This article advises agents on the need during a recessionary period in the real estate market to know the buyer’s liability exposure when the buyer breaches their purchase agreement. With this information, agents will be aware of the maximum dollar amount the seller is entitled to receive.
Windfall provisions, and liability limited to losses
A fundamental premise in law: when you wrongfully cause another person to lose money, you are responsible for repayment of the loss, and nothing more. This economic concept was codified for California real estate transactions in 1872 and remains intact today. [Calif. Civil Code §3307]
However, an equally fundamental and reciprocal premise holds that windfalls are abhorred by all since they are unearned and do not represent the loss.
These two legal precepts are disturbed by the inclusion of a liquidated damages provision (also called a forfeiture provision) in a purchase agreement (and, while we are at it, the inclusion of attorney fee provisions which we do not deal with here).
Use of a liquidated damages provision in a purchase agreement is an attempt to both:
- limit a buyer’s responsibility for payment of losses they inflict on a seller; and
- provide the seller with a windfall at the buyer’s expense.
The presence of a liquidated damages provision in agreements creates aberrations in the natural expectations logically held by individuals in a real estate transaction.
For an example of this distorted thinking: a seller expects to lose nothing of value in exchange for their receipt of the buyer’s good faith deposit when the buyer fails to close the transaction. However, the buyer expects a refund of their good faith deposit when they do not acquire the property as no one has lost or received anything.
A sellers agent needs to understand the financial nature of their seller’s position under a purchase agreement —with or without a liquidated damages provision. With a bit of knowledge, the agent may properly advise the seller when a buyer breaches the agreement negotiated by the agent.
When the buyer breaches and the seller cancels the purchase agreement, enabling the seller to market and resell the property, it is obvious the seller still owns the property. Further, the seller by cancelling has cleared the property of any claim by the buyer to acquire it. The seller has lost nothing, unless the property value was less at the time of breach or the buyer caused a loss of rental income or wrongfully interferes with the resale efforts. [See RPI Form 150]
Losses and resolving a breach
A buyer’s good faith deposit, even when released to the seller before closing after removal of all contingencies, remains the buyer’s money until:
- the buyer receives consideration (i.e., title to the property on close of escrow); or
- the deposit is offset to reimburse the seller for their actual money losses incurred due to a breach by the buyer.
The seller’s purported loss of prospective buyers and recent cyclical market synergies, or the infliction of seller inconvenience and frustration — all attributable to the buyer’s breach — are not money losses. Thus, these ancillary non-monetary conditions leave the seller with nothing in money losses to pursue or collect.
However, the sellers agent properly focuses on resolving a buyer’s breach and the failed sales transaction by immediately turning their attention to assisting their client to “clear out” the breached transaction so the property can be remarketed. Here, the sellers agent is still obligated to locate buyers under the seller’s Exclusive Right to Sell Agreement, unless it has expired. [See RPI Form 102]
To resell, cancellation instructions need to be given to escrow to cancel the breached purchase agreement and escrow instructions, unless the seller has reason to forego reselling the property and pursues a specific performance action to force the buyer to close escrow or simply decides to retain the property.
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Money losses reimbursed
What is the sellers agent to do about a buyer’s good faith deposit when the buyer breaches a purchase agreement?
While the agent’s knee-jerk reaction may be to call for release of the buyer’s deposit to the seller, the first reasonable step to take is to calculate the amount of money the seller lost.
The buyer owes the seller the seller’s actual money losses — expenditures which will not be reimbursed on a resale. Thus, the seller has a claim on the buyer’s good faith deposit as the primary source for recovery of money losses.
To the seller’s benefit, calculating the seller’s recoverable losses are quite straightforward for setting the amount of the demand to be made on the buyer.
Presuming, as a sellers agent must, the seller will not interfere with the listing and will allow the agent to locate a new prospective buyer, the property is likely to be resold in the near future when correctly priced. Again, a further price drop after the breach is not recoverable.
Accounting for income and expenses
Money losses recoverable by the seller include:
- increases in transactional costs on the resale over the costs the seller was to incur on the failed transaction; and
- any transactional costs actually incurred in the failed sale not reimbursed on the resale.
When the comparison of the net sheets on each transaction presents evidence the seller received less proceeds on the resale due to transactional costs differences, the seller has a factual basis for recovery. [See RPI Form 310]
The ongoing operating and carrying costs incurred during continued ownership are not recoverable expenses when the property remains rented or occupied by the owner prior to resale. The actual or implicit rent typically remains the same value, as do the operating expenses and carrying costs, after the breach until the closing of the resale.
However, when rents were decreased, units left vacant, or costs increased by agreement with the buyer and those conditions remain after the breach, the breaching buyer is liable for those amounts as losses foreseeably resulting from their breach.
