Daily Development for Tuesday, January 8, 2002

By: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
prandolph@cctr.umkc.edu

VENDOR/PURCHASER; EARNEST MONEY: Under statute limiting amount of earnest money to 3% of purchase price, parties cannot avoid application of statute by characterizing the preliminary payment as an "option price" where the contract otherwise appears to commit both sides to carry out the sale.

Allen v. Smith, 2002 WL 4602 (Cal.App. 4 Dist. 1/2/02)

Allen submitted an offer to purchase Smith's residential property for $1.75 million. The original offer was a standard form California Board of Realtors contract, calling for an earnest money deposit of $53,250, $20,000 immediately and the rest following the end of the inspection contingency period. Smith counterproposed, and Allen accepted, language that increased the initial deposit substantially following satisfaction of contingencies and characterized the deposit as a nonrefundable payment for a purchase option:

"All contingencies to be removed 21 days from acceptance. Buyer's increased deposit to be $80,000--total deposit of $100,000 to be released to seller as a non refundable purchase option monies."

The reason for this change, both parties apparently admitted at trial, was to circumvent a provision of California law that states that an earnest money of no more than 3% of the purchase price is presumptively valid and reasonable, while an earnest money requirement for a greater amount is valid only if the benefitted party demonstrates that it is a reasonable liquidated damages provision. According to some evidence in the case, it is not uncommon in California for parties to use this characterization device as a way around the statute, since the sellers often are leery of their ability to later convince a court that the large forfeiture amount is valid as liquidated damages.

Following the inspection period, Allen indeed did increase the amount of deposit to $100,000 and the deposit was paid over to Smith.

Of course, later Allen decided that she didn't want to buy the house and demanded back all of the earnest money other than her initial $20,000 deposit. She argued that the characterization of the deposit as a purchase option payment was a naked attempt to circumvent the statute, and was invalid because the substance of the parties' agreement was a contract of sale, and not an option. Allen lost on summary judgment at the trial court level. But, on appeal, the California Court of Appeals reversed, holding, however, that Smith was entitled to the entire 3% earnest money originally in the contract - $53,250. The balance of the $100,000 deposit had to be refunded.

The court based its conclusion on an interpretation of the contract to impose upon both parties the obligation to close. Of course, since the contract originally was drafted with that purpose in mind, it was not difficult for the court to find language that indicated that this was the intent of the parties. It indicated that an option necessarily binds only the seller, and that the buyer has no obligation to perform and cannot, for instance, be sued for specific performance. For instance, the court alluded to language indicating that the buyer was committed to perform upon satisfaction of contingencies:

"The contract provides that on Allen's removal of contingencies she "shall conclusively be deemed to have ... [e]lected to proceed with the transaction[.]""

The court also notes, perhaps significantly, that the contract did not provide for a specific time within which the buyer was to exercise its option or lose it. Although it conceded that courts often will "fill in" a reasonable time for exercise, the absence of such language, together with the inclusion of other language stating that time was of the essence, were inconsistencies that suggested that the parties viewed both sides as bound.

Smith made the argument that all of the language to which the court alluded was "boiler plate" in a printed form, and that the specific customized language that the parties added ought to control the interpretation of their true intent. The court had an answer to that, however, because the parties both initialled the liquidated damages box that appeared in the contract, evincing their agreement that the deposit would be treated as nonrefundable liquidated damages. This, the court concluded, was a "customization" of the contract language that belied the option price argument.

Since the basic contract language indicated that Allen was to increase the earnest money following removal of contingencies, the court continued to apply that language, despite the fact that the parties recharacterized this later deposit as something else. Thus, that amount of earnest money that exceeded 3% was refundable, but Smith got to keep the rest - up to a total of $52,250.

Smith tried to convince the court that the total $100,000 amount was a reasonable liquidated damages figure, but with the statutory presumption running against the seller's position, Smith failed.

Comment 1: Despite the high dollars, this was a consumer instrument, and the Editor always has believed that courts ought to play a more activist role in seeing to it that parties to consumer instruments are treated fairly. Thus, the editor isn't particularly troubled by the court's decision that it had the discretion to "uncharacterize" the alleged option payment. It clearly provided a "safe harbor" for people who really want to use option agreements - right them as real options, not just embroidery on the face of a sale agreement.

Comment 2: It's rare for residential sellers or purchasers to be represented by lawyers during contract negotiations. Since this was a CAR form, however, it is quite likely that brokers were involved. If the broker produced this language, is it possible that the seller has a malpractice claim there?

The editor believes that a claim might lie, and properly so. Brokers are not experts in freehand contract drafting, and should not represent to their clients that they are. The dollar amounts here clearly were sufficient, in any event, to support the retention of legal counsel, and if the seller wanted to do something that was outside the ordinary "cookie cutter" contract language, the broker should have recommended the retention of counsel and should have refused to draft the language itself.

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

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