When “Non-Refundable” Means “Refundable”.

“A long time ago, in a galaxy far, far away” . . . . Well, it may seem that way, but it was actually only a few years ago that sellers of real property in California didn’t worry too much about whether buyers would default on purchase contracts –because they could usually turn around and sell the property for an even higher price. Like the light emitted from a distant star a million years ago but which is only now reaching us, a recent case decided by the California Court of Appeal gives us a peek back into history, from which we can learn lessons that will be useful not only when a rising real estate market returns, but also in the current listless market.

In the recent case of Kuish v. Smith, the buyer agreed in January 2006 to purchase an ocean-front estate in Laguna Beach for $14 million, and put down a $620,000 “nonrefundable” deposit. After the buyer defaulted in September, the seller turned to a back-up offer and promptly sold the property for $15 million. The replacement deal closed in November. The defaulting buyer demanded his $620,000 back, but the seller declined: after all, the contract said the deposit was “nonrefundable,” and “nonrefundable” means “nonrefundable,” right?

The trial court agreed with this way of thinking, and allowed the seller to keep the $620,000 deposit. But the California Court of Appeal reversed and allowed the defaulting buyer to recover the “nonrefundable” deposit, even though it was undisputed that the buyer had broken the contract. The seller lost the case despite doing some things that normally would have helped him to prevail. Unfortunately for him, however, he failed to do the things that were legally crucial.

For example, $400,000 of the deposit had been released from escrow to the seller even before the buyer’s default. Having the deposit in the seller’s pocket rather than in escrow usually discourages a defaulting buyer from trying to get back the deposit. However, releasing the money does not change the legal rights of the parties; it merely places a greater strategic burden on the buyer. The buyer has to chase the seller for the money, rather than simply refusing to sign off on a closing escrow instruction. In this case, the parties would already have been forced into litigation regarding the portion of the deposit still held in escrow, so it was easy to add the claim for the additional $400,000. In addition, $620,000 was a large enough sum to fight over — had the amount in controversy been only $6200, or even $62,000, the buyer might not have thought it worthwhile to undertake the cost and aggravation of litigation.

Most people, including many real estate professionals, are not aware that California law has long held that it is not enough to simply label a deposit as “nonrefundable.” Real estate sales contracts are governed by the same rules as other contracts: in order to recover damages, the seller must prove that he or she has suffered harm that was caused by the buyer’s breach. Although a deposit provides the seller with the security that cash will be there to cover any damage suffered if there is a breach, it does not automatically establish that the seller has a right to receive it (that is, has sustained damages). It may not be possible to prove that the seller was harmed in a rapidly-rising market where — as in Kuish v. Smith — the seller’s carrying costs for continuing to hold the property were far more than offset by the higher purchase price that was obtained on the replacement deal.

The most common way to avoid this hurdle is to include a “liquidated damages” provision in the purchase contract. In fact, the Court of Appeal’s opinion in the Kuish case specifically noted that the agreement did not contain a liquidated damages provision. Under a liquidated damages provision, the parties acknowledge that the damage likely to be sustained by the seller in the event of a default by the buyer will be uncertain or difficult to prove, and they agree on a fixed amount of damages that will be presumed to have been suffered if the buyer defaults. That amount is often the amount of the deposit, but it can be more or less than the deposit.

If the liquidated damages amount is not unreasonable under the circumstances that existed at the time the contract was signed, the seller does not have to prove that there was any actual harm. Unless the buyer can carry the burden of proving that the amount was unreasonable, the courts will enforce the liquidated damages provision.

In the case of residential property, liquidated damages up to 3% of the purchase price are, by statute, presumed to be reasonable; liquidated damages greater than 3% of the purchase price are presumed to be unreasonable. The 3% standard technically does not apply to non-residential property, but it is well-known to judges, and undoubtedly has some influence on their perception of what is reasonable and unreasonable. (To save you from having to do the math, in the Kuish case the “nonrefundable” deposit was equal to about 4.4% of the sales price.)

In a falling market, the seller should be more careful about the use of a liquidated damages provision, because the actual harm caused by a breach might be greater than the specified amount of liquidated damages, and the seller will be limited to the liquidated damages amount. Nonetheless, most sellers should prefer to have a liquidated damages clause, since it will reduce the likelihood and complexity of any litigation over the seller’s entitlement to retain the money.

In order to be enforceable, liquidated damages provisions must also satisfy other standards imposed by statute, such as being separately signed or initialed by the parties; in printed contracts, the written words must meet specified size, typeface and color requirements.

As an alternative to liquidated damages provisions, especially in long escrows, sellers can achieve similar economic results with less risk of litigation through the creative use of options. The law regarding options evolved differently than the law regarding damages, and is far more deferential to the agreement of the parties than is the law of damages.

A payment for the grant of an option will usually be treated as fully-earned (and therefore truly “nonrefundable”) at the time it is granted. Buyers are more likely to go along with the concept that the option payment will be immediately paid to the seller, rather than held in escrow. Further, the parties’ determination of what an option is worth is generally not subject to second-guessing by a court; the provision does not have to be separately signed, or initialed, or printed in a specified way; and the buyer always has the burden of trying to overturn an option contract.