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Frank Talk About Earnest Money By Harold I. Levine You represent the Seller of residential real estate. A contract has been executed. The Seller tells you that he or she is particularly interested in the forfeiture provision(s) because, based on the contract to sell, a contract to purchase another residence is contemplated. You are asked by the seller, your client, "How strong is this forfeiture clause?" As a reminder, the following is a typical default clause: "If this contract is terminated without Purchaser’s fault, the earnest money shall be resumed to the Purchaser, but if the termination is caused by the Purchaser’s fault, then at the option of the Seller and upon notice to the Purchaser, the earnest money shall be forfeited to the Seller and applied first to the payment of Seller’s expenses and then to payment of Broker’s commission: the balance, if any, to be retained by the Seller as liquidated damages." There are two ways you can handle an explanation of the above forfeiture provision(s) with the Seller: 1. You can say the following: . . ."The Purchaser has according to the contract put up $7,500 to be used as earnest money. If there is a default on the Purchaser’s part, you get the $7,500 and the contract is canceled. Seventy five hundred dollars is a lot of money to lose so I am sure the Purchaser is serious and after the mortgage contingency, inspection, and other contingencies, you Mr. and Mrs. Seller, based on this contract can go ahead and buy the house you had in mind." 2. Or you can say . . ."The Purchaser to this contract have put up $7,500 as earnest money. If there is a default your chances of getting the whole $7,500 back are slim to none. Here’s why. The earnest money is usually held by the Broker in an escrow account under the Broker’s control. If there is a default the Broker will not automatically write you a check from this account. The truth is he can’t, even if he wanted to. He or she would be in serious trouble. According to the Broker’s License Act 225 ILCS 18(H)(8) and Administrative Rules 1450.40 and 1440(c), a Broker can only release the earnest money by court order or agreement of the parties. To do otherwise is to invite a serious licensure violation. If the Purchaser defaults, l notify the Broker and make demand for the earnest money. The first thing the Broker will do is send a letter to the Purchaser asking for his consent to release the money. As sure as the sun sets in the west, no consent will be forthcoming. People simply do not give away $7,500. So you have to sue to get it back. There are several problems connected with such suits: 1. Many lawyers will not accept a $7,500 lawsuit; 2. The Purchaser may counterclaim; 3. You will have to pay attorney’s fees; and 4. After paying $2,000 - $3,000 in fees and reaching trial in a year or two an intelligent judge is going to settle the case for 50% or less and after deducting attorney’s fees it will be a miracle if there is $1,500 left." Almost all real estate lawyers who handle a substantial number of closings, have a few of these $5,000 and $10,000 earnest money recovery cases kicking around their office which they regard with dread. For that reason, it is essential that real estate practitioners read the recent Second District Appellate Court case Johnson v. Maki, 197 ILL. App. 475. In this case, Seller entered into a listing contract with Purchaser to sell her home and deposited $2,000 with the Purchaser. The contract provided Broker would not disburse earnest money unless it was provided a written demand to do so by Purchaser and Seller. The parties could not reach an agreement over what repairs were to be made to the house and Purchaser declared they would not go through with the deal. After Seller refused, Purchaser filed suit. After several months of litigation the parties settled their suit. Seller agreed to refund the earnest money and the Purchaser dismissed the suit. On October 13, 1995, the Seller sent a letter to the Broker directing it to return the earnest money to Purchaser. The facts set forth in the Courts Opinion are as follows: "On October 13, 1995, the plaintiff sent a letter to the Broker directing it to return the earnest money to the Buyers. Maki (Broker) refused, demanding that the plaintiff sign a document entitled, "Cancellation Agreement for Contract to Purchase Real Estate" (the Cancellation Agreement), before it would return the earnest money. The Cancellation Agreement contained a general release provision which provided as follows: "The Buyer and Seller shall indemnify, save, and hold harmless Broker and Broker’s agents from all claims, litigation, judgments, and costs arising from the cancellation of the Contract." "On October 13, 1995, the plaintiff (Seller) signed the Cancellation Agreement." On December 29, plaintiff (Seller) filed suit against the Broker alleging the Broker had breached its fiduciary duty to her by making false representations regarding Buyer’s ability to obtain financing and misrepresenting the Home Inspection Contingency among other issues. The Broker filed a motion to dismiss under 2-619 alleging that Seller’s suit was barred by the release. The Seller replied that she received no consideration from Broker in return for her promise not to sue. The trial court granted the motion to dismiss, but the appellate court reversed stating: "Pursuant to these instructions, the plaintiff and Buyers needed only to tender a written request to Maki (Broker) in order for the earnest money to be disbursed. We