Introduction. Disputes involving earnest money deposits are a “zero sum game.” There is one winner and one loser; no in-between. Arbitrators do not – or certainly should not – split the deposit in a misguided effort to equitably allocate the funds. (Note: This analysis refers to the 2022 OREF form, so references to section and line numbers may be different from those today.)
Equity is not the issue; both parties have already stipulated in the Sale Agreement’s liquidated damages clause that if there is a breach, the non-breaching party keeps the deposit. This means that either (a) the buyer recovers back the deposit (because the seller breached), or (b) the seller retains it as “liquidated damages.” There is no provision allowing the arbitrator or court to “apportion” liquidated damages.
Critical to understanding the purpose of a liquidated damages clause is in recognizing the difficulty in quantifying a seller’s damages when their buyer breaches the Sale Agreement. The clause relieves the seller of the difficulty in “proving” the value of the lost opportunity to sell the property to a person who never made an offer.
This is where the liquidate damages clause proves its worth. Otherwise, how is the seller to prove that but for the buyer’s offer, a better offer would have been made? Once a transaction is “pending” in the MLS, most prospective buyers move on – at least assuming other inventory is available. Without this clause it is almost impossible for sellers to prove they were damaged by “losing” an offer they never received.
Earnest Money Dispute Scenarios – Seller Keeps the Deposit
Section 28.3 of the Sale Agreement lays out three scenarios which can result in the buyer forfeiting their deposit. If seller signs and accepts the Sale Agreement, title is marketable, and seller did not breach, he or she may terminate the transaction and keep the deposit if:
- Buyer misrepresented their financial status. Section 4 of the 2022 OREF Sale Agreement provides at lines 55-58:
Buyer represents that Buyer has liquid and available funds for the Deposit and down payment, and if an all-cash transaction, the full Purchase Price, sufficient to Close this transaction and is not relying on any contingent source of funds (for example, from loans, gifts, sale or closing of other property, 401(k) disbursements, etc.), except as follows (describe): _________________________
What this means is that buyers signing an offer of purchase actually have the money. Buyer agents should vet this issue with their clients; the failure to do so is a disservice to the seller and listing agent. And if sellers doubt their buyer’s financial bona fides they should counter the offer with a demand that the buyer provide proof of collected funds capable of being used to fund the deposit and down payment.
Practice Tip: Sellers and their brokers should be careful about inadvertently waiving this provision. Once a seller and/or their broker acquire knowledge that the buyer has misrepresented their financial status, seller must decide whether to terminate, or continue moving forward with the buyer. In the latter scenario, seller should call out the non-performance and give the buyer a choice to either forfeit the deposit or agree to some other solution satisfactory to seller in a written Addendum. Doing nothing and moving forward can result in a waiver of this provision.
Earnest money deposit is not timely paid. If the buyer’s bank (a) does not pay, when presented, a check given as earnest money, or (b) buyer fails to timely make a wire transfer for the deposit, it entitles the seller to claim a breach of contract and retain the deposit. But again, sellers cannot ignore the breach and only later claim it as a basis for retaining the deposit. Unfortunately, buyers’ late payments are frequently overlooked, and the parties continue to move forward, trying to keep the transaction together while the buyer struggles to find the necessary funds.
Practice Tip: Section 37.1 of the 2022 OREF Sale Agreement (Miscellaneous) provides at Line 414: “Time is of the essence of this Agreement.” Upon the failure of the deposit to be timely made, sellers and/or their brokers should immediately address it in an Addendum, reciting the default and obligating the buyer to another performance date for the deposit. Waiting after two or three failures makes it difficult for the seller to later claim that time is still “of the essence.”
- Buyer’s fails to complete the transaction in accordance with the material terms of the Sale Agreement. This provision is a catch-all, and the most significant for sellers. However, the buyer’s failure must be “material,” i.e., a provision or condition that is essential to completion of the transaction. Technical defaults or failures quickly remedied are not always “material.”
Earnest Money Dispute Scenarios – Deposit Returned to Buyer
Refund to Buyer. Section 28.2 of the 2022 Sale Agreement identifies three scenarios that will result in the buyer recovering back the deposit. However, a refund of the deposit is not the buyer’s only remedy should the seller default; buyer may also bring a claim for specific performance and/or damages.
- The parties are under contract, but the seller cannot deliver “marketable title.” Marketable title is title that is free of all objectionable liens and encumbrances. For example, title to property is frequently encumbered by recorded utility easements. While they show up on the preliminary title report, and technically “encumber” or “burden” the property – they are normally not a problem. Utility easements for the installation and maintenance of powerlines, gas lines, water, etc., do not negatively affect the quality of title but, rather, enhance its developability.
When title is “unmarketable” it is encumbered by some recorded instrument, e.g., a judgment lien, a mortgage, or a tax lien, that could result in the owner having to pay money to release the lien. Similarly, certain recorded easements could negatively affect a property making it unmarketable – e.g., an unlimited public right of access over the property to the beach.
Who determines whether title is unmarketable such that the buyer can cancel the transaction and obtain a refund of their earnest money deposit? If the parties cannot agree, the judge or arbitrator will decide whether the lien or encumbrance on title is sufficiently significant as to make it unmarketable.[1]
- Seller fails to complete the transaction in accordance with the material terms of the Sale Agreement. For example, seller refuses to permit access to buyer’s inspector or appraiser. In such a case, a buyer could terminate the transaction and demand a full refund of the deposit. But remember, as noted above, even if the buyer recovers back his or her deposit, they may also bring a claim against the seller for “specific performance.”
