Question: When Does a Nonrefundable Earnest Money Deposit Become Refundable?

Posted on by Phil Querin

Answer: When the provision making it non-refundable has been poorly drafted.

Too many times I have seen sellers want to lock their buyers into a transaction by making the earnest money deposit “nonrefundable”. But what does that mean, standing alone with nothing more than a condition precedent? For example: “Buyer’s deposit shall become non-refundable upon Buyer’s waiver of, or the expiration of, the Inspection Contingency Period, whichever first occurs.”

What If?  Is it possible that the deposit could still be refundable to a buyer, notwithstanding the fact that there was a waiver of the Inspection Contingency Period, or it expired first? Without more, it is likely that the deposit could, under certain circumstances, still be refundable – even if it was disbursed to the seller prior to closing.[1]

For example, what if the buyer’s financing failed or the property appraised for less than the sale price? Without addressing the failure of the financing contingency at the same  time, you would have two mutually inconsistent provisions: (a) One saying the deposit becomes “non-refundable” after the waiver or expiration of the Inspection Contingency Period, and (b) The other  saying that if the buyer fails to obtain financing, or the home under-appraises, they get their deposit back.

  • What if the sale fails due to the seller’s inability to deliver marketable title?
  • What if the lender is unable to close the transaction before the agreed-upon closing date, for reasons outside of buyer’s control or responsibility?
  • What if an event occurs outside the control of both parties that causes the transaction to fail, e.g. the home burns down, or buyer passes away?

Ambiguity and Rules of Construction.  Generally, when there is a disagreement over the meaning of a legal clause in a contract, the language is construed most strictly against the drafter. That’s great if there is only one drafter such as in a consumer contract where it’s presented by the merchant on a “take-it-or-leave-it” basis. But in most residential sale transaction in Oregon, the parties are in an “arms-length” transaction and can freely negotiate any and all terms. And generally, through their respective agents, they mutually agree upon the terms, e.g. with a jointly signed addendum making the deposit nonrefundable upon certain conditions.[2]  Under these circumstances, the ambiguity of a provision is not construed more strictly against one side or the other.

The Oregon rules of evidence generally say that if a provision is “ambiguous” the judge or arbitrator will permit testimony from the parties and/or witnesses to “explain” the intent of the parties and the circumstances surrounding creation of the text. Conversely, if the provision is determined to be clear on its face – i.e. it is not ambiguous – no testimony or evidence is permissible to vary the terms of the contract.

So the take-away here is that if you want to avoid a fight over whether a clause, say one stating that the earnest money deposit becomes “nonrefundable” at a certain time or upon the a certain event, you should make clear and unambiguous, so that no extrinsic testimony or evidence will be allowed to vary its terms. In other words, if  you want the deposit to be nonrefundable, draft it in a manner that leaves no room for argument. Of course, this is easier said than done, since it requires the drafter(s) to be able to address those unanticipate events (such  as the failure of financing) which provide otherwise.

Liquidated Damages vs. Penalties. Oregon law permits the parties to contractually agree upon liquidated damage provision in the real estate sale agreement, so long as it is a genuine pre-estimate of the seller’s damages resulting from the buyer’s failure to close the transaction.  Such damages are, by their nature, difficult to ascertain. For example, if a seller enters into a contract to sell their property, and agrees upon a closing date 45 days hence, the property shows as “Pending” (or words to that effect) in the local multiple listing service. The Pending designation tells other potential buyers that the property is already under contract.  So unless the seller agrees to take a second buyer  a “back-up” position, most buyers look elsewhere. Effectively, the property is off the market for 45 days until closing. So if the buyer walks away, how does the seller establish their damages based upon offers they might have received but for the fact that the property was in a “Pending” status?  Kinda tough – hence the liquidated damage provision.

