EARNEST MONEY DISPUTES

Earnest money disputes are one of the most frequently discussed issues on the Legal Information Line.  Much of the frustration regarding earnest money dispute results from false expectations. Most of the remaining frustration results from the nature of our legal system. Hopefully, the explanation below will assist in reducing some of the frustration.

Earnest Money: What Is It?

Many sellers have come to believe that earnest money is a pot of money the seller gets if the buyer does not perform. While this may be the end result in some cases, it is not the whole picture. Earnest money is generally defined as:

A sum of money paid by a buyer at the time of entering a contract to indicate

The intention and ability of the buyer to carry out the contract. Black’s Law Dictionary, 5^th Ed.

A few things to note. First, earnest money is not required to have a valid contract. Earnest money is often thought to be “the consideration” for the agreement. However, the agreement to sell and the agreement to pay the purchase price can be sufficient consideration and the payment of money is not required (although it is common practice). Second, the seller does not automatically get to keep the earnest money if the buyer breaches the contract. Third, the seller is not automatically limited to the earnest money if the buyer breaches the contract. These last two points are discussed more fully below.

When Is the Seller Entitled to the Earnest Money?

In most cases, the buyer must be in default (or breach) of the purchase agreement before the seller has a claim to any of the earnest money. Accordingly, whether the buyer is in default is the first issue that must be determined. The subject of breach is worthy of its own lengthy article, so for this article, we will deal with general issues regarding default. As a general matter, the buyer will be in default if he does not perform and has no legal excuse for failing to perform. Legal excuses for failing to perform include failure of a contingency (failure to get financing, disapproval of inspections). Other legal excuses (also known as equitable defenses) are estoppel or waiver (such as when the seller prevents the buyer from performing the seller is estopped from asserting default or based on the seller’s actions or words (or those of his agent) he waives his right to assert default).

If it is determined that the buyer is in default, then one must look at the purchase agreement to determine the seller’s right to the earnest money. The issue you are looking for is whether the seller and buyer agreed to “liquidated damages” in the amount of the earnest money. Liquidated damages is a predetermined amount of the damages the parties agree will be paid by the buyer if the buyer breaches the agreement as an estimate of the actual damages the seller may suffer or because the actual amount of damages is difficult to determine.

If the parties have not agreed to liquidated damages, then a seller must provide what damages he has actually incurred as a result of the buyer’s default. This can be difficult to prove and often will require the seller to sell the property to another buyer before the amount can be determined. The seller’s actual damages are not automatically the amount of the earnest money, and could end up being more or less than the earnest money.

Why Won’t the Escrow Company Release the Money to the Seller Without the Buyer’s Written Instruction?

Let’s assume the following facts: Seller and buyer have entered into a purchase agreement; buyer has paid $1,000 earnest money to escrow; purchase agreement provides that it is contingent on buyer obtaining financing (30-year conventional, 6% interest); purchase agreement provides that buyer is to submit all documents required for loan approval within 5 days of acceptance and failure to do so is considered default by the buyer; purchase agreement provides that seller is entitled to $1,000 earnest money as liquidated damages if buyer defaults. Buyer fails to provide the lender with required tax

returns within the 5 days.

From the seller’s perspective, the buyer has clearly defaulted entitling the seller to the earnest money. The seller is frustrated because the escrow company won’t release the money to the seller until the buyer signs cancellation instructions releasing the money to the seller. Of course, the buyer refuses to sign the instructions.

The primary reason the escrow company won’t release the money without both parties signing is to protect the escrow company if it turns out the seller was not entitled to the money. The escrow company is not the judge or jury. Remember the legal excuses discussed previously? Among them are those “equitable defenses” that are very fact specific (such as, the seller or his agent told the buyer he could have additional time to apply for the loan?). The escrow company is not a fact finder or a judge, therefore, the escrow company is not going to make a determination of whether the buyer is in default.

How Does the Seller Get the Money?

If the seller and buyer cannot agree on the disposition of the earnest money, the seller ultimately would have to get a court order to release the money. However, prior to going to court, the seller may want to consider mediation (and he might have to if he agreed to do so in the purchase agreement). If the seller must go to court, he will have to prove that the buyer is in default and (unless the parties agreed to liquidated damages) he will also have to prove what his damages are. The seller should consult legal counsel for advice regarding filing a court action.

The Bottom Line

As you can see, earnest money disputes can be complicated. While you cannot give your client legal advice, you can assist your client by not giving him false expectations. Don’t give your seller the impression that he will be able to get the earnest money quickly if the buyer fails to perform his obligations under the purchase agreement. Don’t give your seller the impression that he is automatically entitled to the earnest money if the buyer defaults. I have often heard the question, “What good is a contract then anyway?” Bottom line, without the contract, the seller wouldn’t even be able to go to court. And remember, many buyers and sellers do perform under the contract and many disputes are resolved short of going to court.