Home Buyer's Deposit in a Rising Market

As the residential real estate market begins to show signs of life, it is worthwhile discussing a recent case about who is entitled to a breaching buyer's deposit in a rising market. Kuish v. Smith (2010) G040743.

In December 2005, the plaintiff/buyer offered to purchase the seller's beach front home in Laguna Beach for the modest sum of $14,000,000. After all contingencies were removed, the buyer unilaterally canceled the lengthy escrow in September 2006 without cause. Two months later, the seller sold the house to another buyer for $15,000,000.

The plaintiff demanded the return of his $620,000 deposit since the seller came out ahead by selling the property for $1 million more. But the seller declined the buyer's request to return the deposit and a lawsuit ensued. The Court of Appeal held that the trial court erred in refusing to return the deposit. The Court held that in a rising market, where the seller could not prove actual damages, the seller's retention of buyer's deposit constituted an invalid forfeiture under Freedman v. The Rector (1951) 37 Cal.2d 16 (Freedman). The Court reached that result despite the agreement by the parties that the deposits were "non-refundable."

The purchase agreement in Kuish v. Smith did not contain a liquidated damages provision. Most purchase agreements in California do contain a liquidated damages provision because of the widespread use of the forms promulgated by the California Association of Realtors, a trade association of real estate agents. The liquidated damages provision in the C.A.R. purchase agreement must be initialed by the parties to become effective. If it is, the buyer may lose his or her deposit up to 3% of the purchase price by breaching the agreement after the waiver or removal of all buyer's contingencies. Civil Code section 1675 governs liquidated damages in the purchase of a dwelling of not more than four units. Under that code section, if the deposit is less than 3% of the purchase price, the breaching buyer has the burden of establishing the amount of the deposit is unreasonable as liquidated damages.

This gets us back to Freedman where the CA Supreme Court held that there are circumstances where a liquidated damages provision will not be enforced: "Since [the seller] resold the property for $2,000 more than [the buyer] had agreed to pay for it, it is clear that [the seller] suffered no damage as a result of [the buyer]'s breach. If [the seller] is allowed to retain the amount of the down payment in excess of its expenses in connection with the contract it will be enriched and plaintiff will suffer a penalty in excess of any damages he caused." (Id. at pp. 19-20). In other words, a rising market may prevent a seller from recovering liquidated damages.

ESCROW EXTENSIONS -- BE REASONABLE!

It has been the law in California for some time that a Landlord must be reasonable in consenting to the assignment of a commercial lease. The California Court of Appeal has recently held that a seller of real property must act in an objectively reasonable manner when asked to extend the close of escrow.

In Peak-Las Positas Partners v. Bollag, the seller told the buyer he did not care how long it took the buyer to entitle a residential development project. But when the close of escrow approached, the seller refused to extend escrow. Imagine the buyers' surprise -- the buyer had already paid 98 percent of purchase price, had invested $5 million in project development costs and had diligently pursued the conditions for closing the sale.

The Court of Appeal held that the seller acted in an objectively unreasonable manner so the buyer would not forfeit the $465,000 it paid for the property and the $5 million in project costs.

A review of the facts demonstrates that the seller invented reasons late in the escrow to refuse the extension. First, the seller claimed he had landslide liability concerns. But the seller had observed soil failures on his property before purchase agreement was signed, and admitted he made no inquiries about insurance costs or availability. Second, the seller claimed the buyer failed to keep him informed about the entitlement processing. To the contrary, the buyer informed the seller about the progress of the land use application and the seller never complained that he lacked information. Even if the buyer had breached its obligation under the purchase agreement to keep the seller informed, the Court of Appeal said it would not constitute reasonable or good faith grounds for the seller to refuse the requested extension.

For guidance about what is objectively reasonable in a commercial real estate transaction, click here to read the opinion in Peak-Las Positas Partners v. Bollag.

Real Estate Contracts -- What is Expressed is Understood; What is Not Can Be Implied By the CA Supreme Court

The legendary folksinger, Pete Seeger, once offered these words of wisdom about written contracts: "Education is when you read the fine print. Experience is what you get if you don't."

In recent years, many individuals and companies decided to obtain experience instead of education by signing loan documents or issuing mortgage backed securities without reading the fine print.

But what if a written contract is silent on an important deal point? You cannot read what isn't there, whether it is in bold or fine print. In late December 2008, the California Supreme Court told us "it ain't necessarily so" in Patel v. Liebermensch (filed 12/22/08) S156797.

In that case, the parties (apparently acting without lawyers) entered into a written lease of a condo with an option for the tenant to buy. The written option contained the essential terms of the purchase except for the time of payment. It was also silent about using an escrow for the purchase. A dispute arose between the parties after the tenant exercised the option to buy, and they could not agree to the terms of a purchase agreement. The tenant, Patel, brought a specific performance action to enforce the option agreement. Patel won at trial and lost before the Court of Appeal which ruled the option agreement was too uncertain to specifically enforce. (See, August 23, 2007 post about the Court of Appeal opinion in this case.)

The Supreme Court had little trouble filling in the blanks. First the Court reasoned, " . . . while the parties are obviously free to include escrow specifications in the contract of sale, they are not necessary terms." Once you assume the parties implicitly decided to have an escrow, the rest is easy. "In the absence of a specified time of payment, a reasonable period is allowable under Civil Code section 1657." In other words, the Court concluded that it is reasonable to assume the purchase price would be paid when the implied escrow closed.

