By K. Michelle Lind & Nikki Salgat

In all of the Arizona Association of REALTORS® (“AAR”) contract forms, earnest money is designated as liquidated damages for the seller in the event of a buyer’s breach. Liquidated damages is the term used when a specific sum of money has been agreed upon by the parties as the amount of damages to be recovered for breach of contract. Liquidated damages serve as an economical alternative to the costly and time consuming litigation involved in a breach of contract lawsuit.

When liquidated damages are specified in a contract, the terms are generally enforceable. However, be aware that if there is an unreasonably large amount of the earnest money at issue, the court may refuse to enforce the liquidated damages clause and deem it to be an unenforceable penalty. A liquidated damages clause will be considered a penalty unless two conditions are met: (1) the amount fixed in the contract must be a reasonable forecast of just compensation for the harm that is caused by any breach; (2) the harm that is caused by any breach must be one that is incapable or very difficult of accurate estimation.

In a recent Arizona Supreme Court case – Dobson Bay, et al. v. La Sonrisa De Sienna, LLC, —P.3d —, 2017 WL 1458856 (Ariz. 2017) – the court opined that a 5% (almost $1.4 million) late fee assessed on a final loan balloon payment was an unenforceable penalty. In this case, the lender loaned $28.6 million to the borrower to purchase four commercial properties. The borrower was not able to pay the entire principal when the balloon payment came due and the parties extended the loan maturity date for three years. The lender sold its interest to an LLC. The LLC noticed a trustee’s sale and claimed the borrower owed more than $30 million, including a nearly $1.4 million late fee as liquidated damages.

In analyzing whether the liquidated damages were enforceable, the Supreme Court examined factors such as, whether the amount was a reasonable prediction of the lenders loss, other fees triggered by the breach and whether the amount was proportionate to the lenders loss. Ultimately, the Court determined that the liquidated damages clause was not a reasonable forecast of just compensation for harm that was caused by the breach, and the harm caused was not incapable or very difficult of accurate estimation. Therefore, the liquidated damages clause was an unenforceable penalty.

Not all large liquidated damage sums are unenforceable. For example, in Pima Sav. and Loan Ass’n v. Rampello, 168 Ariz. 297, 812 P.2d 1115 (App. 1991), the buyer contracted to purchase a condominium complex from Pima Savings for $4.7 million. The contract’s liquidated damage clause stated in the event of the buyer’s breach Pima would be paid $290,000.00 as liquidated damages. When the buyer failed to close, the buyer argued that the liquidated damage clause was unenforceable as a penalty. The court noted that the: “liquidated damage amount was little more than six percent of the total contract price and was reasonable on its face and, when all the facts were considered, reasonable at the time of the contract.” Therefore, the clause was enforceable.

In applying these cases to the AAR contracts, how much earnest money is reasonable so that a court will find the liquidated damages clause enforceable? It depends on the type of transaction and the circumstances surrounding the transaction. Some things to take into consideration are how complicated the transaction is, the length of the transaction, and the amount of damages the party would incur from harm in the event of a breach. Generally speaking, most earnest money deposits are fairly modest and likely be found to be an acceptable amount of liquidated damages.

K. Michelle Lind is an attorney and the Chief Executive Officer and Nikki Salgat is associate counsel for the Arizona REALTORS®, the largest trade association in Arizona, representing more than 46,000 members. This article reflects only the opinion of the authors and is not intended as definitive legal advice.

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