Hello everybody. My discussion this month examines the validity of a “non-refundable” deposit clause in a real estate purchase contract and related liquidated damages provisions.
The California Court of Appeal case of Kuish v. Smith, 181 Cal.App.4th 1419, well illustrates current law.
The Kuish Decision
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 (a few years ago). 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.
In September, 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 me 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.
Did you reach the same conclusion? Personally, I believe that the just result would have allowed the seller to retain the entire deposit. That is because, as the lower court said, the parties were “big boys” who freely negotiated the terms of the contract.
Freedom of contract should be allowed in this country, not to mention in California. In my opinion, if two astute business persons negotiate a non-refundable deposit, the Court should not interfere with their agreement, particularly one so large as to involve a $14 million house or, say, an apartment building.
In any event, the following discussion examines what could Smith have done when the contract was prepared to enhance the likelihood that he could have retained the deposit.
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.
I presume, however, that 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 apartment buildings 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 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 where the property being sold is an apartment building.
Over three decades of law practice, I do not recall ever seeing a liquidated damages clause printed in red. That is not to say they do not exist, but if they do, they are very rare. Almost all liquidated damages clauses in printed agreements are in black font.
Of particular concern and potentially problematic, is the “RIPA” form published by the California Association of Realtors. RIPA is an acronym for Residential Income Purchase Agreement and is often used to purchase apartment buildings.
Years ago, brokers using the RIPA (or a similar) form would fill out the pages on carbonless paper. The liquidated damages clause printed in those forms would typically satisfy the 10-point boldface requirement.
Now, however, brokers typically fill out the RIPA on their laptop computers and then print out hard copies of the pages for signature. The pitfall is that if the computer program or the printer itself reduces the font size of the liquidated damages clause in the paper-printed purchase agreement to less than the mandated statutory 10-point minimum, the provision is void.
Accordingly, brokers, buyers, sellers and attorneys who use the RIPA form, or any other computer generated form, should ensure that the liquidated damages provision is in at least 10-point type on the hard copy paperwork.
Create An Option
The best 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 which the buyer pays for up front in lieu of making a deposit.
In a real estate context, an option 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 because if he later disapproves a contingency (e.g., inspection contingency or financing contingency), the purchase agreement is cancelled but the seller nevertheless 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.
Because options are a more sophisticated concept than liquidated damages, they require skilled and creative negotiation.
As AOA readers can see, 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-refundability provision.
Careful legal 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 the RIPA or other contract to purchase an apartment building, be certain that it appears in at least 10-point boldface font when the paper agreement is circulated for signature.
Finally, buyers should consider using an option in lieu of a liquidated damages clause.
Dale Alberstone is a prominent litigation and transactional real estate attorney who has specialized in real property law for the past 39 years. He has been appointed to periodically serve as a judge pro tem of the Los Angeles Superior Court and is a former arbitrator for the American Arbitration Association. He also testifies as an expert witness for and against other attorneys who have been accused of legal malpractice.
Mr. Alberstone has been awarded an AV rating from Martindale-Hubbell. An AV rating reflects an attorney who has reached the heights of professional excellence and is recognized for the highest levels of skill and integrity. You may Google “Dale S. Alberstone” for further background.
The foregoing article was authored in July 2016. It is intended as a general overview of the law and may not apply to the reader’s particular case. Readers are cautioned to consult an advisor of their own selection with respect to any particular situation.
Questions of a general nature are warmly invited. Address correspondence to Dale S. Alberstone, Esq., ALBERSTONE & ALBERSTONE, 1900 Avenue of the Stars, Suite 650, Los Angeles, California 90067. Phone: (310) 277-7300.