Q: My clients often ask my opinion as to whether they should agree to the Liquidated Damages provision. I do not really understand the paragraph in the contract, and I just tell them that everyone usually initials it. What should I tell the clients? Does this provision benefit the Seller or the Buyer? What happens if all the Parties do not initial this paragraph?
A: A Liquidated Damages provision in a contract is an agreement that IF the Buyer breaches the contract, the maximum amount of damages the Buyer will owe the Seller is an agreed amount of money. To “liquidate” in this context means to make certain.
I. THE LIQUIDATED DAMAGES PARAGRAPH: In the sale of residential real property, the Liquidated Damages paragraph is controlled by Civil Code §§ 1675-1681. Section 1677 provides that to be valid, the provision must be separately signed by each Party to the contract and the provision must be set forth in bold type. The Liquidated Damages paragraph in the CAR Purchase Agreement provides:
“If Buyer fails to complete this purchase, because of Buyer’s default, Seller shall retain, as Liquidated Damages, the deposit actually paid. If the Property is a dwelling with no more than four units, one of which Buyer intends to occupy, then the amount retained shall be no more than 3% of the purchase price. Any excess shall be returned to Buyer. Except as [otherwise] provided … release of funds will require mutual, Signed release instructions from both Buyer and Seller, judicial decision or arbitration award. AT THE TIME OF ANY INCREASED DEPOSIT BUYER AND SELLER SHALL SIGN A SEPARATE LIQUIDATED DAMAGES PROVSION INCORPORATING THE INCREASED DEPOSIT AS LIQUIDATED DAMAGES.”
To better understand this paragraph, this portion of the Tip will focus on its separate parts:
A. If Buyer fails to complete this purchase because of Buyer’s default: This means that the Liquidated Damages paragraph only applies if there is a breach of the contract by the Buyer; it has no applicability to transactions where the Seller has breached or where the Buyer has a legitimate cancellation right.
B. Seller shall retain, as Liquidated Damages, the deposit actually paid. This means the maximum amount of damages that the Seller can claim when there is a breach of contract by the Buyer is the amount of deposit that is actually paid by Buyer into Escrow. If the Buyer has not deposited any funds into escrow and then decides to cancel, Agents representing Buyers and/or Sellers, should advise the clients to immediately consult with their own qualified California real estate attorney (“QCREA”).
C. If the Property is a dwelling with no more than four units, one of which Buyer intends to occupy, then the amount retained shall be no more than 3% of the purchase price. This means that the maximum amount of damages that the Seller can claim when there is a breach of contract by the Buyer is 3% of the purchase price or the amount actually paid into escrow, whichever is less but only if the Property is residential 1-4 units and only if the Buyer intends to occupy 1 of the 4 units. If the Property has 5 or more units and/or the Buyer is an investor, Agents representing Buyers and/or Sellers should advise the clients to immediately consult with their own QCREA since the amount that the Seller is entitled to recover is subject to legal debate.
D. Any excess shall be returned to Buyer. This means that if the amount in escrow exceeds the 3% limit, and the Property is residential 1-4 units and the Buyer intends to occupy 1 of the 4 units, then the Seller cannot make a claim for the amount in excess of 3% and should return the excess deposit to the Buyer.
E. . . .release of funds will require mutual, Signed release instructions from both Buyer and Seller, judicial decision or arbitration award. This means that even if the Buyer has actually breached the contract, both the Buyer and the Seller must sign mutually-consistent escrow instructions to release the funds.
F. At the time of any increased deposit, Buyer and Seller shall sign a separate Liquidated Damages provision incorporating the increased deposit as Liquidated Damages. Civil Code § 1678 specifies that if the Buyer makes multiple deposits, each additional deposit must be accompanied by a separate signed/initialed Liquidated Damages paragraph. Escrow officers do not provide receipts that include a Liquidated Damages provision and thus Agents must use a Receipt for Increased Deposit form (either the CAR “RID” or the PRDS “RID”).
II. WHAT IS THE ADVANTAGE OF INCLUDING LIQUIDATED DAMAGES IN THE CONTRACT?
The main advantage is that it creates some degree of certainty as to how much the Buyer will have to pay to the Seller if the Buyer breaches the contract. The provision may also serve to limit what the defaulting Buyer must pay if the Property is re-sold within 6 months of the date of the breach.
Although including Liquidated Damages may make it easier for a Seller to prove damages, if the actual damages that a Seller suffers exceeds the 3%, then the Liquidated Damages provision could harm the Seller.
