Liquidated Damages: The Earnest Money Deposit Disappearing Act

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Almost anyone who ever bought or sold a home, or has been involved with a home sale, knows that buyers typically pay a deposit at the time the contract is signed. These deposits are usually smaller sums, meant to show the good faith and seriousness of the buyer, and get credited to the buyer at closing. But what if there is no closing? What if unforeseen circumstances prevented the sale, or the contract was canceled without explanation by one party? Let’s look at a hypothetical scenario from the eyes of an attorney and consider how to deal with these issues.

Justin and Jimmy want to sell their jointly owned townhome in Northern Virginia, which they operate as a rental property. They select an agent who lists the property for sale, and before long an offer is made by Chris. The offer includes a $35,000 deposit and gives Chris the option to walk away if he is dissatisfied with the results of a home inspection. Justin and Jimmy accept the offer and Chris pays the deposit.

When Chris shows up for the home inspection the tenant denies access and threatens to call the police. In response, Chris immediately texts Justin and Jimmy to say he is terminating the contract and to demand the return of his deposit.

Any attorney reviewing these facts must first start with the contract. Real estate contracts frequently treat deposits as “liquidated damages.” This means the parties agreed in advance that the deposit would be assessed as damages in the event of a breach. The party collecting the deposit is deemed to have been made whole, and the matter is concluded.

In Virginia, liquidated damages clauses are allowed when potential damages would have been difficult to determine at the time the contract was written, so long as the liquidated damages are not “grossly” excessive compared to actual damages. On numerous occasions, the Virginia Supreme Court has found that liquidated damages provisions in a real estate contract are enforceable. When one party breaches their real estate contract and a default occurs, the deposit must be released to the non-breaching party.

Some real estate contracts allow a plaintiff to either collect the deposit as liquidated damages, or sue for actual damages. Though there are some dissenting voices, if the contract is well written, the right to choose either course of action is enforceable.

This law firm recently succeeded in enforcing such a liquidated damages provision against a buyer who failed to obtain financing and did not show up for closing. In Court, the buyer argued that the liquidated damages clause was unenforceable for a number of reasons. However, the language of the Contract was written to allow for liquidated damages, and to waive any objection the defendant had to the liquidated damages provision. Ultimately the Court agreed, entered summary judgment in favor of our client, and awarded attorney’s fees.

Returning to the case of Jimmy and Justin, an attorney must first determine if there is a default at all, and who is in default. That analysis starts with the contract. Even form contracts are frequently and easily modified by agents, and edits can be signed electronically without much delay. There are also many form addendums, and even blank addendums, that are published by various realtor associations. Any one of them could have been added to a contract. The attorney must understand what obligations the parties had at each stage of the contract.

For Chris, it is crucial to know whether he had a right to immediately cancel the contract or whether he needed to allow Jimmy and Justin to make an effort to reschedule the inspection. There are also statutory rights the renter has as well, and the attorney may want to know whether sufficient notice was provided.

Deposit disputes often linger when the facts are unclear, or there is room for different understandings of contract language, such as the word “reasonable.” Any attorney reviewing these cases will look to prior case law that may have addressed similar situations, and they will want to better understand why things fell apart.

As you may imagine, the economics of this process is often frustrating for clients, as the cost of litigation appears to outweigh its benefits. However, no escrow agent will ever release a disputed deposit without first receiving either a court order or an agreement from the parties. After a better understanding of the case, an attorney may counsel a client to offer to split a deposit to resolve a dispute, or they may try to help a client salvage a sale that previously appeared to have fallen through.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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