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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