An real estate lawyer may be the best place to turn when there is a dispute about an earnest money deposit. There is a good deal of misunderstanding about the purpose of an earnest money deposit. This article discusses the general purpose of earnest money, and the rules that govern the earnest money. However, the principle place to look for answers is the earnest money contract itself, since the contract can create change the general rules.
If earnest money is not paid, is the contract valid?
Generally, the answer is yes. Contracts do not generally need earnest money in order for a contract to be enforceable. See eg. Limestone Grp., Inc. v. Sai Thong, L.L.C., 107 S.W.3d 793, 796 (Tex. App. – Amarillo 2003, no pet.). Consideration is required. A simple way to describe consideration is a bargained-for benefit to both parties. An earnest money contract usually provides consideration without earnest money because one party promises to buy the property, and the other party promises to sell the property. Those promises are consideration, and will support the validity of a contract. In sum, an earnest money provision is not required to make a contract valid.
What if a required earnest money payment fails?
If a contractually required earnest money check bounces, or if it fails in some other way, the buyer is generally in breach of a contractual covenant, or promise. Generally the buyer is not in breach of a condition precedent, which would mean that the contract had not formed at all. This question was considered by Hudson v. Wakefield 645 S.W.2d 427, 429 (Tex., 1983)
Purchasers contend that rather than being a condition precedent, the earnest money provision of this particular instrument was but one of the many covenants of the parties and that Sellers were not entitled to back out of the agreement [just] because…[the earnest money check bounced]. Sellers urge that the earnest money provision was a condition precedent to the formation of the contract. If they are correct, they must prevail.
The court ruled that the failure of the earnest money was not a condition, and reversed the summary judgment.
Remember, this is a general rule. If a contract says that a valid earnest money deposit is a condition precedent to contract formation, then that term will usually govern. This means that in such a contract, the failure of earnest money would make the contract enforceable as a matter of law.
Even so, a contract may still be unenforceable if the breach of the earnest money provision is material. Real Estate Journal, Tierra Grande examines one case in which failure of the earnest money was not material, and one in which it essentially was material. That article reminds us that
As a general rule, the materiality of a breach is a question of fact for a jury. However, sometimes it is a question of law for the courts when the terms of the contract are clear, unambiguous and conclusively established.
The journal considered Crandall Med. Consulting Servs., Inc. v. Harrell, No. 03-07-00689-CV, 2009 WL 280658 (Tex. App.-Austin Feb. 5, 2009, pet. denied). In Crandall, the Court decided that the purchaser was not in material breach when he deposited $2000 at the outset of the contract, but failed to deposit $100 at the end of the feasibility period. As a result, the Seller was ordered to specifically perform by selling the property. Tierra Grande states that the Court found that the failure of the $100 deposit did not harm the Seller, but the case is richer than what the journal’s analysis suggests.
The court cited the factors for materiality, and averred that the Sellers failed to contend that the failure to deposit $100 a) was a material breach or b) had harmed the seller. Thus, materiality and harm were not really at issue in the case. The Seller, instead, relied on the argument that time was of the essence in the contract. The court distinguished this case from other “time is of the essence cases” by considering that in this case, the Buyer tendered the purchase price timely.
The Seller also attempted to rely on its right to terminate in order to avoid specific performance. The contract allowed the Seller to terminate if “the earnest money” was not timely deposited (emphasis added). The Court construed that provision to mean the initial earnest money deposit only.
Finally, the Sellers attempted to rely on the default provisions, which stated that if the Buyer was in “default,” the Seller could terminate. The Court said that such a broad interpretation would would “modify the law of contracts and specific performance to allow [Seller] to terminate the Contract no matter how immaterial the breach.” Based on the language of the contract, the Court refused to allow an immaterial breach to excuse the Seller’s performance, contrary to the Seller’s argument.
Compare this case to the other case cited in the Tierra Grande article, Limestone Grp., Inc. v. Sai Thong, L.L.C., 107 S.W.3d 793 (Tex. App.-Amarillo 2003, no pet.). The Buyers in Limestone were denied specific performance when they deposited $25,000 in earnest money, instead of the contractually required $75,000. The contract limited the Buyer’s remedy by allowing specific performance only if the Buyer was not in “default.” The court called the Buyer’s absence of default a “potential condition precedent” to enforcing specific performance.
The Court recognized that a breach must be material in order for a court to withhold specific performance. However, the Court distinguished those cases on the basis that those cases had not dealt with the limitation on specific performance in this case (that limitation being the absence of a “default”). Prior cases had defined “default” as broader in nature than breach, being defined as an omission, a failure to act or a breach. The Court said:
And, in so reading the term [omission], we eschew attempt to affix words of qualification or measure to it, such as substantial or material. In short, the parties omitted words from the contract modifying the degree of default needed.
Analysis
The two Courts above seem to display common sense: One seller deposits $2000 out of $2100, and he is allowed to specifically enforce the contract; the other seller deposits only $25,000 out of $75,000, and he is not allowed to specifically enforce the contract. However, courts are based on law, and not common sense, and a deeper analysis uncovers a difference in contract philosophy between the two courts.
