How can transaction parties avoid earnest money conflicts?
Part of the toll of the ongoing commercial real estate slump is the high frequency of terminated deals. Scarcity of financing, valuation disconnects, and general economic concern all contribute to the “kill rate.” Of course, any time a deal is terminated, the earnest money deposit must be released by the escrow holder in accordance with the agreement of sale. But what happens if the agreement of sale does not clearly state which party should get the deposit?
Who Gets the Money?
Compared with residential deals, where consumer protection laws might trump the express language of the contract, courts are more likely to enforce the unambiguous agreement terms in commercial transactions. However, when a commercial transaction is terminated and the agreement is silent or ambiguous as to which party should get the deposit, the presiding judge is forced to make that decision.
In Wawa, Inc. v. Insnetvest Corp., a recent Philadelphia trial court case, the buyer and seller under a terminated purchase agreement each sought the entire $150,000 escrowed deposit. The purchase agreement gave the buyer the right to terminate if it could not obtain necessary conditional-use approvals at an “acceptable” cost. Although the buyer’s application for conditional-use approvals was approved — subject to the satisfaction of certain conditions — the buyer elected to terminate, maintaining that it was not cost effective to proceed to closing.
The purchase agreement between Wawa and Insnetvest did not state which party would get the deposit if the buyer terminated for cost-based reasons, leaving the trial judge to make that determination. The judge ruled that Wawa properly terminated the agreement of sale and held that the termination constituted a “rescission” of the contract. The object of rescission is to return the buyer and seller to the position that each occupied prior to signing the contract. Although the parties to a terminated agreement of sale can never truly return to their pre-contract positions (for example, how can the seller get back the time it lost while its property was under contract), the court determined that the buyer should recover its entire earnest money deposit.
Similarly, a 2010 California appeals court decision affirmed the rescission of an agreement of sale in Sharabianlou v. Karp. In that case, a prospective commercial property buyer brought an action to rescind the agreement after the transaction failed to close on time. After it found certain deposit release language in the agreement of sale to be ambiguously drafted, the Sharabianlou court awarded the full escrowed deposit to the buyer.
Transaction participants should heed the following guidelines to avoid deposit disputes.
Clear contract terms.
The purchase contract needs to clearly spell out what happens to the earnest money deposit upon termination on specific grounds. The contract, and any amendments to the contract, also must specify whether additional deposits are to be handled the same as the initial earnest money deposit if termination occurs.
Before entering into a commercial agreement of sale, even the most cost-conscious sellers and buyers should hire competent counsel — the alternative could end up being far more costly. In the Sharabianlou case, a commercial broker — not a lawyer — drafted the ambiguous amendment that led to the rescission of the agreement of sale and, ultimately, a lawsuit against the broker.
Generally worded termination letters.
As a rule of thumb, termination notices should broadly reference the rights of the terminating party to cancel the deal. If the termination letter gives one specific justification for termination (without citing other legitimate grounds for cancelation) and a court later rules the lone justification to be invalid, the terminating party might find itself bound under a contract that it could have otherwise properly terminated.
Unbiased escrow holder.
Deposit holders generally are regarded to have a fiduciary duty to both buyer and seller. However, neutrality can be compromised when the deposit is held by an attorney, broker, or other agent for one of the parties to the transaction. Typically, title companies work well as escrow holders, as long as the agreement of sale provides that the escrow-holding title agent must be acceptable to both buyer and seller. As a general rule, any deposit holder should require buyer and seller to sign an escrow agreement indemnifying the deposit holder.
Matters concerning contract termination and deposit release vary by state law and are highly fact-dependent. Any buyer or seller involved in a deposit release dispute should obtain appropriate representation.