How to negotiate earnest money and avoid pitfall of forfeiting unlawful liquidated damages

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Christopher J. Charles, Esq.



Nearly every real estate contract contains an earnest money clause that requires the buyer to deposit some amount of money at the beginning of the transaction. The earnest money serves at least two important purposes: (1) the earnest money payment is a pledge of the buyer’s good faith and intent to proceed with the transaction; and (2) the earnest money can serve as a quasi-bond to compensate the seller for the seller’s damages if the buyer defaults on its performance obligations under the contract. Most commonly, the parties will negotiate for the earnest money to be deposited with a neutral escrow agent. But depending on market conditions or the seller’s bargaining position, the parties may negotiate for the buyer to immediately deposit the earnest money with the seller.

This article examines the legal limits placed on the amount of earnest money in real estate transactions. Generally speaking, in any arm’s length transaction, the parties are free to negotiate as they wish and the courts will not interfere with the parties’ decisions. But of course the law places certain public policy limitations and safe guards to protect the vulnerable and in furtherance of the “interests of justice.” First, any contract that is the product of fraud, undue influence, duress is void. Second, if the party to be charged is deemed incompetent at the time of contract, then the contract is void. Third, if the contract term is unconcsionable, then the unconscionable contract term is void. Pursuant to the Arizona Supreme Court, substantive unconscionability concerns the actual terms of the contract and examines the relative fairness of the obligations assumed. Maxwell v. Fidelity Financial Services, Inc., 907 P.2d 51 (1995). “A bargain is unconscionable if it is such as no man in his senses and not under delusion would make on the one hand, and as no honest and fair man would accept on the other.” Phx. Baptist Hosp. & Med. Ctr., Inc. v. Aiken, 179 Ariz. 289, 293 (App. 1994); accord Restatement (Second) Contracts § 208, cmt. B. Contract terms may be found to be unconscionable if they are “monstrously harsh” or “shocking to the conscience.”  Ariz. Coffee Shops, Inc. v. Phx. Downtown Parking Ass’n, 95 Ariz. 98, 101 (1963) (quoting Domus Realty Corp. v. 3440 Realty Co., 40 N.Y.S.2d 69, 73-74 (Special Term 1943)).

And finally, a contract term may be found void and unenforceable if it is an unlawful liquidated damage. Liquidated damages are not per se unlawful and indeed serve a useful purpose: A liquidated damage clause is a contractual provision that determines in advance the measure of damages if a party breaches the agreement. Blacks Law Dictionary, 942 (7th ed. 1999). Traditionally, courts have honored liquidated damages as long as the liquidated damage amount is not simply a penalty for default with an amount that is unrelated to the anticipated damages.

Although real estate contracts do not usually expressly refer to earnest money as “liquidated damages,” upon careful examination, that is exactly what earnest money is. This point is clear because any carefully drafted real estate contract will provide that if the buyer defaults on its obligations under the contract, then the seller may retain the earnest money as its damages.

In Dobson Bay Club II, the Supreme Court clarified what circumstances are needed for liquidated damages to be lawful. Dobson Bay Club II DD, LLC v. La Sonrisa de Siena, LLC, 242 Ariz. 108, 393 P.3d 449 (2017). That case involved a dispute between a commercial lender and borrower involving a real estate loan for $28.6 million. After the borrower defaulted on its payment obligations, the lender assessed a late fee of $1.4 million per the loan agreement’s liquidated damage clause. After evaluating the parties’ claims and defenses, the Supreme Court ruled that the $1.4 million late fee constituted an unlawful liquidated damage. In reaching its decision, the Supreme Court adopted the Restatement (Second) of Contract’s position on liquidated damages and articulated the following rule: “[A] liquidated damages provision is enforceable, but only at an amount that is reasonable in light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss.” Id. at 111, 452.

Put another way, a liquidated damage amount is reasonable and enforceable as long as the amount of the liquidated damage is a fair estimate of the seller’s anticipated damages and if it is difficult to prove the seller’s damages.

PRACTICE POINTER: In light of the potential risk associated with enforcing any liquidated damages clause (including in regard to earnest money), when representing a seller, be sure to include custom language in the purchase contract whereby the buyer stipulates that if the buyer defaults, the seller’s damages will be difficult to prove and the negotiated earnest money is an accurate estimation of the seller’s anticipated damages.

If you or someone you know needs help drafting language to protect a buyer or seller in a real estate transaction, or require help in resolving any real estate dispute, call our office today to schedule a consultation with Mr. Charles or one of the firm’s other real estate attorneys.

Christopher J. Charles is the Founder and Managing Partner of Provident Law ®. He is a State Bar Certified Real Estate Specialist and a former “Broker Hotline Attorney” for the Arizona Association of REALTORS ® (the “AAR”). In 2017, Mr. Charles obtained one of the Top Ten Civil Verdicts for his client in a real estate dispute. Mr. Charles holds the AV ® Preeminent Rating by the Martindale-Hubbell Peer Review Ratings system which connotes the highest possible rating in both legal ability and ethical standards. He serves as an Arbitrator and Mediator for the AAR regarding real estate disputes; and he served on the State Bar of Arizona’s Civil Jury Instructions Committee where he helped draft the Agency Instructions and the Residential Landlord/Tenant Eviction Jury Instructions. Christopher regularly teaches continuing education classes at the Arizona School of Real Estate and Business, and he can be reached at or at 480-388-3343.

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