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NON REFUNDABLE DEPOSITS

In California, “nonrefundable” does not always mean “nonrefundable,” especially when it comes to a Buyer’s earnest money deposit. The following is a synopsis of California law and contract negotiation strategy when it comes to addressing nonrefundable deposits.

In Kuish, the buyer (Kuish) entered into a written contract to purchase from the seller (Smith), Smith’s home in Laguna Beach for $14,000,000. The final agreement consisted of one offer and nine counteroffers. It also required the buyer to make two “non-refundable” deposits into escrow.

The first deposit was to be $400,000 and to be made upon the opening of escrow in January of that year. That deposit was to be released to the seller upon approval of the contingencies. The second deposit of an additional $400,000 was to be made on or before February 12, and escrow was to close by July 28. Importantly, the agreement did not contain a liquidated damages provision.

Subsequently, the parties signed escrow instructions which reduced the total deposit due from the buyer to $620,000. Of that amount, $400,000 was released during escrow by the escrow company to the seller, with the remaining $220,000 held in escrow. Thereafter, Kuish cancelled escrow and then Smith promptly resold the property for $15,000,000. That was a $1 million profit over the Smith/Kuish contract price. Kuish then filed suit against Smith for the return of his full $620,000 deposit. Smith defended on the basis that the deposit was expressly stated in the contract to be non-refundable, and therefore the court, Smith said, should enforce the agreement of the parties as written.

The trial court found that both parties were “big boys” who were sophisticated businessmen that understood all the ramifications of their actions and freely negotiated the deposits to be non-refundable. Because of that, the trial court held that Smith had the right to retain the deposits because the contract clearly said they were non-refundable.

What do you think? Should Smith have had to refund the deposits? If so, all of the deposit amount, or just a part of it? Before addressing those questions, let’s discuss the concept of “forfeiture” under California law.

Courts Abhor Forfeitures

Our California courts have long expressed great antipathy toward the forfeiture of money. As early as 1951 in Freedman v. The Rector, the California Supreme Court explained that if a seller is allowed to retain a down payment greater than his expenses in connection with a contract, he would be unjustly enriched, thereby allowing the buyer to suffer a penalty in excess of any damages he caused.

Civil Code Section 3307 provides that the general measure of damages to a seller for the wrongful refusal of a buyer to purchase a property under contract is the difference between the contract price and the property’s lesser market value (if any) at the time of the breach.

Analyzing the statutory law and prior judicial precedents, the Court of Appeal in Kuish concluded that the non-refundable nature of the deposit, particularly under circumstances where the seller resold the property for a $1 million dollar profit, constituted an unenforceable penalty and forfeiture which would not be sanctioned by judges. The appellate court then concluded that Smith had to refund the entire deposit to the buyer.

Liquidated Damages

One measure Smith could have taken was to provide in the purchase agreement that the deposit constituted “liquidated damages” if the buyer defaulted. A liquidated damages clause is a provision that states that upon a buyer’s breach, the seller can retain a stated sum of money as liquidated damages. As such, the seller forgoes the right to sue the buyer for any additional damages above the liquidated amount, as would have otherwise occurred in Kuish if the property decreased by a million dollars in value, rather than increased by that same amount.

With residential real property consisting of a single family home or four units or less and in which a buyer intends to live, Civil Code Section 1675 limits the amount of liquidated damages to 3% of the purchase price, unless the seller proves in court that a greater amount is reasonable. If the seller can satisfy the burden of reasonableness, then the stated percentage for liquidated damages may exceed 3%.

Surely the seller’s attorney (or his broker) in the Kuish case, when he approved the non-refundability language in lieu of a liquidated damages provision, had the 3% limitation in mind, but chose to ignore it. That is because the $800,000 original deposit was 5.7% of the purchase price. Unfortunately, the seller’s lawyer (or broker) decided to denominate the entire deposit as “non-refundable” rather than just limit it to 3% of the contract price as liquidated damages.

However, if the seller engaged a lawyer (which is usually the case with homes selling for $10 million or more), his lawyer was not a seasoned real estate attorney. If he were, he would have been familiar with the problem of a non-refundable deposit, as explained in the 1951 Freedman case (referenced above). If the seller only used a broker, that licensee almost certainly never even heard of Freedman. Given the huge sale price of $14,000,000, the broker should have recommended to the seller to engage real estate counsel to review the contract provisions.

With most residential sales, whether they are multi-family or single-family dwellings, parties who insert a liquidated damages provision typically provide that any forfeited deposit is limited to 3% of the purchase price. That is a wise thing to do. While courts abhor forfeiture, they will customarily approve one if it is denominated as liquidated damages and limited to 3% of the contract price (assuming certain other technical statutory requirements are satisfied).

Had the parties in Kuish designated 3% of the deposit as liquidated damages, the seller, most likely, could have at least retained $420,000. By not being aware of the applicable law, the seller lost the right to retain any of the deposit when he provided that the whole amount was non-refundable.

Liquidated Damages Pitfall

One huge but little-known pitfall with liquidated damages is that if the provision is included in a printed contract (which it almost always is, if it is included at all), the entire provision must be in at least 10-point boldface type, or in contrasting red print in at least 8-point bold type. That requirement applies to all liquidated damages clauses, including those involving the sale of real property. Accordingly, brokers, agents, buyers and sellers that use CAR Forms, should ensure that the liquidated damages provision is in at least 10-point type on the hard copy paperwork.

Create an Option Contract

One way for a seller to maximize the likelihood that he will be able to retain an amount equal to a contemplated deposit is to create an option contract which the buyer pays for up front in lieu of making a deposit. In a real estate context, an option contract is a separate contract entered into between the buyer and seller whereby the buyer pays a fixed sum of money (in the Kuish case, it would have been either $800,000 or $620,000), in exchange for a contractual right to purchase the seller’s property on specific terms set forth in a separate purchase agreement. If the buyer then elects not to purchase the property, the seller can retain the price paid for the option, not by way of penalty, but by reason of the option contract.

Of course, a buyer may not favor an option contract because if he later disapproves a contingency (e.g., inspection contingency or financing contingency), the purchase agreement is cancelled but the seller  retains the option money. Conversely, if the Buyer paid the money as a deposit under the purchase contract, then upon his proper cancellation, the deposit would ordinarily be refundable. Sellers, on the other hand, should prefer an option contract. Because options are a more sophisticated concept than liquidated damages, they require skilled and creative negotiation.

Concluding Remarks

There are competing interests between buyers and sellers and much to be considered with respect to non-refundable deposits. No matter how sophisticated the parties are and regardless of the clarity of their contract, the court may nevertheless void as “unreasonable” a non-refund-ability provision. Careful analysis should be given before a purchase contract is executed which designates a deposit as non-refundable, particularly where the deposit exceeds 3% of the purchase price. Also, when using a printed liquidated damages provision in CAR purchase forms or other contract to purchase real estate, be certain that it appears in at least 10-point boldface font when the paper agreement is circulated for signature. Finally, buyers should consider working with a brokerage that is familiar with this issue and how to protect their clients.

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