What to Do When the Contract Goes “Breach”; What happens to the Deposit on Cancellation

Most Residential Real Estate Purchase Agreements have provisions for payment of a “deposit” by the buyer into the escrow, to be credited toward the purchase price of the contract upon closing.  Sometimes, even with all good intentions (and sometimes not so good), “bad things happen”, and the deal falls through.  Sometimes the buyer can’t arrange financing; sometimes the buyer gets “cold feet” and just “backs out” of the deal; sometimes the seller breaches.  The question that invariably arises is:   “what happens to the  buyer’s deposit?”  Buyer wants it back; Seller wants to keep it.  Meantime the Escrow officer is standing there “holding the bag.”

California Real Estate Contracts, using the standard “CAR” form carry a provision (para. 25), attempts to set forth the answer:

“25.  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.  Any excess shall be returned to buyer.  Release of funds will require mutual, signed release instructions from both Buyer and Seller, judicial decision or arbitration award.  AT TIME OF INCREASED DEPOSIT BUYER AND SELLER SHALL SIGN A SEPARATE LIQUIDATED DAMAGE PROVISION FOR ANY INCREASED DEPOSIT (CAR FORM RID).”

I use the word “attempts” to set forth the answer because in reality, the clause creates more problems than it solves.

The first problem is that both buyer and seller have to “agree” and sign a joint escrow instruction to release the deposit to their agreed recipient (buyer or seller).  If Buyer objects to payment to seller, or visa versa, the  Escrow Agent must continue to hold  the deposit until the parties resolve the dispute between themselves, or go to court for a judicial determination on the issue.

While the CAR language may look good in theory, it has some serious pitfalls when it comes to putting it to work in reality.  The provision for seller to keep the deposit if the Buyer “defaults”, is fine.  But  problems arise because of the triggering term, “Buyer’s default”.  What does that mean?  The Buyer will usually say “I didn’t default”;  “It’ wasn’t me, judge.”

What is a Buyer “Default”.  The contract provides for several “contingencies”, which must be timely exercised:  “loan contingency”, “appraisal contingency”, and a number of “inspection” contingencies.  The “trap” here is that these “contingencies” have time fuses running, such that if the  contingency exercise date has passed, the contingency is waived.  Since the contract also provides that “Time is of the essence” (para. 28) the time limits for these contingencies, and for the closing date are all “material” terms, such that missing any of these dates would be a “material breach” of the contract.  Thus, if buyer misses any of the  contingency dates, or the closing date, for any reason, he is in material breach, and the Seller is entitled to keep up to 3% of the purchase price from Buyer’s deposit as “liquidated damages” under the contract.

The “liquidated damages” are authorized by Califonia Statutes, Civ. Code sec. 1675.  However, the statute has some important nuances.  First, the amount of the “liquidated damages” is based solely on the Buyer’s deposit actually deposited into escrow by cash or check (even a “post-dated” check would suffice).   Unperformed promises to make a  deposit at some future point in time would not count as a recoverable liquidated damage. Likewise, “IOUs” or some non-monetary “trade” (e.g., stocks) don’t count.

Second, the Buyer also has an opportunity to show that the “the amount is unreasonable as liquidated damages.”  (CC 1675(c) Thus if the amount of the deposit, or even the 3% of the purchase price can be shown to be “unreasonably excessive”, then only some lesser “reasonable” amount may be recovered.  However, the Buyer carries the burden of proof to make a showing of “unreasonableness” of the amount under subparagraph (c) of 1675.

Third, the 3% amount is deemed to be “reasonable” under the statute (Civ. Code 1675).  However, the Seller has an opportunity to show that the full amount of the Escrow deposit, even over the 3% amount, should be paid as liquidated damages.  However, the Seller would carry the burden of proof to show reasonableness of the full deposit amount, for this alternative to apply, under 1675(d).  Hence, the Civil Code could allow the Seller to keep the entire deposit, even in excess of the 3% statutory limit, if the Seller can prove that the total deposit amount is “reasonable as liquidated damages.”  (Id.) This can be accomplished if seller can show that his actual damage exceeds the 3% amount–e.g., re-sale price to a mitigating buyer is lower than the contract price (loss of profits and consequential damage); payments for intervening taxes, insurance, interest, and other  costs, repairs and expense of upkeep of the property which the Seller would not have incurred but for the buyer’s breach (incidental damages).  (Civ. Code 1675(e)(1) and (2))

Fourth, if the Buyer made a “timely” and “proper” exercise of any contingency and cancels based on that exercise, then there would be no “default”, and the full deposit must be returned to the Buyer.   However, the “sticky-point” here is that the buyer’s exercise of the contingency must be both timely and proper.   For example, exercise of an “inspection contingency” of the condition of the property, based on buyer’s speculation that his future development plans might not be approved by the City Planning Dpt., would not count because the “inspection contingency” must be based on the existence of present specified “conditions of the property” (e.g., termites, structural defects, mold, history of death, or crime, and the like).   Likewise, if the exercise of the purported contingency is made past the 17 day time limit, it would be invalid, and Seller will be entitled to the deposit.

