Releasing Earnest Money Deposits as Liquidated Damages and California’s Real Estate Response to COVID-19

Real estate in California has seen a consistent theme: a dearth of closings for pending transactions. Parties commonly utilize a Residential Purchase Agreement (C.A.R. Form RPA-CA) (“C.A.R. Form”), provided by the California Association of Realtors (“C.A.R.”), to make offers, counteroffers, and accept the negotiated purchase and sale of real estate. Immediately after the impacts of coronavirus became publicized and stay-at-home and related executive orders were issued, the C.A.R. developed and circulated amendments to its real estate forms. Real estate attorneys’ telephones rang, with clients asking if they should sign the new forms and, if they were the buyer, whether they could cancel the transaction and receive their earnest money deposit back. Such an inquiry first concerns the concept of force majeure: can buyer cancel a real estate transaction solely because of the coronavirus pandemic? A force majeure provision assumes that there is an event outside the control of both parties to the contract that either makes contract performance impracticable or frustrates the purpose of such performance. Is the coronavirus pandemic a foreseeable event that should qualify as an event under a “force majeure” provision? While reasonable minds may disagree, the answer is immaterial because the C.A.R. Form includes no “force majeure” provision. The answer to the buyer’s question depends on specific circumstances related to each transaction and governing legal standards under California law.

The CAR Addendum

To address the impact of the coronavirus, the C.A.R. developed new forms ostensibly to address Covid-19 as a “force majeure” event. The primary forms relevant to this article are the Coronavirus Addendum or Amendment (C.A.R. Form CVA) and Notice of Unforeseen Coronavirus Circumstances (C.A.R. Form NUCC).[1] The forms are meant to be used as an addendum to an offer or counteroffer, or an amendment to an accepted agreement, and provide additional time for buyers to conduct contingencies or close escrow. If an addendum or amendment form was executed, it arguably provides the buyer with an additional opportunity to cancel the transaction without losing their deposit. Indeed, parties executing the NUCC clarified (or created a new definition of) unforeseen circumstances that could provide a contractual basis for not closing escrow and cancelling the transaction based on the coronavirus—a basis and legal right not provided under the original C.A.R. Form. The addendum and amendment are optional and, similar to what has actually occurred in many of the pending transactions, this article assumes that the parties declined to sign the addendum for fear it could unfavorably alter their legal rights.

Civil Code Section 1511

Despite the lack of a force majeure provision in the C.A.R. Form, performance of an obligation may be excuses by certain causes, including performance that is “prevented or delayed by an irresistible, superhuman cause, or by the act of public enemies of this state or of the United States, unless the parties have expressly agreed to the contrary.” See Cal. Civ. Code § 1511(2). Whether the coronavirus qualifies as an “irresistible or superhuman cause” is hopefully something courts will never have to decide. And whether a buyer can truly not perform the agreement – as opposed to performance being merely more difficult or burdensome – is a difficult burden and one required to utilize Section 1511[2] as a basis for non-performance under the agreement. Here again, it is fair to assume that Civil Code § 1511 will not excuse a party from performing due to the coronavirus pandemic.

The Liquidated Damages Clause

Parties commonly initial the liquidated damages provision found in Paragraph 21.B of the C.A.R. Form. This paragraph allows the seller to retain the earnest money deposit if the buyer waives all contingencies or exercises a contingency in bad faith, and thereafter fails to close escrow. Under paragraph 21.B, “[i]f the [p]roperty 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.” Under paragraph 9.A of the C.A.R. Form, the buyer must indicate whether it intends to occupy the property as a primary residence. As such, when a dispute regarding the deposit occurs after a transaction does not close, the threshold inquiry is whether the buyer will occupy the property as primary residence. The answer to this inquiry will affect whether a court will easily award the deposit to the seller or require evidence of the seller’s actual damages caused by the buyer’s breach.

Enforcement of Liquidated Damages: What is the Standard?