This opinion offers both education and experience for parties to a real estate contract in California. If you are willing to invest the time and money to take your case to trial, then to the Court of Appeal and finally to the Supreme Court, you can get a definitive opinion about what the parties did (and did not) agree to. This took about 3 years in the Patel case. During that time, the real estate market declined substantially and it became much more difficult to obtain financing.

If you want to save time and money, it is better to hire a lawyer at the outset so that your agreement covers the essential points of agreement and the incidental points as well. In the case of an option to buy real estate, you can agree to the form and content of the purchase agreement itself to avoid problems down the road.

After the Fall -- What Now?

On December 26, 2006, I wrote a post entitled "'Creative' Financing -- The Slippery Slope in 2007."

On December 28, 2007, I wrote a post entitled "Non-Traditional Mortgage Products -- The Slippery Slope Became an Avalanche."

Now it is time for my third year end post. I read an insightful column in today's the Wall Street Journal about the global economic reversal. It is entitled, "The Economic News Isn't All Bleak" by Zachary Karabell. In the last paragraph of his column, Mr. Karabell observes:

"The rush to declare the future bleak has obscured the fact
that no one knows the outcome of an unprecedented event.
No one. The worst course in the face of uncertainty is blind
faith in conventional wisdom and past patterns. The best is
to stay humble in the face of the unknown, creative and
unideological about solutions, and open to the possibility
that as quickly as things turned sour they can reverse."

To the loyal readers of CalRealEstateLawBlog.com, watch out for wolves in sheeps' clothing and have a productive and healthy 2009!

HOME SWEET HOME --The Price of a Great Love Affair

On June 13, 2005, TIME magazine reminded us that Americans were at the height of a great love affair with residential real estate. On October 3, 2008, we learned that every American taxpayer, now and in the future, would share in the cost of mortgage defaults and the rescue plan through the Troubled Assets Relief Program (TARP). The recent federal "rescue" legislation and the government's takeover of Fannie Mae and Freddie Mac make the United States the largest mortgage company in the world.

Two maxims of California jurisprudence provide food for thought in assessing the fallout from the messy aftermath of the latest residential real estate binge: "He [or she] who takes the benefit must bear the burden"; and, "He [or she] who consents to an act is not wronged by it." California Civil Code sections 3521 & 3515.

With that said, let us acknowledge the participants who benefited from and consented to the questionable transactions in the United States that have resulted in extraordinary actions by governments around the developed world:

Buyers who used "creative financing" while they were in denial about the consequences of a variable interest rate loan readjusting and the inevitable decline in housing prices;

Mortgage brokers and real estate brokers who did not adequately warn buyers about the credit risk of buying a home without a down payment or a fixed rate loan;

Appraisers who, in some cases, participated in the validation of inflated prices or worse; i.e., mortgage fraud;

Mortgage companies and banks who defied reality by making loans without following reasonable underwriting standards;

Investment bankers who "securitized" pools of loans ("mortgage backed securities") that were not properly underwritten or backed by capital in the event of widespread defaults;

Rating companies that bestowed their pedigrees on the mortgaged backed securities at they same time they were compensated by the investment bankers;

Hedge funds, insurance companies and investment bankers who wrote contracts ("credit default swaps") to pick up the losses on the mortgage backed securities without the financial ability to do so in the event of widespread defaults;

And the United States government which failed to warn, regulate and control the participants before it became the world's biggest mortgage company.

PROTECTION FOR BUYERS' BROKERS AS THE BUBBLE BURSTS

Four years ago, during the week of 2004 Democratic Convention, I vacationed with my family in San Diego, California. One day I read a local newspaper and learned that the number of licensed real estate salespersons in San Diego County had skyrocketed to an all time high. The article was like the ringing of a bell, warning that the real estate market had reach a top.

A recently published California case arises from speculation during 2002 in the downtown San Diego condominium market and the slowing of that market. More importantly, it affirms that a buyer's broker will be protected under under an exclusive buyer-broker commission agreement when the buyer defaults. In Schaffter v. Creative Capital Leasing Group, LLC (2008) D047364, the Fourth Appellate District held that a buyer's broker is owed a commission if the buyer defaults after the broker locates residential property and the buyer signs a purchase agreement.

If Schaffter, the buyer tied up two new condominiums in lengthy escrows with the hope that they would significantly appreciate in value before the closing. (One of the buildings is pictured above.) When the condos did not appreciate enough to satisfy the buyer, it refused to close the escrows. The Court of Appeal found that the principal of the buyer, ". . . never intended to finalize the purchases if the market did not perform as he expected, or to pay commissions on units that did not close escrow."

The buyer's primary defense -- that it was not in default under the commission agreement because the developers decided not to sue for breach of contract -- was disingenuous. The buyer's principal apparently was successful in threatening and bullying the developers into accepting the buyer's cancellations. The Court of Appeal rejected this "defense" and affirmed the ruling of the trial court that: "'there are consequences when people cancel contracts' without valid reason. Here the consequence is CCLG's payment of commissions."

Buyer's brokers will be heartened by the holding in the Schaffter case and the Court's recognition that a commission agreement should be honored when a purchase is cancelled without justification.