When A Deposit Becomes A Penalty: Relief From Forfeiture In Real Estate Transactions

Canadian common law has long considered deposits in real estate transactions to be in a special class, treated distinctly from penalty clauses in other contracts. Deposits are generally deemed to be a partial pre-payment that a vendor may retain if the purchaser breaches the contract. In rare circumstances, however, courts have departed from this practice and ordered that a deposit be returned to a defaulting purchaser. Vendors in real estate transactions should familiarize themselves with these circumstances to avoid returning a deposit to a defaulting purchaser.

Deposits vs Penalties

Canadian common law generally precludes the operation of penalty clauses in contracts, which would otherwise cause the forfeiture of a predetermined amount following a default. Courts have consistently applied this doctrine since the Supreme Court of Canada's decision in Canadian General Electric Co v Canadian Rubber Co of Montreal, which describes impermissible penalties as any "payment of a stipulated sum on breach of the contract, irrespective of the damage sustained" (at 351).

As described by the British Columbia Court of Appeal in Tang v Zhang, a deposit is an invention of law that motivates parties to a contract to carry out their obligations, establishing a pre-paid amount that the buyer will forfeit if they buyer fails to complete the transaction, without any requirement for evidence of the vendor's damages. In this way, deposits are an exception to the general rule against contractual penalty clauses. The risk of forfeiture means deposits also represent a guarantee or security for ensuring completion of the purchaser's obligations.

While contemporary Canadian decisions continue to affirm deposits as distinct from standard penalties, they have acknowledged that deposit clauses are not immune from judicial scrutiny and in appropriate cases, remedies of relief from forfeiture in the purchaser's favour. In Redstone Enterprises Ltd v Simple Technology Inc, the Ontario Court of Appeal, following the British Columbia Court of Appeal's decision in Tang,  stated that "the deposit constitutes an exception to the usual rule that a sum subject to forfeiture on the breach of a contract is an unlawful penalty unless it represents a genuine pre-estimate of damages. However, where the deposit is of such an amount that the seller's retention of it would be penal or unconscionable, the court may relieve against such forfeiture."

Unlike penalty clauses, the forfeiture of a deposit does not depend on whether that deposit is a genuine pre-estimate of damages. Relying on the UK case of Stockloser v Johnson, Redstone  sets out the applicable factors to be considered in granting relief from forfeiture:

1. whether the forfeited deposit was out of all proportion to the damages suffered, and
2. whether it would be unconscionable for the seller to retain the deposit.

With respect to the first factor, the Ontario Court of Appeal refrained from specifying a percentage of the purchase price at which a deposit becomes grossly disproportionate. Even the absence of evidence that the vendor suffered any damage will not automatically render a deposit amount disproportionate. The British Columbia Court of Appeal in Tang  acknowledged previous decisions finding deposits of 10%-20% as reasonable.

With respect to the second factor, Redstone  set out factors in assessing unconscionability, including: inequality in bargaining power, a substantially unfair bargain, a difference in the parties' sophistication, the existence of bona fides negotiations, the nature of the relationship between parties, the gravity of the breach and the parties' conduct. Unconscionability is rare and will only be established in exceptional cases, but it is possible.

Successful Relief From Forfeiture Cases

In both Tang  and Redstone,the respective courts of appeal overturned a relief from forfeiture granted by lower courts. Conversely, while relatively rare, Ontario courts have sometimes granted relief from forfeiture in the purchaser's favour based on the test above.

In Scicluna v Solstice Two Limited,the deposit for a residential property purchase amounted to 80% of the purchase price before the purchaser entered bankruptcy and was unable to complete the transaction. Shortly after the bankruptcy of the original purchaser the vendor found a replacement purchaser willing to pay a significantly higher purchase price. The Ontario Court of Appeal affirmed the remedy of relief from forfeiture with respect to all but C$30,000 of the deposit, writing that the "substantial disparity between the value of the property forfeited and the damage caused [to the vendor] by the breach is so manifest and so grossly disproportionate that relief from forfeiture is patently a correct result." This decision relies primarily on the first Redstone  factor, proportionality to damages suffered, without much comment on the second Redstone  factor, unconscionability.

