Anticipating Earnest Money “Damages” – Don’t Assume It

The Arizona Supreme Court issued an opinion last month in Thomas v. Montelucia Villas, LLC, 2013 Ariz. LEXIS 152 (June 14, 2013) that adds a few wrinkles to efforts by sellers in real estate transactions to retain “earnest money” from a buyer upon the buyer’s default.   While the opinion addresses issues that are fairly unusual in the earnest money world, the holding is one that any seller or developer of real estate should keep in mind when drafting real estate contracts.

The facts in Thomas are fairly simple.   On January 20, 2006, the buyers signed a contract to buy a to-be-built custom villa for $3,295,000.   The buyers then made three installment payments totaling $695,000 (20% of the purchase price), which were paid and had become due as construction on the villa proceeded, and were apparently used to help fund the construction of the villa.   The parties’ contract expressly characterized these payments as “earnest money deposits,” which the contract further provided would be deemed to be “liquidated damages” if the buyers breached the contract.  

On April 25, 2008 – a little over two years after the parties entered into the contract – the seller notified the buyer that closing would occur three weeks later, on May 16.   Shortly thereafter, on May 6, the buyers notified the seller that they would not close on that date and that they were demanding a return of their deposits to date because they contended that the seller had failed to perform under the contract, and that the seller itself was not able to close on this date (because it did not have a certificate of occupancy, among other things).  

The trial court agreed with the buyers and ordered the sellers to return the deposits.   The Court of Appeals reversed and held that because the buyers “anticipatorily breached” the contract – by notifying the seller that they would not close on May 6 – the seller was not required to “show its ability to perform.”

The Arizona Supreme Court, however, held that the Court of Appeals had not followed the correct line of reasoning.  First, the Court held that for the seller to recover any damages in an anticipatory breach setting, the seller needed to demonstrate that it was able to perform on the contract itself (in this case presumably by demonstrating that it had or could have obtained the certificate of occupancy at closing, as required under the contract).  Because the Court concluded that there were disputed issues of fact on the issue of whether the seller “was able to perform its obligations,” the Court remanded the case to the trial court for further proceedings on that issue.

Second, and perhaps most significant to real estate sellers and developers, the Arizona Supreme Court rejected the argument by the seller  that the deposits were “earnest money” or “liquidated damages” that would be recoverable by the seller upon the buyer’s default regardless of whether the seller was able to perform.   The Court rejected the notion that these were traditional “earnest money deposits” (notwithstanding that the parties had expressly agreed to characterize them as such) because they “did not serve the traditional function of earnest money deposits.”   They were, in fact, being used to “fund the construction” not to “show the [buyers’] good faith” to proceed with the transaction.   Thus, the Court deemed them to be “progress payments,” not earnest money deposits, and as such not recoverable by the seller as a matter of law as liquidated damages.

Two lessons here:   (1) sellers cannot rely on a buyer’s anticipatory breach of a contract to recover damages unless the seller can demonstrate that it was ready, willing, and able to perform itself and (2) “earnest money” is not earnest money simply because the parties agree to characterize payments to be deemed such.