EARNEST MONEY, An Old Dog That Teaches New Tricks
It is safe to say that many real estate brokers consider the topic of earnest money logistics and protocols to be a tired discussion. In this fast-paced market, earnest money is often a sideshow to the main event of price wars and multiple offer battles. Maybe so…but broker's failure to properly document and safeguard earnest money is still one of the leading causes of discipline by the Washington State Department of Licensing (DOL). This article will consider the wisdom and challenges of both “non-refundable earnest money, released to seller” and instructing buyers to deposit earnest money directly to the earnest money holder so that broker may avoid handling the funds.
Should Buyer Brokers Instruct Buyers To Deposit Funds Directly To Escrow So That Broker Can Avoid Handling The Funds?
There is not a one-size-fits-all approach to getting earnest money deposited. Having buyer deposit funds directly into escrow may be the best approach for some buyers in some transactions but it is absolutely not the best practice for all brokers and all buyers. Likewise, it is not the best practice from a seller's perspective.
First, it is important to understand the basic operation of Form 21, paragraph b, the statewide form provision that controls the deposit of earnest money. The provision requires buyer to deliver earnest money within two days following mutual acceptance. Buyer must deliver within two days following mutual acceptance regardless of whether buyer is delivering to buyer's broker or to escrow. Buyer is not given any extra time because buyer is delivering directly to escrow. Buyer's delivery of the earnest money is due not later than two days following mutual acceptance based on the boilerplate language of the purchase agreement.
If buyer delivers earnest money to buyer's broker, buyer's broker must then deliver the earnest money to the agreed holder of the earnest money within three days following receipt of the earnest money or within three days following mutual acceptance, whichever is later. For example, if buyer gives broker a check for the earnest money on Monday, when buyer writes an offer, but the offer is not accepted until Wednesday, then buyer's earnest money check must be delivered to the agreed holder of the earnest money not later than three business days later, which is the following Monday (assuming a normal week with no holidays).
There is another piece of background knowledge that is essential to answering this question. DOL mandates, without exception or excuse, that every transaction file include proof that buyer's earnest money was deposited timely and if not, that seller was immediately put on notice of buyer's failure. DOL audits both buyer and listing broker transaction files equally with respect to this issue. Using an example where mutual acceptance is reached on Wednesday, DOL will audit both listing and buyer broker transaction files to confirm that: 1) if buyer deposited earnest money directly, the deposit was received by the agreed holder of the funds not later than Friday; or 2) if earnest money was delivered to buyer's broker, that delivery to buyer's broker was made not later than Friday (there must be a receipt or other proof of buyer's timely delivery in both listing and selling transaction files) AND that earnest money was then deposited with the holder of the earnest money within three days following either buyer's delivery to buyer's broker or mutual acceptance, whichever came later (again, there must be proof of the timely delivery to escrow or deposit in the firm trust account, whichever is required by the terms of the agreement).
If there is no proof of timely delivery and/or deposit in the listing and selling files, then DOL expects to see proof that seller/listing broker was put on notice of buyer's failure not later than the day following the date on which delivery or deposit was due. Again, DOL expects both listing and selling firms to confirm timely delivery and/or deposit and will hold both brokers and firms responsible if there is a failure of deposit and seller is not notified of the failure.
This issue is one of the often cited failures leading to disciplinary action by DOL. Brokers either do not have the necessary receipts or other proof in transaction files and/or brokers do not have proof that in the event of buyer's failure to make timely deposit, seller was notified of buyer's failure. DOL has jurisdiction over this issue because brokers are required, pursuant to RCW 18.86.030 (the Agency Law) to disclose “material facts.” DOL is authorized, by statute, to enforce RCW 18.86.030 and DOL interprets “material fact” to include a buyer's failure to make timely earnest money deposit. Accordingly, DOL requires strict compliance with the documentation protocols described above and disclosure to seller of any failure by buyer to make timely deposit.
