Liquidated Damages in a Typical California Residential Real Estate Contract

LIQUIDATED DAMAGES IN A TYPICAL CALIFORNIA RESIDENTIAL REAL ESTATE CONTRACT—THINGS ARE NOT ALWAYS AS THEY SEEM; OR, CLEAR CONTRACT LANGUAGE IS NOT CLEARLY ENFORCEABLE.

THE SCENE:  Suppose a Buyer and Seller agree on a purchase price for Seller’s home (for this hypothetical assume $850,000.00), they sign the customary California of Association of Realtors (“CAR”) form Residential Purchase Agreement and Joint Escrow Instructions (“Agreement”) and open escrow.  Buyer deposits $25,000.00 into escrow.  Buyer’s lender approves Buyer for a purchase money loan.  The typical written disclosures are made by Seller.  This is Buyer’s first home purchase, or at least he is not sophisticated in real estate purchases. 

After loan approval and after the disclosures, Buyer removes all contingencies.  Seller incurs thousands of dollars in obtaining termite clearance and in removing Seller’s junk from her yard, in contemplation of the sale.  Thereafter, however, Buyer’s lender does an about face and disapproves the loan.  Buyer also discovers several conditions regarding the house that Buyer believes were misrepresented (e.g., an open insurance claim, fire damage, mold, water damage and unpermitted work). 

THE DISPUTE:  Therefore, within days of these discoveries, Buyer signs a Cancelation of Escrow and demands his deposit back.  The cancellation occurs after all contingencies were removed, so Seller claims Buyer is in default, refuses to agree to allow escrow to release the deposit and claims the right to the entire deposit based on a liquidated damages clause the parties signed.  Both parties agree that the sale is cancelled but cannot agree on entitlement to the deposit.  Seller subsequently, within a month or so of the cancelled sale with Buyer, sells her property to a new buyer for more money:  $870,000.00.  Further, other than typical Seller’s costs (termite, property clean up), Seller’s has no actual damages as a result of the aborted sale.  (Note:  We are assuming for purposes of the Article that this is a good faith dispute between Buyer and Seller; the CAR Agreement at Paragraph 14G states that if a good faith dispute regarding cancellation does not exist a party might be subject to a civil penalty for refusal to sign cancelation instructions according to Civil Code section 1057.3; that code section is not the subject of this Article.)  

THE ISSUE:  Should Buyer be able to recover his deposit, or can Seller enforce the liquidated damages clause and keep all the entire deposit?

THE SHORT ANSWER:  As set forth below, notwithstanding the somewhat clear contract language in the customary CAR Agreement, it is likely that Buyer is entitled to recover his deposit under these circumstances (possibly minus minor escrow fees); Seller should only be able to recover, if anything, actual damages as a direct result of Buyer’s default—even though the contract language suggests otherwise. 

DISCUSSION

BACKGROUND

First, before trying to solve this dispute, we need to be clear at to what is a liquidated damages clause?  Simply, such a clause is a provision in a contract by which damages for a breach of contract are determined—ahead of time—in anticipation of the breach and usually are enforceable only if determining actual damages is impracticable or extremely difficult.  (Ridgley v. Topa Thrift & Loan Assn. (1998) 17 Cal.4th 970, 976-977.)  In the absence of a reasonable relationship between the liquidated damages and the actual damages the parties could have contemplated for breach, “a contractual clause purporting to predetermine damages ‘must be construed as a penalty.’” (Id. at p.  977.) “‘A contractual provision imposing a “penalty” is ineffective, and the wronged party can collect only the actual damages sustained.’ [Citations.]”  In Ridgley, the California Supreme Court held that a clause in a promissory note imposing a charge of six months' interest if borrowers prepaid loan principal, but also provided that a charge would not be imposed six months after execution of the note, unless borrowers had made late interest payment or otherwise defaulted, was an unenforceable penalty for late payment.  The court noted:  “[a] liquidated damages clause will generally be considered unreasonable, and hence unenforceable . . . [omitted reference to Civ. Code § 1671(b)], if it bears no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach.”   (Emphasis added.)  The court noted that the provision operated as a penalty on the borrowers, because it created a severe burden on them if they tried to pay off the note or tried to sell the property to pay off the note; on the other hand, the lender’s actual damages were minimal due to the event (a late payment) triggering the damage provision. 

Second, we need to set forth the usual CAR Agreement clause at Paragraph 21B of the Agreement which states as follows:

LIQUIDATED DAMAGES:  If Buyer fails to complete this purchase because of Buyer’s default, Seller shall retain, as liquidated damages, the deposit actually paid.  If the Property is a dwelling with no more than four units, one of which Buyer intends to occupy, then the amount retained shall be no more than 3% of the purchase price.  Except as provided in paragraph 14G, release of funds will require mutual Signed release instructions from both Buyer and Seller, judicial decision or arbitration award.

Note how severe and absolute this language seems:  If Buyer defaults, Seller SHALL (a mandatory word) retain, as liquidated damages, the deposit actually paid.  BUT THINGS IN CONTRACT LAW ARE NOT ALWAYS AS THEY SEEM.