So, what happens if a seller demands a $50,000 earnest money deposit for a $400,000 sale transaction?  While some might argue that this size of deposit is disproportionate to the sale price, that is not really the issue. The issue is what damages would the seller suffer if the sale failed?  Suppose the the seller was under contract to purchase another home in another state due to a job relocation, and was putting down a sizeable deposit to secure deal?  Under these circumstances, a $50,000 deposit might be considered a reasonable amount of liquidated damages.

But does the equation change if the $50,000 becomes “nonrefundable” after a certain time or event, and then the sale fails for reasons unrelated to the buyer’s performance? Say, for example, the transaction fails to close on time, and the seller has a back-up buyer for $450,000, i.e. $50,000 more that the first-position sale. Under these circumstances, the nonrefundable deposit begins to look like a penalty, since the seller would benefit by the sale-fail of the first-position transaction.  In short, even though it is called “non-refundable” without airtight language, the deposit could be deemed refundable under certain circumstances.

Drafting Tips. Ambiguity occurs because reasonable minds differ about the meaning of a legal provision. If they don’t differ because the text is clear on its face, as noted above, the language is not ambiguous, and the court or arbitrator will not permit extrinsic evidence to vary the terms  of the clause.

So from a drafting perspective, one should strive to make language sufficiently clear on its face so that no one can argue about its meaning. How does a drafter do this? They draft the desired language, then ask a neutral third party who is completely unfamiliar with the transaction, to explain the meaning of the clause. If the third party understands it – without the intervention or explanation of the drafter to supplement or clarify – then it is unambiguous.

However, this test comes with a caveat: The neutral third party must be someone familiar with deposits, their non-refundability, and the vagaries of real estate transactions in general.  In most cases, that someone should be a managing principal broker, or one with substantial experience.

The Unlawful Practice of Law.   Lest someone balk at drafting these or any other clauses generally used in residential real estate transactions, let me calm their fears. The drafting of standard addenda language, e.g. for nonrefundable deposits, extensions of time, waiver of contingencies, and the litany of other garden-variety events that occur in the ordinary course of a residential real estate transaction, is not the unlawful practice of law. That is OREF’s raison d’etre, i.e. to provide the real estate forms to sellers, buyers, and their brokers, thus avoiding the necessity of real estate agents drafting them for each transaction.  If in doubt, agents should always check with their managing principal broker for direction and guidance.

Conclusion. In my opinion, making a deposit “nonrefundable” is a two-edged sword. Yes, sellers may like the idea, but unless it is sufficiently watertight to survive the storm of arguments[3] from a buyer’s attorney challenging it, there may be downsides. It may scare buyers away from proceeding, since they do not fully understand how it would work in the event of some unforeseen circumstance derailing the transaction. While most buyers do not plan on breaching their sale agreements, they may balk at releasing their deposit solely because of their fear of Murphy’s Law, i.e. something going wrong, simply because it can go wrong. And the larger the deposit, the greater the invitation for a legal fight.

In the final analysis, is a nonrefundable clause really that effective in keeping a buyer in the transaction?   And is it bullet proof?  Putting this in perspective, how much more effective is such a clause, rather than simply requiring that additional earnest money be deposited upon the occurrence of a certain event or at a pre-determined time? While the former may have a certain appeal because of its in terrorem effect, its enforceability demands the drafting of a clause that is absolutely airtight, while the latter does not depend upon that level of draftsmanship, since the Sale Agreement already addresses the consequences of the buyer’s default – and isn’t that all a seller should be concerned about? ~PCQ


[1] To be clear, early disbursement of the deposit when it becomes nonrefundable, does not make it “more” nonrefundable. Granted, it means that the funds are no longer in escrow, and to an extent, buyer is left with having to “chase” the money, rather than having it held by a third party who will disburse upon the ruling of a court or arbitrator (after the relevant appeal periods have expired).

[2] Obviously, the bulk of all residential transactions follow the terms of the pre-printed documents. If an argument arose over alleged ambiguity of a provision in a standard form, there is no basis to construe the document for or against one side or the other.

[3] Pardon the weather pun.

Posted in Miscellany, Real Estate General, Realtor Risk Management, Realtors | Tagged ,
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