Parties in California may agree to a presumed amount of damage (i.e., liquidated damages) sustained from a breach if it would be impracticable or extremely difficult to calculate the actual damages from a future breach. See Cal. Civil Code § 1671. Section 1671(b) provides that “a provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.”  In general, a liquidated damages clause is considered unreasonable if it has no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach. See Ridgley v. Topa Thrift & Loan Assn. (1998) 17 Cal.4th 970, 977. There are several key exceptions to this standard; the most relevant precluding application of the standard if “another statute expressly applicable to the contract prescribes the rules or standard for determining the validity of a provision in the contract liquidating the damages for the breach of the contract.” Cal. Civ. Code § 1671(a). In a real estate transaction where a buyer fails to complete the purchase of real property, Section 1675 is the other “statute expressly applicable” as referenced by Section 1671(a).

Civil Code Section 1675, when applicable, governs the presumed validity (and invalidity) of a liquidated damages clause. The threshold question to identify the appropriate standard depends on whether the property subject to the dispute is “residential property.” For purposes of liquidated damages rules, a property is considered “residential” only if, “at the time the contract to purchase and sell the property is made, the buyer intends to occupy the dwelling or one of its units as his or her residence.” See Cal. Civ. Code § 1675(a)(2).

The parties in Allen v. Smith, (2002) 94 Cal. App. 4th 1270, executed a standard C.A.R. Form to purchase and sell a residential property for $1,775,000. The buyer first deposited $20,000. Later that month the buyer deposited an additional $80,000 into escrow and released all contingencies. Roughly two months later the buyer refused to purchase the residence; in turn, the seller refused to refund the $100,000 deposit. The court applied Civil Code § 1675(d), which states:

If the amount actually paid pursuant to the liquidated damages provision exceeds 3 percent of the purchase price, the provision is invalid unless the party seeking to uphold the provision establishes that the amount actually paid is reasonable as liquidated damages.

The court first rebuffed the sellers’ assertion that the agreement was actually an option contract—i.e., the buyer received an option to purchase when she made the second deposit of $80,000. After this argument failed, the sellers maintained that they should keep the $100,000 deposit as reasonable liquidated damages. Id. at 1282. The court also rejected this argument, and held that the seller provided no evidence establishing their actual damages or a reasonable relationship of the $100,000 deposit to the range of harm the sellers may have suffered because of the buyer’s breach. For her part, the buyer did not argue that the liquidated damage provision violated Civil Code Sections 1677 or 1678, or that $52,520 (or three percent of the purchase price) was an unreasonable amount of liquidated damages.[3] The court ultimately held that the sellers did not meet their burden under Section 1675(d) and ordered that they retain only three percent of the purchase price ($52,520). See id. at 1283.

But what about the pending purchase of a second home that never closed due to coronavirus? This factual circumstance is common in and around the Lake Tahoe region and a different legal standard applies.  In this situation, the buyer would not have contracted to purchase “residential” property because it was their second home, and Section 1675 should not apply. See Cal. Civ. Code § 1675(a)(2). Instead, as stated by the California Court of Appeal:

If the liquidated damages clause in a nonresidential property agreement meets the formal requirements in section 1677, it is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.

See Herrera v. Chambers (2004) Cal. App. Unpub. LEXIS 8033 *8 (unpublished) (citing Cal. Civ. Code § 1671(b); see Cal. Law Revision Com. com., § 1676; Hong v. Somerset Assoc. (1984) 161 Cal. App. 3d 111, 115).

