Earnest Money: Risky Refunds

August 1, 2007

Is there an old saying about handling other people’s money? If not, there should be. When disputes arise over the disbursement of earnest money funds, you may find yourself caught in the middle, facing civil liability, forfeiture of compensation, or disciplinary action by the real estate commission. Fortunately, you can reduce the risk to your clients and to yourself by ensuring that all parties understand their rights and obligations regarding earnest money deposits. Some tips:

Understand your duties.

Although you may represent only one party in a real estate transaction, you should recognize that you may nonetheless owe the other party a fiduciary duty with respect to deposited funds. For example, in Vicki Bagley Realty Inc. v. Laufer, 1984, the District of Columbia Court of Appeals upheld the trial court’s finding that the buyer’s broker owed the sellers a fiduciary duty concerning the earnest money deposit. The court found a breach of duty in part because the buyer’s broker had accepted the deposit check, though he knew, or should have known, that because there were insufficient funds in the buyer’s account, the check couldn’t be cashed for 10 days.

When brokers act as escrowees of the funds in a real estate transaction, they have a duty to act in accordance with the escrow instructions. In the absence of such instructions, brokers should hold the funds for the benefit of both parties. If a dispute arises without clear written instructions signed by both parties, the safest course is to remain neutral and not release the funds until the parties can reach an agreement or until the court decides the issue.

If you wish to take a proactive approach during a disagreement, you can file a lawsuit seeking a judicial declaration—essentially a request that the court determine what the contract says about disbursing funds. Alternatively, you can wait for one of the parties to bring a similar action.

Follow rules to the letter.

Be extremely careful when handling other people’s funds and follow regulations. For instance, in Depugh v. Ohio Dept. of Commerce, 1998, the Ohio Court of Appeals upheld a one-month suspension of a broker’s license after the broker had waited a week—longer than the law allowed—to deposit a $1,000 check into a trust account. The broker had only clipped the deposit check to his client’s file during that week.

Clarify the deposit terms.

Take the time in every transaction to review the proposed contract language and determine whether it clearly states how deposit funds will be handled. Confusion often occurs if the broker representing the other party is using forms with potentially inconsistent deposit provisions. For example, in Sheaffer v. Ohio Dept. of Commerce, 1996, the broker found himself in a self-described “catch-22” because the earnest money deposit contract terms in the parties’ primary contract were arguably inconsistent with the terms in the parties’ inspection addendum.

The primary contract form gave the sellers certain notice rights before the deposit funds could be released. By contrast, the addendum form appeared to authorize the broker to immediately release the earnest money without any notification or authorization. Relying on the addendum, the broker returned the deposit to the buyers after the parties had reached an impasse. Although the Ohio Court of Appeals recognized the inconsistency in the forms, which were widely used in the area, the court upheld the finding that Sheaffer (the broker) had engaged in misconduct and suspended his license for 30 days.

Provide adequate written disclosure.

Brokers should clearly and immediately communicate (preferably in writing) all material information concerning the deposit to all persons having an interest in the funds. Material information can include the fact that an uncashed deposit check has been returned to the buyer or that a deposit check was returned by the bank for insufficient funds.

RE/MAX Realty 100 v. Basso, 2003, helps shed some light on the consequences of a failure to provide adequate disclosure concerning deposit funds. The Wisconsin Court of Appeals found that a brokerage representing both the buyer and the seller in the transaction through different agents violated Wisconsin law by returning the buyer’s personal check for the deposit without notifying the seller. The check was returned with the understanding that it would be replaced with a certified check. But the buyer never provided such a check. When the buyer breached the contract, no earnest money funds were available to compensate the seller. The court found that by returning the deposit check to the buyer in violation of the listing contract, the broker “arguably placed the needs and interests of its business ahead of [the seller’s] needs.”

Use an authorized third-party escrow depository, if possible.

Depositing the funds in your own trust account or otherwise acting as the escrowee will obviously put you in the middle of a dispute concerning the funds (though such a deposit may be required under the purchase agreement).

You may reduce that risk by depositing the funds with an authorized third-part depository. But first ensure that third-party escrow depositories are permitted in your state and that the escrow company meets state law requirements. For example, although California permits the use of a “neutral escrow depository,” only certain entities such as banks, trust companies, and insurance companies qualify to act as neutral escrow depositories.

Although the correct course of action in a particular transaction depends on the laws of your state and the dictates of the purchase agreement and other legal documents, following the basic principles outlined here will help you navigate the challenges of handling earnest money deposits.

Damon Rubin is a licensed California real estate broker, an attorney, and a partner in the law firm of Ritz Rubin Hall LLP. You can reach him at 310/461-1325 or drubin@rrhllp.com.