Under California law forfeitures of money (which includes non-refundable deposits) are not favored and as a matter of public policy may not be enforceable in court. The law does however recognize the concept of liquidated damages where specifically allowed by statute. Under Civil Code sections 1675 – 1680 liquidated damages clauses are valid and enforceable in connection with the sale of one to four residential units if the requirements of the code are met.
The following points address some of the most common questions and misconceptions concerning liquidated damages:
If both the seller and the buyer initial a liquidated damages clause, the damages recoverable by the seller in the event of a default shall be the amount of the buyer’s actual deposit but not to exceed 3% of the purchase price. If the buyer has deposited more than 3%, the buyer would be entitled to the return of the amount over 3% even if the buyer is in default.
A liquidated damages clause must be separately initialed by the parties and be either at least 10-point bold type or at least 8 point red type. These requirements are met in the standard California Association of Realtors Residential Purchase Agreement form. If after the initial deposit the buyer increases the deposit, for example at the time contingencies are removed, the parties must initial another liquidated damages clause if they intend that the increased in the deposit be treated as additional liquidated damages.
The release of the buyer’s deposit to the seller as liquidated damages is by no means automatic and is usually disputed by the buyer who denies being in default. In such cases the deposit stays in escrow until there has been a determination pursuant to agreement of the parties, mediation, arbitration or a court.
The dispute usually involves the following question: Was there really a default or did the buyer legitimately exercise their right to cancel based on the failure to satisfy a contingency or some other grounds for cancellation such as a default on the part of the seller?
When applicable, liquidated damages are the sole monetary remedy of the seller in the event of default of the buyer irrespective of whether the seller’s actual damages are more or less than the liquidated damages.
It is impossible to say that initialing the liquidated damages clause is a good or bad idea in a vacuum because there are many variables involved. A low deposit tends to favor the use of the clause by the buyer as buying a right to change their mind (also known as defaulting) for a nominal amount. In a rising market liquidated damages can favor the seller who might get a windfall by virtue of the fact that no actual damages are sustained.
A liquidated damages clause only applies to the issue of damages and does not preclude either party from suing for specific performance if applicable.
The main advantage of initialing the liquidated damages clause is that it creates certainty. If the buyer defaults the amount forfeited is fixed and there is no argument as to the amount of the seller’s damages.