SELLER MUST REFUND BREACHING BUYER'S “NON-REFUNDABLE” EARNEST-MONEY DEPOSIT WHERE NO FINANCIAL HARM INCURRED

Recently, a California appellate court, in reversing the Orange County Superior Court, held that a seller may not retain the earnest-money deposit of a buyer who breached a real estate purchase and sale agreement by unilateral cancellation, notwithstanding that the deposit is specifically declared to be “non-refundable” under the contractual terms, where the seller sustained no actual damages as a consequence of the buyer's breach.  Kuish v. Smith (2010), 181 Cal. App. 4th 1419 [105 Cal. Rptr. 3d 475].

In December 2005, Bradford Kuish (“Buyer”) offered to buy the Laguna Beach residence of William W. Smith (“Seller”).  On January 7, 2006, the parties entered into a written agreement in which Buyer agreed to purchase the property for $14 million.  The purchase agreement did not contain a liquidated damages provision, nor did it constitute an option contract for the purchase of real property.  Escrow instructions, dated March 24, 2006, required Buyer to make two “non-refundable” deposits into escrow, totaling $620,000, and stated that escrow was to close on or before September 15, 2006.  Buyer paid the required $620,000 earnest-money deposit, of which $400,000 was immediately released out of escrow to Seller.

On September 18, 2006, Buyer's legal counsel sent a letter to the escrow company, requesting that the escrow be cancelled.  The unilateral cancellation represented a breach. The parties signed cancellation escrow instructions, dated October 17, 2006, at which time Seller turned to a backup offer it had received from a third party who was interested in purchasing the home.  Seller then proceeded to sell the Laguna Beach residence to the third party for a higher price — $15 million — which represented the fair market value of the property on both September 18 and October 17, 2006.  Seller refused to return any portion of Buyer's earnest-money deposit which had already been released, and refused also to allow the escrow company to return any portion of the deposit still held in escrow.

The Orange County trial court held that Seller was entitled to retain almost all ($600,000) of Buyer's $620,000 deposit, reasoning that such a result did not constitute an unlawful forfeiture “because both parties were ‘big boys,' that is, sophisticated business people, [who] understood all the ramifications of their actions in freely negotiating to make the deposits non-refundable.”  In the trial court's view, Seller was entitled to keep a portion of the deposit “on the basis that it constitutes separate and additional consideration for extending the time and length [of] keeping escrow open for nine months.”  The court went on to find that such “separate and additional consideration” was valued at $620,000.

The Court of Appeal (4th District, Division 3) reversed the trial judge, holding that insofar as Seller made a $1 million profit on the resale to the third party, there were no damages sustained by Seller as a consequence of Buyer's breach of the purchase contract, and that, therefore, Seller's retention of the deposit was an invalid forfeiture.  In a rising real estate market, as existed in 2006, Civil Code §3307 limited Seller's damages to the recovery of consequential damages and interest, notwithstanding a willful breach having occurred.  The appellate court held that in the absence of a valid liquidated damages provision, the term “non-refundable” is to be interpreted to mean that Seller may retain the deposit only to the extent of actual dam