This article discusses the return of the buyer’s deposit on the failure of escrow to close and the penalties for a bad- faith refusal to permit a refund.

First clear out the deposits

The day before escrow is to close, a buyer hands escrow instructions calling for the return of his entire deposit and the cancellation of both the escrow instructions and the purchase agreement. The buyer’s cancellation is not excused by the exercise of a contingency provision, or justified due to a misrepresentation of facts or the failure of an agency. Thus, the buyer’s instructions constitute a breach of the purchase agreement with the seller (and, for the agents, an interference with payment of their fees).

A copy of the cancellation instructions is forwarded to the seller to sign and return to escrow. No funds will be released from escrow without mutual, conforming instructions from both the buyer and seller.

However, the seller is unwilling to sign the instructions. The seller believes he is entitled to the buyer’s deposit and wants the funds released to him:

  • as compensation for the time, effort and resale opportunities he has lost;
  • as consideration for his consent to a cancellation of the purchase agreement; and
  • as stated in the liquidated damages provision agreed to in the purchase agreement for forfeiture.

The listing agent, not wishing to spend time on a dead deal, redirects his energies to locating a prospective buyer for the property. However, the lack of a cancellation of an outstanding sales transaction on the property looms as a potential problem should the buyer who cancelled decide to pursue acquisition of the property or otherwise interfere with title to the property.

The seller is adamant about enforcing the purchase agreement’s liquidated damages provision which states he is entitled to the entire deposit now held in escrow. However, the listing agent informs the seller the liquidate damages provision is applicable only if the buyer voluntarily releases the deposit to the seller. If the buyer is unwilling to release the funds to the seller, the seller is entitled to the funds only to the extent necessary to reimburse the seller for actual money losses he has incurred and any decline in property value he has experienced prior to cancellation of escrow.

A quick review with the seller demonstrates that the seller has not incurred any money losses as a result of the buyer’s breach of the purchase agreement. The expenditures he has made to ready the property for closing will be fully recovered on a resale of the property to another buyer. Further, the property value now equals or exceeds the price the buyer agreed to pay since property values have not yet fallen.

When the buyer makes a claim for the release of his deposit, the buyer implicitly challenges the seller’s right to the deposit under the liquidated damages provision. It then becomes incumbent upon the seller to “prove up” his out-of-pocket money losses brought about by the buyer’s failure to complete the transaction if the seller is to recover any money. Here, the seller will be unable to provide proof of money losses as he has none.

The listing agent further informs the seller he could become liable to the buyer for a money penalty of up to $1,000, in addition to the deposits since the property involved is a one-to-four unit residential property. The liability arises if the seller wrongfully interferes with the return of the buyer’s good-faith deposit for a period beyond 30 days after the buyer demands its return. [Calif. Civil Code §1057.3(b)(2)]

The release-of-deposit scheme

The sale of property containing one-to-four residential units is subject to numerous legislative schemes intended to limit or enlarge the existing contract rights of the buyer and seller. More generally, the schemes alleviate burdens which regularly arise in real estate transactions and need a uniform procedure for their resolution.

One set of rights and burdens has as its subject matter the troublesome nature of failed real estate sales escrows which hold funds. When a buyer and seller cannot agree on a mutually acceptable disbursement of the funds on the cancellation of escrow, escrow cannot close out its trust account and avoid further responsibility to account for the funds.

The failed escrow scheme sets up a deadline for the buyer and seller, or their agents, to work out an acceptable disbursement. If the deadline is not met with a release of funds and the cancellation of escrow, a monetary penalty (and attorney fees) is imposed on the seller or buyer who interfered with the release and did not have a good-faith, reasonable legal basis for making a claim on the funds.

Also, the scheme clarifies the right of the buyer and seller to cancel escrow instructions without losing any rights to pursue claims they may have against one another under the purchase agreement which remains uncancelled.

Consider a sales escrow which does not close on the date scheduled for closing. The purchase funds of the buyer are on deposit with escrow. A demand is made on escrow by the buyer for a return of the deposit, followed by a demand on the funds by the seller.

Within a period of 30 days after the first demand received by escrow for the funds, the buyer and seller are obligated to determine who is entitled to the funds and hand escrow cancellation and release of funds instructions which will clear the deposits out of escrow. If they fail to do so, the person entitled to the funds is to be awarded a penalty and attorney fees for enforcing his right to receive the funds.

