This article presents the unenforceability of liquidated damages provisions in real estate purchase agreements and the limitation on a buyer’s breach to recovery of the seller’s money losses.
Windfalls and responsibility for losses
Everyone, by the time they reach the age of capacity to contract, understands the fundamental premise that when you wrongfully cause another person to lose money, you are responsible for repayment of the loss. This moral concept was codified for real estate transactions in 1872 and remains intact today. [Calif. Civil Code §3307]
However, an equally fundamental premise holds that windfalls are abhorred by all since they are unearned.
These two precepts are frustrated by the inclusion of a liquidated damages provision in a purchase agreement. Use of a liquidated damages provision is an attempt:
· to limit a buyer’s responsibility for payment of losses he inflicts on another; and
· to provide the seller with a windfall at the buyer’s expense.
The contractual liquidated damages provision creates aberrations in the natural expectations held by everyone in the transaction.
For instance, a seller expects to lose nothing of value in exchange for what is the buyer’s good-faith deposit should the buyer fail to close the transaction. However, the buyer expects a refund of his good-faith deposit if he does not acquire the property. Ironically, the listing agent looks at the liquidated damages provision in the purchase agreement as a way to be paid a small fraction of the fee he earned since he has not bargained for a full fee should the buyer breach the purchase agreement. All of these expectations are without concern for the amount of money the seller and agents lost or that the breaching buyer caused the losses and should reimburse them.
A listing agent, being charged with a duty of care for his seller, needs to understand the contractual and financial nature of his seller’s position under a purchase agreement so he can properly advise the seller when the purchase agreement is breached by a buyer. When the buyer breaches and the seller cancels the purchase agreement, the seller still owns the property, although with no further claim by the buyer of a right to acquire it.
Also, the good-faith deposit, even if released to the seller after contingencies have been removed, is the buyer’s money until:
· the buyer receives consideration (the property); or
· the deposit is offset by reimbursement to the seller for his actual money losses suffered due to a breach by the buyer.
The seller’s purported loss of prospective buyers and prior market synergies and the infliction of seller frustration and inconvenience, all due to the buyer’s breach, are not money losses. Thus, these ancillary or collateral situations leave the seller with nothing to collect.
However, the seller’s agent properly focuses on resolving a breached and failed sales transaction by immediately turning his attention to assisting his client to “clear out” the transaction so the property can be remarketed to another prospective buyer. The listing agent is still obligated to locate buyers under the seller’s exclusive right-to-sell agreement, unless it has expired.
Thus, cancellation instructions need to be given to escrow to terminate the breached purchase agreement and escrow instructions, unless the resale value of the property has dropped or the seller has reason to pursue a specific performance action and forego reselling or retaining the property. [See Chapter 46]
Money losses reimbursed
What is the listing agent to do about a buyer’s good-faith deposit when the buyer breaches a purchase agreement?
While a listing agent’s knee-jerk reaction may well be to get the buyer’s funds to the seller so half of the deposit will be earned as a brokerage fee, the first reasonable step to be taken by the agent is to analyze the extent of the seller’s loss of money now that the sales escrow is dead. The buyer owes the seller the seller’s actual money losses since they are expenditures which will not be reimbursed by a resale. Thus, the seller has a claim on the buyer’s good-faith deposit as the primary source for recovery of the losses.
Fortunately for all, the seller’s recoverable losses are quite straightforward for calculating the amount of the demand to be made on the buyer. Getting all the figures for the demand will take time and effort. Presuming, as the listing agent must, that the seller will not interfere with the listing and allow the agent to locate a new prospective buyer, the property will be resold in the near future.
A seller’s net sheet used to lay out the net proceeds received on the closing of a resale, when compared to a seller’s net sheet estimating the net proceeds the seller would have received on the canceled sale, will present a fairly accurate representation of the money losses the seller incurred due to a decline in property value and the transactional costs not reimbursed by the resale.
The ongoing operating and carrying costs, if the property remains rented or used by the owner prior to resale, generally are not recoverable expenses. The actual or implicit rent usually exceeds the operating expenses and carrying costs of the property until the closing of the resale. Also, operating income and expenses usually are not altered due to the terms of the purchase agreement. Hence, little loss, if any, exists for the seller to recover on his continued ownership of the property.
Demands, challenges and limitations
The seller making a demand on a breaching buyer for the deposit is confronted with a decision as to when to make the demand. The seller may make a demand for all or a portion of the good-faith deposit at either:
· the time of the breach; or
· after closing a resale of the property when a loss, if any, is known.
To analyze the demand process, first look to the provisions of the purchase agreement used for the sale of a one- to-four unit residential property to a buyer-occupant. If a liquidated damages (forfeiture) provision is included in the purchase agreement and the buyer and seller both initialed the provision, they have actually agreed that the buyer’s good- faith deposit is to be forfeited to the seller on a breach by the buyer.
However, liquidated damages provisions are initially enforceable by a seller only to set the limit of the buyer’s liability to the seller by placing a ceiling on the seller’s recovery at the amount of the deposit agreed to be forfeited.
