Q: I am the Buyer’s Agent on a single-family home; I just received a Counter Offer that specifies that the initial deposit be increased to $50,000 and that when it is put into escrow it will be immediately “passed through” to the Seller as a “non-refundable deposit.” The $50,000 deposit is more than 3% of the sales price. According to the Listing Agent, the Seller is in desperate need of money to pay overdue mortgage payments and the Seller’s Attorney fees. The Listing Agent also said that the Seller wanted assurance that my client was a serious Buyer who would close the transaction.
My client is worried about allowing her money to be released from escrow to the Seller and wants me to assure her that her money will be safe with the Seller. What should I tell my client?
A. First, if the Counter Offer is accepted by your client, then the Buyer’s funds will be at risk and it will be extremely difficult for her to get those funds back if the deal does not go forward. Second, everyone needs to recognize that non-refundable deposits are illegal. You need to tell your client in an email:
“A NON-REFUNDABLE DEPOSIT PROVISION IS NOT ALLOWED IN THE SALE OF CALIFORNIA RESIDENTIAL PROPERTY (1-4 UNITS).”
I. What is a Non-Refundable Deposit and why is it illegal?
Basically, if any money deposited into escrow is “passed through” to the Seller as a “non-refundable deposit,” then, even if the Buyer was legally able to cancel the contract in good faith (e.g., the Buyer exercises a legitimate contingency right), the Seller would still be able to keep the deposit!
Standard industry purchase agreement forms provide that if the Buyer is legally able to cancel the contract in good faith (i.e., the Buyer has not breached the contract), then the Buyer would be entitled to recover their deposit. Adding a non-refundable deposit provision to the purchase agreement would effectively create a new Buyer penalty that, no matter what happens in the transaction, the Seller keeps the deposit.
The illegality of non-refundable deposits was clearly explained by the Appellate Court in Kuish v. Smith, (2010). That case involved a deposit of $620,000 on a $14,000,000 home in Laguna Beach. The purchase contract specified that the deposit would be “non-refundable.” The liquidated damages paragraph was not initialed by any of the Parties. Buyer cancelled and sued for the return of the deposit. The trial court believed that both Seller and Buyer were “sophisticated business persons” who understood what they were doing; even though the Seller eventually sold the Property to someone else for $1 million more that what the Buyer had offered to pay, the Trial Court held that the Seller could keep the deposit.
In reversing the trial court, the Appellate Court stated that “any provision by which money or property would be forfeited without regard to actual damage suffered would be an unenforceable penalty. To construe the term “nonrefundable” to establish [the sellers’] entitlement to the full deposit without regard to actual damages would essentially create a [new] liquidated damages provision.” In other words, the only damage provision that can be included in a contract for the sale of residential property (1-4 units) is the one authorized by California statutory law and that is the Liquidated Damages provision contained in standard real estate contract forms.
The CAR Residential Purchase Agreement includes the following warning in paragraph 21A to gently remind everyone that non-refundable deposits are illegal:
“Any clause added by the Parties specifying a remedy (such as release or forfeiture of deposit or making a deposit non-refundable) for failure of Buyer to complete the purchase in violation of this Agreement shall be deemed invalid unless the clause independently satisfies the statutory liquidated damages requirements set forth in the Civil Code.”
The only provision that meets the Civil Code requirements is the statutory Liquidated Damages clause that is pre-printed in every industry standard residential purchase agreement.
II. What are the risks of including a “Non-Refundable Deposit” clause in a Residential Purchase Agreement?
A. Buyer’s Risks: Once the money is released to the Seller, it is extremely unlikely that the Seller will voluntarily give the money back, Then, the Buyer will need to institute legal action against the Seller which is usually a long and costly process. The Buyer’s risks increase if the Seller is in financial difficulties (which is true in the facts of this question) because the Seller may file bankruptcy and the Buyer will become an unsecured creditor. The Seller could lose the Property through foreclosure and the Buyer would have no claim on the Property. In other words, the Buyer will probably face significant difficulties in trying to recover any of the money.
B. Seller’s Risks: If the Seller believes that the “non-refundable” deposit is the Seller’s money to keep, the Seller may end up being involved in a lawsuit which could result in the Seller paying attorneys’ fees and costs.
C. Broker/Agent’s Risks: Any financial losses sustained by the Parties will be blamed on the real estate professionals who allowed the situation to occur in the first place.
III. What are the risks of including a “Pass-Through Deposit” provision that does not include the word “non-refundable?” If deposits in escrow are “passed through” to the Seller (even if not described as non-refundable), the risks detailed in Section II will still apply since the Seller may still believe the money in their possession is theirs to keep and legal action will then follow if the Buyer wants their deposit back.
PRACTICE TIPS:
- Listing Agents: If a Seller is insisting that the Buyer’s deposit be “non-refundable,” advise your client in an email that it is your “understanding that such provisions are not legally enforceable”. That email should urge the Seller to consult with a qualified California real estate attorney regarding that issue. If the Seller refuses to follow that advice, notify your Broker or Branch Manager for further direction.
- Buyer’s Agents: If a Seller issues any type of contract document that includes a “pass-through” of Buyer’s funds to the Seller and/or the Seller is to receive a “non-refundable” deposit, advise your client in an email not to sign that document because the Buyer’s money will be at risk. Recommend that the Buyer negotiate to remove that provision or walk away from the deal. If the Seller insists and Buyer wants to proceed anyway (“I’ll do anything to get that Property”), then recommend, in writing, that the Buyer discuss this with a qualified California real estate attorney before signing anything. If the Buyer agrees to release the funds, then document that the client is proceeding against your advice and recommendations.
See Weekly Practice Tip: Handling Clients Who Will Not Follow Advice (11/16/18)
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