III. HOW DOES THE ABSENCE OF LIQUIDATED DAMAGES AFFECT THE PARTIES?
Assuming there is a binding agreement between the Parties and no Liquidated Damages provision was included, then, if the contract is breached by the Buyer, the Seller will be required to prove their actual damages in order to win a judgment in court or arbitration. The amount that the Buyer may have to pay in that event could be larger, even much larger, than the amount of the Buyer’s deposit; it could also conceivably be less, or even none at all. Depending upon the facts of the transaction, the absence of Liquidated Damages may benefit either Party
Example 1: Assume the sale price is $1 million on a home and the Buyer has $30,000 (3%) in escrow. If the Buyer breaches and if the Liquidated Damages paragraph has been agreed to, then $30,000 is the maximum amount the Seller will recover regardless of the Seller’s actual loss. If the Property is re-sold for $900,000, the Seller’s actual loss is $100,000; inclusion of the Liquidated Damages provision would then strongly benefit the defaulting Buyer and would harm the Seller in this example.
However, if the Liquidated Damages paragraph had not been agreed to, then the Seller is able to seek the full amount of the Seller’s actual damages of $100,000. The absence of a Liquidated Damages provision would then strongly benefit the Seller and would harm the defaulting Buyer in this example.
Example 2: Same facts as in Example 1, but the Seller is able to quickly re-sell the Property for $990,000; the Seller only has a $10,000 loss. If Liquidated Damages has been agreed to, the Seller would be entitled to the entire $30,000 deposit. The inclusion of a Liquidated Damages provision would then benefit the Seller.
If the Liquidated Damages provision has not been agreed to, the Seller would only be entitled to seek the Seller’s actual damages. Unless the Seller has other provable actual damages, the most the Seller would recover would be the $10,000. Absence of a Liquidated Damages provision would then benefit the Buyer in this example.
IV. SHOULD AN AGENT ADVISE CLIENTS TO INITIAL LIQUIDATED DAMAGES OR NOT?
No. As illustrated by the examples above, the benefits or disadvantages to agreeing to Liquidated Damages will depend upon legal and economic factors which cannot be predicted. Agents who advise clients on whether or not to initial the Liquidated Damages paragraph could be accused of the unlawful practice of law because the Parties may be giving up substantial legal rights. Ultimately, it is up to the Buyers and Sellers to decide for themselves whether they want to initial Liquidated Damages.
V. WHAT SHOULD AGENTS RECOMMEND IN SALES NOT SUBJECT TO THE 3% LIMIT?
In the sale of a 5+ unit dwelling, or a 1-4 unit dwelling where the Buyer does not intend to occupy one of the units, a liquidated damage provision in excess of 3% may be valid unless the Party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was entered into. See Civil Code Section 1671(b).
Because of the uncertainty of what could later be found to be an “unreasonable” amount of deposit subject to Liquidated Damages, Agents should refer clients to their own QCREA for advice on what limit to set.
VI. WHAT HAPPENS IF ALL OF THE PARTIES DO NOT INITIAL LIQUIDATED DAMAGES?
Most standard form contracts specify that if there are any inconsistencies in the initialing of the Liquidated Damages provision, then the Parties do NOT have a mutually-consistent agreement; a Counter Offer is thus required (see, for example, paragraph 26 of the CAR RPA, paragraph 39 of the PRDS REPC). All of the standard Counter Offer forms specify that if all of the Parties have not consistently initialed the Liquidated Damages provision and have not otherwise agreed in writing, then the Liquidated Damages paragraph is excluded.
PRACTICE TIPS:
- Since it can be considered legal advice for a real estate licensee to advise clients whether or not to initial Liquidated Damages, Buyers and Sellers must make their own decision on this issue. Prior to preparing or presenting any contracts, Agents should discuss the topic of Liquidated Damages by using the information that is contained in either the CAR Statewide Buyer Seller Advisory (“SBSA”) or the PRDS® San Mateo/Santa Clara Counties Advisory (“SMSCA”)
- If clients have further questions about Liquidated Damages, Agents should either provide the clients with a copy of CAR’s Legal Memo, “Liquidated Damages and Deposit Disputes” at: https://www.car.org/riskmanagement/qa/contract-forms-folder/liquidateddamagesdepositdisputes and/or recommend that the clients consult with their own qualified California real estate attorney (“QCREA”).
- Any time that there is a possibility that a Buyer may have breached the contract, the Buyer and the Seller should be immediately advised to consult with their own QCREA.
- Special rules apply to Liquidated Damages in subdivided lands contracts; thus, when clients have questions about that type of contract, they need to be referred to a QCREA.
DO NOT FORWARD TO CLIENTS. This Weekly Practice Tip is for the exclusive use of clients of Broker Risk Management and their agents. It may not be reproduced or distributed without the express written consent of Broker Risk Management. The advice and recommendations contained herein are not necessarily indicative of standards of care in the industry, but rather are intended to suggest good risk management practices.
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