Neither party in Herrera presented evidence as to whether the property was “residential property.” On appeal, the court, sua sponte, highlighted that the buyer did not intend to occupy the property as his residence by checking the box in paragraph 9.A of the C.A.R. Form. Accordingly, the court held that the industry-standard “three percent of the purchase price” rule was not applicable. See id. at *8 fn. 3. Whether the buyer should receive a refund of his deposit was governed by Civil Code Section 1671 and 1677. The court first found that Section 1677 was satisfied because the liquidated damages provision was typed on a blank form in an addendum, was separately signed by the both parties. Because the addendum was not a printed contract, the 10-point bold type or contrasting red print requirements under Section 1677 did not apply. Turning to the analysis under Section 1671, the buyer made no attempt in the trial court to establish that the nonrefundable deposit provision was unreasonable when it was signed. See id. at *9. The buyer instead attempted to argue that actual damages incurred by the sellers should be the standard—and that the seller suffered no harm as a result of the buyer’s failure to purchase the property. The court rejected this argument because, when analyzing liquidated damages for a nonresidential property under Section 1671, “the amount of damages actually suffered has no bearing on the validity of the liquidated damages provision.” Id. at *9-10. Herrera demonstrates that a second homebuyer cancelling a real estate closing because of the coronavirus must show that the liquidated damages clause was unreasonable when the agreement was signed. If the seller can quickly resell the property or cannot otherwise prove actual damages from the buyer’s breach, it still does not help the buyer recover his deposit.

Conversely, if the property is residential and therefore subject to Section 1675, the buyer may show that the liquidated damage provision was amounts to an invalid and illegal forfeiture provision. California Civil Code § 1675(e) states that the reasonableness of an amount actually paid as liquidated damages shall be determined by considering: 

(1) The circumstances existing at the time the contract was made; and
(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.

Courts faced with this analysis commonly agree that a deposit in an amount consistent with the industry standard for the type of transaction will support a finding of reasonableness. See, e.g., Hong v. Somerset Assocs., 161 Cal. App. 3d 111, 116, 207 Cal. Rptr. 597 (1984) (noting that the liquidated damages figure of 2% of the purchase price of an apartment complex was standard in commercial real estate transactions); Cal Civ. Code § 1675(c) & (d) (discussing the presumed validity of a deposit amount of three percent of the purchase price); Edwards v. Symbolic Int’l, Inc., 2009 U.S. Dist. LEXIS 37523, *21, 2009 WL 1178662 (finding that a non-refundable deposit of 10% for a vintage car contracted to be sold for $3.1 million is a standard amount in the industry). Despite the potential to show the unreasonableness of a deposit, if the liquidated damages amount for a residential real estate transaction is at or below three percent of the purchase price, a buyer trying to recover their deposit likely faces an insurmountable hurdle.

There is, however, a strong legislative purpose to protect buyers in real estate transactions. As stated by the California appellate court in Guthman v. Moss (1984) 150 Cal.App.3d 501, there is “little doubt that the purpose of enacting sections 1675, et. seq. was to protect buyers who fail to complete the purchase of real property and not sellers.” Id. at 510. The court further held that the California Law Revision Commission recommended carefully drafted statutory limitations regarding liquidated damages “to protect a defaulting buyer ‘from forfeiting an unreasonably large amount [on money] as liquidated damages.’” Id. at 511. Under the appropriate factual circumstances, creative counsel may succeed in arguing that despite a buyer’s agreement to lose its deposit as liquidated damages, the court must invalidate the provision and require evidence of the seller’s actual damages.

The buyers in Timney v. Lin, (2003) 106 Cal.App.4th 1121, succeeded in arguing that their deposit was an illegal forfeiture. The case is unique because it revolved around a settlement agreement that required buyers to deposit funds into escrow deposit a quitclaim deed within five days of the closing date. The buyers deposited $31,250 into escrow but had failed to timely deposit a quitclaim deed, which resulted in forfeiture of their deposit under the agreement. The trial court enforced the settlement agreement and permitted the sellers to retain the deposit.[4] On appeal, the appellate court reversed and rejected the sellers’ attempt to retain the deposit because the sellers had “no cognizable damages.” Id. at 1128. The sellers produced no evidence in the trial court demonstrating damages from the buyers’ delay and cancellation. The court refused to presume that damages existed merely because the house may have been kept off the market for three weeks. As a result, allowing the sellers to keep the deposit was an impermissible forfeiture of the buyers’ property.

