Daily Development for Wednesday, July 7, 2004
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin Kansas City, Missouri dirt@umkc.edu

VENDOR/PURCHASER; SELLER’S REMEDIES; EARNEST MONEY; FORFEITURE: New York adheres to rule that earnest money forfeiture need not satisfy traditional liquidated damages test, even where forfeiture is for 25% of purchase price and exceeds $8 million in residential deal!!

Uzan v. 845 UN Limited Partnership, 778 N.Y.S.2d 171 (N.Y. 2004)

Two brothers, Turkish billionaires, decided to acquire a little pied a terre in the Big Apple and contracted to buy adjacent condominium penthouses at the top of the planned Trump World Tower in New York City. The contracts called for the consolidation of two planned units into single apartments for each of the brothers, for a total price of $32 million. The project was two years away from construction at the time of the contract, and the brothers negotiated to pay an earnest money deposit of 25% during the next succeeding year as construction plans firmed up. The brothers were represented by experienced counsel and in fact negotiated a number of provisions favorable to them, not the least of which was a $7 million reduction in the purchase price and a unique right to remarket the units prior to completion and closing.

The time for closing of the contracts to purchase was October 19, 2001. Terrorists attacked and destroyed the World Trade Center in New York City less than six weeks prior to this, and the brothers did not appear at the closing. They claimed inter alia that the Trump developers had advance knowledge that terrorists were targeting high rise “trophy” buildings in New York and had fraudulently failed to disclose this risk and had otherwise neglected to protect their purchasers from possible terrorist attack. Not surprisingly, these arguments got short shrift from the New York court, and the brothers were faced with the reality of forfeiture of their $8 million earnest money deposit. The contract provided for forfeiture of this deposit on default as liquidated damages:
“[u]pon the occurrence of an Event of Default ... [i]f Sponsor elects to cancel ... [and i]f the default is not cured within ... thirty (30) days, then this Agreement shall be deemed canceled, and Sponsor shall have the right to retain, as and for liquidated damages, the Down payment and any interest earned on the Down payment.”

The New York court outlined quite a lot of evidence presented at the trial that would have supported the conclusion that a 25% earnest money forfeiture clause was a reasonable attempt to liquidate damages in the super luxury condominium submarket in New York. Despite its outlining these arguments, however, the court proceeded to adhere to the established New York rule that earnest money deposits in New York real estate contracts may be forfeited whether or not they meet the traditional liquidated damages test for reasonableness. The sole question the court should ask is whether the buyers understood and voluntarily agreed to their contract obligation:
“For over a century, courts have consistently upheld what was called the Lawrence rule and recognized a distinction between real estate deposits and general liquidated damages clauses. Liquidated damages clauses have traditionally been subject to judicial oversight to confirm that the stipulated damages bear a reasonable proportion to the probable loss caused by the breach. By contrast, real estate down payments have been subject to limited supervision. They have only been refunded upon a showing of disparity of bargaining power between the parties, duress, fraud, illegality or mutual mistake.”

The court cited as the most important recent case the 1984 decision in Maxton Builders, Inc. v. Lo Galbo, 68 N.Y.2d 373, 509 N.Y.S.2d 507, 502 N.E.2d 184. There, the court had noted that the forfeiture rule for earnest money in real estate contracts probably represented the majority approach in America and was justified by the bargaining realities of these contracts. It stated that "[R]eal estate contracts are probably the best examples of arms length transactions," and broadly concluded:
“Except in cases where there is a real risk of overreaching, there should be no need for the courts to relieve the parties of the consequences of their contract. If the parties are dissatisfied with the rule of [Lawrence ], the time to say so is at the bargaining table.”

Summary judgment for Trump and his friends. A TV mini-series about the incident is planned, with Antonio Banderas as a Turkish brother and Brad Pitt as Trump.

Comment 1: Note that the forfeiture rule was applied here despite the fact that the parties chose to characterize the remedy as a liquidated damages remedy. The court simply concluded that the tests normally applied to liquidated damages clauses in other contexts doesn’t apply here. Other jurisdictions take pains to differentiate an earnest money forfeiture clause from a liquidated damages clause, but uphold the forfeiture nevertheless. Despite the court's express holding, however, we should note that it did take some pains to outline the evidence produced that supported the reasonableness of the remedy along traditional liquidated damages analysis.

Where there is no characterization of the remedy as liquidated damages, the sellers may have even more options. In the Editor’s home state of Missouri, sellers can elect to forfeit the earnest money and also pursue a claim for damages or even specific performance, simply applying the forfeited sums against any further recovery. In one interesting Texas case, the court refused to limit the seller’s relief to the liquidated damages provision even though it stated that it was the seller’s exclusive remedy. But compare Palmer v. Hayes, 892 P.2d 1059 (Utah App. 1995) (The DIRT DD for 9/22/95) (if seller wishes to pursue damages option, it must first relinquish any claim to earnest money.) In Community Dev. Service, Inc. v. Replacement Parts Mfg., Inc., 679 S.W.2d 721 (Tex.App.1984) the court concluded that the clause was not a reasonable attempt to measure actual damages, since retention could be triggered by very minor defaults of the purchasers. Hence the court held the clause u nenforceable, permitting the vendor to recover actual damages far in excess of the earnest money.

