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Liquidated Damages in a Rising Market

by / Tuesday, 14 January 2014 / Published in Articles

Liquidated Damages in a Rising Market 

By Bryan Mashian, Esq.  

 

Given the changing commercial real estate market, buyers and sellers should carefully evaluate using a liquidated damages provision for each deal. Routinely initialing such a provision, which is in most printed purchase and sale agreements, may not advance the interests of the buyer or the seller in every situation.

Under the typical liquidated damages provision, if the buyer breaches and does not close escrow, the seller can then retain a certain agreed upon amount as the seller’s damages. The objective of liquidating damages is to stipulate to a pre-estimate of damages so the contracting parties may know with reasonable certainty the extent of liability in the event of breach.

A real property seller’s main measure of damages is essentially the difference between the contract price and the property’s value at the time of the buyer’s breach. If the property increases in value after the buyer’s breach or the seller resells the property at a price equal to or higher than the contract price, then the seller has no loss-of-bargain damages. In a rising market, the seller may be the party who benefits more from a liquidated damages clause since the seller can recover damages, even if the seller has not suffered any actual damages or if the seller’s actual damages are less than the liquidated damages amount. Such a provision protects the seller from potential losses from the buyer’s breach, without going through protracted litigation, or having to prove actual damages.

Conversely, in a declining market, the buyer benefits more than the seller since the buyer’s exposure is uncertain as the buyer does not know how much the property’s value may decline. So, it is advantageous for the buyer in a declining market to use a liquidated damages provision to establish the buyer’s maximum exposure if the buyer defaults or decides not to purchase the property. With a valid liquidated damages provision, if the property’s value declines more than the liquidated damages amount, then the buyer can walk away from the deal, knowing the buyer will lose only the amount agreed upon as liquidated damages.

But to effectively allocate these risks, the parties must have a valid liquidated damages clause in their agreement. Simply using terms such as “nonrefundable” will not suffice. For example, in one case, the buyer released a $600,000 “nonrefundable” deposit to the seller outside of escrow. The buyer then defaulted and canceled purchase of the property. The seller sold the property to another buyer for $1 million more, but the seller refused to refund the buyer’s deposit. The buyer sued the seller to recover the money released to the seller, and the court of appeal ruled that the seller had to refund the buyer’s money.

The court ruled that because the parties’ purchase and sale agreement did not contain a liquidated damages provision, the seller could not retain the deposit on that basis. The court also held that a “nonrefundable” deposit is such only where the seller has incurred actual losses. Since the seller had not suffered such actual loss, the forfeiture of the deposit became an unenforceable penalty.

This case highlights the importance of having a valid provision for liquidated damages in a contract for the sale of real property, which must meet the specific legal requirements. To have a valid liquidated damages provision for the sale of property (other than four or fewer residential units where the buyer intends to occupy one of the units), the amount of the damages is not limited to a set amount or to a set percentage of the purchase price. Rather, the amount of such liquidated damages must be reasonable under the circumstances existing at the time the contract is made. Also, the contractual provision must be separately signed or initialed by each party and must be in either ten-point bold type or eight-point red type.

When the contract involves the sale of four or fewer residential units, and the buyer intends to occupy one of the units, a liquidated damages provision is presumed valid if the clause satisfies the above requirements and the liquidated amount does not exceed 3% of the purchase price. A new law will become effective July 1, 2014 which applies to the sale of newly constructed attached residential condominium units located within a structure of 20 or more residential condominium units, standing over eight stories high, that is high-density infill development, located in a city or county with a population density of 1,900 residents per square mile or greater. The new law provides that a liquidated damage in the amount of 6% of the purchase price is presumed valid if the purchase price for the unit is greater than $1 million and the other requirements are satisfied.

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