While the Timney case highlights an opportunity to argue that unreasonableness of a liquidated damages clause, the appellate court mentioned the $31,250 deposit exceeded three percent of the purchase price. Even though this discussion was merely a footnote, if the dispute concerned an executed C.A.R. Form for the purchase of residential property, the excessive amount of the deposit would have been presumed invalid under Section 1675(d). The court held that the legal principles related to illegal forfeitures equally apply to real estate contracts and settlement agreements, and heavily weighed the sellers’ lack of evidence of any actual damage due to the buyers’ breach. The court further diminished use of its opinion when acknowledging that “[i]f the provision in question, authorizing the forfeiture of a substantial deposit by reason of a minor delay in delivery of the quitclaim deed, were included in a real property sales contract, this provision would be void as an illegal forfeiture.” Tinmey, 106 Cal. App. 4th at 1126. Thus, a buyer seeking to recover a deposit is unlikely to use Timney as persuasive authority to require court to consider the lack of actual damages incurred by the seller.

Final Thoughts

The chance of a buyer retaining an earnest money deposit diminishes substantially once contingencies are removed. In these uncertain times and economic difficulties, a buyer could lose its deposit solely due to its lender reversing its position to fund the transaction. Real estate brokers and lenders must be careful when commenting on a buyer’s decision to remove contingencies. If contingencies are removed and the deposit is lost to a seller, a buyer is likely to explore claims against the broker or the lender if they were not advised of consequences or were inappropriately told remove contingencies. No matter the reason, if your client is a buyer debating on closing escrow due to coronavirus-related concerns, you should promptly advise of the legal standards applicable to a liquidated damages clause under California law and the likelihood that a buyer will lose its deposit.

Ethan Birnberg is licensed in California, Nevada, Colorado, and Wyoming. He regularly assist clients with all types of asset sales, acquisitions, and real estate issues, including landlord/tenant matters, lease formation and construction issues, and HOA disputes. He holds dual certifications as a business bankruptcy and consumer bankruptcy specialist from the American Board of Certification, and has extensive insolvency experience assisting entities seeking to restructure under chapter 11 of the U.S. Bankruptcy Code, borrowers and lenders seeking out-of-court workouts, representing chapter 7 trustees, and advising directors, officers, and executive management regarding fiduciary duties and corporate governance issues. He can be reached at birnberg@portersimon.com.

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[1] C.A.R. also developed a Coronavirus Property Entry Advisory and Declaration (PEAD) and Listing Agreement Coronavirus Addendum or Amendment (RLA-CAA). These forms relate to the real estate broker’s duties and for parties to agree that providing access to their property was dangerous or unsafe, and could expose the owner or visitor (i.e., potential buyer) to Covid-19. In short, these forms seek to alleviate liability for real estate brokers. All four forms were again amended on April 16, 2020, after the originally amended forms developed in late March resulted in several concerns voiced from buyers, sellers, broker, and other C.A.R. association members.

[2] All references to a “Section” refer to statutory section of the California Civil Code.

[3] Section 1677 requires the parties to initial or sign the liquidated damages provision and be typed in at least 10-point bold or at least eight-point bold if in contrasting red print.

[4] Even more unique to this case (and possibly inferring the sellers’ knowledge of the provision’s unenforceability), the parties declined to explicitly use the term “liquidated damages” in the settlement agreement. The sellers reasoned that deleting referring to liquidated damages demonstrated the parties’ intent to not agree to these types of damages. The appellate court found this immaterial because any provision providing for an illegal forfeiture without regard to the damage caused was forbidden under California law, regardless of its formal label. See Timney, 106 Cal. App. 4th at 1128 (“This forfeiture provision is invalid, whether analyzed as a forbidden forfeiture, or as a void provision allowing the recovery of liquidated damages.”)