With all of this background information, it is time to answer the question. Again, there is no answer to this question that is the correct answer in every transaction. But, considering the heavy burden placed on brokers to document timely deposit of buyer's earnest money and to take immediate action if the deposit is not made timely, doesn't it seem like the greater control broker has over the logistics of buyer's deposit, the better? Doesn't broker have greater control over timely collecting buyer's earnest money and timely depositing buyer's earnest money if buyer broker collects an earnest money check at the time buyer signs buyer's offer? The answer is yes. Broker has the greatest control if broker collects buyer's earnest money at the time buyer signs an offer. To the extent that is possible, that should be buyer broker's goal. In cases where buyer cannot or will not give buyer broker a check for the earnest money at the time buyer signs the offer, then buyer has the freedom to make deposit directly to the holder of the earnest money within two days following mutual acceptance. Both brokers must then calendar and follow up on the duty to confirm buyer's timely deposit and notify seller/listing broker of any failure.
Assume buyer broker does collect buyer's earnest money at the time buyer signs buyer's offer; buyer broker has a separate duty to safeguard buyer's funds. DOL requires that buyer's broker deliver the earnest money within three days of receipt. If buyer and seller reach mutual acceptance within those three days so that broker can simply deliver to the holder of the funds, so be it. But, if buyer and seller are still negotiating three days after buyer wrote the earnest money check, then buyer's broker must deliver the earnest money check to broker's managing broker for safe keeping. Buyer broker and managing broker will then have an obligation to insure that the check is timely deposited following mutual acceptance.
It is likely because of this extra step of safe handling, that instruction is given for brokers to avoid handling earnest money. The effort to avoid that step of safe handling, however, results in a situation where both brokers and the seller are left to trust that buyer will make timely deposit. This is not to say that buyer's “trustworthiness” should be questioned. The risk may have nothing to do with buyer’s “trustworthiness” but rather, buyer's memory, attention to detail, ability to handle the logistics of the deposit and other more mundane characteristics. Moreover, relying on buyer to make timely deposit results in a burden on both brokers to confirm timely deposit. But, if the earnest money check is given to buyer's broker, it is expected that buyer's broker will automatically provide proof to listing broker of broker's timely receipt and broker's timely delivery of the earnest money.
Again, there is not a one-size-fits-all answer to this question. It would be a mistake to believe that a buyer's broker should always avoid collecting an earnest money check at the time buyer makes an offer. To the contrary, when buyer's broker can collect the earnest money check at the time buyer writes the offer, buyer's broker has the greatest control over the outcome for deposit and both brokers and seller enjoy the safest measure of protection with respect to the required deposit and proofs.
More and More Sellers Demand Non-Refundable Deposits, Released To Seller Prior To Closing. Is This A Good Practice?
No. It is a horribly risky practice, jeopardizing buyers, sellers and brokers/firms. First, it is important to note that this author will not get lost in a discussion about the difference between “earnest money” and some other form of “deposit.” Brokers too often believe that the risks presented by this situation are eliminated if the parties label the non-refundable, released funds with a particular title. The fact is, the buyer and seller do not care what title is given to the funds. The parties intend a scenario where seller eventually gets to keep an agreed sum of buyer’s money if buyer defaults but where buyer recovers the money if seller fails to close.
It should be noted that the statewide forms are created to achieve this outcome if the parties do not add any additional language and simply enforce the terms of the boilerplate language. If buyer has no contingencies, then the earnest money is non-refundable to buyer. If buyer fails to close and buyer has no contingencies excusing buyer's performance, then buyer's failure to close constitutes a breach of contract. If buyer breaches the contract, then seller is entitled to the remedies specified on the face of Form 21. But, if seller is unable or unwilling to provide marketable title to buyer, then buyer is entitled to recover the earnest money. Both outcomes are mandated by the boilerplate language of the statewide forms.