For example, if the buyer demands the deposit be refunded, the seller becomes obligated to provide an accounting showing his losses equaled or exceeded the amount of the deposit in order to keep the entire deposit. Should the losses be less, the seller is not entitled to the entire deposit. Thus, the seller can recover the money he has lost up to the total amount of the deposit referenced in the agreed liquidated damages provision, no matter the amount of the deposit.
Thus, when a liquidated damages provision exists, the proper initial reaction of the seller and the listing agent is to make a demand on the buyer for the entire good-faith deposit if it does not exceed 3% of the price since this amount of forfeiture is presumed valid.
Once the demand for the forfeiture has been made on the buyer — and it will be made without concern for the actual money losses the seller may have experienced or will experience on a resale — the seller merely waits for the buyer’s response. If it is positive and the funds are released to the seller, the seller has won the war. Hopefully for the seller, the buyer will not later realize that the seller’s actual money losses were less than the amount released and then make a demand for a refund.
However, if the buyer’s agent and the buyer are as well informed as the seller and listing agent, the buyer will challenge the liquidated damages provision as voidable and demand a return of his deposit. Thus, the provision as a forfeiture is unenforceable since the provision’s validity is a rebuttable presumption.
The seller must have sufficient losses to justify his retention of the entire liquidated damages deposit. In other words, the amount of the deposit, always being arbitrary in amount and coincidental to the price paid, has no relationship to the losses the seller might suffer on the buyer’s breach.
The seller, confronted with the buyer’s challenge that the liquidated damages provision is voidable, is back to square one. Namely, the seller must now calculate his losses on the resale and his permissible interim operating and carrying costs of the property prior to a resale as though:
· no liquidated damages provision existed in the purchase agreement;
· the amount of the deposit for liquidated damages was more than 3% and thus initially presumed invalid;
· the liquidated damages or liability limitation provision placed a ceiling on the buyer’s liability for the seller losses; and
· no provision limiting recovery existed in the purchase agreement restricting the seller’s right to recover all his losses.
Under any of the above scenarios, the seller is to itemize his money losses, which include:
· any decline in the property’s value by the time of the buyer’s breach;
· the seller’s transactional costs incurred on the lost sale which are not recoverable on a resale; and
· any increased operating costs or rent losses caused by the purchase agreement with the buyer and incurred prior to the resale.
The buyer will cover these itemized losses from the good-faith deposit up to any dollar limitation set by a liquidated damages or liability limitation provision in the purchase agreement.
The seller who seeks to recover losses caused by the breaching buyer when the buyer asserts his right to pay only the seller’s actual money losses, needs to:
· proceed to resell and close a resale of the property rather than retain the property;
· calculate the total amount of the price-to-value loss, lost transactional expenses and the loss of nonvalue-added improvements or repair expenditures;
· make a demand on the buyer for the amount of the itemized money losses; and
· if not paid, pursue collection of the lost money and a release of the amount from the buyer’s deposit, subject, of course, to any agreed limitation on the dollar amount of the buyer’s liability for his breach.
Challenging the validity of a forfeiture
A buyer and his agent, when the seller demands any of the buyer’s good-faith deposit, need to understand:
· the funds belong to the buyer until escrow closes, which will not occur due to the buyer’s breach;
· the seller has a claim against the deposit for recoverable losses; and
· the buyer is to make a demand on the seller for an itemized statement of the seller’s losses before the buyer will pay any compensable losses incurred by the seller.
Thus, when a liquidated damages provision exists on the sale of a one-to-four unit residential property which is initialed by both the seller and buyer, the buyer’s demand for an itemization of the seller’s money losses constitutes a legal challenge which rebuts the presumed validity of a forfeiture provision for deposits not exceeding 3% of the purchase price.
On making the request of the seller for an accounting, the buyer awaits the seller’s response. If the seller fails to respond with an accounting, he either did not incur a recoverable loss or waived any claim he may have to recover his losses.
Limiting the breaching buyer’s liability
Without a liquidated damages provision or contract liability limitation provision in the purchase agreement, a seller is entitled to recover the entire amount of his money losses caused by the buyer’s breach.
Conversely, the seller is limited in his recovery to the amount of the forfeitable deposit should the purchase agreement (for the sale of one-to- four residential units to a buyer-occupant) include an initialed liquidated damages provision or a contract liability limitation provision.
In either case, if an accounting is sought by the buyer for the seller’s recoverable money losses, the seller must present an accounting in order to be reimbursed for them.
When an initialed liquidated damages provision is included in a purchase agreement, the breaching buyer avoids the forfeiture called for by challenging the presumed validity of any amount up to 3% of the purchase price.
However, for the seller to enforce a forfeiture of any portion of a deposit exceeding 3% of the purchase agreement price, the seller must challenge the presumed invalidity of the excess by demonstrating in an accounting that his losses on the sale exceeded 3% of the purchase price.
Thus, the liquidated damages provision has a “split- personality” aspect. The responsibility for challenging the presumed validity of a forfeiture of 3% or less is the buyer’s, and the responsibility for challenging the presumed invalidity of a forfeiture of more than 3% is the seller’s.
