What Happens When A Party Defaults?
When Things Go Wrong...
Okay, you've signed a contract, you have your loan, you've been approved by the Board (if it's a co-op)--what happens if the seller refuses to close? What about if you're the seller and the buyer wants to unreasonably delay the closing or simply refuses to close?
Most people (irrespective of business sophistication) are shocked at what happens when a dispute arises in a co-op or condo transaction. Most sellers operate under the misconception that if the buyer defaults, the seller automatically gets to keep the contract deposit. That's simply not the case. Here's the skinny on how typical defaults usually play out.
When Does a Dispute Arise?
Disputes between the parties arise at three key times during a residential transaction:
when a buyer is turned down by a co-op board;
when a buyer is turned down for a loan commitment; or
- when either party refuses to close.
There are many other reasons why a transaction breaks down, but we'll just deal with several of the biggies for the purposes of this conversation.
The Buyer Defaults
If the seller believes that the buyer has not acted in good faith in connection with the buyer's application for approval to the Board of Directors or in connection with the buyer's application for a mortgage loan, the seller may attempt to retain the contract deposit, which is almost always held by the seller's attorney. Unless otherwise specifically provided in the contract, the seller does not automatically retain the contract deposit in such a situation. Once the seller believes that the buyer has defaulted, the seller will give notice to the "escrowee", that is, the party holding the contract deposit (again, almost always the seller's attorney). The seller will demand that the ecrowee release the contract deposit to seller as a result of the buyer's alleged default. The escrowee will then notify the buyer (through the buyer's attorney) of the seller's request, to see if the buyer has any objection. As you may have guessed, most buyers will object and will so notify the escrowee. The net result will be that the seller, even if the buyer has truly defaulted, does not immediately retain the contract deposit.
When a Bank Fails to Fund
A new reality of the market we are living in is that banks can withdraw financing even after a commitment issued. Although buyers should provide for this contingency in the contract, sometimes the contract is silent on this point. When the bank causes the transaction to fail because financing is withdrawn at the last minute, a seller may wish to hold the buyer liable since a mortgage commitment had been issued by the bank. Litigating this point is a slippery slope for sellers, as courts have held that a buyer has not satisfied the mortgage contingency if a bank refuses to fund the loan. If a buyer has acted in good faith and the bank withdraws financing on a technical point or for reasons unrelated to the buyer (like shaky finances on the part of the coop or condo), attempting to hold the buyer in default can be a challenge.
What Happens Next?
Once the escrowee has been notified by one of the parties not to release the contract deposit, unless both parties thereafter reach a settlement, a lawsuit will have to be brought by either the buyer, seller or escrowee, to determine who is entitled to the contract deposit. If nothing is done, the escrowee will continue to hold the contract deposit until someone finally takes action.
Contract Deposit Litigation
Once litigation is commenced, it takes on a life of its own. It will be time consuming and expensive. If the contract deposit is small by today's standards (under $50,000), the cost of pursuing such a claim can be cost prohibitive. In most cases, these lawsuits get settled long before trial, but only after many dollars have been spent on attorneys. What seemed like an open and shut case when the buyer originally defaulted, can get more complicated. The buyer will allege various breaches by the seller, which the court will have to consider. When the buyer is truly in default, the buyer's attorney will try to find a way to bring matters to a close. If the buyer can retain a portion of the contract deposit in such a situation, the buyer will usually not want to fight a losing battle. In most cases, emotions run high at the beginning. People do things for reasons of principle. A year and a half into a lawsuit, each side realizes that fighting for a principle can be costly. In almost all residential real estate contracts the seller's damages are limited to the contract deposit. Unless there is a lot of money at stake, if the buyer decides to defend a contract deposit lawsuit, the seller can quickly find him or herself between a rock and a hard place.
The Seller Refuses to Close
Now, back to my original scenario, you've done everything you're supposed to do, and the day before the closing, your attorney gets that call from the seller's attorney with the bad news--the seller isn't going to close. Having had this experience, I can tell you that conveying this information to the buyer isn't a lot of fun. In most cases, a buyer has lined up a mover or has sold or given up the buyer's present residence and basically has no place to go. It's a mess. So what happens next? If there is no dispute between the parties (in other words, the seller doesn't have a legitimate claim against the buyer), the buyer's remedy will be to commence an action in specific performance, asking the court to enforce the contract and order the seller to close. In most cases, the buyer will be successful in his or her specific performance lawsuit. The real issue, however, is how long will it take and how much will it cost? Such a lawsuit could easily take at least six months to a year to complete and could cost $25,000 to $30,000 in legal fees , or more. Each situation is different so costs can vary. Sometimes when the specific performance action is brought, the reality of the seller's situation kicks in, and the seller will agree to close without continuing the lawsuit. Most sellers don't realize that they will most likely be forced to close if the buyer litigates. The seller's hope is that the necessity for litigation will make the buyer "go away". Sometimes that works...sometimes not.
What About the Broker?
Where the seller refuses to close, the seller will also be vulnerable to lawsuits from his or her real estate broker. Most brokerage agreements provide that the commission is payable only if the transaction closes, except in the case of the seller's willful default. If the seller intentionally refuses to close, a commission may be payable, even though the closing did not take place. If the seller willfully defaults, the seller's liability to the real estate broker for the commission will depend upon whether the broker believes it is economically warranted to pursue the seller. Again, each situation is different.
A Word About Defaults Under Sponsor Contracts
Over the past two years, there have been many defaults and many lawsuits relative to buyers who have changed their minds about going forward with a purchase of a new construction condominium unit. Many of these situations arose because the price of the unit dropped substantially from the contract price agreed to in the purchase agreement that had been signed at the height of the market. In other cases, financing in many of these new developments has dried up or buyers simply no longer have funds available or the ability to arrange financing in order to purchase the apartment. Many disputes have been resolved with reduced purchase prices and compromises on the return of a portion of the deposit. In other cases, buyers looked for technicalities for getting out of their contracts, sometimes successfully. At the moment, there are still many unresolved cases and it is still unclear how sponsors and defaulting buyers will work out their differences. It should be noted that a recent decision by the Federal District Court in New York, on an issue related to the disclosure required by a developer as a part of the Offering Plan, has been decided in favor of the developer. Although many buyers were hoping that a favorable decision would create an escape hatch from their contracts, sponsors may now be successful in retaining deposits that are presently the subject of a dispute or a lawsuit.
Residential Reality: Avoid Litigation, If You Can
Although most folks view a residential real estate transaction as a “win win” proposition, in many cases, when parties litigate a dispute, it often turns out to be a ”lose lose” proposition for all involved. As we navigate through the difficult waters of a shaky real estate market, both sellers and buyers have to consider carefully whether litigation is appropriate when a dispute arises that prevents the parties from closing. At the end of the day, if at all possible, find a solution that each party can live with and move on.