Civil Code section 1675 relates to the dispute raised herein and states in pertinent part as follows:

(c) If the amount actually paid pursuant to the liquidated damages provision does not exceed 3 percent of the purchase price, the provision is valid to the extent that payment is actually made unless the buyer establishes that the amount is unreasonable as liquidated damages.

In other words, a liquidated damages provision is not always valid.  The amount paid must be reasonable.  Section (c) states that the liquidated damages clause above is presumptively valid unless a buyer can prove the amount is unreasonable as liquidated damages.  (See also  Allen v. Smith (2002) 94 Cal.App.4th 1270, 1278, which stated:  “A liquidated damages provision is presumed valid if the deposit does not exceed 3 percent of the purchase price, unless the buyer establishes that amount is unreasonable”.)  (As an aside, and not discussed here, an amount paidpursuant to a liquidated damages clause which exceeds 3% of the purchase price is presumed invalid unless the party seeking to enforce it can establish that the amount actually paid is reasonable. Civ. Code § 1675(d).) 

Section 1675(e) states:  “the reasonableness of an amount actually paid as liquidated damages shall be determined by taking into account both of the following:  1) the circumstances existing at the time the contract was made.  2) The price and other terms and circumstances of any subsequent sale or contract to sell and purchase the same property if the sale or contract is made within six months of the buyer’s default.”   

In other words, assuming that Buyer was in default for cancelling, Buyer can invalidate the liquidated damages clause (in whole or in part) by meeting both of the above factors. 

ARGUMENT

A.   The Circumstances Surrounding the Contract in the Above Hypothetical Demonstrate the Unreasonableness of the Amount of Liquidated Damages.

In one case, the court of appeal held:   “. . . the forfeiture of appellants' deposit as a result of the delay in delivering a quitclaim deed, a delay which caused the [Sellers] no cognizable damages, constitutes an illegal forfeiture provision and is invalid.”   (Emphasis added.)  (Timney v. Lin (2003) 106 Cal.App.4th 1121, 1129.)  Three facts in Timney are helpful in understanding when a court might strike down an otherwise enforceable liquidated damages clause:  The time delay triggering the potential forfeiture of the deposit was deemed to be slight by the court (three weeks), the delay was not the fault of the buyers (but due to the events of September 11, 2001) and the sellers suffered no clearly identifiable (“cognizable”) damages.   

In another case, Buyer deposited $25,000.00 for the purchase of a convalescent hospital.  (Cook v. King Manor and Convalescent Hospital (1974) 40 Cal.App.3d 782.)   The deposit was a non-refundable deposit and was to be used by Seller to get the hospital ready to turn over to the purchaser.  When the Buyer failed to perform the purchase contract, Seller retained the entire $25,000 deposit, which resulted in a suit to recover the deposit by Buyer.  The court of appeal noted:  “There was substantial evidence before the trial court from which it could conclude that it was not, in fact, impracticable or extremely difficult to fix actual damages in event of breach of contract; that the provision regarding payment of $25,000.00 outside of escrow was in fact a penalty or forfeiture which the attorney for [Seller] attempted to conceal and disguise as a bona fide clause for liquidated damages.”  (Id. at p. 476.)  The court found that forfeiture of the entire amount would be an invalid penalty, but the court did determine that the amount the Seller reasonably proved as actual damages was properly withheld by Seller.  As shown by Cook (and even though it predated Section 1675), case law is consistent:  Only actual damages proven by a seller may be retained as liquidated damages. 

There is another important component to this analysis.  As to liquidated damages, one court noted “. . . the purpose of enacting sections 1675, et seq. was to protect buyers who fail to complete the purchase of real property and not sellers.”  (Guthman v. Moss (1984) 150 Cal.App.3d 501, 510.)  The buyers in Guthman sought to limit their liability for damages and asserted the validity of a provision that violated Civil Code section 1677 by not being separately signed.  The sellers sought to invalidate the clause because their damages exceeded the deposit amount.  However, in finding that the clause substantially complied with the law and that buyers had the option of enforcing such a clause, the court noted the (helpful) legislative purpose in enacting specific statutes regarding liquidated damages: 

“It [the Legislative Law Revision Commission] recommended very carefully drafted statutory limitations (§§ 1675, et seq.) to protect a defaulting buyer ‘from forfeiting an unreasonably large amount [of money] as liquidated damages.’”  (Id.)  “Therefore, notwithstanding the requirement of seller's signature, we conclude that sections 1675, et seq. were designed solely for the protection of the buyer.”  (Emphasis added.)  (Id. at p. 511.) 

Guthman indicates that in disputes relating to liquidated damages clauses are to be interpreted in buyer’s favor and in the context of protecting the buyer from unreasonable payments.

Based on the foregoing, there are several reasons why the amount of liquidated damages is unreasonable in the above hypothetical.  First, per Guthman, section 1675 is a buyer protection statute, designed with buyer’s interest in mind, first and foremost.  So, close calls should go in favor of the buyer, and the law seeks mandates that the buyer must not pay an unreasonable amount.   