The next problem arises from the language of the CAR Liquidated Damage provision itself.   Both parties (Buyer and Seller) must sign a joint Escrow instruction authorizing the Escrow Officer to release the deposit proceeds to the parties designated recipient.   Thus the parties must agree among themselves as to who should get the Escrow Deposit.  The problem here is that in most cases of “breach” or cancellation, the parties are in some form of a “dispute” with each other, and cannot reach agreement as to who should receive the deposit funds (even the statutory 3%).  It is surprising how unreasonable people get when it comes to deciding who should get the money.   In that case, litigation is inevitable (either by breach of contract action, specific performance, Fraud, or Declaratory Relief).

As a concluding piece of “free legal advice” the parties finding themselves in this situation should seriously consider the cost, expense and time involved in litigation.  Most Real Estate litigation cases are complex, with conflicting testimony and documents, and both sides may easily run up legal fees and costs in excess of $40,000 to $50,000, even in the most basic of disputes, double that if the  case then goes to trial.

There is an attorneys’ fees recovery provision in most CAR Real Estate PSAs, but the parties won’t find out who “wins” until after the trial is over, and even then, it might be only a “partial victory” depending on the ruling of the judge.  Anyone finding themselves in this situation should seriously consider whether or not there is any “cost-benefit” to pursuing the litigation course.  I’m a litigator, so I would say “go for it”.  But, the client is the one who will  have to pay for it, so only the client can make that decision.  If the other side will not be flexible enough to reach a compromise wherein both sides “share” in the deposit, then litigation may be the only alternative available.

Real Estate: Buyers and Sellers Beware

There are Pitfalls and traps for the unwary using the standard California Association of Realtors (“CAR”) form of Real Estate Purchase and Sale Agreement (“PSA”) in real estate sales transactions.  Here are some highlights to watch out for:
1  Purchase Price terms; Deposits; early release to Seller

One of the most frequent areas of dispute in real estate transactions lies in the terms for the purchase price. Most of the time, the price term is prepared by the broker for the Buyer. The problem is that frequently the buyer and seller have agreed to certain special terms of payment, for example for early release of some portion of the buyer’s “Earnest Money Deposit” (“EMD”) to the seller. This can occur because the seller will have ongoing expenses and costs of sale, including payments coming due on the mortgages while the transaction is “pending”. Thus, many times sellers ask the buyer for an early release of all, or some portion of the EMD. There’s nothing wrong with this, but it does require a special note in the PSA contract document itself (or addendum to it), and a special joint escrow instruction as to the amount to be released and the specific date on which the release is to be made. Make sure that both buyer and seller sign and initial both the Addendum and a set of Joint Escrow Instructions requiring the early disbursement to the Seller. Otherwise, the EMD will be held up in escrow until a “Joint Escrow Instruction” is signed by buyer and seller.

I once had a case where the parties had agreed in the PSA itself that the Buyer’s Deposit was to be “immediately released” to Seller. However, the buyer had sent a unilateral “e-mail” to the escrow officer asking her to hold off on making the disbursement until after the seller signed some added provisions to the PSA.  Of course the seller did not agree to the added provisions. Nevertheless, the escrow officer held up the early distribution anyway, merely because the buyer sent her a unilateral instruction contradicting the earlier “joint” instruction. Had the parties prepared a specific escrow instruction, in advance, requiring the early disbursement on a specific date, the Escrow officer would have been legally and ethically required to make the disbursement upon the agreed date.

2  Inspection, Appraisal and Financing “Contingencies”

Many people involved in real estate transactions think that they can “back out” of the deal, for any reason, and at any time before closing.  Not so. The standard CAR PSA contains time limits for “inspections” and for “exercise” of an “inspection contingency”. This must be done in writing by the buyer, within a certain period of time. The inspection contingencies also appear to be limited to only certain “conditions” related to the condition of the property which can be identified by a buyer’s inspection (termites, water damage, roof leaks, structural damage, appliances, electrical problems, plumbing, heating, and the like). Financing contingencies require the Buyer to arrange financing to pay the balance of the purchase price by a specified date. Once financing has been committed, then a written removal of the financing contingency must be made by the buyer. The same is true for the “Appraisal” contingency. If there is a loan contingency, buyer’s removal of the loan contingency also removes the appraisal contingency. Otherwise, the buyer must give a written removal of the appraisal contingency or cancel within a specified period of time (usually 17 days from acceptance). If written removal is not given, or the transaction is not cancelled  within the 17 day timeframe, the legal effect should be that the buyer has waived the contingency as not having been timely exercised, cancelled or extended by an amendment or addendum to the PSA.. There is a provision in all CAR PSAs that “time is of the essence” (para. 28). Also, any extensions alterations modifications or changes of time periods for removal of contingencies or cancellation rights must be done by a written agreement. The “time is of the essence” clause means that the contract time periods are “material terms” to the PSA contract, and any expiration of any given time requirement is a material breach (unless extended which requires a writing).  What this means is that, contrary to common thought, the PSA contract cannot be cancelled at the whim of either buyer or seller. If buyer misses his deadlines, and the contingency period passes without cancelation, the buyer is bound and can be compelled to close, or sued for damages (usually the liquidated damages consisting of the buyer’s earnest money deposit), or for Specific Performance.

