Most real estate contacts, in California at least, include an optional “liquidated damages” clause. If both parties initial the clause, that section becomes part of the contract. Almost everybody does this, but very few people (or agents) understand exactly why.

In the most basic sense, the liquidated damages clause sets a limit on the amount of damages the seller may collect if the buyer defaults on the contract. The limit is the amount of the deposit, up to a maximum of 3% of the purchase price. If the deposit is increased in stages, each addition must be accompanied by a new liquidated damages clause to make sure the entire amount is covered by this clause. That is why, in the San Francisco peninsula area at least, most sellers and their agents want to see an initial deposit of 3% right up front. In a competing offer situation, if there are two equal offers and one has a 3% initial deposit and the other has a lesser amount, to be increased later, almost always the one with the initial 3% deposit will be the winner!

It sounds simple enough, but it is more complicated that it first appears. First of all, there is sometimes a dispute as to what constitutes a default. I always look at it as a failure to act in good faith to try to complete the transaction. If there is a loan contingency (rare in this area, where sellers expect buyers to be preapproved before even submitting their offer) and the buyer simply can’t get a loan, they can withdraw from the contract and get their deposit back. But, if there is a contingency for the buyer to have a roof inspection and the roof inspection turns up just fine, I would be mighty disturbed if the buyer refused to remove that contingency. Sometimes buyers will do that, thinking that as long as they have not removed the contingency they cannot be considered in default, but that might not stand up in court. There must be some good reason for them not to remove the contingency.

Also, even if the buyer does default, the escrow holder cannot automatically release the deposit to the seller. Both parties must agree or the court must order the release before the fund can be released. Sometimes deposit disputes go on for years. Buyers and sellers may release each other from the contract but stipulate that the deposit will remain with the title company until the issue can be resolved. Sometimes a seller will release the deposit if they get another, better offer for their property and that transaction closes. It would be pretty hard to demonstrate damages in that case. But it can happen.

Finally, it may not be in the seller’s best interest to include the liquidated damages clause in the contract. I had a transaction a few years ago where the buyer wanted a 6 month escrow. In this area 60 days is considered to be extraordinarily long. Many transactions close in 2 weeks or less. 30 days is considered at the outside edge of the norm. Many, many things can go wrong during an escrow, so I was uncomfortable with just a 3% deposit. We asked for, and got a 10% deposit and did NOT initial the liquidated damages clause (if we did and the buyer defaulted, the maximum we could keep would have been 3%). Not only that, but the buyer agreed to have the deposit released to the seller immediately after all the contingencies were removed. That put a lot of pressure on the buyer to complete the transaction, because he know that if he did not, he would have great difficulty in getting any of his deposit back.

Sure enough, wouldn’t you know it, that was the year of the 1989 Loma Prieta earthquake? Property values took a dive (although not by 10%.) Without the 10% deposit, the buyer may very well have withdrawn from the contract. But the transaction closed and everybody ended up happy. My seller was very impressed by the way I had protected him by understanding the benefits and the limitations of the liquidated damages clause.

© by Lynne Mercer 2006

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