What is an option agreement?

An option agreement is a contractual document required when investors and developers purchase land under an option. An option gives the purchaser time to undertake due diligence, secure required funds, and submit any development applications regarding rezoning or subdivision of the land.

Usually prepared by lawyers, with a standard contract for sale annexed to it, an option agreement includes terms such as the agreed purchase price of the land, a commencement date for the option agreement to begin, as well as an expiry date which is the last day the purchaser has to "call" the option.

Under an option agreement, a vendor is referred to as the grantor of the option, and the purchaser is referred to as the grantee.

Assigning or novating grantee rights under an option agreement

It is common for an option agreement to include a term giving the grantee authority to assign or novate their rights held under the option, to a third party. The term sets out how their rights with respect to the land can be assigned or novated.

If an assignment or novation of the right to exercise the option is not done in accordance with the term of the option agreement, there is a risk that the purported assignment or novation will be deemed invalid and unenforceable.

Assignment or novation of rights held under option must be exercised properly

A recent case in the NSW Supreme Court of Appeal called for an evaluation of the assignment and novation requirements under an option agreement which was under dispute, in order to decide whether the option had in fact been assigned or novated. (See Kai Ling (Australia) Pty Ltd v Rosengreen [2019] NSWCA 3.)

The court heard that an option agreement had been entered into by two parties; with the vendor (grantor) granting an option for a company (grantee) to purchase his land.

Some months later, the company's representative presented the grantor with a single document, almost identical to the one contained within the already executed option agreement. However, the original company name had been replaced with a substituted company name as grantee, and already bore two signatures.

The company's representative requested the grantor to sign the new document, noting that it would not alter the option agreement and it merely related to a change of grantee name. The grantor signed the document.

Substitute company contends effective novation of option agreement

The substitute company contended that the option agreement had been effectively novated as a result of the document being signed by the grantor. The company also contended that as a result of the purported novation, they were now the rightful holder of the interest in the grantor's land under the option agreement.

The case was initially heard in the Supreme Court, where it was found that novation did not occur and the substitute company accordingly did not hold any rights in the grantor's land.

The substitute company appealed the decision, reasoning that the grantor was aware that the new single document bore the name of an entity other than the original grantee, and he was also aware that the substitute company had already signed the new single document. The substitute company also claimed that the original company's representative was acting for it when he approached the grantor.

Court of Appeal deems novation of option agreement invalid

The Court of Appeal dismissed the appeal, finding that the evidence did not suggest that the original company's representative was acting as the substitute company's agent. The judge found that the tripartite element required for novation to have occurred was not present in these circumstances.

Also, the fact that the grantor and original company had later entered into a Deed of Variation to the option agreement, suggested that both parties had remained of the view that the original company was the grantee under the option agreement.

Reduce the risk of losing a right of interest under an option agreement

This case illustrates the difficulties a purchaser can face when buying property under an option agreement. It also demonstrates the implications of failing to exercise an assignment or novation clearly and correctly, and in accordance with the terms of the contract.

To reduce the risk of losing a right of interest under an option agreement, proposed substituting grantees need to ensure that any assignment or novation is clearly documented in writing. The technical requirements for all parties must be stipulated by the relevant terms of the option agreement and adhered to stringently.

If another party is attending to the assignment or novation on another party's behalf, the authority of that party and the capacity under which they are involved needs be clearly defined to avoid any doubt.

Failure to exercise an assignment or novation properly can potentially cost a substituted grantee their understood rights. It is highly recommended to seek legal advice for any assignment or novation arrangement under an option agreement.

Zohra Ali
Commercial property
Stacks Champion

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.