Hello everybody. My topic this month discusses problems with the legality of a “non-refundable” deposit provision in a real estate purchase contract, and presents possible alternatives.
The Problem with Non-Refundable Deposits
Often, the seller of real property wants the buyer’s deposit to be non-refundable meaning that if the buyer defaults under the contract or wrongfully refuses to complete the purchase, the seller may keep the buyer’s entire deposit and then resell the property to someone else.
To accomplish that, the seller includes in the contract, or in a counteroffer, a provision saying that the deposit is not refundable upon the buyer’s default, and if the buyer breaches the seller may retain the entire deposit.
While a non-refundable deposit is simple in concept, its legal validity is anything but certain.
That problem is well illustrated in the Court of Appeal case of Kuish v. Smith, 181 Cal.App.4th 1419. There, the buyer (Kuish) entered into a written contract to purchase the seller’s (Smith’s) home in Laguna Beach for $14,000,000.
The contract required the buyer to make two “non-refundable” deposits into the 6-month escrow. The first deposit was to be $400,000 and to be made upon the opening of escrow. The second deposit was for an additional $400,000 and due one month later.
During escrow, the parties signed escrow instructions reducing the total deposit from $800,000 to $620,000.
Before the sale consummated, the buyer decided to cancel the escrow. The seller was agreeable, but had in mind that the deposit was non-refundable. Both the buyer and seller signed escrow cancellation papers. Promptly following the cancellation, the seller resold the property for $15,000,000. That was a $1 million profit over the contract price! But the seller refused to return any of the $620,000 deposit to the original buyer. The original buyer then filed suit against the seller for the return of the entire $620,000 deposit.
The seller defended on the basis that the deposit was expressly stated in the contract to be non-refundable, and therefore the court, he urged, should enforce the agreement of the parties as written.
The trial court found that both parties were “big boys” and sophisticated businessmen who understood all the ramifications of their actions and freely negotiated the deposits to be non-refundable. Because of that, the trial court held that the seller had the right to retain the deposits because the contract clearly said they were non-refundable.
What do you think? Should the seller be allowed to retain the $640,000? If not, should he have to return all of it or just a part of it? Before responding to those questions, let me discuss the concept of “forfeiture” under California law. After all, if the seller could retain the deposit, the buyer would “forfeit” his $640,000.
Courts Abhor Forfeitures
Courts have great antipathy toward the forfeiture of money. As early as 1951 the California Supreme Court explained that if a seller is allowed to retain a down payment to the extent that it is greater than his expenses in connection with a contract, he would be unjustly enriched, thereby making the buyer suffer a penalty in excess of any damages he caused. (Freedman v. The Rector)
In general, the damages to a seller for the wrongful refusal of a buyer to purchase a property are the difference between the contract price and the property’s lower market value (if any) at the time of the breach. (Civil Code Section 3307)
On the other hand, if the seller resells the property for more than the contract price he/she had with the original buyer, the seller suffers no damages.
In the Kuish case, because the seller resold the property for a $1 million dollar profit, obviously he was not damaged. Therefore, the appellate court held that the “non-refundable” deposit constituted an unenforceable penalty and forfeiture which would not be allowed. The appellate court concluded that seller had to refund the entire deposit to the buyer. In other words, courts abhor forfeitures, particularly where the seller is not damaged.
Did you reach the same conclusion, namely that the seller has to refund the entire $640,000 deposit? Personally, I believe the correct ruling would have allowed the seller to retain the entire deposit. That is because, as the trial court said, the parties were “big boys” and sophisticated businessmen 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 with a contract so large as to involve a $14 million house or, say, an apartment building.
In any event, the following discussion examines what a seller might do when he signs a contract to later retain the deposit.
Owner Occupied Residential Properties Under 5 Units: Instead of calling a deposit “nonrefundable,” the purchase agreement should refer to it as “liquidated damages.” A liquidated damages clause is a provision that states that upon a buyer’s breach, the seller can retain all or a stated portion of the deposit as liquidated damages. As such, the seller forgoes the right to receive any amount of money above the liquidated amount regardless of whether the seller resells the property for less or more than the purchase price with the first buyer.
With residential real property consisting of a single family home or four units or less and in which a buyer intends to live, liquidated damages are generally limited to 3% of the purchase price, unless the seller proves that a greater amount is reasonable (which is difficult to do). (Civil Code Section 1675)
So in the Kuish case, when the seller included a non-refundable deposit provision (originally $800,000!) in the contract rather than a liquidated damages provision, the Court voided it in its entirety. $800,000 was 5.7%, and $640,000 was 4.5%, of the $14,000,000 purchase price.
