housing property in St. Louis.

Between the signing of a contract and the closing of the deal, interest rates jumped significantly, which deteriorated the expected returns of EEI from the investment. As a result, it sought a way out of the deal. Like Musk, it seized on any possible pretext for canceling the contract: In this case, they averred that the reported estimate of the number of units in the development they were purchasing was incorrect because it included a leasing office, storage and a gym. As a result, they were left with only 425 units to rent out instead of 429, and they argue that this discrepancy is enough to allow them to end the contract and receive their earnest money.

The seller, an entity called Southfield Partnership, countered that the two model units, storage and the fitness center could easily be rented once the transaction was completed and the building was close to fully occupied. It averred that Java Capital wished to end the contract simply because it no longer made financial sense for it.

Under the terms of the contract, that would entitle Java Capital to keep the earnest money; since the price it is worth today has undoubtedly fallen, that would compensate Southfield Partnership for the fact that the deal it signed with Java Capital in April precluded it from pursuing other potential buyers over the next few months, before the Missouri real estate market softened.

Around the time Java Capital signed this acquisition contract, another affiliate of Emerald Empire also signed a contract to acquire another property in the St. Louis area that was developed by an entity called VA7 Trilogy. As with Java Capital’s pending purchase, the profitability of the deal fell with the increase in interest rates, and it has now alleged that the seller misrepresented the deal in some way, which it wants to use to cancel the contract.

EEI is also involved in another lawsuit arising out of a similar situation; it closed on a multifamily residential property in St. Louis in May, and is suing to have that transaction voided as well, with its earnest money returned.

Real estate investments can be risky: The leverage most developers and builders employ to finance their investments (and us homebuyers as well) means that a modest downturn in the market can wipe out an investor’s equity in short order. It’s understandable that an investor who sees that happen between the agreement and the closing would want to escape it.

However, the real estate market would become much less efficient if agreements could be easily undone by the buyer ex post simply because the market changed. Sellers would demand higher prices to compensate them for that risk, place additional conditions on the transaction to try to make them inviolable—adding to transaction costs—or possibly delay selling altogether and hold onto properties longer, further increasing real estate prices.

The Delaware Court of Chancery held Elon Musk to the terms of his contract because the agreement clearly spelled out the conditions to cancel it had not been met, and to do otherwise would have injected a significant degree of uncertainty into future transactions in the market.

The same reasoning applies to these real estate transactions. Businesses need to abide by their contracts and the courts must uphold their terms, even if they may no longer be financially advantageous for one of the entities. It’s a notion that serves as a foundation of our economic system.