If it walks like a duck, and quacks like a duck … You
know the rest. Common sense tells us that you can't change the nature of a
thing simply by deciding to call it something else. In at least one situation (Allen v. Smith et al.) a California Court of Appeal seems
to agree with common sense.
The issue at hand was an attempt to circumvent
California's statutory 3% limit on liquidated damages in a residential purchase
agreement.
Liquidated damages are an amount that contracting
parties may in advance agree to be the measure of damages that would be
suffered should there be a default. Thus, if there is a default there will be
no need to prove how much the injured party has been damaged. The amount will
already have been agreed upon.
Liquidated damages provisions are commonly used in
residential purchase agreements. When buyer and seller agree that the deposit
(and sometimes a second, increased deposit) will be subject to liquidated
damages they are saying that, should the buyer default, the deposit amount is
the damages amount that will be owed to the seller. California Civil Code
section #1675 generally limits the valid amount of liquidated damages in a
residential purchase agreement to 3% of the purchase price. This limitation is
specifically stated in most residential purchase contracts.
Sometimes sellers want to be able to exact more from
defaulting buyers than the 3% liquidated damages limit; and sometimes their
agents can get creative in trying to help them do so. That is what happened in Allen v. Smith, and the court didn't like it.
Allen submitted an offer to the Smiths to purchase
their Rancho Santa Fe home for $1,775,000. With the offer Allen submitted a
$20,000 deposit along with an agreement to increase the deposit by $33,250
after the removal of inspection contingencies. The entire $53,250 (3% of the
purchase price) would be subject to the liquidated damages provision.
The Smiths wanted to receive a larger amount,
specifically $100,000, if Allen were to default. In order to get around the 3%
limit the agent wrote this in the counter offer: "Buyer's increased
deposit to be $80,000 -- total deposit of $100,000 to be released to seller as non
refundable purchase option monies." (Italics added by the court.) But
nothing in the counter offer changed the general nature of the purchase
agreement. No option period was specified. No manner of exercising the option
was indicated. Both parties still had the same mutual obligations that they had
under the original offer.
Allen agreed to the counter offer, the deal went
forward until, you guessed it, Allen defaulted. Naturally, the Smiths held on
to the $100,000, so everyone went to court.
Allen, or Allen's lawyer, said that the Smiths
shouldn't be able to keep the full $100,000 because they had "sought to
circumvent the policy of the law concerning liquidated damages in residential
sales contracts through a sham mechanism in which [they] labeled the deposit
monies falsely as option monies."
The San Diego County Superior Court agreed with the
Smiths and let them keep the $100,000 "nonrefundable option fee"; but
the Fourth District Appellate Court disagreed. On examining the contract they
found that it had none of the characteristics of an option, except for the
reference to the deposit amount. For that reason the court agreed with Allen.
It allowed the Smiths to keep the $53,250 (3% of purchase price) but required
that the rest be returned, along with Allen's court costs.
There were other issues in Allen v. Smith,and I
have presented a simplified version here in order to keep focus. Still, a
general lesson emerges. While creativity may be an admirable quality in real
estate agents, be careful when it extends to attempting to change reality.
Bob Hunt is a director of the California Association of
Realtors®. He is the author of Real Estate the Ethical Way.
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