The notions of “non-refundable” and “released to seller” developed because of the difficulty sellers experience in taking possession of money after buyer breaches. The expenditure of resources, by sellers, to collect funds to which seller is entitled cannot be overstated. It can be extremely difficult and expensive. The question, then, is whether that anticipated difficulty justifies the risks of buyer releasing money to seller, in advance of closing, with the hope that seller will honor the purchase agreement and convey marketable title to buyer. Industry lawyers do not agree on the answer to this question. Some industry lawyers believe it is a productive practice to release buyer funds to seller prior to closing. This author believes the risks grossly outweigh the benefits. Until the recent, unprecedented seller’s market, this practice was never widely utilized in residential sales. It is only because of the unequal bargaining power of this market that sellers are able to extract what would, historically, be viewed as an unreasonable concession.
With respect to the concept of “non-refundable,” brokers often create inconsistencies in purchase agreements. If a buyer has a Financing Contingency (Form 22A) or the right to terminate based on the Seller Disclosure Act or a Title Review Contingency (Form 22T) or any other lawful excuse for terminating and also agrees that funds will be “non-refundable,” who is entitled to the funds if buyer properly terminates the purchase agreement based on a lawful excuse? Seller will believe seller is entitled to the funds…if not, then what was the purpose of “non-refundable?” Buyer will believe buyer is entitled to the funds…if not, then what was the purpose of the contingency or statutory right to terminate? The confusion is obvious, yet brokers draft purchase agreements with these internal conflicts too often by simply adding a notation that funds will be “non-refundable.”
Instead of making funds ”non-refundable,” listing brokers should be attentive to making sure that sellers take the steps necessary to insure that a buyer’s lawful excuses to terminate are timely eliminated. Seller’s need to deliver the Notice of Right to Terminate allowed by buyer’s financing contingency (Form 22A, paragraph 3). Sellers must timely deliver properly and fully completed disclosure statements. Sellers must timely deliver preliminary commitments for title when buyer has a Form 22T contingency. Simply put, seller must do everything required of seller to timely eliminate a buyer’s right to lawfully terminate the purchase agreement. If seller does everything required of seller and eliminates all of buyer’s lawful excuses for terminating, is it then appropriate for brokers to write the purchase agreement releasing buyer funds to seller in advance of closing?
No. In every purchase agreement, seller has an obligation to provide buyer with marketable title in exchange for buyer's full performance of the purchase agreement. What if seller has taken possession of buyer's money and then seller cannot or will not provide marketable title? This happens for any number of reasons. If seller dies or becomes incapacitated prior to closing, it is unlikely that seller's estate and/or caregivers will take the steps necessary, prior to the closing date, to create marketable title. It could be that a mortgage holder fails to submit a timely pay off, the title company discovers a needed quit claim deed from a long-ago former spouse, an unresolvable, neighbor encroachment is discovered or seller was in pre-foreclosure when the property was listed, something not identified on the title report, but by closing, seller is in foreclosure and cannot close. In the current market, the problem is often that seller simply changes seller's mind. Seller discovers, after agreeing to sell, that seller cannot find a replacement property and terminates the agreement with the buyer. In any of these situations, all would agree that buyer should not forfeit any money to the seller who cannot or will not close. Yet, buyer's difficulty in recovering money that was released to a seller may be great.
If buyer cannot recover pre-released funds from the seller, where will buyer turn to be made whole? It is likely that buyer will seek recovery of the lost money from buyer’s broker and firm. Recall that broker is held to the standard of care of a lawyer when drafting a purchase agreement and there will be no shortage of lawyers willing to testify, on behalf of the residential buyer, that they would not have released buyer’s funds to seller prior to closing. If, in an unusual circumstance, seller is dependent on the release of buyer funds prior to closing, then listing broker should advise seller to seek legal counsel so that seller's lawyer can hold the funds in the lawyer's trust account until seller fully performs the terms of the purchase agreement.
Although earnest money is a subject that has consumed hours of continuing education for many brokers, the logistics of earnest money management is still a high-stakes issue. The Agency Law obligates brokers to account for consumer money entrusted to broker’s care and the Supreme Court holds brokers to the standard of care of a lawyer when drafting purchase agreements. These are demanding standards. Brokers must think critically as they advise clients with respect to all aspects of earnest money.