Liquidated Damages Clauses
Palo Alto, California and the San Francisco Bay Area are home to some of the most expensive residential property in California. Most real estate purchase and sale transactions are completed successfully by well-intentioned buyers and sellers with the assistance of knowledgeable real estate brokers and attorneys.
However, from time to time, real estate transactions do fail before or during the close of escrow. Resolving Escrow and Earnest Money Disputes can be complex. However, a liquidated damages clause can ease such a dispute by enabling the seller and buyer to agree, before any dispute arises, on an amount of damages to be awarded to the seller if the transaction fails due to the buyer’s breach.
Legal Requirements for a Valid Liquidated Damages Clause
A liquidated damages clause must satisfy certain legal requirements to be presumptively valid.
- First, the funds defined as liquidated damages must not be excessive; rather, the amount must be a “reasonable estimate” of the seller’s actual loss due to a buyer’s breach. California Civil Code § 1671(b). A seller may not treat buyers unjustly or make an unreasonable profit above the financial harm. In fact, where the property at issue is residential, 1-4 units and to be occupied by the purchaser as a personal residence, the liquidated damages amount generally cannot be greater than 3 percent of the sale price. California Civil Code § 1675(c). In certain limited circumstances, however, even liquidated damages of 3% of the purchase price can be deemed unreasonable; such as where the seller sells the property for a higher price within six months of the buyer’s default. Civil Code §1675(e)(2).
- Second, the liquidated damages provision must satisfy special format requirements. The liquidated damages clause must be in bold 10 point type or bold red contrasting 8 point print. California Civil Code § 1677
- Third, the liquidated damages clause must be signed by both parties to the purchase contract. California Civil Code § 1677
Initialing the Liquidated Damages Clause
Whether the liquidated damages clause is enforceable where all parties to the contract do not initial the provision will be determined by a court of law. Notably, the California Association of Realtor purchase contracts require initialing the liquidated damages clause if a party intends to be bound by this provision.In the absence of language stating that parties must initial the liquidated damages clause, for the clause to be enforceable, the California Court of Appeals held that where the clause was not initialed, the clause was enforceable or voidable at the buyer’s option. Guthman v. Moss, 150 Cal. App. 3d 501, 506-512 (Cal. App. 2d Dist. 1984)
Potential Benefits of a Liquidated Damages Clause
Above all, a liquidated damages clause is beneficial because it creates certainty regarding the amount a buyer may lose where a transaction fails. Additionally, fixing the amount of damages in advance also may make it easier to resolve disputes. Moreover, if no liquidated damages clause is contained in the purchase agreement, a seller must prove the amount of the financial loss rather than the pre-negotiated amount and a wrongful breach.However, a liquidated damages clause is merely an approximate measure of damages that a seller may be entitled to due to a buyer’s breach. This approximation could differ significantly from the actual monetary damages incurred by the seller. Therefore, both parties to the contract should carefully consider whether a liquidated damages clause is most beneficial.
It is worth noting that a buyer does not always forfeit its deposit if the transaction does not close escrow. A transaction may not close for a variety of acceptable reasons such as a buyer’s good faith inability to remove valid contingencies.
Release of Funds by Escrow Holder
The escrow holder requires permission from both parties to release funds held in escrow. If a buyer breaches the contract and fails to agree to a release of escrow funds to the seller, the buyer must have a valid good faith reason, or the buyer can be liable for damages, costs and penalties to the seller.