Although some jurisdictions may not permit forfeiture as well as a damages action, many would view the equitable remedy of specific performance as always available unless specifically precluded by contract language. See, e.g. Conner v. Auburn Partners, L.L.C. 852 So. 2d 755 (Ala. Civ. App. 2002) (cert. den. 12/12/02) (The DIRT DD for 3/2/04)

Comment 3: Although, in 1986, the New York court may have been correct in stating that the majority approach in America favored earnest money forfeiture without a reasonableness analysis, this may no longer be the case in residential contracts. Many jurisdictions have adopted buyer friendly statutes requiring liquidated damages analysis. Indeed, due to the dominance in many parts of the contract of form contracts prepared for use by all powerful residential brokerage companies and their trade associations, it would be difficult to argue that many residential real estate sale contracts today in fact reflect an extended and knowledgeable negotiated agreement between the parties. Although the parties might have negotiated extensively about other parts of the contract, such as price or time for closing, or even about the amount of the earnest money, the terms of the contract relating to default provisions likely would not be part of the negotiation. Indeed brokers for both buyer and seller likely would use the same form agreements and would counsel their clients that this language should be accepted as is. “After all, it was written by a lawyer.” The Editor has had brokers, knowing that he was a real estate law professor, tell him that any departure from the form language provided in their form contract was against the law.

Comment 4: Notwithstanding the above comment, where statute does not intervene, the editor believes that the New York approach indeed does continue to represent the majority view. But Dale Whitman, in Section 10.4 of his book “Property”, written with Bill Stoebuck (Third Ed., West, 2003) concludes otherwise:
“The seller's right to forfeiture of earnest money is often mentioned in a contract clause, and its wording may be of great significance, but numerous states permit a forfeiture even in the absence of any clause. The right is usually explained on the grounds (1) that the seller could always seek specific performance and hence is only retaining a portion of the entire price which a court of equity would award him, or (2) that the buyer, being in breach, has no standing to assert any rights under the contract. There is little logic in these statements; at the point at which the forfeiture occurs, there is no judicial finding that specific performance is available to the vendor, who in any event usually does not seek it. A seller who in fact sought specific performance would have to tender a conveyance of the land, while the seller who seeks a forfeiture has no intention of doing so. Moreover, courts generally do not make the validity of forfeiture turn on whether the vendor still has the property or has resold it; yet the vendor obviously could not have specific performance if he or she had parted with the title. Finally, the buyer who seeks a refund of earnest money is arguably not relying on contract rights, but is merely asking relief from the seller's unjust enrichment. For all these reasons it is very doubtful that courts should impute an automatic right of forfeiture in every realty sale contract, and some refuse to do so.” (Footnotes omitted.)

See Birdwell v. Ferrell, 746 S.W.2d 338 (Tex.App.1988) (commercial contract) (standard rule in Texas stated to be that forfeiture clauses are penalties unless they are supported by language stipulating that the forfeiture is liquidated damages and unless the stipulation satisfies the “reasonableness test.)

Comment 5: Dale’s comments fail to take into account an important cost to the seller that the forfeiture remedy represents - the lost opportunity cost that the seller incurred when seller took the property off the market during the closing period. Although certainly real estate contracts are unique in the feature of a lengthy pre-closing period, they may be one of the few contract models that consistently involve such a period in the context of an uncertain market. The market for residential houses is particularly uncertain because each American home tends to have a unique character and generalizing about value is very difficult. Hence, the buyer’s agreement to commit to the earnest money arrangement is, in a very real sense, consideration for an option to purchase. If the buyer does purchase, the option price applies to the purchase price. If the buyer improperly fails to purchase, the editor believes that it is appropriate to consider the seller’s right to forfeit the earne st money without further investigation a form of compensation for locking up the property. Although, still, the editor would continue to apply the New York test that the contract itself reflect a level bargain between the parties (which eliminates many residential deals these days, as stated above), where there is clear understanding and adequate bargaining strength, the editor would not require that the damages be shown to approximate the reasonably anticipated damages on default. In such cases, fairness is assured by asking only one question: “Is that your signature on that contract?” Absent fraud, duress, or mistake, and absent special consumer considerations, that’s all we ought to ask.

Comment 6: Other DIRT DD discussions of this issue include Timney v Lin, 106 CA4th 1121, 131 CR2d 387 (2003) (DIRT DD for 7/14/03) (Illegal forfeiture provision, providing for forfeiture of buyer's deposit, was unenforceable even when illegal provision was included in settlement agreement. Roger Bernhardt’s DD notes discuss California statutory scheme here.); Olcott Lakeside Development, Inc. v. Krueger, 616 N.Y.S.2d 841 (App. Div. 1994) (The DIRT DD for 5/2/95) (Because liquidated damages provision of 10% of the purchase price is reasonable compensation for loss of sale alone, the buyer's agreement to pay an additional amount representing the actual cost of expenses for modifications to the property is valid as reasonably related to additional damages that might be incurred by the seller.) (DD also discusses Washington authority requiring liquidated damages analysis.)

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