Liquidated Damages and Buyer’s Refusal to Close Escrow

Real Estate Contracts & Transactions by Simon Offord, Esq.

Buyers seeking to back out of a purchase contract after all contingencies have been removed is one of the matters we see the most in our office.  This is not surprising, given the crazy Bay Area real estate market and the fact that so many of the offers made are non-contingent, made on very short notice, or have limited or short contingency periods.  The snap decision on what is typically people’s biggest investment can lead to cold feet, or the discovery of new information, leading to buyers seeking to cancel the contract.  The question then becomes, do they have a right to and what happens to the deposit?

Lin this month’s article, let’s look at the more clean cut example (next month, we will examine a slightly more convoluted set of facts).  Imagine a buyer sees a home for the first time on an open house on Sunday.  The open house is packed with eager buyers, and the listing agent tells the buyer’s agent that they are accepting offers on Tuesday, a mere two days away.  The buyer receives the disclosures later that night, and is expected to decide on whether they will make an offer in an extremely limited time frame.  The buyer decides to make the offer for $1,000,000.00 with no contingencies, as the listing agent informs the buyer’s agent that they are expecting multiple offers with no contingencies. The buyer initials the liquidated damages provision in the contract, which is commonly done in the Bay Area. Tuesday afternoon comes and the buyer gets good news, the offer is accepted.  The buyer thereafter deposits $30,000.00 in escrow, known as the earnest money deposit, which is typically 3% of the purchase price.

A few days later, the buyer starts getting cold feet.  Whether they felt rushed in making the decision, or another property they like better has come available, or they simply decide they want to leave the Bay Area to live off of the land in a remote place of the world, they want out.

The buyer’s agent alerts the listing agent of the proposed cancellation.  The seller is not happy, and demands that the buyer release the $30,000.00 deposit to the seller.  The question then becomes, does the buyer have to turn over the full deposit?  In typical lawyer fashion, the answer is “it depends.”

Many people seem to be under the impression that since the liquidated damage provision of the contract is signed, this means that if the buyer backs out of the contract without a right to do so, the seller automatically gets to keep the deposit.  A plain reading of the commonly used real estate purchase agreements in California may be susceptible to such interpretation, however a little thing called “the law” trumps such position.

California has a specific law that deals with just this situation.  The law is Civil Code Section 1675.  Section 1675 says, in pertinent part:

(a) As used in this section, “residential property” means real property primarily consisting of a dwelling that meets both of the following requirements:

(1) The dwelling contains not more than four residential units.

(2) At the time the contract to purchase and sell the property is made, the buyer intends to occupy the dwelling or one of its units as his or her residence.

(b) A provision in a contract to purchase and sell residential property that provides that all or any part of a payment made by the buyer shall constitute liquidated damages to the seller upon the buyer’s failure to complete the purchase of the property is valid to the extent that payment in the form of cash or check, including a postdated check, is actually made if the provision satisfies the requirements of Sections 1677 and 1678 and either subdivision (c) or (d) of this section.

(c) If the amount actually paid pursuant to the liquidated damages provision does not exceed 3 percent of the purchase price, the provision is valid to the extent that payment is actually made unless the buyer establishes that the amount is unreasonable as liquidated damages.

(d) If the amount actually paid pursuant to the liquidated damages provision exceeds 3 percent of the purchase price, the provision is invalid unless the party seeking to uphold the provision establishes that the amount actually paid is reasonable as liquidated damages.

(e) For the purposes of subdivisions (c) and (d), the reasonableness of an amount actually paid as liquidated damages shall be determined by taking into account both of the following:

(1) The circumstances existing at the time the contract was made.

(2) The price and other terms and circumstances of any subsequent sale or contract to sell and purchase the same property if the sale or contract is made within six months of the buyer’s default.

Subsection (e)(2) is the most critical provision for the present situation.  This provision essentially says that a liquidated damages provision can be considered unreasonable, and thus unenforceable, after considering any subsequent sale of the property within six months of the buyer’s default.

So what does this mean?  Let’s imagine that after the buyer decides to back out, the seller either re-lists the property or reaches back out to the prior offerors.  In doing so, the seller enters into contract with a new buyer for $1,050,000.00.  All other terms and conditions are essentially the same, and the new buyer can close escrow at approximately the same time.  Therefore, the seller would actually be in a better situation than had the original buyer closed escrow, as the new buyer is willing to pay more than the original buyer.  Given that, it would make no sense for the seller to also get to keep the original buyer’s deposit, as such situation would result in a windfall for the seller.

Of course, the seller finding a new buyer willing to pay more than the original buyer will not happen every time, or frankly, all that often.  However, there are certainly many situations where a new buyer will enter into contract for an equal or similar amount to the original buyer.  In those situations, it is likely possible to determine the exact amount of damages suffered by the seller.  For example, if the new buyer is willing to pay $1,000,000.00 as well, is the seller actually damaged?  Again, it depends.  If the new buyer cannot close when the original buyer was in contract to close, the seller will argue that it has additional carrying costs due to the delay in closing (such as mortgage interest, property taxes, HOA dues, insurance, storage costs etc.).  However, it is unlikely that those costs are $30,000.00, or even close to it.  Thus, the original buyer will argue that the seller is only entitled to collect the actual damages suffered, not a punitive figure that has no relation to the actual damage suffered.  This is exactly the point of Civil Code Section 1675.  When there is an obvious way to determine how much a party is actually damaged, that is what the parties should use, not some speculative figure that does not actually represent the real damages.

The moral of the story is thus that just because the liquidated damages provision has been signed, this does not mean that the seller is automatically entitled to keep all of that deposit.  Oftentimes, it is actually impossible to determine right away what should happen with the deposit.  Because of this, a common resolution of this issue is to agree to cancel the contract with the funds held in escrow so that the seller can attempt to find a new buyer.  That way, the parties know what the property re-sold for and can negotiate a resolution based thereon.  However, some parties prefer to resolve the dispute right away, and thus are willing to gamble on what may happen with the property on an attempted re-sale.  This is certainly an option as well, and thus it is strongly recommended that the parties both consult with counsel before deciding how to handle such disputes.

Our next article will look at the situation where the buyer believes they have a right to back out of the contract, and what issues may arise in those scenarios.

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