COVID-19 has had far reaching economic effects that continue to ripple through every industry, and real estate is no exception. In this time of uncertainty many of those who have recently entered into real property purchase contracts find themselves unwilling or unable to complete the transaction. These buyers often have thousands of dollars at risk as their earnest money deposits, which typically are also earmarked as liquidated damages per the purchase contract in the event that they breach the contract. Sellers also face significant damages in this uncertain market if their buyer cancels the purchase contract, potentially above and beyond the liquidated damages. This article will address three of the defenses that buyers have when cancelling real estate contracts in an attempt to protect their deposits and cancel without consequence if they have been impacted by the ongoing pandemic. However, this is certainly an unusual time, and as such, the law surrounding these defenses is not well settled.
Liquidated damages provisions in real estate purchase agreements are governed by Civil Code section 1675. Pursuant to that section, liquidated damages amounts are presumed valid if they do not exceed at 3% of the purchase price. Anything above 3% is presumed invalid and the burden shifts to the seller to prove to the trier of fact that the higher amount is reasonable given the circumstances. In addition, there is protection built in for buyers to avoid the potential for the seller to “double dip.”. Notably, if a seller is able to successfully sell the property within 6 months of the buyer’s breach, the trier of fact may consider that subsequent sale in determining if the liquidated damages are reasonable (for instance, the buyer may recover all or some of their liquidated damages amount if the actual damages suffered by the seller are less than the amount of the deposit or liquidated damages amount, such as when the property re-sells for the same or close to the breached contract).
While Civil Code section 1675 does impose some restrictions upon liquidated damages provisions (See Attorney Simon Offord’s article on those limitations here), they do offer a general protection for both buyers and sellers in the event of a breach. The sellers can be assured at the time of contracting that they will have recourse in the event of a breach, and have some certainty as to the amount of money they will likely be able to retain (if unable to re-sell for the same or greater amount). However, it also protects the buyers from having to pay general damages (the actual amount of the seller’s loss) for their breach. In some cases the amount of general damages far exceeds the liquidated damages or deposit amount, but the buyer’s loss is capped by the liquidated damages provision of the purchase agreement (note, there is an argument that a seller can seek “specific performance” if a buyer defaults in lieu of damages, however this is a topic for another day).
California Civil Code section 1511 allows for an excuse to performance on a contract due to “acts of god,” and codifies what is commonly known as the “force majeure” defense. It states in relevant part that:
“The want of performance of an obligation, or of an offer of performance, in whole or in part, or any delay therein, is excused by the following causes, to the extent to which they operate… when it is prevented or delayed by an irresistible, superhuman cause, or by the act of public enemies of this state or of the United States, unless the parties have expressly agreed to the contrary…”
Many contracts have specific clauses that deal with the potential of an “act of god,” however the commonly used residential purchase contracts in California contain no such clause, so we have limited guidance on the topic.
The ongoing pandemic may constitute an uncontrollable “irresistible” and “superhuman” event completely outside of a buyer’s control. However, we are in uncharted territory with regard to the applicability of Civil Code section 1511 to the current circumstances. First, the reason for the non-performance matters, and California allows for some amount of flexibility in what constitutes an act of god if the event is unforeseen at the time of contracting. However, the California Courts have not yet ruled on whether the pandemic meets this legal standard. Additionally, there are many reasons why closing would or could be delayed or deemed impossible, some of which may fall outside the realm of section 1511. If the delay is due to concerns about personal safety, the lack of an appraisal or the inability to complete repairs, or even the sudden and unforeseen lack of funding due to a stock market crash, performance is not automatically excused by Civil Code section 1511.
There is some precedent for the applicability of this defense in Timney v. Lin, which dealt with a situation arising out of the September 11th terrorist attacks. (2003) 106 Cal.App.4th 1121. The case arose out of a delay in the recording of a quitclaim deed due to the events of September 11th, 2001. The court ruled that the forfeiture of the appellants’ deposit was illegal and invalid because: 1) the time delay by the Buyers which triggered the potential forfeiture of the deposit was deemed to be slight by the court (three weeks); 2) the delay was not the fault of the buyers (but due to the events of September 11, 2001); and, 3) the sellers suffered no clearly identifiable (“cognizable”) damages. However, this circumstance is narrow and specific, and only deals with the concept of delay, as opposed to an outright termination. Thus, while it provides some support for the position that buyers cannot be held responsible for delays or non-performance due to acts of god, it does not account for many situations now arising from the pandemic.
