Earnest money is a critical part of real estate sales. The collection, retention and disbursement of earnest money is something every real estate agent must understand and deal with. The subject is fraught with peril for the unwary agent. Disputes between buyers and sellers over earnest money are common and brokers are often caught in the middle. The use of checks and promissory notes further complicate the handling of earnest money.
A number of state laws and rules dictate the handling of earnest money from initial collection to final disbursement. The rules are arcane, complicated and not altogether consistent. Practices have grown up in the industry which complicates the handling of earnest money even more. All these factors work together to make earnest money a complicated subject.
Statutory Provisions Involved
ORS 696.241 Clients' Trust Accounts; notice to agency; authority to examine account; branch trust account; interest earnings on trust account; when broker entitled to earnest money; funds not subject to execution; rules. Click HERE for an explanation of the statute.
Explanation of Statutory Provisions
ORS 696.241 is the state statute that controls broker client trust accounts. As such, it implicates the collection, holding and disbursement of earnest money. Under ORS 696.242(1), each principal real estate broker must maintain in the state a clients' trust account in which all trust funds received from clients must be deposited, unless the parties agree in writing to place the funds directly in escrow. If the parties do agree to place the funds directly into escrow, the licensed escrow must be in Oregon.
It is not hard to see the impact of ORS 696.241 on earnest money practices. The law demands deposit of earnest money received or handled by a real estate licensee in a clients' trust account or, with the written agreement of the parties, into a licensed neutral escrow depository. There are no other choices. The statutory requirement immediately raises the issue of how long an agent can hold funds before they must be deposited as required under the statute. It also raises the issue of whether it is "better" to put earnest money into a client trust account or directly into escrow.
Whether to place earnest money directly into escrow is a business issue discussed in the Understanding Earnest Money section of this subject. The time an agent can hold earnest money is handled by administrative rule and is discussed in the Administrative Rules Affecting Earnest Money section of this subject. These holding rules depend upon the form of the earnest money: for instance, earnest money in the form of a check or a promissory note or cash.
Whatever the form of the earnest money, the single biggest issue with earnest money is always who gets it when the deal fails. This issue has plagued real estate brokers for years. It is for that reason that ORS 696.241 was amended by the Legislature in 2005 to require that the Real Estate Agency establish a procedure for the disbursal of disputed funds held in client trust accounts. See ORS 696.241(10).
According to the statute, the administrative rule must allow for disbursal to the person who gave the broker the money within 20 days of a request for disbursal. The disbursal, however, does not affect entitlement to the money. In effect, the Legislature directed the Real Estate Agency to develop a procedure by which brokers could move disputed earnest money out of their client trust accounts in an expedited manner. The Real Estate Agency responded with OAR 863-015-0186, an administrative rule to accomplish the legislative mandate. The rule is discussed in depth in the Administrative Rules Affecting Earnest Money section of this subject.
ORS 696.243 ORS 696.243 is a relatively new provision of real estate law made necessary by modern electronic banking practices. Under the statute, real estate agents who are required to maintain canceled checks used to disburse money from a licensee's clients' trust account may substitute a copy of the original canceled check with an optical image or other process that accurately reproduces the original or forms a durable medium for reproducing the original. In addition, brokers and property managers may use electronic fund transfers for the deposit into or for withdrawal from a clients' trust account established under ORS 696.241. The statute was thought necessary to authorize modern banking practices and has no substantive effect on earnest money rules.
ORS 696.581 ORS 696.581 is the state law under which escrow is opened and closed. Two provisions of the law affect earnest money. According to the statute, an escrow agent may not accept funds in any escrow transaction without dated, written escrow instructions from the principals to the transaction or a dated executed agreement in writing between the principals to the transaction. Typically, escrow is opened on a dated executed agreement in writing in the form of a sale agreement. It is for this reason that how earnest money is to be handled, if it is to go to escrow, must be detailed in the sale agreement itself.
The second way ORS 696.581 affects earnest money is in its disbursal. An escrow agent may not close an escrow or disburse any funds or property in an escrow without obtaining "dated, separate escrow instructions in writing from the principals to the transaction." This provision effectively traps earnest money in escrow if there is a dispute. That is the case because escrow can release the earnest money only if the parties separately agree to that result, unless earnest money is to be released pursuant to a court order.
Because ORS 696.581 requires "separate" signed written instructions, there is no way to have an a priori agreement regarding the disbursal of earnest money. Thus, a provision in a sale agreement that dictates who will receive the earnest money under what circumstances is ineffective if the parties to that agreement refuse to sign separate disbursal instructions in escrow.
The effect of ORS 696.581 is seen in commonly used termination agreement forms. A significant part of such agreements are the escrow cancellation and disbursement instructions. On the form, the parties agree to the disbursal of the earnest money. Notwithstanding agreement to disburse the funds, the parties also "mutually agree to sign any further documentation, including a release of Escrow for making the above disbursement reasonably required by the Principal Broker or Escrow."
One of the "further documents" is the separate instructions required by ORS 696.581. Thus, the release of earnest money from escrow remains in doubt even after the parties have signed a termination agreement. These matters are discussed further in the Understanding Earnest Money section of this subject.
Administrative Rules Affecting Earnest Money
Explanation of Administrative Rules Affecting Earnest Money
OAR 863-015-0135 is the administrative rule the Real Estate Agency has developed to dictate how real estate licensees will handle offers to purchase. Among the provisions of the rule, is language dealing with earnest money. Under OAR 863-015-0135(5), the type of earnest money, whether in the form of cash, a check or promissory note must be stated in the "document serving as the earnest money receipt."
