Legal Update

A “NONREFUNDABLE” DEPOSIT NEVER IS

A deposit does not become “non-refundable” merely by labeling it as such.  To keep a defaulting buyer’s deposit, the seller must satisfy the statutory requirements for liquidated damages.  Kuish v. Smith (2010) 181 CA4th 1419.

FACTS:  In December 2005, plaintiff Bradford Kuish (“Buyer”) entered into a written agreement to purchase defendants William and Rhonda Smith’s (“Seller”) Laguna Beach residence for $14 million.  The agreement required Buyer to make two “nonrefundable” deposits into escrow, totaling $620,000.  After Buyer paid the deposit on February 13, 2006, $400,000 was released to Seller and $220,000 was held in escrow.  Escrow was scheduled to close July 28, 2006. 

Nine months later Buyer has still not closed.  Finally on September 16, 2006, Buyer requested that escrow be cancelled, and both Buyer and Seller signed cancellation escrow instructions on October 17, 2006.  Seller then sold the property to a third party for $15 million.  Seller refused to return any portion of Buyer’s deposit that had already been released to Seller, or to allow the escrow company to return any of the deposit still held in escrow.

Buyer filed suit against Seller to recover the deposit, but the trial court concluded that the Seller was entitled to keep the entire nonrefundable deposit ($600,000), plus interest amounting to $20,000.  The trial court based its decision on its interpretation that the deposit constituted separate and additional consideration for extending the time and length of keeping escrow open for nine months.  Having lost the full deposit, Buyer appealed the trial court’s decision to the Court of Appeal.

DECISION:  The Court of Appeal began its analysis with a discussion of Civil Code §3307, which provides that the measure of damages for the breach of a real estate purchase agreement is the excess, if any, of the amount which would have been due to the seller under the contract over the value of the property to him or her, plus consequential damages and interest.  The court went on to state that because the seller’s primary measure of damages is essentially the difference between the contract price and the property’s value at the time of the breach, if property values are rising such that the property is sold to a new buyer at a price equal to or greater than the value of the contract, the seller is no longer entitled to any loss-of-bargain damages.

The court next turned its attention to whether Buyer’s deposit could properly be considered nonrefundable, even though the purchase contract did not have a liquidated damages clause.  Despite Seller’s argument that it was nonrefundable based on the language of their contract, the court held that, absent a valid liquidated damages provision, any contract provision by which money or property is forfeited without regard to the actual damage suffered would be an unenforceable penalty.  Because the parties had expressly stipulated that no liquidated damages clause existed in their contract, and Seller suffered no actual damage as a result of Buyer’s breach, the court ruled that Seller’s retention of the $600,000 “nonrefundable” portion of the deposit constituted an invalid forfeiture.

Finally, Seller argued that the deposit was rightfully retained as separate consideration for Seller’s agreement to extend the escrow closing date.  However, the court rejected this argument, pointing out that the parties’ escrow instructions contained no mention of Buyer’s agreement to disburse additional funds in exchange for an extension of the escrow closing date.  Because the court could find no legal authority to support Seller’s argument, Seller’s retention of the deposit was held to be an invalid forfeiture.  As a result, the trial court’s decision was reversed and the full “nonrefundable” deposit was refunded to the Buyer.

ANALYSIS:   This result is to be expected where the Seller kept $600k from defaulting Buyer #1, then promptly sold the property to Buyer #2 for an extra million dollar profit. Seller was not damaged by Buyer’s breach.  Calling the deposit “non-refundable” does not make it so. 

A liquidated damage provision that complies with Civil Code 1675 is presumptively valid and will allow the seller to keep the defaulting buyer’s deposit.  However, the buyer can still recover some or all of the deposit if the buyer proves the amount is unreasonable under the circumstances (Civil Code 1675(e)).

When buyer fails to close escrow on time, the seller should consider executing an addendum to the contract granting an extension of time, in exchange for new funds (not the deposit) paid directly to seller.   This structure overcomes the court’s objections in the Kuish case and becomes truly non-refundable because it is consideration for extra time.  The seller earns these funds by the passage of time and keeps them regardless of whether or not he is ultimately damaged by the defaulting buyer.

Don’t plan on a deposit being nonrefundable just because you call it that.

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This case was recently decided and is subject to change by further appellate court review.  You should consult legal counsel to evaluate this legal precedent in the context of your specific facts.  The distribution of Legal Update does not by itself create an attorney-client relationship with the reader.