Finally, for any buyers seeking to avail themselves of the “force majeure” defense, they must be able to prove that the pandemic is the proximate cause of their non-performance. In most cases, the buyer’s non-performance is caused by voluntary human behavior. For example, take the case of a buyer hoping to cancel a purchase agreement because their small business has slowed. An argument against this may be that business has not slowed because of the pandemic, the business has slowed because customers have chosen not to spend money there, for whatever reason. While there are stay-at-home orders in effect, it is unclear that this governmental order would be sufficient to constitute the proximate cause of the buyer’s inability to complete the purchase.
Frustration of Purpose
California law also allows for the frustration of purpose defense to non-performance of a contract. Frustration of purpose can be invoked when the following conditions are met:
- Performance on the contract remains possible;
- However, the fundamental reason of both parties for entering into the contract has been frustrated by an unanticipated circumstance; and
- That circumstance substantially destroys the value of performance by the party standing on the contract.
- Additionally, the frustration must be so severe that it is not considered within the risks that were assumed under the contract.
The frustration of purpose defense requires that a supervising or intervening event destroy the main purpose of the contract. The Second Restatement of Contracts outlines this requirement by explaining that “the object [of the contract] must be so completely the basis of the contract that, as both parties understand, without it the transaction would make little sense.” Take as an example the matter of Dorn v. Goetz, in which a court rejected the seller’s frustration of purpose argument relating to a real estate contract. 85 Cal. App. 2d 407 (1948). In that case, a federal law had been passed which prevented the sellers from building the home they had intended to with the proceeds from the sale. However, because the main purpose of the contract was the sale of the old home and not the construction of the sellers’ new one, there was no frustration of the contract at issue. As such, it is likely that a buyer who does not want to complete a real estate transaction because the value of the home has decreased would not be able to avail themselves of the frustration of purpose defense.
Impossibility and Impracticability
In the even that a buyer is not able to avail themselves of the “force majeure” or frustration of purpose defenses, there is a final option. Impossibility is a defense to contract performance requires that 1) an unforeseen event that is 2) outside the parties control and 3) renders performance impossible or impracticable. In effect, “a condition in a contract, the fulfillment of which is impossible or unlawful …, or which is repugnant to the nature of the interest created by the contract, is void.” California Civil Code section 1441.
However, impossibility also does not offer a perfect protection for buyers. Impossibility must relate to something that must be done under the contract, in this case completing the transaction to purchase the property. It does not relate to the buyer’s ability to complete the transaction. The Second Restatement of Contracts addresses impossibility in section 254. It states in essence that if it is possible to perform the act contemplated by the contract, then impossibility is not a defense absent “extreme and unreasonable difficulty, expense, injury or loss.” If such extreme and unreasonable difficulty can be shown, performance may be excused as impracticable.
As the state of California has issued a sweeping shelter in place order, there is some support for the impracticability defense because all non-essential businesses have been shuttered leading to widespread economic effects. However, real estate services have been deemed essential, and therefore it is still possible to complete real estate transactions. As with “force majeure,” the courts are not settled on the applicability of this defense. It largely depends on the individual circumstances of the transaction.
California courts have demonstrated an aversion to discharging parties from their contractional obligations. They tend to hold that parties should be held to what they agree to in a contract most of the time absent exceptional circumstances or contractual provisions stating otherwise, as this is typically seen as the fairest outcome. As such, each of these defenses are narrow and reserved for extreme hardship. It is possible that the California courts will allow for some of these defenses in light of the pandemic, however it is unclear at the time this article is authored to know how and to what extent they may be applied (and this will not be known until we have binding precedent from new cases, which may take years). The extent to which any of these defenses can be successful also depends on the specific circumstances surrounding each transaction. If you are trying to cancel a real estate purchase agreement, or you are a seller who has a buyer claiming one or more of these defenses, you should consult with an experienced real estate attorney. They can help you understand the applicability of these principals to your specific case and navigate this difficult and uncertain time.