Earnest Money Disputes

Introduction

Disputes over earnest money usually occur when either buyer or seller perceive the other to be at fault for breaching the contract in some manner. The parties can be emotional, unreasonable, and determined to stand on principle, all common shortcomings in persons who may threaten to file lawsuits but are unacquainted with the costs and burdens of litigation.

The orderly disposition of disputed earnest money is governed by paragraph 18 of the TREC 1-4 residential contract. Problems and the potential for litigation most often arise when a party refuses to do what the contract says.

This article does not address what occurs when earnest money is not deposited by the buyer at all, except to observe that this constitutes a breach (a default) by the buyer in the case of an otherwise valid and accepted earnest money contract. Failure of the buyer to perform in this regard does not, as many believe, cause the contract to fail altogether, since earnest money is not a requirement of a valid real estate contract in Texas (although not delivering required earnest money does permit the seller to terminate the contract under paragraph 5C).

Nor does this article discuss the return of earnest money during the option period provided in paragraph 5B of the contract. So long as an option fee was paid, and notice of termination was duly given before the option period expires, the return of the buyer’s earnest money is usually non-controversial.

References to contract paragraph numbers are to the paragraphs of the TREC 1-4 residential contract.

Buyer’s Failure to Obtain Financing

A common area of dispute is the buyer’s inability to obtain financing. Note that the TREC Third Party Financing Addendum contains a blank for a specific time during which the buyer must notify the seller of his inability to obtain financing. If this notice is not timely given, the contingency is waived. Buyers often miss this detail and insist on their continuing right to get their earnest money back if their loan application is denied, even after the specified time has run.

Sellers, on the other hand, may believe that the buyer did not make “every reasonable effort to obtain credit approval” (as required by the TREC addendum) and therefore should not be entitled to return of earnest money even if notice is given within the prescribed period. Unfortunately, the addendum does not go into detail about what “every reasonable effort” means. (Practice note: a buyer’s special provisions addendum should include a clause to the effect that production of a legitimate turn-down letter will satisfy this requirement).

Seller’s Failure to Cure Buyer’s Objections

Paragraph 6D states: “Provided Seller is not obligated to incur any expense, Seller shall cure the timely objections of Buyer or any third party lender [to the title commitment or survey] within 15 days after Seller receives the objections and the Closing Date will be extended as necessary. If objections are not cured within such 15 day period, this contract will terminate and the Earnest Money will be refunded to Buyer unless Buyer waives the objections.”

Failure of Seller to Complete Required Repairs

A less common area of disagreement leading to a demand for the earnest money pertains to repairs required to be completed by the seller (paragraph 7D(2)). The contract provides that “If Seller fails to complete any agreed repairs and treatments prior to the Closing Date, Buyer may exercise remedies under Paragraph 15 [the default paragraph] or extend the Closing Date up to 15 days if necessary for Seller to complete the repairs and treatments.” Paragraph 15 goes on to allow the buyer the option to accept the return of the earnest money and terminate the contract.

Cases in this area are not always clear cut. The seller may believe that it completed required repairs, but the buyer may not agree; or the buyer may not like the look of the repairs. There can be a good-faith disagreement about whether or not the repairs performed were satisfactory; or perhaps the repair process uncovered the need for additional remedial work. A frustrated buyer whose enthusiasm for the property had been waning may use this as an opportunity to declare the seller in default and demand the return of the earnest money.

Casualty Loss

Rarely, the property will be totally or partially destroyed before closing, perhaps by flood or fire. Paragraph 14 governs in such instances: “If any part of the Property is damaged or destroyed by fire or other casualty after the effective date of this contract, Seller shall restore the Property to its previous condition as soon as reasonably possible, but in any event by the Closing Date. If Seller fails to do so due to factors beyond Seller’s control, Buyer may (a) terminate this contract and the Earnest Money will be refunded to Buyer (b) extend the time for performance up to 15 days and the Closing Date will be extended as necessary or (c) accept the Property in its damaged condition with an assignment of insurance proceeds and receive credit from Seller at closing in the amount of the deductible under the insurance policy.”