What he should have done was to specify a 3% liquidated damages clause instead. That would have been $420,000, and the seller might have been able to retain the entire amount if the buyer refused, without good cause, to complete the purchase.
Residential Properties Over 4 Units: The law is somewhat different with apartment buildings having 5 or more units. A liquidated damages provision may be enforceable even if the amount exceeds 3% of the purchase price. In that case, the buyer would have to prove that the amount was unreasonably high at the time the contract was made in order to void the provision. (Civil Code Section 1671)
Also, the amount of the liquidated damages will be presumed to be the amount of the seller’s damages if, from the nature of the transaction at the time the purchase contract is signed, it would be impracticable or extremely difficult to determine the actual damage.
There are additional requirements and considerations for the validity of a liquidated damages provision with apartment buildings of 5 or more units, but they are too technical to discuss in this article. With apartment buildings, it is best that buyers and sellers confer with seasoned counsel or knowledgeable brokers if they desire to include an enforceable liquidated damages clause in the contract for the sale of an apartment property.
Liquidated Damages: The Huge Pitfall!
The 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. (Civil Code Section 1677(b)) That requirement applies to all liquidated damages clauses, including those where the property being sold is an apartment building.
Over four 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. Suffice it to say that virtually all liquidated damages clauses in printed agreements are set forth in black font.
Thus, the important point is that buyers and sellers should be certain when they sign a printed contract containing a liquidated damages provision that the clause appears in 10-point bold type.
Of particular concern is the “RIPA” form published by the California Association of Realtors. RIPA is an acronym for Residential Income Purchase Agreement and is frequently used to purchase apartment buildings.
Years ago, real estate 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 satisfy the 10-point boldface requirement.
Now, however, RIPA forms are often filled in on their laptop computers and then hard copies of the pages are printed out 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.
With the advent of electronic on-line signatures on the RIPA form, whether the liquidated damages clause appears in 10-point type is problematic. It may depend on a variety of factors, such as the size of the screen on a computer, laptop, tablet or cell phone, and the program by which the font size is displayed on the respective screen. So even though an original paper copy of the RIPA form may be printed in 10-point type, the electronic version may display in less than 10-point type. It remains to be seen how a court would resolve the issue if challenged by a buyer who wants his deposit back on that technical ground.
Additionally, to be enforceable the liquidated damages clause must be signed or initialed by both parties adjacent to the provision. (Civil Code Section 1677(a)) There are other technical requirements for the enforcement of a liquidated damages provision, but space does not permit a discussion of them. It is best if AOA readers confer with their attorney or knowledgeable real estate broker.
Create an Option
The best way for a seller to maximize the likelihood that he/she will be able to retain some amount of money if the buyer backs out of the purchase is to create an option. With an option, the buyer pays for it up front, typically 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 exchange for a contractual right to purchase the property in the future 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/she 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 (as the buyer would favor), then upon his proper cancellation, typically the deposit would be refundable (as in the Kuish case). Sellers, on the other hand, may prefer an option. Because options are a more sophisticated concept than liquidated damages, they require careful negotiation and skilled legal drafting.
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-refundable provision.
Careful legal analysis should be given before a purchase contract is executed if it will designate a deposit as non-refundable, particularly where the deposit exceeds 3% of the purchase price.
With most residential sales, 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 forfeitures, they will customarily approve one if it is designated as liquidated damages and does not exceed 3% of the sale price (assuming certain other technical statutory requirements are satisfied).
Also, when using a printed liquidated damages provision in the RIPA or other contract to purchase an apartment building, be certain that the provision appears in at least 10-point boldface font when the agreement is circulated for signature.
Finally, sellers might consider using an option in lieu of a liquidated damages clause.
On August 24, 2020, the California Court of Appeal ruled that public policy prohibits arbitration agreements and arbitration provisions in residential leases and rental agreements. (Keisa Williams, No. B297824) – more about that determination next month.
Dale Alberstone is a prominent real estate attorney who has specialized in real property and resident manager law for the past 40+ years. He also serves as a mediator of real estate disputes and is a former arbitrator for the American Arbitration Association.
Mr. Alberstone has been awarded a 5-Star AV rating from Martindale-Hubbell, the 125 year old national rating service of attorneys. A 5-Star AV rating is the highest possible rating bestowed and reflects an attorney who has reached the heights of professional excellence and who is recognized for the highest levels of skill and ethical standards.
The foregoing article was authored on September 1, 2020. It is intended as a general overview of California law only and may not apply to the reader’s particular case. Readers are cautioned to consult a lawyer 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, 269 S. Beverly Drive, Suite 1670; Beverly Hills, California 90212, or phone: (310) 277-7300.