Liquated Damages Clause Can BE Valuable, But May Be misunderstood
Is a liquidated damages clause a good thing to have in a real estate contract? If so, for whom is it good? The buyer? The seller? Both? Like so many questions in real estate, and life in general, the first answer to such questions is, "It depends." Before we get into that, though, a word about what a liquidated damages clause is.
A liquidated damages clause sets in advance -- at the time of contract formation -- what the monetary value of damages shall be in the event of contract breach by one of the parties. Often, a liquidated damages clause (actually, a paragraph or section) will include a recitation that the parties are agreeing ahead of time, because it would likely be difficult to determine the actual damages should a breach occur. But such a statement is not necessary.
A liquidated damages clause could be directed toward both parties. For example, "If either of us fails to perform, he will owe the other $10,000." But it need not do so. Commonly, a liquidated damages clause will be directed towards only one. E.G., "If the commercial landlord doesn't deliver the property within fifteen days of the date promised, he will owe the tenant $10,000."
The standard residential purchase contract produced by the California Association of REALTORS®(CAR) contains a liquidated damages clause. It says this:
"If Buyers fails to complete this purchase because of Buyer's default, Seller shall retain, as liquidated damages, the deposit actually paid. If the Property is a dwelling with no more than four units, one of which Buyer intends to occupy, then the amount retained shall be no more than 3% of the purchase price. Any excess shall be returned to Buyer. Release of funds will require mutual, Signed release instructions from both Buyer and Seller, judicial decision or arbitration award..."
Three items are worth noting: (i) This provision is asymmetrical. That is, it burdens only one party, the buyer. It does not provide for any preset damages should the seller breach. (Presumably, a seller breach could lead to a suit for performance.) (ii) It is limited. For residential properties of less than five units, one of which will be occupied by the buyer, the amount cannot be more than 3% of the purchase price. This has been set by legislation (Civil Code 1675). (iii) Payment of the damages would still require the agreement (by signatures) of both parties. That is because there has to be agreement that there has been a breach. Otherwise, a judicial or arbitration conclusion will have to be reached.
Signing (or initialing) a liquidated damages clause is optional. Although it is preprinted into the CAR purchase agreement, it will only apply if both parties so indicate. This is where problems, based on misunderstanding, may arise.
Commonly, when encountering a liquidated damages clause, a principal is liable to ask, "What does this mean?" It would not be unusual for an agent to say something like, "This means that if the buyer breaches, the seller gets to keep the deposit." That, unfortunately, does not go far enough in explanation for many sellers. They need to know that it means that, in the event of breach, they would be entitled to no more than the deposit (or no more than 3% of the purchase price, if the deposit is larger than that). Often, when buyers have breached a contract, the seller feels wounded and entitled to more than the deposit. If a liquidated damages clause is in effect, that will not be an outcome.
Let us consider some possibilities. Say the purchase price of a single family home intended for owner occupancy is $300,000. The liquidated damages limit is 3% of the purchase price -- $9,000. Suppose the CAR liquidated damages provision has been signed and that the buyer subsequently breaches.
(a) The deposit is $5,000. The seller has a right to the $5,000; but not to pursue the buyer for the additional $4,000. Liquidated damages is limited to the amount of deposit actually paid.
(b) The deposit is $15,000. The seller is entitled only to $9,000, the statutory limit.
(c) The original deposit is $5,000, but it had subsequently been increased by another $5,000.
(i) If the increased deposit was accompanied by a separate liquidated damages provision (CAR form R.I.D.,Increased Deposit/Liquidated Damages Addendum), signed by both parties, then the seller would be entitled to $9,000 of the $10,000 actually paid.
(ii) If the deposit had been increased by $5,000, but no separate liquidated damages provision had been executed, then the seller would only be entitled to the original $5,000.
Is a liquidated damages clause a good thing? For both buyers and sellers the answer may be ‘yes' and ‘no'. It depends. Suppose the buyer backs out -- breaches -- very early into the transaction. Typically, that would not cause a lot of damage to the seller. A liquidated damages provision may give too much to the seller. Conversely, a seller who has gone through a long escrow and who has made plans and commitments -- sometimes financial -- may feel that limiting the damages to the deposit (or 3% of the price) is not sufficient.
For both parties, though, if they have agreed to a liquidated damages provision, they at least know what is at stake.
Bob Hunt is a director of the California Association of Realtors®. He is the author of Real Estate the Ethical Way. His email address is email@example.com.