3.  Earnest Money Deposits and “Liquidated Damages”

The standard CAR PSA contract also has a provision for the buyer to deposit his or her “EMD” (Earnest Money Deposit) into escrow. If the buyer cancels for no fault of the seller, and without support of any contingency, then buyer is in breach. The EMD also serves as “liquidated damages” (to the extend that it does not exceed 3% of the purchase price). Liquidated Damages means that the parties have agreed that the EMD amount will be the stipulated amount of damages owed to the seller by the buyer in the event of a buyer’s breach of the contract. Most real estate agents and brokers usually allow their clients to sign the “liquidated damages” clause (CAR PSA para. 25) without giving any thought to its consequences.  This is a mistake.  For the buyer, this means that buyer will forfeit his EMD if the contract is cancelled due to buyer’s breach. Since the seller does not put any EMD into escrow, there is little risk for the seller; and, there is no provision under the liquidated damages clause as to what the damages will be in the event of a Seller default.  If you are the Seller, however, you might want to reserve your right to sue for money damages (measured by the difference between the “contract price” and the price on re-sale to a replacement buyer), which is usually lower than the first sale price to the defaulting buyer, and will net a positive recovery from a damage lawsuit. Theoretically, the liquidated damages provision should work both ways. However, the CAR PSA contract does not so provide, and since the seller has no “deposit” in escrow, he has nothing “at stake”. This means that the buyer will have to prove actual damages in the event of a seller’s breach, or sue the seller for “specific performance”.  Specific Performance is probably the buyer’s best option if he really wants the property, and the seller has breached without any valid ground, defense or excuse. The buyer will also be able to recover any “incidental and consequential” damages incurred by the seller’s breach, and of course, the CAR PSA contract includes an “attorneys fees” clause, which means that attorneys’ fees are awarded to the prevailing party in any litigation.

4  Dates; Closing; special Escrow Instructions

There a number of deadlines set forth in the standard PSA contract. For example, contingency periods are usually 17 days, there may be a deadline for the buyer to make his initial deposit (usually 3 days from acceptance), or to make any “increased deposit” (time frame to be inserted). Closing is also left to be filled in by the parties, but the standard closing is 30 days. For some types of purchases, e.g., “short sales” the closing period requirements may have to be longer (90 days). Note, under paragraph 14 of the CAR PSA any extensions of the contingency periods must be in writing. Likewise, any extension of the closing date must be made in writing. Technically, if the deal does not close within the contract period, and buyer has not exercised his rights to cancel within the “inspection” timeframe, then the buyer is in breach based on the “time is of the essence” clause. Seller would be entitled to cancel and keep the buyer’s deposit for buyer’s breach, or if buyer cancels for no valid reason under the PSA. Hence, it is very important for Real Estate Agents and Brokers to make sure the time deadlines under the contract are met. While there are a few cases on the books that have permitted a “non-material” breach to slide by where the buyer has otherwise fully performed, the prevailing rule is that “time” is a material term in the face of express contract language stating: “time is of the essence”. (CAR PSA para. 28)

Additional Resources

For more information or answers to specific questions concerning the standard CAR Real Estate Purchase and Sale Agreement, call the California Bureau of Real Estate, or California Association of Realtors directly. 1-877-373-4524; or visit the CBRE website at: http://www.calbre.ca.gov/Consumers/

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Indemnity Strategy in Legal Malpractice Cases

Few have considered the possibility using an indemnity cross-complaint against the underlying tortfeasor in a legal malpractice case. Yet, it can prove to be an effective defense strategy, with assured favorable results, at a minor fraction of the cost.

In the typical legal malpractice case, the attorney blows the statute of limitations in an “underlying” tort claim for a client, and the client then sues the attorney for the damages based on the loss of the underlying claim due to attorney negligence. In the usual case the attorney has to step into the shoes of the underlying tortfeasor defendant, and defend the underlying tortfeasor in the “trial within a trial” in the malpractice case. This puts the attorney in an impossible “Hobson’s Choice”, promoting the suit against the underlying tortfeasor to the client; and then turning around and defending the same lawsuit in the legal malpractice case.  There is a better way of handling this beast.

