UK: Large Deposits In Land Transactions: Are They Penalties?

Last Updated: 10 December 2014
Article by Tim Foley

It is customary for sellers of land to take a deposit of 10% of the purchase price upon exchange of contracts. The deposit is treated by the common law as an "earnest of performance". If the buyer fails to complete then the seller may terminate the sale contract and keep the deposit. However in recent times it has become fashionable, particularly for developers of high-end residential developments, to require deposits of 20% from their purchasers. Might it be that such deposits, double the conventional percentage, are vulnerable to being struck down as penalties?

It is common for parties to a contract to agree that, in the event of breach, the guilty party will pay his counterpart a pre-agreed sum of money by way of liquidated damages. A liquidated damages clause is a useful tool. Since the sum is due as a matter of contract and without any enquiry as to actual loss, it avoids the risk and expense of proving loss, the risk of under-compensation and also questions of remoteness of damage.

However it is possible to over-egg the pudding such that, what might have been a liquidated damages clause in fact takes effect as an unenforceable penalty. Nearly 100 years has passed since the House of Lords gave guidance on the issue in Dunlop Pneumatic Tyre Co v New Garage and Motor [1915] AC 79. A genuine pre-estimate of loss will give rise to liquidated damages, whereas an obligation to pay a sum that is intended to deter breach, rather than compensate likely losses, will be struck down as a penalty. In such a scenario the innocent party is restricted to recovery of actual losses rather than the (often higher) penalty sum.

Workers Trust: an unreasonably large deposit is a penalty

In Workers Trust & Merchant Bank Ltd v Dojap Investments [1993] AC 578 the Privy Council heard an appeal that concerned the sale of property by the Workers Trust Bank to Dojap Investments for some USD 11.5 million. The contract provided for a payment of 25% of the contract price upon exchange (USD 2.875 million) and the balance within 14 days. Dojap failed to complete and the Bank terminated the contract and forfeited the deposit. Dojap issued proceedings to obtain relief from forfeiture of the deposit. Lord Browne-Wilkinson stated as follows:

"In general, a contractual provision which requires one party in the event of his breach of the contract to pay or forfeit a sum of money to the other party is unlawful as being a penalty, unless such provision can be justified as being a payment of liquidated damages being a genuine pre-estimate of the loss which the innocent party will incur by reason of the breach."

The Court held that 25% was unreasonably large. As such Lord Browne-Wilkinson said that "since the 25% deposit was not a true deposit by way of earnest, the provision for its forfeiture was a plain penalty".

So the message following Workers Trust was clear: sellers who wished to extract and keep deposits of greater than 10% should be ready to explain the reasons why the parties' contemplated losses might be greater than 10% at the time that the bargain was made. If they could do that then the deposit may be retained, but not otherwise.

Amble Assets: an unreasonably large deposit is not a penalty

In Amble Assets LLP v Longbenton Foods Ltd [2011] EWHC 3774 (Ch) the High Court refused to follow Workers Trust and reached a different conclusion. Amble Assets concerned the sale by an administrator of a building plus some equipment with a deposit of 59.6% of the price paid in two tranches. The purchaser (Longbenton) failed to complete and the administrator of Amble Assets terminated the sale contract and retained the deposit.

Longbenton submitted, in reliance on Workers Trust, that the deposit was plainly a penalty. It said that a provision could be a penalty whether it required payment of a sum or forfeiture of a sum already paid (note that is precisely what Lord Browne-Wilkinson had said in the quotation set out above: "pay or forfeit").

The Court disagreed and declined to follow Workers Trust which, in the Court's view, ignored the difference between the legal treatment of loss of sums paid prior to a breach (properly characterised as a forfeiture) and sums payable in consequence of a breach (potentially a penalty, subject to the question of pre-estimate of loss). The treatment of each is summed up as follows:

Penalties

The question of whether a provision is a penalty is a matter of construction of the contract to be judged at the time the contract is made. This asks whether the requirement for payment on breach is intended to deter breach or whether it is a genuine pre-estimate of loss. If it is the former then the provision is a penalty and is enforceable only to the extent of actual loss (Dunlop). The rule is mechanical and does not involve an exercise of discretion. If the provision is not a penalty then the only basis for the court to order return of the deposit is statutory, under section 49(2) Law of Property Act 1925. A statutory power that is rarely invoked.

Forfeiture

This rule looks at the position at the time of breach when the forfeiture takes effect. The equitable remedy of relief from forfeiture applies and will be granted, in the Court's discretion, if it appears unconscionable for the forfeiture to take effect.

It is perhaps unsatisfactory that penalties and forfeiture are governed by different principles when their effect is so similar, but the distinction is clear and based upon authority. The fact that unreasonable deposits are not liable to being stuck down as penalties does not give the green light to excessively large deposits. The equitable right to relief from forfeiture will operate as a significant (and flexible) brake upon a developer that clearly goes too far and seeks to forfeit where it would be unconscionable to do so. However the hurdle is not an easy one to clear. The concept of unconscionability denotes an outcome that is so manifestly unfair that the Court cannot stand idly by and allow the forfeiture of the deposit to stand.

So where does that leave a 20% deposit? In the context of a freely negotiated contract, with both parties having the benefit of legal advice (as is usually the case in a property transaction), in the writer's view the Court is unlikely to intervene. If a deposit of 10% is so usual that nobody would seek to characterise it as anything other than an earnest of performance, what is it about a deposit of 20% that makes it so repugnant? Clearly there is a line to be drawn between an 11% and 99% deposit but 20% would seem too low, especially if the market is moving in the direction of 20% deposits.

A distinction without a difference?

The best way to avoid relief from forfeiture is to consider, upon exchange of contracts, the particular features of the transaction that would make forfeiture of the deposit fair. Perhaps the buyer is based abroad? Is there a long gap between contract and completion? Is there a risk of buyer's insolvency? How easy would it be to successfully re-sell in an uncertain market? These factors can be ventilated in legal correspondence so that the Court can be sure at a later stage that everybody was on the same page. That mental exercise is not, in practical terms, any different from a genuine pre-estimation of loss that would save a liquidated damages clause from being struck down as a penalty. As such whether one follows the analysis in Workers Trust or Amble Assets, the advice is likely to be the same and, in practical terms, the distinction is one without a difference.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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