The "standard" real
estate contract usually has a provision spelling out the legal
remedy of the buyer or seller upon default of the agreement. In most
cases, the buyer wants to limit his risk of loss by offering a small
earnest money deposit and inserting a "liquidated damages"
provision.
A liquidated damages provision states that if the buyer breaches the
agreement by failing to close title, the seller's sole legal remedy
is to keep the buyer's earnest money. Without a liquidated damages
provision, the seller could sue the buyer for his actual, provable
damages or force the buyer to purchase the property (called
"specific performance"). The liquidated damages provision is thus an
agreed-upon, estimated guess of the actual damages the seller would
sustain if the buyer breached the agreement by failing to close.
Many court battles have been fought over the validity or
enforceability of liquidated damages clauses, since they often
result in unfair consequences to the buyer. For example, if the
buyer placed 10% or more of the purchase price in escrow with the
seller or his agent, the seller would get a windfall if the buyer
did not close. The seller could resell the property for full price,
even more, and still legally keep the buyer's earnest money. The
buyer's legal argument in challenging the clause is that it result
in a civil penalty which is against public policy.
In determining whether a liquidated damages clause is unenforceable
as a penalty, the courts generally look at whether the amount
settled upon is a "genuine pre-estimate of damages" in the case of
breach. C. McCormick, Damages, §149. In most cases, the issue
in litigation is whether the amount is too large and thus penalizes
the buyer. However, McCormick further states that if the
stipulated amount is unreasonably small in relation to the actual
damages sustained, the Court will disregard it and permit the
injured party to recover actual damages.
The Federal Bankruptcy Court in In Re Ilana Realty, Inc., 154
B.R. 21 (S.D.N.Y. 1993) applied this rationale in awarding damages
to the plaintiff upon breach of a real estate contract. In Ilana
Realty, the purchasers wrongfully refused to close and then sued
for return of their earnest money deposit held in escrow. The
earnest money was only 5% of the purchase price. The Court used its
equitable powers to award damages beyond the amount of the
liquidated damages. The Court did so because it found that the
amount stipulated was disproportionately lower than damages actually
sustained by the sellers. The Court further reasoned that the
buyer's breach and failure to release the earnest money upon breach
resulted in further consequential damages to the sellers.
This case brings up another point: what if the buyer is in breach
of contract, yet refuses to let the escrow agent release the earnest
money to the seller? Courts have sometimes ruled that the
liquidated damages provision may not apply and the seller could sue
for further damages. The rationale is that the release of the
earnest money is a condition of the limitation of liability afforded
to the buyer under the liquidated damages clause
This exact issue was presented in Fuels Research Company v.
Roberts, 458 P.2d 751 (1969). In Fuels Research, the
defendant agreed to purchase a business from the plaintiff, which
involved holding certain papers in escrow (stock certificates,
formulae, trademarks, etc.). The defendant defaulted on the payment
of purchase money after making total payments of $1,000 and refused
to return the escrow items to the plaintiff. Plaintiff then sued for
breach of contract, and the trial Court awarded the Plaintiff a
judgment for $15,000. On appeal, the defendant argued that the
liquidated damages clause limited plaintiffs' recovery to the
purchase money paid, that is, $1,000. The Court rejected this
argument:
"[W]e consider
the return of the escrowed items as a condition subsequent to the
effectiveness of the liquidated damages provision . . . The
condition subsequent not having occurred, the provision limiting
plaintiff's recovery to liquidated damages is not operative."
The liquidated
damages clause is for the benefit of the buyer, to limit their
liability in the case of breach. If the buyer has breached a real
estate contract by failing to close and have refused to forfeit the
escrow money, the seller is not bound by the liquidated damages
clause.
There is little case law on this subject, so the result of a court
trial would be unpredictable. The moral of the story? If you fail to
close on a contract, don't play games. Do the right thing and
release the earnest money from escrow to the seller.
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