If the seller does not comply with buyer’s demand under this section, then the default and mediation provisions of paragraphs 15 and 16 become the next steps in the legal process.

Failure of a Party to Close

Another common circumstance leading to demand for payment of the earnest money arises when either buyer or seller fail to close as agreed. Paragraph 9A states: “The closing of the sale will be on or before [inserted date], or within 7 days after objections made under Paragraph 6D have been cured or waived, whichever date is later (Closing Date). If either party fails to close the sale by the Closing Date, the non-defaulting party may exercise the remedies contained in Paragraph 15.”

The Process for Demanding Release of Earnest Money

Whatever the cause of the dispute or default, paragraphs 18.C through E address the procedure for demanding release of the earnest money:

C. DEMAND: Upon termination of this contract, either party or the escrow agent may send a release of earnest money to each party and the parties shall execute counterparts of the release and deliver same to the escrow agent. If either party fails to execute the release, either party may make a written demand to the escrow agent for the earnest money. If only one party makes written demand for the earnest money, escrow agent shall promptly provide a copy of the demand to the other party. If escrow agent does not receive written objection to the demand from the other party within 15 days, escrow agent may disburse the earnest money to the party making demand reduced by the amount of unpaid expenses incurred on behalf of the party receiving the earnest money and escrow agent may pay the same to the creditors. If escrow agent complies with the provisions of this paragraph, each party hereby releases escrow agent from all adverse claims related to the disbursal of the earnest money.

D. DAMAGES: Any party who wrongfully fails or refuses to sign a release acceptable to the escrow agent within 7 days of receipt of the request will be liable to the other party for liquidated damages in an amount equal to the sum of: (i) damages; (ii) the earnest money; (iii) reasonable attorney’s fees; and (iv) all costs of suit.

E. NOTICES: Escrow agent’s notices will be effective when sent in compliance with Paragraph 21 [the paragraph stating where notices should be sent]. Notice of objection to the demand will be deemed effective upon receipt by escrow agent.

The contract process is clear. Upon failure of the contract for any reason, the party desiring the earnest money must make written demand upon the title company. A copy of the demand should be sent to the other party. The written demand triggers a 15-day window during which the other party may make written objection to the title company. Phone calls, almost always legally insufficient in real estate for notice purposes, will not meet the requirements of the contract. Fax? Maybe. Email or text might be sufficient, since Texas is gradually recognizing the legitimacy of these forms of communication, but certified mail to both the title company and the other party is always best, particularly if litigation is a possibility. There is nothing like being able to show a signed green card to a judge in order to prove that notice was given. Send another copy by first class mail.

The language of the contract is vague about which demand—demand from the party desiring the earnest money versus demand from the title company—triggers the 15- and 7-day periods, but it is prudent to be conservative and assume that these periods begin when the first party makes written demand. It is always best to be conservative about interpreting contract deadlines and timelines. One should never wait until the last minute to deliver required notices.

What happens next?

The title company will follow up with a notice of its own that written demand has been made and enclosing a release form for signature. It must be signed by all parties and their brokers. Fifteen days are allowed for written objections to be made.

Mediation is the likely next step. The TREC contract formerly made the choice of mediation elective in paragraph 16. There is no longer a “yes or no” box to check on the latest form of this contract, so mediation is now required as a means of settling disputes—unless this paragraph is either struck and initialed or a special provisions addendum is attached that deals differently with dispute resolution.

Lawsuit Remedy

Lawsuits may be filed in justice court without necessity for an attorney so long as the total amount claimed (including attorney’s fees if any) does not exceed $20,000. If total damages exceed that amount, then suit may be filed in the county court at law. Named defendants should include the party refusing to sign the release and the title company holding the earnest money. Title companies will usually respond by interpleading the earnest money (depositing it into the court’s account) which removes them from the merits of the litigation. The title company may then seek dismissal from the case or decide to remain involved in an attempt to recover attorney’s fees from the party at fault.

Before filing a legal action concerning earnest money, it is useful to consider the practical reality that attorney’s fees and costs, once added up, can easily exceed the amount of earnest money in dispute. As a consequence, many earnest money disputes are resolved by the parties’ splitting the funds and going their separate ways, respective claims of principle notwithstanding.