By Jones Osborn II

It sounds like asking "Can you ever be too rich?"

Surprisingly, however, it is possible to have too much earnest money.

Virtually every contract for the sale of real estate contains a provision for the forfeiture of earnest money if the buyer defaults. A seller might therefore assume that the more earnest money he obtains the better off he will be if there is a default. This generally is true -- but only up to a point.

A recent Arizona case has spelled out the rules.

A provision calling for the forfeiture of earnest money is known as a "liquidated damages" clause. This is because the seller doesn't have to prove how much he was damaged when the buyer breaches his contract -- he gets a "liquidated" or previously agreed amount, usually the amount of the earnest money deposit. He thereby avoids the difficult task of proving exactly what the buyer's breach has cost him. In addition, he may avoid litigation altogether, because the escrow agent will often disburse the deposit to the seller on demand, at least if there has been a clear breach.

However, the parties are not free to agree on any amount of liquidated damages they choose. The amount must meet two tests: One, the amount must be a reasonable forecast of the actual damages the seller will suffer if the buyer defaults. Two, the actual damages must be impossible or very difficult to accurately determine.

The reason for the first requirement is that the law will not impose a "penalty" for a breach of contract. Punitive damages are available only for wrongs known as torts, not for breach of contract. In the case of breach of contract, the law will provide only for the recovery of the amount necessary to make the non-breaching party whole. That is, it will seek to place the seller in the same economic position he would be in had the buyer performed. That is why the amount of liquidated damages cannot be excessive or punitive.

The reason for the second requirement is the idea that if actual damages may readily be proven it is better to use this as the measure of recovery rather than resorting to an arbitrary "liquidated" amount. Fortunately, the courts have consistently held that the damages occasioned by the breach of a contract for the sale of real estate are difficult, if not impossible, to accurately determine. As a result, the second requirement is not generally an impediment to the forfeiture of an earnest money deposit.

So how much is too much? There is no clear answer. It depends on many factors, such as the type of property, its liquidity, the condition of the market, whether the sales price was above or below market, and so on. However, the recent Arizona case mentioned above found that the forfeiture of a $290,000.00 deposit, which was equal to six percent of the purchase price, was reasonable. An earlier Arizona case, on the other hand, found the forfeiture of a 25% deposit to be excessive and unenforceable.

If the amount is excessive, the seller gets no liquidated damages at all. Instead, he must attempt to prove exactly what he lost as a result of the buyer's default, because in the absence of liquidated damages he can recover only what he can prove he lost. If he can't prove his damages, he gets nothing. Normally, this means the seller must prove that the sale was above market, or that he lost interest on the sales price because it would be months before the property could again be sold even at the same price.

The lesson is that an adequate earnest money deposit is of great benefit to the seller -- but he shouldn't be greedy or he may end up with nothing.

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The recent case referred to above is Pima Savings and Loan Association v. Rampello, 86 Ariz. Adv. Rep. 55 (Az. Ct. App., Div. 2, 1991).