In Crandall the Court held that when a Buyer is in “default,” the Buyer could be denied specific performance, only if the default was a material breach. According to the Court, the opposite holding would “modify the law of contracts and specific performance to allow [Seller] to terminate the Contract no matter how immaterial the breach.”
On the other hand, the Limestone Court held that the term that limited the Buyer’s specific performance only to situations where the Buyer was not in “default” could be interpreted to mean any omission, failure or breach. For the Limestone Court, a “default” could be a breach or any omission or failure. The Court relied on precedent defining “default” as such. The Court in Limestone, essentially held that that any default, material or not, could prevent a Seller from asserting specific performance, when the “default” was a condition precedent to asserting specific performance.
Tierra Grande appears to conclude that the timing of the deposit will yield different results. (“The Harrell
decision…held that the default refers to the failure of the first deposit and not the second.”) However, that analysis misses the nuance. The different outcome in the two courts is a simple difference in philosophy in contract construction. One court was willing to read around the term “default” and substitute common law concepts for express terms, and the other court was unwilling to modify the express terms of the contract.
It is settled law that a prior material breach excuses the non-breaching party’s non-performance. Mustang Pipeline Co. v. Driver Pipeline Co., 134 S.W.3d 195, 196 (Tex.2004). The Crandall court opined that allowing the express term “default” to supplant or override that rule would “modify the law of contracts.” On the other hand, the Court in Limestone recognized that “default” has a different meaning than breach, and the Court refused to modify the language of the contract and override the express terms of the contract with a different interpretation. The difference in outcome is not technically related to the timing of the earnest money deposit, but whether the Court will give the term “default” a broad meaning, like the Limestone court, or whether the Court will equate the term “default” with breach, like the Crandall court.
Another possibility is that the Crandall Court reviewed at least one other factor to come to its conclusion. The Crandall Court noted that the contract allowed the Seller to terminate if “the earnest money” was not timely deposited (emphasis added). The Court used that to reason that the failure to deposit the second earnest money was inconsistent with the express requirement that Seller could terminate if the first earnest money failed. It was an unstated expressio unius interpretation. If the parties agreed that the Seller could terminate upon failure of the earnest money deposit, then a failure to mention that the second deposit would give rise to the same rights meant that such a right did not exist in the contract. Under this analysis, the “default” portion of the opinion was another part of an analysis that buttressed the Court’s reasoning.
Even if this is true, however, it appears that the Court’s have a significant difference in opinion as to how to construe the term “default.” For one court, “default” means what the common law would call material breach. For the other court, “default” means breach, omission or failure to act.
One Houston Court examined the same issue as the Crandall court-the right to terminate. Capcor at KirbyMain, L.L.C. v. Moody Nat. Kirby Houston S, L.L.C., 509 S.W.3d 379, 391 (Tex. App. -Houston [1st Dist.] 2014, no pet.). In Capcor the buyer failed to pay part of the purchase price on the date of closing, because the title company required wired funds, and the Seller offered a cashier’s check. The Court construed the following verbiage:
“[i]f either party fails to close the sale by the Closing Date, the non-defaulting party may exercise the remedies contained in Paragraph 15.” [Seller’s] remedies in Paragraph 15 included “terminat[ing] the contract and receiv[ing] the earnest money as liquidated damages.”
The Capcor Court, cited the Limestone court, and like that Court did not read a materiality requirement into the failure to close on time. The Court respected the express terms of the contract-failure to close on time=right to terminate…simple. The Court noted that normally, a failure to perform on time is not a material breach, but a contract may make a failure to perform on time material by stating that time is of the essence or by drafting even more specific terms.
Admittedly, the Capcor court construed a much more specific default-a failure to close, while the Crandall court construed a general “default” provision. Even so, the Capcor court made it a point to say “[w]hether or not Capcor’s breach would otherwise be considered material is irrelevant to the outcome of the case.” The Court held that the express terms were clear enough and that parties were free to modify the legal and equitable remedies by contract. It seems that the Capcor court is in accord with the philosophy expressed in the Limestone court.
To answer the question, “what if an earnest money deposit fails?”-it depends. It depends on what the contract espresses should happen; on whether the term “default” or “breach” is used in that expression; and how the court will interpret the term “default.”
Importantly, the most recent TREC-promulgated One To Four Family Contract, expressly states that time is of the essence in the Termination Option section. One rule of contract law (expressio unius) suggests that the inclusion of the time is of the essence provision in the termination option, excludes it from application in the earnest money section.
So, what is the use of earnest money?
The Court in Harrel used the initial earnest money deposit to evidence the Seller’s intent to close the transaction. That is generally the purpose of the earnest money. The earnest money also provides a potentially remedy to the Seller. That remedy may be governed by the terms of the contract. If not, the practical reality is that if the Buyer wishes to back out of the transaction, a Seller may negotiate to retain some or all of the earnest money to cover his damages by a Buyer’s breach.