In San Francisco, California and throughout the San Francisco Bay Area most real estate purchase and sale transactions are completed successfully by well intentioned buyers and sellers with the assistance of knowledgeable real estate brokers and attorneys.

It is reality, however, that real estate transactions sometimes do fail before or during the close of escrow. Resolving Escrow and Earnest Money Disputes can be complex. However, a liquidated damages clause ("LDC") can ease such a dispute by enabling the seller and buyer to agree, before any dispute arises, on an amount of damages to be awarded to the non-breaching party if the transaction fails.

The type of LDC frequently used in real estate transactions awards liquidated damages to the seller where a buyer fails to perform the terms of the contract. However, LDCs may take other forms, as in commercial leases or by awarding liquidated damages to a buyer due to a seller's breach.

Most LDCs are drafted in such a way as to award the buyer's deposit to the seller, as damages, when the buyer does not close the transaction. It is possible that the liquidated damages provision identify another amount as compensation for the buyer's breach; however, the buyer's deposit is frequently used.

Legal Requirements for a Valid Liquidated Damages Clause

An LDC must satisfy certain legal requirements to be presumptively valid.

First, the funds defined as liquidated damages must not be excessive; rather, the amount must be a "reasonable estimate" of the seller's actual loss due to a buyer's breach. A seller may not treat buyers unjustly or make an unreasonable profit above the financial harm. In fact, where the property at issue is 1-4 units and to be occupied by the purchaser as a personal residence, the liquidated damages amount cannot be greater than 3 percent of the selling price.

Second, the liquidated damages provision must satisfy special format requirements. The LDC must be in bold 10 point type or bold red contrasting 8 point print.

Third, the LDC must be signed by both parties to the purchase contract.

Initialing the Liquidated Damages Clause

Whether the LDC is enforceable where all parties to the contract do not initial the provision will be determined by a court of law. The California Association of Realtor purchase contracts require initialing the LDC if a party intends to be bound.

In the absence of language stating that parties must initial the LDC, for the clause to be enforceable, one California appeals court held that where the clause was not initialed, the clause was enforceable or voidable at the buyer's option.

Potential Benefits of a Liquidated Damages Clause

Above all, an LDC creates certainty regarding the amount a buyer may lose and a seller may recover where a transaction fails. However, fixing the amount of damages in advance also may make it easier to resolve disputes. Also, if no LDC is contained in the purchase agreement, a seller must prove the amount of the financial loss rather than the pre-negotiated amount AND a wrongful breach.

However, an LDC is merely an approximate measure of damages that a seller may be entitled to due to a buyer's breach. This approximation could differ significantly from the actual monetary damages incurred by the seller. Therefore, both parties to the contract should carefully consider whether an LDC is most beneficial.

Contingency Removal

It is worth noting that a buyer does not always forfeit its deposit if the transaction does not close escrow. A transaction may not close for a variety of acceptable reasons such as a buyer's good faith inability to remove valid contingencies.

Release of Funds by Escrow Holder

The escrow holder requires permission from both parties to release funds held in escrow. If a buyer breaches the contract and fails to agree to a release of escrow funds to the seller, the buyer must have a valid good faith reason, or the buyer can be liable for damages, costs and penalties to the seller.

Non-Refundable Deposit/Liquidated Damages Clause

A non-refundable deposit typically requires that a buyer forfeits his initial deposit even where there is a legitimate reason for the buyer not to complete the purchase. By comparison, an LDC provides that the seller shall recover the buyer's deposit only in the event the buyer is in breach of contract.

© 2010 Kabak Law Group. This material does not constitute legal advice and is for general informational purposes only. This material may be reproduced for personal use and for non-commercial distribution. All copies must include this copyright notice.