As in any transaction which has failed to close, the person entitled to the funds may file a lawsuit to enforce a refund or release of the deposit and the payment of a bad-faith penalty of not more than $1,000. When litigation exists on the transaction, escrow deposits all funds held in the escrow account with the court, less escrow cancellation charges. The deposit by escrow with the court terminates any further responsibility of escrow to account for the funds. On conclusion of the lawsuit, the prevailing party is entitled to attorney fees — and the funds.

Good-faith dispute

Consent by a seller to a return of the buyer’s deposit is not required if a legitimate, good-faith dispute exists over the seller’s entitlement to the funds. Neither the buyer nor the seller will be entitled to the penalty or statutory attorney fees on court resolution of a good-faith dispute. The good-faith standard for an individual’s refusal to release escrowed funds requires a reasonable belief honestly held by the individual about his right to the funds. [CC §1057.3(f)(2)]

For example, a seller of any type of real estate cannot reasonably believe he is entitled to the buyer’s deposit when a mere cursory review of the liquidated damages forfeiture codes indicates he has no right to compensation. The liquidated damages codes apply in spite of forfeiture wording to the contrary in the purchase agreement. Unless the seller has actually sustained out-of- pocket money losses on transaction-related expenditures or experienced a decline in the property’s value by the date of the buyer’s breach, he is making a demand without legal basis. [CC §§1671 et seq.]

It is important for a seller to understand that a buyer who breaches the purchase agreement is entitled to a refund of his entire good-faith deposit, undiminished, so long as no money losses are incurred by the seller. Conversely, the seller who refuses to release the buyer’s deposit and cancel escrow instructions based solely on the fact the buyer breached, has himself failed to act in good faith.

Thus, a seller’s unjustified adverse and hostile reaction to a buyer’s breach subjects the seller to the civil money penalty and attorney fees for not instructing escrow to refund the buyer’s deposits, after first deducting and reimbursing the seller for his out-of-pocket money losses incurred on the failed transaction which will not be recovered on a resale of the property.

The seller’s recovery

Consider a seller who incurs money losses due to a buyer’s breach of their purchase agreement. Money losses include lost rent, a decline in the property’s value, transactional expenses and other expenditures directly related to the transaction which will go uncompensated (on a resale or retention of the property) if the buyer does not close escrow.

On the buyer’s breach, the seller sends escrow instructions authorizing escrow to release to the seller a portion of the buyer’s deposit equal in amount to the seller’s out-of- pocket money losses. Any funds remaining after escrow deducts its cancellation charges are to be returned to the buyer.

The seller promptly provides the breaching buyer with an itemized accounting of his money losses incurred in the transaction prior to the breach. The buyer is requested to sign the disbursement instructions which includes a cancellation of escrow, but not a cancellation of the purchase agreement.

The buyer refuses to sign the instructions due to the reduction in the amount refunded. Instead, the buyer demands the seller sign conflicting instructions releasing the entire deposit to the buyer and calling for cancellation of both escrow and the purchase agreement.

More than 30 days after the seller instructed escrow to disburse the buyer’s funds, the seller makes a demand on the buyer for his losses and files a money action for:

  • the release of the portion of the deposit necessary to reimburse the seller for his itemized money losses;
  • a civil penalty of up to $1,000 against the buyer for wrongfully interfering with the release of funds; and
  • attorney fees incurred in the action to recover the funds. [CC §1057.3(b)]

However, the buyer defends his conduct, claiming neither the penalty nor the attorney fees can be awarded since a good-faith dispute exists over the seller’s entitlement to the funds.

The seller claims the buyer acted in bad-faith since the seller provided complete documentation of his losses and sought the release of only the amount of his losses.

Is the seller entitled to the penalty and attorney fees under the escrow refund statute?

Yes! The buyer’s (unreasonable) belief that he entitled to a full refund of his deposit was entirely without legal foundation. Thus, the buyer’s demand for a full refund was unreasonable.