Second, Buyer came into this transaction, not as a sophisticated, veteran homebuyer but generally was inexperienced in real estate matters, reasonably trusting in Seller to properly disclose all material facts, reasonably trusting in the lender’s agent who said Buyer qualified for a loan and reasonably trusting in his own broker to guide him through the process.  These facts are all the more reason to invoke the buyer protection purpose of section 1675 and invalidate the clause.

Third, like the buyers in Timney, the failure of a sale was not Buyer’s fault.   As mentioned, Buyer reasonably removed the contingencies because lender informed him that he was approved for the loan; he removed the contingencies because he reasonably believed the Seller told them everything material about the property.  It was not Buyer’s fault that the lender flip flopped.  It was not Buyer’s fault that the fire damage was not properly disclosed or that Seller’s “open” insurance claim effected Buyer’s ability to obtain homeowner’s insurance.  It was not Buyer’s fault that Seller had failed to disclose unpermitted work, water damage, and mold in the closet.  Had these items been disclosed, had Buyer known the lender would deny his loan (after approving the loan), Buyer never would have removed the contingencies and there would be no question but that the entire $25,000.00 should be returned to him.  Like Timney, the absence of Buyer’s fault demonstrates that enforcing the liquidated damages clause here would be unreasonable.  (Note:  Buyer may have a claim against the lender, but that is not relevant for purposes of this discussion.)   

Finally, as soon as the disclosures were made or discovered (as to the loan disapproval and the Property disclosures), Buyer acted quickly to cancel, just like the buyers in Timney. 

In other words, the first element of section 1675 unreasonableness should be easily met.  And Buyer meets the second element too.

B.   The Quick Subsequent Sale and the Lack of Evidence of Actual Damages also Demonstrates the Invalidity of the Liquidated Damages Clause.

Recall, the second element in determining the unreasonableness of the clause is evaluating “[t]he price and other terms and circumstances of any subsequent sale or contract to sell and purchase the same property if the sale or contract is made within six months of the buyer’s default.”  (Civ. Code § 1675(e)(2).)  

In Smith v. Mady (1983) 146 Cal.App.3d 129, 133, the court stated:  “. . . a vendor of real property is not to be . . . ‘placed in a better position by the buyer's default (citations omitted.)’” (Emphasis added.)  In Smith, a seller was denied certain damages against a defaulting buyer because the seller was able to obtain a higher price on resale of the property.  The court held:  “The increased resale price should not be disregarded in considering an offset to consequential damages awarded to a vendor against a defaulting purchaser of real property.”  (Id.)  Interestingly, the court noted the timing of the sale as a factor in considering the sale to deny seller some of his damages and stated:  “In cases where the resale at a higher price occurs at a time much more distant from the breach than here, the vendor may show a lower property value at the moment of breach as well as increased costs of continuing ownership. However, in the case at bench the resale took place within a few days after the breach and established the value of the property at the time of breach. Realistically, the vendors here had sold their property to defendants at a price lower than the then value of the real estate.”  (Id.)   

In addition to the circumstances surrounding the contract, the law (Civ. Code § 1675(e)(2)) requires consideration of any subsequent sale occurring within 6 months.  The Smith case does not allow a seller to profit from the liquidated damages clause in the event the house sells for more money than the original sale.  Here, in our hypothetical, Seller re-sold the home in a month or so from the cancellation, for a profit, well within the statutory time frame.  Like the sellers in Smith, here, Seller benefitted from Buyer’s cancelation.  Because Seller profited, enforcing the liquidated clause should be unreasonable.  (Note:  there may escrow costs and fees still due to third parties.) 

C.   Seller Typical Defenses Would Change the Result Absent Establishing Actual Damages.

It is anticipated that Seller would argue that she incurred substantial costs and, therefore, is entitled to the entire deposit both based on the contract language and damages suffered.  However, based on the foregoing, there must be identifiable damage that actually flowed from the alleged breach, and that damage simply does not exist in our hypothetical.

Seller may argue that the cost of termite clearance (sometimes many thousands of dollars) was damage justifying the liquidated damages, but those costs are typically a seller’s expense and not actual damages under the law for liquidated damage purposes.   Also, in our hypothetical, the costs to remove Seller’s “junk” would be a typical demand made by any buyer and should not be seller damage recoverable under the law. 

The only evidence in our hypothetical is that Seller profited from the new sale, which should preclude enforcement of the liquidated damages clause and should entitle Buyer to recover his $25,000.00, less possibly some escrow fees. 

CONCLUSION

It is important to understand contract terms and the purposes for various clauses.  For a buyer:  do not necessarily give up simply because a contract term seems impossibly clear.  There may still be hope.  For a seller:  do not simply rely on contract language—even terms that seemingly protect you—without considering all the facts and circumstances of the deal.  FOR ALL CONTRACTING PARTIES:  WORDS DO NOT ALWAYS MEAN WHAT YOU THINK THEY MEAN. 

Consult with a lawyer about the significance of contract terms before you sign a contract.  And, if you have already signed a contract, consult with a lawyer to help you determine whether the terms are enforceable.