Due Diligence Fees: When Are They Refunded?
- Bulletin 2017-V48-1
By Robert A. Patchett, Associate Legal Counsel II
As brokers are keenly aware, the due diligence process is one of the most important phases of a real estate transaction. The standard form Offer to Purchase and Contract (Form 2-T) is used in the majority of residential transactions in North Carolina. The standard form includes a due diligence period which is the opportunity for buyers to fully investigate a property and transaction with only a minimal risk of loss.
The due diligence fee is paid directly to the seller, generally at the time the contract is executed. The amount of the due diligence fee varies between transactions depending on a range of factors, such as the listing price of the home and duration of the due diligence period along with local market conditions. A buyer should also consider the amount of money they can afford to lose if they choose to terminate.
In the course of a successful transaction, the due diligence fee is paid to the seller at the time of contract execution and credited to the buyer at the closing. In the event of an unsuccessful transaction in which the buyer exercises their right to terminate the contract during the due diligence period, the due diligence fee will be retained by the seller. It is important to note that in most transactions, regardless of whether the transaction is successful, the seller will retain the due diligence fee. This outcome makes sense because the purpose of the due diligence fee is to secure a time period in which the buyer can inspect the property and access the transaction without fear of a competing buyer luring the seller away.
The more complicated issues surround the instances in which the buyer demands the refund of the due diligence fee. In standard form 2-T, Paragraph 1(i) states that the due diligence fee is nonrefundable unless the seller materially breaches the contract, the buyer terminates the contract under Paragraph 8 (“Seller Obligations”) or Paragraph 12 (“Risk of Loss”), or in accordance with any addendum attached to the contract.
A buyer may terminate the Offer to Purchase and Contract if a seller materially breaches the contract. A material breach of contract occurs when a party fails to satisfy a material condition or term of the contract. There are some terms of a contract that are not likely to be viewed as material, such as certain seller representations. Representations are important because they provide valuable information to parties but some representations may not rise to the level of materiality. For example, whether the seller has owned the property for one year versus less than one year (Paragraph 7(a)) is likely not material to the transaction. If you believe a seller has materially breached a contract, contact an attorney who can provide legal advice on the matter. In the event a seller materially breaches the contract, the buyer may be entitled to a full refund of the due diligence money, earnest money, and reasonable costs incurred in connection with the buyer’s due diligence. However, this is rare.
A buyer may also terminate the contract and receive a full refund of the due diligence fee, earnest money, and reasonable costs of due diligence, if a seller materially fails to comply with any of the enumerated obligations in Paragraph 8, “Seller Obligations.” Whether a seller materially complies with a stated obligation in Paragraph 8 is a legal question brokers should direct their client to discuss these issues with an attorney before deciding on a course of action.
Paragraph 12, “Risk of Loss” also gives the buyer the right to terminate the Offer to Purchase and Contract and receive a full refund of the earnest money and due diligence fee. Under this paragraph, if “improvements on the[p]roperty are destroyed or materially damaged prior to closing,” the buyer may terminate the contract and receive an earnest money and due diligence fee refund or proceed with the execution of the contract. For example, if a house burns to the ground in a fire, the buyer can terminate the contract and receive a full refund because the seller can no longer perform a material term of the contract. Whether improvements on a property are destroyed or materially damaged will require a legal opinion and, most likely, a determination by an insurance provider.
Finally, a buyer may receive a refund of their due diligence fee if a contract addendum provides for it. Just as actual due diligence fee refunds are rare, contract addendum provisions providing for due diligence fee refunds are also rare. The Contingent Sale Addendum (2A2-T) states in Paragraph 2 that if a seller, in accordance with that addendum, terminates the contract during the due diligence period then the seller must refund the due diligence fee to the buyer. Buyers and sellers may enter into other addenda that may provide for a due diligence fee refund but those provisions must be drafted by the parties or, preferably, by an attorney.
As a general rule, the due diligence fee is paid to the seller at the time of contract formation and is nonrefundable except in the rarest of circumstances. Unless the contract was materially breached by the seller, the seller failed to materially comply under Paragraph 8 of the Offer to Purchase and Contract, the contract was terminated under Paragraph 12 of the Offer to Purchase and Contract, or if explicitly provided for in a contract addendum, then the buyer is not entitled to a due diligence fee refund.
This article came from the May 2017-Vol48-1 edition of the bulletin.