find that the obligation [*11] to release the escrow money was a pre-existing legal duty under the original real estate contract and could not constitute consideration for the release contained in the Cancellation Agreement. See Columbia Homes, Inc., 115 ILL. App. 3d at 653. Moreover, we do not believe that the consideration for the release flowed from the original contract. A review of the real estate contract indicates that such a release goes beyond the scope of the bargain agreed to between the plaintiff and Maki. Nowhere in the original contract does the plaintiff relinquish her rights to sue Maki. Therefore, the original real estate contract could not have been the basis for providing consideration for the release. For these reasons, we find that the release in the Cancellation Agreement lacked consideration and was therefore invalid." The Maki case shows among other things, the depth of the Broker’s financial interest in the escrow. This raises the interesting question of "Should the Broker be the escrowee?" Is the Broker really independent? This brings us to some reflections on the very motive of earnest money in residential real estate transactions. What is earnest money supposed to do? Is it supposed to force people to comply with their contracts? If so, is 5% really enough? Is it a substantial penalty? If so, why do many real-estate contracts provide that on forfeiture the earnest money funds go first to the Broker and then the Seller, thereby setting up a whole separate set of conflicts as to whether the Broker has earned those funds in a transaction which as not closed. No discussion of earnest money can go very far without a discussion of the Grossinger case. Grossinger Motorcorp v. American National Bank & Trust, 240 Ill App. 3d 737. The Grossinger case holds that where the Seller has optional remedies in addition to forfeiture of the earnest money such a clause is suspect. This is a growing school of thought that the listing contract is a unilateral contract and that unless the Broker performs the Broker should not be entitled to recover. What is needed is the certainty of payment on default. In Grossinger the court said: "A recent decision by the Florida Supreme Court involved a clause similar to the one at issue here. By reasoning which we find persuasive, that court held unenforceable a provision in a real estate contract which allowed the Seller of the property to retain earnest money as liquidated damages, or at the Seller’s option, to precede in law or equity to enforce his rights under the contract. Lefemine v. Baron, (Fla. 1991), 573 So. 2d 326. The court stated that the existence of the option reflects that the parties did not have the mutual intention to stipulate to fixed amount as their liquidated damages in the event of a breach and indicates an intent to penalize the defaulting Buyer. Lefemine, 573 S. 2d at 329. The court explained: The buyer under a liquidated damages provision with such an option is always at risk for damages greater than the liquidated sum. On the other hand, if the actual damages are less that the liquidated sum, the Buyer is nevertheless obligated by the liquidated damages clause because the Seller will take the deposit under that clause. Because neither party intends the stipulated sum to be the agreed-upon measure of dames, the provision cannot be a valid liquidated damages clause." Lefemine, 573 S. 2d at 329-30. In essence, such an optional liquidated damages provision fixes a minimum which must be paid from the Buyer to the Seller, but leaves the door wide open to him to prove actual damage in addition to the so-called liquidated damage. This is no settlement at all and it permits the [Seller] to have his cake and eat it too." Dalston Construction Corp. v. Wallace, (N.Y. Sup. Ct 1960) 26 Misc. 2d 698." For a more conventional view see Elliot v. God’s Harbor for All Souls, (unpublished opinion), 3-96-1003, 3rd District. (Oct. 1997) Further, in addition to other risks, the Seller’s earnest money is at risk due to the particular language of the agreement and how it deals with the remedies available on default of the Buyer. A practical solution is for a title company to act as the escrowee. The title company can do so for a modest fee, without the usual conflicts that the Broker or lawyer would have. They are trained to follow the terms of the parties agreement and to administer the agreement professionally. We are dealing with a mechanism that does not work. It works for the brokerage industry, but it does not work for Purchasers and Sellers who depend on it and believe that the forfeiture clause in a real estate contract says what it means and, more importantly, make decisions on that basis. When real estate Purchasers and Sellers believes that contracts should be obeyed is frustrated, they develop a deep cynicism for law and lawyers. It is our responsibility as lawyers to look at this mechanism and see how we can improve it to meet the expectations and needs of our clients. It is our further obligation as lawyers to be honest with ourselves. If this mechanism is inconsistent with modern real estate transactions, it should be replaced with something new that works. Harold I. Levine is Of Counsel to Arnstein & Lehr, Chicago. He has written and lectured frequently for the DCBA. His practice is concentrated in Real Estate Litigation; primarily foreclosures, mechanic’s liens and chancery pratice. He received his Undergraduate Degree in 1953 from the University of Chicago. He received his Law Degree in 1956 from Northwestern University. |