Here, the buyer received itemized documentation of the seller’s uncompensated losses stemming solely from the buyer’s breach, neither of which were in dispute. The seller’s performance under the purchase agreement alone necessitated the transactional expenditures the seller now seeks to recover. Thus, the buyer acted in bad faith for lack of an honestly held belief about his entitlement to a full refund and cannot avoid liability for the penalty and the seller’s attorney fees.

However, the seller must document his money losses should the buyer challenge a forfeiture of his funds before the buyer can be reasonably expected to agree to release compensating funds to the seller. If the seller does not provide documentation of his actual money losses, the buyer will likely escape penalties and attorney fees by claiming he acted in good faith when he disputed the release of the funds demanded by the seller.

The purchase agreement remains
(but the escrow file is closed)

The primary purpose of the release-of-funds statute is to distance escrow from buyer-seller disputes over funds held in escrow.

The cancellation of escrow and the release of funds do not cancel the underlying purchase agreement or alter the rights of either party to litigate any past or future performance of the purchase agreement since the purchase agreement is not the subject of the cancellation instructions. [CC §1057.3(e)]

For example, a buyer’s cancellation of escrow due to the seller’s nonperformance does not affect the buyer’s right to pursue specific performance of the purchase agreement since the purchase agreement remains in effect, unless it too is cancelled. Also, if the funds are withheld by escrow due to a wrongful claim on them by the seller, a purchaser’s lien on the property is available to the buyer. The lien can be foreclosed to collect the funds withheld. [CC §§3050; 3375 et seq.]

However, the seller, and (especially) his listing broker, do not want the property tied up by a buyer during an on-going attempt to recover funds in a lawsuit.

A listing agent’s best advice to his seller is for the seller to consider rescinding the underlying purchase agreement at the same time escrow is cancelled — a moment when the buyer is most apt to rescind the entire transaction in exchange for the release of his funds.

The incentive for the seller and his agent to rescind the purchase agreement is to eliminate any claims the dissatisfied buyer may later attempt to advance against the seller, the property or the agent. On eliminating the buyer’s claims, the agent is free to move on to the ultimate objective of locating a prospective buyer who is ready, willing and able to purchase the property.

In a declining real estate market, a seller’s losses will include the difference between the price agreed to by the buyer and the lower value of the property at the time of the buyer’s breach. This amount could easily exceed the amount of the escrow deposit. The seller may want to consider retaining the purchase agreement uncancelled to go after the buyer for losses caused by the buyer’s breach.

Finally, a buyer’s cancellation of escrow and the release of the escrow deposit to the seller without also entering into a mutual cancellation of the purchase agreement leaves intact the seller’s right to enforce specific performance of the sale or the collection of the remainder of his losses (money and any price- to-value decline) brought about by the buyer’s breach. [CC §1057.3(e)]

An interest-bearing account offsets losses

Consider a buyer and seller who enter into a purchase agreement regarding property other than one-to-four residential units. The escrow instructions state the buyer’s deposit will be placed in a non-interest-bearing trust account.

While in escrow, the buyer and seller get into a dispute and the seller cancels escrow. The buyer makes a demand on the seller to close escrow, which is rejected. The buyer files an action for specific performance of the purchase agreement seeking to acquire ownership of the property.

In the meantime, the funds on deposit in escrow will remain unproductive in the non-interest-bearing trust account or on deposit with the court.

Can the buyer and seller avoid losing interest on deposits held by escrow when a dispute arises and the funds are not released?

Yes! The buyer and seller can agree and instruct escrow to deposit the funds into an interest-bearing account. [10 Calif. Code of Regulations §1737(b)]

The interest-bearing trust account allows escrowed funds to realize their earning power in a savings account instead of allowing the funds to remain dormant during the extended escrow period. The consent of both the seller and buyer is needed to authorize the placement of the funds into an interest-bearing account.

Further, without mutual instructions from the buyer and seller, the escrow agent has no duty to redeposit the funds into interest- bearing accounts. An escrow holder is a limited agent who follows instructions, not a trustee with discretionary authority to act. [Hannon v. Western Title Insurance Company (1989) 211 CA3d 1122]

On occasion, a buyer or seller may refuse to reach an agreement to place the deposit in an interest-bearing account. However, the party entitled to the funds is then also entitled to interest on the funds from the party who wrongfully refuses to allow the funds to be released, or who refuses to authorize placement of the funds in an the interest-bearing account.