In the old days, buyers were given a separate "earnest money receipt." Over time, these "receipts" became part of "earnest money agreements." Today, the "document serving as the earnest money receipt" is the sale agreement form. The requirement contained in OAR 863-915-0135(6) is incorporated into the sale agreement in the form of a "receipt for earnest money" clause.
Further, OAR 863-015-0135(7) requires that if a promissory note is used for earnest money, "a licensee must make the note payable upon the seller's acceptance of the offer or payable within a stated time after the seller's acceptance." This requirement is based on the legal requirement that promissory notes must be due at a "time certain." Making a note "due on closing" violates the rule because "closing" is not certain to happen. There are endless variations on the contingent due date theme. This and other problems associated with the use of promissory notes are covered in the Understanding Earnest Money section of this subject.
The Real Estate Agency has also seen fit to admonish licensees in OAR 863-015-0135(7) that "absent a written agreement to the contrary, the note must be made payable to the seller" This advise is based on the fact that a note can be enforced only by its "holder." The holder of the note is the person the note is made out to or the person a previous holder has transferred the note to.
OAR 863-015-0135(7) says the seller is ordinarily the holder of a note for earnest money. The "in the absence of a written agreement to the contrary" language accommodates an industry tradition of having the note made out to the broker. This tradition is facilitated in commonly used note forms. The utility and wisdom of this practice is discussed in the Understanding Earnest Money section of this subject.OAR 863-015-0186 OAR 863-015-0186 is a provision of real estate law concerning disbursal of disputed funds held in a client trust account. The rule is a direct response to the problem of earnest money being held hostage by the seller when a buyer backs out of a transaction. Prior to enactment of this rule, brokers were often dragged into nasty disputes between buyers and sellers over who was entitled to the earnest money when a deal failed. Such questions are legal questions and, therefore, beyond the expertise of a real estate broker. OAR 863-015-0186 acknowledges this reality and forces the parties to either settle their differences by mutual agreement or initiate legal action within a short period of time after a dispute arises.
Under OAR 863-015-0186, a real estate broker may disburse disputed funds (typically earnest money) held in their client trust account simply by giving notice to both parties and waiting twenty (20) days before returning the money to the buyer. "Disputed funds" are funds delivered to the broker pursuant to a written contract and the parties dispute entitlement under that contract. Disbursal under the rules is completely discretionary with the broker who remains free to hold or disburse the funds as they might have before OAR 863-015-0186 was enacted.
In order to use the new rules, the broker must, as soon as
practicable after receipt of a demand for the disbursal of
deliver written notice to all parties that a demand has been made
and that such
funds may be disbursed to the party who delivered the funds to the
20 calendar days of the date of the demand. The form of the notice
to be given
is set out in the rule and must include a warning that the broker
authority to resolve the dispute and that the funds will be
disbursed unless the
parties reach agreement or initiate legal action within 20 days of
the date of
demand. Both parties must be warned to seek legal
advice. Oregon Real Estate
Forms publishes a form for brokers to use.
Dispersal of earnest money under this rule does not affect anyone's legal claim to the money. There is no requirement that brokers use this procedure but if they do, their responsibility for the earnest money is ended. The rule applies only to disputed funds and does not prevent disbursement of funds in other situations or prevent brokers from handling disputes in other lawful ways, including filing an interpleader action. The provision is simply a way to prevent disputed earnest money from being held hostage in broker client trust accounts.
OAR 863-015-0255 OAR 863-015-0255 is the Real Estate Agency's records rule. Records include records for the broker's client trust account. Because earnest money often ends up in a client trust account, many of the provisions of the rule affect the handling of earnest money. Earnest money ends up in client trust accounts because under OAR 863-015-0255(3) a real estate agent must transmit to their principal real estate broker any money, checks, drafts, warrants, promissory notes or other consideration that comes into their possession. Once money is in the principal broker's possession, ORS 696.241 forces the principal broker to put it in the client trust account unless provisions have been made for direct deposit to escrow.
Earnest money can be deposited directly to escrow only if the office has a written company policy to that effect, or the parties agree in writing to that result. Almost all brokers have written company policies allowing direct deposit in escrow. Standard contract forms universally contain provisions for deposit directly to escrow. It is, therefore, common in Oregon for earnest money to be deposited directly in escrow. Indeed, it is believed that less than half of all brokerages even have client trust accounts. Trust account or not, the real estate broker is still required to track the earnest money deposit from the buyer to the escrow depository.
When earnest money is not directly deposited in escrow, holding onto the money becomes an issue under OAR 863-015-0255. If a check is used as earnest money, the real estate broker may hold the check until the offer is accepted or rejected if the sale agreement used allows that and states where and when the check will be deposited upon acceptance of the offer. Form contracts in common use in Oregon contain the necessary language for holding earnest money checks until acceptance. However, once there is acceptance, the check must be deposited into a clients trust account or escrow "before the close of the third banking day following acceptance of the offer or a susequent counter offer"
If a promissory note is used for earnest money, the broker must record and track the transfer of the note by a ledger account or by other means including, but not limited to, written proof of transmittal or receipt retained in the real estate broker's offer or transaction file. The use of promissory notes for earnest money is now the most common way earnest money is handled in Oregon. That practice is not without its difficulties, many of which are discussed in Understanding Earnest Money.
Understanding Earnest Money
Earnest money has been part of real estate sales for longer than anyone can remember. It is, therefore, surprising how poorly earnest money is understood 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 felt 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 $5000 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 parties, most earnest money disputes end 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 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.