Conversely, unless the Sale Agreement provides otherwise, a seller’s sole remedy on account of their buyer’s breach is to retain the deposit as “liquidated damages.” The OREF Sale Agreement, as most residential sale agreements, limits the seller’s damages to the amount of the deposit. In other words, the seller cannot pursue a defaulting buyer for “specific performance” or additional damages.[2]
- If a buyer-contingency fails through no fault of the buyer. For example, if the professional inspection contingency fails, buyer is entitled to a refund of the deposit. In addition to ones inserted in the offer (e.g., sale of buyer’s residence), there are several pre-printed buyer contingencies in the Sale Agreement. Realtors® should become familiar with all of them.
Note that the “no fault of the buyer” clause does not mean the buyer cannot exercise their right of termination by disapproval of a sewer, septic, inspection report, or well water report – this is their right.
However, if a buyer sabotaged their financial statement so as to be rejected for financing, that would prevent them from obtaining a refund of the deposit. The law implies an obligation on parties under contract to exercise them in good faith; the failure to do so is a breach of that implied obligation and a breach of the contract.[3]
Liquidated Damages. There are only two or three major Oregon cases that are material to a discussion of liquidated damages. The law is fairly well settled. A well-drafted liquidated damages clause should contain the necessary recitals the law looks to in upholding them. For example, the OREF Sale Agreement, provides at Section 28.3:
The parties expressly agree Seller’s economic and non-economic damages arising from buyer’s failure to close this transaction in accordance with the terms of this Agreement would be difficult or impossible to ascertain with any certainty, that the Deposits identified in this Agreement are a fair, reasonable, and appropriate estimate of those damages, and represent a binding liquidated sum, not a penalty.
The Seller’s sole remedy against Buyer for Buyer’s failure to close this transaction in accordance with the material terms of this Agreement is limited to the amount of earnest money paid or agreed to be paid in this Agreement. Seller’s right to recover from Buyer any unpaid earnest money agreed to be paid in this Agreement will be resolved as described in the Dispute Resolution Sections below.
What has not been addressed above – but should not be ignored in any discussion of earnest money deposits, is that under the OREF Sale Agreement, and similar forms in Oregon, retention of the earnest money deposit is the seller’s sole remedy in the event of a buyer’s breach. That is why the amount of the deposit is so important.
It is one thing if the breach occurs soon after the Sale Agreement is signed, such as the buyer’s check for the deposit fails to clear – the seller can quickly declare the default and put the property back on the market. But it is quite another thing if the buyer fails to show up for closing six weeks into the transaction.
The take-away for listing agents is that they should discuss with their sellers in advance, what damage might occur if the buyer defaulted late in the transaction. The raison d’être for the deposit is to make a seller think twice about defaulting. In other words, walking away from the transaction must “hurt” financially. This is not to say it should be designed to “penalize” the buyer for defaulting, but it should be a sufficient amount to keep them incentivized to remain in the transaction.[4] A deposit the buyer can walk away from without concern is not a real deposit.
Conclusion. As noted at the beginning, earnest money disputes are a “zero-sum” proposition, since a forfeiture or refund depends upon who committed the breach. Once determined, the prevailing party gets the deposit.[5]
But an equally important issue is whether both parties are prepared to roll the dice, knowing that the prevailing party is entitled to recover their attorney fees from the losing side. The loser loses big; this directs the focus on the size of the gamble. A large deposit, say $75,000 or $100,000, or more, might incentivize one side or the other to pursue the funds; but lesser amounts require more evaluation, especially when the amount of the deposit can be exceeded by the attorney fees expended to win – or lose.
©Copyright 2022 QUERIN LAW, LLC. Phillip C. Querin
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[1] Note: Title being “unmarketable” is different from saying the property cannot be sold or that it has no value. “Unmarketability” is sufficient if it reduces the property’s value such that it no longer is worth what a ready, willing and able buyer would pay for its intended purpose. For example, if the property is zoned residential, but because of recorded easements or other limitations on use, it cannot be sold as a residential lot, it is unmarketable for its highest and best use.
[2] I am speaking of customary practice in Oregon, not elsewhere.
[3] Note that all inspection reports can be rejected by buyers without having to give a reason. In other words, they can reject the “report” not some particular item in that report. If the latter standard were the rule, sellers would be forever arguing that the item buyer rejected, e.g., the furnace was fully functional, and not a good faith basis to terminate the transaction.
[4] For example, a deposit of $50,000 – $75,000, if duly considered by the seller in advance (assuming the sale price was significant), e.g., $1,000,000 would likely withstand scrutiny. $500,000 likely would not. Beware: Brokers should avoid applying a simple 10% or 20% multiplier since that is not “a fair, reasonable, and appropriate estimate” of damages – it is just a formula pulled out of the air.
[5] Lest the reader ask, rhetorically, “what happens if both seller and buyer are in default?” the answer is the latest default is the only one that counts. For example, if the buyer failed to timely make the deposit, but eventually did so – and it was accepted – that “default” has been waived by the seller. If the next default occurs, say by the seller in failing to close on time, buyer can terminate and get their deposit back. But note that the Sale Agreement expressly provides that a refund of the buyer’s deposit does not mean the seller is off the hook. The reason is because even if the deposit is returned to the buyer, he or she still has a right to seek specific performance. Otherwise, a seller could avoid having to sell to a buyer by simply creating their own default and refunding the deposit.
