Earnest Money, Liquidated Damages and Purchase Options
William A. Kozub
The earnest money deposit is a common feature of Arizona real estate transactions. Earnest money is the sum of money paid by a buyer at the time of entering into a contract to indicate the intention and ability of the buyer to carry out the contract. Often, the contract provides that the earnest money is forfeited if the buyer defaults under the contract. However, the right of the seller to retain the earnest money is not automatic. In fact, Arizona law presumes that a contract provision providing for the forfeiture of an earnest money deposit is a penalty and thus not enforceable.
The forfeiture of the earnest money will only be allowed if the contract provision allowing forfeiture is found to be a valid
liquidated damages clause.
An alternative to an earnest money deposit is an option to purchase the real property. Arizona courts generally consider the option price to merely be the buying of the right to tie up the real property for a specific period of time, thus the buyer will have received valid consideration for the option price upon breach or expiration of the option. Because an earnest money forfeiture clause is presumed invalid and must be found to be a liquidated damages clause before it can be enforced, the seller of the real property will generally find it easier to terminate an option contract and retain the option price, then to terminate a purchase contract that contains an earnest money deposit and retain the earnest money deposit.
Liquidated Damages: The traditional role of liquidated damages clauses is to serve as an economical alternative to the costly and lengthy litigation process involved in a conventional breach of contract lawsuit. Arizona courts have long recognized this role and have generally adhered to the idea that the efforts of the contracting parties to avoid litigation and to equitably resolve potential conflicts through the use of a liquidated damages provisions should be encouraged. However, the parties to a contract are not free to provide a penalty for its breach. The central theory behind the system of contract enforcement is compensatory, not punitive. In addition, contract theory promotes the intentional breach of a contract when such breach promotes economic efficiency.
Therefore, punishment of a promisor for having broken his promise has no justification economically and a term in a contract providing a penalty is unenforceable on the grounds of public policy.
Liquidated Damages Test: The test for whether a contract fixes a unenforceable penalty or an enforceable liquidated damage is whether payment is for a fixed amount or varies with the nature and extent of the breach. This seems to mean that any agreement setting forth a specific damages amount in the event of breach that is made in advance of a breach (such as an earnest money forfeiture provision) is a penalty and thus unenforceable.
However, Arizona law provides that such contract agreement will not be deemed a penalty if two conditions are met.
First, the amount fixed in the contract must be a reasonable forecast of the just compensation for the harm that is caused by the breach.
Second, the harm caused by the breach must be incapable or very difficult of accurate estimation. For purposes of determining whether a liquidated damages clause in the contract is enforceable, the difficulties of proof of loss are to be determined at the time the contract is made and not at the time of breach. Furthermore, the amount fixed as the liquidated damage is reasonable to the extent that it approximates the loss anticipated at the time the contract is made, even though it may not approximate the actual loss. However, it must be noted that the amount retained upon the contract’s breach will be considered a penalty if it is unreasonable.
What is a Penalty: A penalty is an agreement to pay a stipulated sum on breach of contract, irrespective of the damage sustained. Its essence is a payment of money stipulated as in terrorem of the offending party, while the essence of liquidated damages, as explained above, is a genuine covenanted pre estimate of damages. A key distinction between a penalty and a provision for liquidated damages is that a penalty is in effect a security for performance while a provision for liquidated damages is for a sum to be paid in lieu of performance. A penalty is designed to punish for breach of contract whereas liquidated damages are intended as fair compensation for the breach; a penalty is designed to prevent a breach by the threat of punishment.
Presumption that Earnest Money Clause is a Liquidated
Damage Provision: Arizona courts attempt to provide meaning and effect to the terms of a contract entered into between the parties. Accordingly, when liquidated damages are specified in a contract, the terms of the contract generally control. However, many contracts are silent on the issue of liquidated damages and merely contain a clause allowing for the forfeiture of the earnest money upon breach. As explained above, a mere forfeiture is generally invalid. Therefore, Arizona courts have adopted the policy that “a provision for the forfeiture of earnest money on breach of a contract to purchase real estate has been held a stipulation for liquidated damages.” The forfeiture provision is then analyzed under the liquidated damages clause test set forth above.
Options for Purchase: An option to purchase real property, in its most basic form, is an agreement in which one party is given the right to buy property within a period of time for a consideration paid to the seller. The option is simply a contract by which the owner of real property agrees with another party that the other party shall have a right to buy the owner’s property at a fixed price or under other agreed upon terms within a certain period of time. If the option to purchase is not exercised, it will expire with the potential buyer having received full value for the option price. Thus, unlike a provision calling for the forfeiture of an earnest money deposit, there is no forfeiture in the option transaction and thus no need to analyze the option price under the test for determining if a valid liquidated damages clause exists.
While an option may at times give the seller an edge over a buyer at retaining money given to secure the performance of the transaction, merely naming an earnest money deposit forfeiture clause an option will not be sufficient to avoid scrutiny of the courts. Arizona courts will look to the nature of the clause to determine whether it was in fact an option, or a forfeiture provision that must be reviewed under the test for a liquidated damages clause to be enforceable. It is well settled that in determining whether a particular clause calls for an option, liquidated damages or for a penalty, the name given to the clause by the parties is not conclusive, and the controlling elements are the intention of the parties and the special circumstances of the case.
William A. Kozub is a partner with the Scottsdale based law firm of Berens, Kozub & Kloberdanz, PLC, and may be reached at (480) 624-2777, or by email at WKozub@bkl-az.com. Mr. Kozub practices real estate, business and commercial law, is licensed to practice law in both Arizona and California, and is a licensed real estate broker.