Operating income and expenses and carrying costs of ownership – taxes, mortgage payments, assessments – are not typically altered by the terms of the purchase agreement. Thus, little (if any) loss exists for the seller to recover on their continued ownership of the property unless the value of the property declined below the agreed sales price at the time of the breach.
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Brokerage Reminder: Disbursement of funds when a transaction fails
Demands, challenges and limitations
When may the seller make the demand on the breaching buyer?
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.
When a liquidated damages provision is included in the purchase agreement for one-to-four residential units and the buyer and seller both initial the provision, they have agreed that the buyer’s good faith deposit is to be forfeited to the seller on a breach by the buyer. But like all agreements, the provisions are subject to judicial enforcement based on contract law principles that then exist.
Here, liquidated damages provisions are enforceable by a seller, but only to set the limit of the buyer’s liability to the seller. Thus, the ceiling on the seller’s recovery is set at the amount agreed to be forfeited — typically the good faith deposit.
However, that is not where the analysis stops. When a breaching buyer demands the deposit be refunded, the seller becomes obligated to provide an accounting. When the accounting shows the seller’s losses equaled or exceeded the amount of the deposit, the seller is entitled to the entire deposit, but no more.
When the losses are less, the seller is entitled to recover only the amount of their actual money losses, not the entire deposit as actually worded in the liquidated damages provision. Here, the seller can recover the money they lost up to the total amount of the deposit referenced in the agreed liquidated damages provision and no more, no matter the amount of the deposit.
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Making a demand
When a liquidated damages provision exists, the proper initial reaction of the seller and the sellers agent is to make a demand on the buyer for the entire good faith deposit when it does not exceed 3% of the price. This percentage amount of forfeiture is presumed valid (though it may not be collectible) [CC §1675(c)]
Once the demand for the forfeiture has been made on the buyer — without concern for the actual money losses the seller has incurred or will experience on a resale — the seller merely waits for the buyer’s response. When it is positive and the funds are released to the seller, the seller has won without argument. Ideally (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, when the buyers agent and the buyer are well informed, the buyer will challenge any seller demand for the deposit under any type of liquidated damages provision. The buyer’s claim is that the validity presumption is voidable and demand a return of their deposit. In analysis, the provision’s validity is a rebuttable presumption giving the buyer the upper hand. Thus, the provision is a forfeiture and unenforceable as such.
Further, the total amount of the deposit — arbitrary for losses and coincidental to the price paid, not losses — has no legal relationship to the losses the seller may suffer on the buyer’s breach. Still, the deposit is the source of funds for the recovery of actual losses.
Calculating the seller’s losses
When a breaching buyer challenges any liquidated damages or forfeiture provision as voidable, the seller needs to itemize and calculate their losses on the resale, along with their permissible interim operating and carrying costs of vacant property prior to a resale, even when:
- no liquidated damages provision exists in the purchase agreement;
- the amount of the liquidated damages is more than 3% and thus presumed invalid;
- the liquidated damages or liability limitation provision places a ceiling on the buyer’s liability for the seller losses; or
- no provision limiting recovery existed in the purchase agreement restricting the seller’s right to recover all their losses.
Under any of the above scenarios, the seller is to itemize their money losses to include:
- any decline in the property’s value by the date of the buyer’s breach;
- the seller’s transactional costs incurred on the lost sale which are not recovered on a resale; and
- any increased operating costs or rent losses caused by the terms of the purchase agreement for the benefit of the buyer and incurred through the date of a resale.
Collecting from the buyer
The buyer is to 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.
Before the seller may recover losses caused by the breaching buyer when the buyer asserts their obligation to pay only the seller’s actual money losses, the seller needs to:
- promptly proceed to market, resell and close a resale of the property rather than retain the property;
- calculate the total amount of the price-to-value difference at the time of the buyer’s breach, lost transactional expenses on the breached sale and the loss of expenditures on non-value-adding improvements or repairs called for under the breached purchase agreement;
- make a demand on the buyer for the amount of the itemized money losses; and
- when not paid, pursue collection of the lost money and a release of the amount from the buyer’s deposit — subject to any agreed limitation on the dollar amount of the buyer’s liability for their breach.
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Challenging the validity-of-forfeiture presumption
When the seller demands the buyer’s good faith deposit, the buyer and buyers agent 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 a statement of itemized losses before the buyer pays any compensable losses incurred by the seller.
Thus, when an initialed liquidated damages provision is included in a purchase agreement, the buyer’s demand for an itemization of the seller’s money losses constitutes a legal challenge. The demand rebuts the presumed validity of a forfeiture-of-deposit provision for deposit amounts not exceeding 3% of the purchase price.
Following the request of the seller for an accounting, when the seller fails to respond, they either did not incur a recoverable loss or waived any claim to recover their losses.
