Semantics Wont Avoid Liquidated Damages Limit

Written By: Bob Hunt
Monday, October 27, 2014

If it walks like a duck, and quacks like a duck You know the rest. Common sense tells us that you cant 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 Californias 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 didnt 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: "Buyers increased deposit to be 80,000 -- total deposit of 100,000 to be >

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 Allens lawyer, said that the Smiths shouldnt 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 Allens 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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