Contract termination and release of earnest money

This contract will not close—now what?

by Dennis R. Schmidt    We have all been involved in transactions for the sale of real estate where the deal doesn't close. Sometimes a contingency in the contract is not satisfied, as is the case when a buyer cannot obtain the type of loan specified in the contract. Sometimes one of the parties to the contract refuses to close for no legally justifiable reason. This is sometimes referred to as a breach of contract or default by that party.

Whatever the reason for the failure of the transaction to close, at least two issues are likely to arise. One is the formal termination of the contract and the other is the release of earnest money deposited pursuant to the contract. While these are separate issues, they are often closely, and sometimes inextricably, connected to each other.

The legal justification for the termination of the contract can be an issue in many cases. However, even when it would appear that reasonable minds would conclude that one party is clearly entitled to the earnest money deposit, the parties often continue to prolong the settlement of these issues although it is quite certain that the transaction will never close.

A seller might feel wronged because of lost market time even though no one disputes the fact that the buyer will not obtain the loan contracted for despite the buyer's reasonable efforts. The seller refuses to sign a release of the earnest money to the buyer in order to obtain part of that earnest money or to punish the buyer for the delay in selling the property. A buyer might refuse to sign a termination of contract form in order to try to retain the earnest money despite the fact that the buyer refused to close the transaction for no legally recognized reason. Both sides have their own goals, and both sides have their own leverage to obtain those goals.

Formal and final termination of a contract happens in one of two ways. One way is by agreement of the parties, usually accomplished by both parties signing some written document. The other way is by a judge entering an order terminating the contract. If the parties have not agreed on the termination of the contract and no judge has decided the issue, brokers should avoid giving the parties legal advice about the termination of the contract. Sellers should seek the advice of an attorney concerning the risks and advisability of proceeding with a subsequent sale of the property without a final settlement of the issue of contract termination. It is because of the potential risk of an adverse ruling by a judge concerning the seller's right to terminate the contract that title companies often refuse to open a second escrow file on a property where the first contract has not been formally terminated.

Similarly, the only formal and final way to resolve the issue of entitlement to the earnest money is by written agreement of the parties or an order of a court. Generally speaking, the escrow agent holding the earnest-money deposit is entitled to insist upon the agreement of the parties as to the disposition of the earnest money. Absent that agreement, the escrow agent is entitled to ask the court to decide the issue by placing the funds in the registry of the court by an interpleader action. The escrow agent would usually be entitled to have its attorney's fees paid out of the funds deposited with the court.

Although the amount of the earnest money involved in a transaction may not be very substantial, the losing party in any suit litigating the issue of entitlement to earnest money and/or contract termination could end up losing more than the earnest money. Paragraph 17 of the standard Texas Real Estate Commission (TREC) residential contracts provides that the prevailing party is entitled to recover reasonable attorney fees and court costs from the non-prevailing party in any action brought with respect to the transaction described in the contract. Those attorneys fees and court costs could very likely exceed the amount of the earnest money involved. Even in the absence of a specific contract provision, a court may order attorney fees to be paid by the non-prevailing party in a contract action under Section 38.001 of the Texas Civil Practice and Remedies Code.

It should be noted that paragraph 18 of the standard TREC contracts provides that the escrow agent will be released from liability if the escrow agent disburses the earnest money upon the demand of one party where the other party does not object to that disbursement within 30 days after notice to the other party is given by the escrow agent. This provision has limited applicability and covers only those situations where the other party does not object to the disbursement or has not made a demand for the earnest money.

Regardless of the amount of the earnest money involved in a transaction, and sometimes in spite of the equities involved in any given situation, it is usually in the best interest of all parties to resolve the earnest money and contract termination issues as soon as possible. Stubborn resistance to the resolution of these issues can often involve considerable time, expense, and needless emotional drain. Add to that the risk of an adverse court ruling awarding attorneys fees, and the incentive to settle these matters should increase.

Dennis R. Schmidt is associate counsel for TAR.

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