Limiting the breaching buyer’s liability
A seller is entitled to recover the entire amount of their money losses caused by the buyer’s breach when the purchase agreement does not contain a liquidated damages provision or contract liability limitation provision.
Conversely, the seller is limited in their recovery when the purchase agreement (for the sale of one-to- four residential units to a buyer-occupant) includes an initialed liquidated damages provision or a contract liability limitation provision.
In either case, when an accounting is sought by the buyer for the seller’s recoverable money losses, the seller needs to present an accounting to be reimbursed.
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 demanded by the seller up to 3% of the purchase price. [3 CC §1675(c)]
However, for the seller to enforce a forfeiture of any portion of a deposit exceeding 3% of the purchase agreement price, the seller challenges the presumed invalidity of the excess demand by demonstrating their losses on the sale exceeded 3% of the purchase price. [CC §1675(d)]
Thus, the liquidated damages provision has a “split-personality” — the responsibility of the buyer is to challenge the presumed validity of a forfeiture of 3% or less, while the responsibility for challenging the presumed invalidity of a forfeiture of more than 3% is the seller’s. Either way, the seller needs to account for losses.
In general, liquidated damages provisions, other than on the sale of one-to-four residential units to a buyer-occupant, are initially presumed to be valid. However, they are unenforceable when they do not represent an amount which bears some reasonably close relationship to the actual losses the seller will incur due to money lost resulting from the buyer’s default.
When the amount of the forfeiture exceeds the seller’s losses, the buyer can void the provision as unreasonable.
Liability ceiling or forfeiture
When a buyer and seller do not agree to either a liquidated damages provision or a contract liability limitation provision, the buyer who enters into such a purchase agreement and breaches is liable for an unlimited amount of losses incurred by the seller due to the buyer’s breach. In a stable resale market for property or one of rising prices, the buyer takes little risk when entering into a purchase agreement without a ceiling on their liability exposure.
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However, during a falling price environment, the buyers agent needs to be diligent in their protection of the buyer by explaining the need for a ceiling on liability exposure. Otherwise, when the value of the seller’s property has dropped below the sales price, the defaulting buyer may be liable for large seller losses.
In contrast, the sellers agent advises their seller in times of weak or weakening pricing power to avoid agreeing to a ceiling on the buyer’s liability and to obtain a larger deposit.
Seller’s refusal to refund is a breach
Consider a buyer of a single family residence (SFR) who has entered into a purchase agreement containing an initialed, liquidated damages provision.
Prior to closing, the buyer waives all contingencies and releases their 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 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 in the amount of the reduced net proceeds on the resale (although the buyer is liable only for the decline in value which took place by the time of the buyer’s breach).
The seller rejects the buyer’s demand for a refund, claiming the funds released were option money which they are entitled to keep as consideration for their irrevocable offer to sell the property to the buyer, which the buyer did not exercise by closing escrow, a unilateral contract situation.
A bilateral agreement, or option to buy
In the previous example, the liquidated damages provision in the purchase agreement establishes the agreement is bilateral. The purchase agreement called for a forfeiture of the deposit when the buyer fails to close escrow, the antithesis of an option agreement which is unilateral and contains no forfeitures by its nature. Thus, the seller’s defense for keeping the buyer’s deposits as option money consideration for granting an option is without merit.
Further, the seller did not attempt to show that their 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, non-value-adding expenditures for repairs or maintenance, 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 — or release — that 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 their losses is a breach by the seller of the liquidated damages provision and the purchase agreement. [Allen v. Smith (2002) 94 CA4th 1270]
Further, when the purchase agreement does not contain a liquidated damages provision or other contractual liabilities limitation, the seller is still limited to collecting no more than their actual losses. Thus, the excess amount of the buyer’s deposit over the seller’s losses is refunded by the seller or released from escrow to the buyer.
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Extending performance dates to attain purchase agreement objectives
Court-ordered forfeiture is also unenforceable
Consider a buyer and seller of a SFR property who enter into a court-ordered settlement agreement to resolve their dispute over their performance of the purchase agreement and agree to close escrow. The settlement agreement contains a forfeiture provision calling for the release of the buyer’s good faith deposit to the seller when 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 their obtaining a mortgage.
The seller seeks to recover the total amount of the buyer’s good faith deposit. However, the seller incurred no loss due to the buyer’s failure to perform. The property is resold at a higher price.
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 existing 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 to recover the buyer’s good faith deposit unless they can show an actual money loss.
The court-approved settlement agreement is a contract agreed to by the buyer and seller, not an award determined by the court. Thus, as controlled by contract law, enforcement of liquidated damages provisions in a real estate purchase is prohibited, unless the seller incurs a loss. Even then, the recovery is limited to their money losses. [Timney v. Lin (2003) 106 CA4th 1121]
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