The attorney’s “flip-flop” does not bode well with the jury because most jurors distrust attorneys in the first place.

Further, the attorney can expect no cooperation from the underlying tortfeasor in defending the underlying case, and in most legal malpractice cases the underlying defendant is not available to testify, and much less cooperative.

However, if the underlying tortfeasor can be brought into the legal malpractice lawsuit based on a “comparative fault” cross-complaint, everything changes. The same statute of limitations problem is not present in the indemnity case because the statute of limitations does not commence in the indemnity case unless and until damages are paid. Hence, while the statute of limitations may have been blown for the client in the underlying case, it is still open to the attorney in the attorney’s indemnity cross complaint case in the legal malpractice case.

The indemnity action against the underlying tortfeasor will force the underlying tortfeasor to appear in the legal malpractice action and defend the underlying tort case, in the indemnity action.  The underlying tortfeasor cross-defendant is also “motivated” to defend because of the potential for indemnity liability.  The injured plaintiff still has the burden of proof for the underlying tort case, but the attorney’s cross-claim against the underlying tortfeasor now puts the burden of the defense back on the underlying tortfeasor, where it belongs in the first place.

By pursuing this strategy, the attorney “wins” regardless of the outcome. If the underlying tortfeasor defenses the underlying case in the indemnity cross-claim, then the attorney defenses the legal malpractice case. There will be no damages in the legal malpractice case if the underlying case is without merit, or somehow defensed.

On the other hand, if the underlying tortfeasor loses the underlying case, then the underlying tortfeasor (or his carrier) will have to indemnify the attorney-defendant (i.e., pay the damages found by the jury to be due to the injured client plaintiff) in the indemnity cross-claim case.

The beauty of this strategy is that the underlying tortfeasor shoulders the burden of proving the underlying defense, the economic costs of trial prep and experts, and the ultimate “indemnity” liability if he or she loses.

Why hasn’t anybody tried this before,  you might ask. The answer is, they have. However the case law has been “mixed”. In California, an early case in the development of comparative fault, Munoz v. Davis, 141 Cal. App. 3d 420 (1983), rejected an indemnity cross-claim in a legal malpractice case because the two torts were not the same, and the duties owed to the injured client-plaintiff were not the same. However, the Munoz case was decided in the earlier days of “comparative fault”, such that the court was misinformed of the theory behind comparative fault under the American Motorcycle case. Under American Motorcycle, it makes no difference if the indemnity cross-defendant parents owed different duties, or caused different damages to the injured plaintiff, than the Motorcycle Ass’n. defendant in the injury case.

In a more recent case, Platt v. Coldwell Banker Residential Real Estate Servs., 217 Cal. App. 3d 1439, 1450 (1990)., the court ruled to the contrary. There, the attorney was sued for legal malpractice in connection with a failed real estate transaction. The attorney was allowed to file an indemnity cross claim against the client’s real estate brokers and advisers who gave faulty investment advise to the investor client.

In American Motorcycle Assn. v. Superior Court (1978) 20 Cal.3d 578 [146 Cal. Rptr. 182, 578 P.2d 899], the California Supreme Court held that, in general, one co-tortfeasor may obtain partial equitable indemnity from another on a comparative fault basis.  The reasoning of the court has since taken on a life of its own;  “‘There is obvious lack of sense and justice in a rule which permits the entire burden of a loss, for which two defendants were…unintentionally responsible, to be shouldered onto one alone, …while the latter goes scott free.’” Id., (citing, Prosser, Law of Torts [(4th ed. 1971)] § 50, p. 307.) The court concluded:  “.  .  .  we hold that under the common law equitable indemnity doctrine a concurrent tortfeasor may obtain partial indemnity from co-tortfeasors on a comparative fault basis.”  (American Motorcycle, supra., at pp. 607-608.)

American Motorcycle involved an indemnity claim by the defendant Motorcycle Association, charged with negligent design of the race course, against the parents of the injured minor rider, who the Motorcycle Association alleged were negligent in the supervision, training and education of the minor in safety principles of motorcycle racing. The “duties” owed by indemnitee vs. indemnitor were different.  Yet, indemnity was allowed, and the case went on to become a historical landmark in the law of “comparative fault”.

Since then, cases from other jurisdictions have varied as to whether or not an indemnity cross-claim should be allowed against the underlying tortfeasor in a legal malpractice case. The better rule in keeping with the public policies underlying “comparative fault” principles and American Motorcycle, would be to allow the indemnity cross claim, which has since been permitted in virtually all different kinds of indemnity claims in other contexts (construction defects, products, auto accidents, “dual impact” theory, etc.).