Earnest Money Disputes

Imagine a common situation:  You are showing a house to a potential buyer.  She notices there is a problem with drainage in the basement.  The buyer is concerned because she wants to use the basement as a home office.  After speaking with the seller, you reassure the potential buyer that the problem will be fixed before closing.  She decides to purchase the house.  The buyer signs a Purchase and Sales Agreement for the house.  The Agreement contains a contingency that the Seller will fix the basement.

Now imagine that the date of closing is fast approaching.  A contractor has worked on the drainage problem and the seller tells you the problem has been fixed.  The buyer inspects again and discovers a significant amount of water in the basement.  The buyer becomes very frustrated and discouraged and decides to terminate the transaction before closing and demands the return of her earnest money.

At this point, what would you as a REALTORÒ do?  Would you disburse the earnest money to the sellers because the buyer forfeited her rights by terminating the agreement?  Would you give it back to the buyer since the basement was not dry to her satisfaction?  This is the situation that arose in the case of Edmonds v. J.L. Scott Real Estate, 87 Wn. App. 834, 1997.

The REALTORSÒ in the Edmonds case asked their legal counsel what to do with the earnest money.  John L. Scott’s attorneys did not ask about the buyer’s (Edmonds) complaints regarding the water in the basement.  They did not investigate whether any warranties covered the work that had been done.  Instead, Scott’s attorneys unilaterally determined that all of the drainage problems had been remedied.  They then declared the buyer to be in default, and directed the company’s Trust Department to distribute half the Earnest Money to the sellers and half to their agents.

Edmonds sued to get her money back.  In her lawsuit, Edmonds alleged many things, including unlawful forfeiture of her Earnest Money deposit and a violation of the Consumer Protection Act.  The case went all the way up to the Court of Appeals.

The Court of Appeals agreed with Ms. Edmonds.  They held that a real estate agency should not unilaterally disburse Earnest Money to the seller and the seller’s agent when there is a dispute with the buyer over whether the terms are satisfied.  This constitutes an unfair or deceptive act or practice under the consumer Protection Act (RCW 19.86).  This practice violates the Consumer Protection Act because unilateral disbursements of Earnest Money without investigating or resolving disputes has the potential to harm hundreds of people if it is followed with regularity.

The Court noted that the only way a Purchase and Sale Agreement terminates is when the terms have been satisfied or the buyer executes a written release of the Earnest Money.  Here, the selling agency’s attorney simply said, without investigation, that the transaction failed to close, and therefore the buyer forfeited her Earnest Money.  The Court strongly disagreed with this practice.

The Court also recognized the relationship of trust between the holder of the Earnest Money and the buyer.  An Earnest Money trustee breaches its fiduciary duty to a buyer who deposits money with them if they unilaterally declare that the buyer is in default without investigation.  This applies when there is a dispute over whether the buyer is in breach of the Purchase and Sale Agreement.

The Court also reminded the agents of their duty of care in these situations.  Licensed real estate brokers and salespersons have the same standard of care as a practicing attorney when completing Purchase and Sale Agreements.

If you are in a situation like the one in the Edmonds case, there are several lessons to adhere to.  As always, be careful when completing a Purchase and Sale Agreement.  Make sure the Agreement specifically references what events must occur for it to terminate.  This will protect the buyer and lessen the likelihood of a dispute.  Another lesson to consider is to make sure all applicable terms of the Purchase and Sale Agreement have been satisfied before disbursing any Earnest Money.  If there are any disputes over completion, be sure that a factual investigation into the merits of the dispute is made before taking any action.  Both sides should be contacted to get their side of the story, and the issue thoroughly investigated.  Be thorough, and inquisitive before taking any definitive action.  Best of all, get written instructions and releases from the buyer and seller explaining how they agreed to handle the Earnest Money.  Doing so helps prevent either party from accusing the agency involved of violating its duties.

Published June 1998

This article contains information of general interest, and is not intended to be, nor should it be relied upon as a substitute for specific legal advice.