In general, liquidated damages provisions agreed to by a buyer and seller of real estate, other than on the sale of one-to-four residential units to a buyer-occupant, are presumed to be valid. However, they are classified as forfeitures and are unenforceable if they do not provide an amount which bears some reasonably close relationship to the actual losses the seller will incur due to harm inflicted by the buyer on a default.
When the amount of the forfeiture exceeds the seller’s losses, the buyer can void the provision as unreasonable. Thus, the liquidated damages provision is voidable as it is only presumed to be valid if the amount is reasonably close to actual losses.
Liability ceiling or forfeiture
If a buyer and seller do not agree to either a liquidated damages provision or a contract liability limitation provision, then the buyer who enters into such a purchase agreement and breaches will be liable for an unlimited amount of losses incurred by the seller due to the buyer’s breach. In the economic environment of a stable resale market for homes or one of generally rising or fast rising prices little risk is taken by a buyer when entering into a purchase agreement without a ceiling on his liability exposure.
However, it is for buyers in a static market or one following a peak in prices when mortgage rates rise that the buyer’s agent needs to take utmost care to explain the need for a ceiling on liability exposure.
As for the listing agent, he should advise his seller in times of weak or weakening pricing power to avoid agreeing to a ceiling on the buyer’s liability and to get a huge deposit.
Seller breach by refusal to refund
Consider a buyer of a single family residence who has entered into a purchase agreement containing an initialed, liquidated damages provision.
Prior to closing, the buyer waives all contingencies and releases his original and additional good-faith deposit to the seller in an amount in excess of 3% of the agreed price. At the time of closing, the buyer decides not to close escrow on the purchase of the property.
The seller promptly remarkets the property, accepts an offer and quickly closes a resale of the property, but at a slightly lower price. The buyer then makes a demand on the seller to return that portion of the deposit now held by the seller which exceeds the seller’s losses. The breaching buyer is willing to cover the seller’s loss due to the reduced amount of net proceeds on the resale.
The seller rejects the buyer’s demand for a refund, claiming the funds released were option money which he is entitled to keep as consideration for his irrevocable offer to sell the property to the buyer, which the buyer did not exercise by closing escrow.
However, the liquidated damages provision in the purchase agreement indicates the agreement is bilateral. The purchase agreement called for a forfeiture of the deposit should the buyer fail to close escrow, the antithesis of an option agreement which is unilateral and by its nature contains no forfeitures. Thus, the seller’s defense for keeping the buyer’s deposits as option money consideration for granting an option is a non-starter.
Also, the seller did not attempt to show that his losses caused by the buyer’s breach equaled or exceeded the buyer’s deposits. The seller did not produce closing statements for either the lost sale or the resale, lost transactional expenses, nonvalue– adding expenditures for repairs or maintenance, or any recoverable operating costs for carrying the property or lost rental value until the close of the resale.
Here, the liquidated damages provision becomes a promise by the seller to refund the portion of the deposit which exceeds the seller’s recoverable losses, due to either:
· a buyer’s challenge of the forfeiture’s reasonableness; or
· the forfeiture amount being in excess of 3% of the purchase price.
Thus, the seller’s failure to refund (or release) the amount exceeding his losses is a breach by the seller of the liquidated damages provision and the purchase agreement. [Allen v. Smith (2002) 94 CA4th 1270]
Had the purchase agreement not contained a liquidated damages provision or other contractual liabilities limitation, the seller would still have been limited to collecting no more than his actual losses. Thus, the excess amount of the buyer’s deposit over the seller’s losses must always be refunded by the seller or released from escrow to the buyer.
Court-ordered forfeiture not enforced
Consider a buyer and seller of a one-to-four unit residential property who enter into a court-ordered settlement agreement to resolve a dispute over their purchase agreement by agreeing to close escrow. The settlement agreement contains a forfeiture provision calling for the release of the buyer’s good-faith deposit to the seller if the buyer does not complete the sale as agreed.
However, the buyer is unable to secure purchase-assist financing and cancels escrow, a breach of the settlement agreement since closing escrow was not contingent on his obtaining a loan.
The seller seeks to recover the buyer’s good-faith deposit. However, the seller has incurred no loss due to the buyer’s failure to perform.
The buyer claims the seller cannot enforce the forfeiture provision in the court-ordered settlement agreement since any provision agreeing to the forfeiture of the good-faith deposit is limited by contract law to a provable loss.
The seller claims the forfeiture provision is enforceable without a proof of loss since the provision is contained in a court-ordered settlement agreement between the buyer and seller, not in a privately negotiated real estate purchase agreement.
Here, as in all forfeitures of money arising out of any real estate transaction, the seller may not enforce the forfeiture provision and recover the buyer’s good-faith deposit without a showing of his actual money losses. The court-approved settlement agreement is a contract agreed to by the buyer and seller and contract law prohibits the enforcement of liquidated damages provisions in real estate purchase agreements, unless the seller incurs a loss. [Timney v. Lin (2003) 106 CA4th 1121]