Location: https://oregonrealtors.org/rmt_article/understanding-earnest-money/

Earnest money has been part of real estate sales for longer than anyone can remember. However, there remains substantial confusion surrounding earnest money in real estate today. For years, it was common to hear that a contract for the sale of real property was “illegal” or “void” unless the buyer paid earnest money at the time of contract. It was thought that without earnest money there was no consideration to support the contract. It is simply not true as a matter of contract law that a contract for the sale of real property must have earnest money to be valid or enforceable.

The origin of the “must have earnest money at the time of offer to be valid” myth is lost in time. There are, however, some clues that may point to the origin of the myth. Historically, (we are talking 19th century here) in the commercial sale of goods, the part payment of the purchase price, or delivery of part of the goods, was taken as evidence or ratification of the sale. This part payment or delivery was called “earnest” or “earnest money.” Earnest was a convenient and speedy way to evidence agreement in a sale of goods made by verbal offer to sell, standard order form or handshake.

Prior to the wide availability of lender financing after World War II, most real estate was purchased on a financing contract with the seller. Seller finance contracts were essentially installment contracts where the seller retained title until, and unless, the buyer made all the payments. The negotiation and drafting of such installment contracts made purchasing property uncertain because it took time to work out the details (it still does and modern real estate contracts now contain express seller financing or land sale contract clauses). During the time a land sale contract was being worked out, the buyer had no real claim to the property. “Earnest money agreements” were an early solution to this problem borrowed from the tradition of “earnest” in the commercial sale of goods.

Early earnest money agreements were essentially offers to make a contract. They were more like a modern letter of intent, where the parties agree they will make a contract in the future than a modern contract for the sale of real property. Pre-WWII, earnest money agreements were not bilateral contracts for the sale of the property and, therefore, (like a modern letter of intent) not enforceable unless backed by some consideration. The necessary consideration was the “earnest money” pledged and receipted for in the earnest money agreement. It was paid at the time the earnest money agreement was offered so that, if accepted, the agreement to form a contract would be backed by consideration.

It is easy, given this history, to see how earnest money became tied to consideration for the contract. As “earnest money agreements” morphed over time into true bilateral contracts, the need for earnest money as consideration disappeared. Earnest money itself, of course, did not. The reason it did not disappear can be seen in the modern legal definition of “earnest money: A sum of money paid by the buyer at the time of entering into a contract to indicate the intention and ability of the buyer to carry out the contract.”

Put simply, earnest money is used by buyers today to show sellers they are serious. Signaling to sellers that the buyer is serious about carrying out the purchase is a reasonable business need on both sides of a real estate contract. This, and the vagaries of contract law, explains the survival of the practice of the buyer pledging earnest money in a contract for the sale of real property. It does not, however, explain the manner in which earnest money is handled in the real estate industry today.

The administrative rules promulgated by the Real Estate Agency assume collection of earnest money, in one form or another, by the licensee writing the offer prior to the offer being presented to the seller. Click here to view the applicable administrative rules. Until the advent of buyer agency in the late 1980s, earnest money was collected from the buyer by the seller’s agent. This, in effect, transferred the money from the control of the buyer to control of the seller.

The transfer of control of earnest money to the seller’s agents was not completely consistent with the intent and ability purpose of earnest money. It was, however, completely consistent with the sales industry idea that earnest money should be available to compensate the seller for taking the property off the market, making repairs and otherwise changing position in reliance on the buyer’s intent to purchase. It is this dual purpose – evidence of ability and intent, and source of compensation if the deal fails – that complicates the way earnest money is handled.

In order for this seller compensation purpose to work, the money had to be placed out of the control of the buyer so it was available if the seller became entitled to it. At the same time, earnest money had to be out of the control of the seller so it could be returned to the buyer if the transaction failed through no fault of the buyer. Two solutions to this dilemma quickly evolved. One was for the seller’s agent, or subagent, to place the money in a client trust account opened and operated by the broker. The other was to place the money in escrow as soon as escrow was opened on the contract. Both methods placed the earnest money out of the unilateral control of either party.

Initially, almost all earnest money was kept in broker client trust accounts. This was an extremely efficient way to handle earnest money. There were, however, problems. One problem was what to do about agents holding the money while they waited to see if the seller would accept. Another was the broker getting caught in the middle of a dispute over the earnest money if the deal later failed. The first problem was solved by administrative rules detailing how various forms of earnest money were to be handled. Click here to view the applicable administrative rule. The second problem was papered over for years but never resolved.

The idea that earnest money should compensate the seller if the buyer failed to perform transformed earnest money from a positive indication of financial wherewithal to an a priori measure of damages. Rather than simply an indication of intent and ability to perform, earnest money became the source of funds to pay damages if the deal failed. The shift from a source of confidence in the buyer’s financial position to the source of funds to pay damages is subtle but critical to understanding the modern use of earnest money.

Using earnest money as an a priori measure of damages raises the legal issue of “liquidated damages.” Liquidated damages are the sum a party agrees to pay if the party breaches a contract. Liquidated damages must be a good faith estimate of the actual damages anticipated by a breach. They must be reasonable in light of the anticipated or actual harm caused by the breach. If liquidated damages are set too high, that is if they are unreasonable, they risk being declared a penalty and are not enforceable.

There is no bright line between a reasonable estimate of damages and a penalty. There is a famous Oregon court case where a forfeiture of $50,000 in earnest money on a $500,000 purchase is considered a penalty and not enforced. On the other hand, $5,000 forfeitures on $500,000 properties are routine and rarely contested as penalty. Somewhere between these extremes is the line between reasonable estimate and penalty.

Wherever the line between estimate and penalty may exist, forfeit of earnest money is rarely a simple matter. Although often missed by sellers (and sometimes their agents) the seller has no right to earnest money other than as specified in the contract. There is no general rule that the seller gets the earnest money if the buyer doesn’t perform. Instead, the seller gets the earnest money if the contract pledges the money to the seller under certain circumstances and those circumstances are proved to have occurred.

The circumstances under which a seller may claim earnest money under a real estate contract vary with the contract. It is, therefore, necessary to read the contract to determine the legitimacy of a particular claim to legal entitlement to the money. Reading contracts to determine the validity of a legal claim is the practice of law. Real estate licensees cannot practice law. It is never a good idea for a real estate licensee to advise a buyer or a seller on entitlement to disputed earnest money.

Most earnest money disputes fall within the $10,000 jurisdictional limit for small claims court actions. The sale forms used in Oregon direct claims within the jurisdiction of small claims courts to the small claims court exclusively. Given that most earnest money is now held in escrow where it cannot be released without separate signed instructions from either party, most earnest money disputes end up being resolved by one side or the other simply giving up, or the parties reaching some compromise or a small claims trial.

Small claims courts are county courts, making earnest money disputes strictly local matters. Attorneys are not allowed in small claims court. Filing a small claims action is not free but it is not expensive either. Each county has a separate small claims department but the process is generally standardized across the state. Most counties now have websites that explain the process and even provide copies of the necessary forms.

Earnest money disputes most often involve disagreements over failed contingencies. Disputes arise, for instance, when the seller believes the buyer has not used the inspection contingency correctly, or when the deal fails at the last minute due to financing. Often, these disputes involve serious misunderstandings of the law or assumptions regarding buyer or seller motivation. The inability of real estate licensees to give legal advice makes it extremely foolish for an agent to offer any opinion regarding the likely outcome of a small claims action over earnest money.