In Naeem v Bowmanville Lakebreeze West Village Ltd,  the purchaser bought a residential home from a developer for nearly C$630,000 with a deposit of roughly C$82,000. After the deal fell through, the Ontario Superior Court of Justice held that retaining the deposit was unconscionable largely because the developer's conduct, including misrepresentations made to the purchaser to induce execution of a closing date extension addendum. The purchaser expressed their desire to terminate the purchase agreement and receive their deposit back after being notified of the delayed closing, but the developer indicated that it was not possible and that the purchaser had no choice but to accept the new closing date. In affirming the remedy of relief from forfeiture in favour of the purchaser for the entirety of their deposit, the Ontario Court of Appeal considered the significant gap in sophistication between the parties. The purchaser was a single mother with two jobs going through cancer treatment while the vendor was a housing developer with an in-house legal department. In this case, the relatively standard amount of the deposit, approximately 13% of the total purchase price, was not a barrier to relief from forfeiture. Because relief from forfeiture is an equitable remedy, the conduct of the parties was a relevant consideration before the court. The findings of fact of the lower court were sufficient to find misconduct by the developer and a conclusion of unconscionability, factor two in Redstone.

In the recent case of Pleterski (Re), 2024 ONCA 711, leave to appeal denied, the Ontario Court of Appeal affirmed Redstone while adding a wrinkle to the unconscionability consideration. In this case, the trustee in bankruptcy, overseeing Pleterski's assets in trust, sought to have a deposit paid by Pleterski to a vendor returned in full. Pleterski paid a C$500,000 deposit on a C$5.5 million commercial property. After paying the deposit Pleterski was arrested and charged with fraud in connection with his cryptocurrency business. Bankruptcy proceedings revealed that all of the deposit paid on the property had been misappropriated from funds collected from investors for the purpose of investing in cryptocurrencies. The Ontario Court of Appeal affirmed the grant of relief from forfeiture, partially due to the original property owner being able to turn around and sell the property for more, but also because of the misappropriated funds. The appellant argued that that Redstone  ought to be interpreted narrowly, i.e., only considering Pleterski's actions and position, rather than by the actions and position of the trustee and the creditors in bankruptcy. Citing Redstone, the Court stated “[t]he analysis of unconscionability requires the court to step back and consider the full commercial context.” Both Redstone factors appear to have been relevant to the motion judge's decision and the Court of Appeal's affirmation. The vendor found an alternative purchaser at a higher purchase price than Pleterski had agreed to pay. Thus, the forfeited deposit amounted to a windfall for the vendor and the deposit was disproportionate to the damages suffered. The innocent nature of Pleterski's victims, as creditors in the bankruptcy proceedings seeking to recover a portion of their losses from the deposit, appears to have weighed towards the second factor in Redstone. While the vendor was also an innocent party, the motion judge appeared to find that the balance of equity favoured of the creditors, and the Court of Appeal expressed no error in this finding.

Conclusion

While remedies for relief from forfeiture of deposits are uncommon, they do arise. Case law suggests that the factors described in Redstone  arenot treated by courts as a two-step test, requiring both parts to weigh in favour of relief, but rather as distinct factors, either of which or both may weigh in favour of relief from forfeiture. In Scicluna,  avast disparity between the 80% deposit forfeited and the damage (or lack thereof) suffered by the vendor was sufficient to justify relief, even absent any express finding of unconscionability. Conversely, in Naeem, the findings of a disparity of sophistication between the parties and the vendor's misconduct were sufficient to justify relief, notwithstanding the absence of any finding of a disparity between the deposit and the damages of the vendor. Pleterski  refers to both factors: the existence of a disparity between the deposit and the damage suffered by the vendor and the indicia of unconscionability in the nature of innocent victims of the purchaser's fraud. While these cases were all decided in Ontario, courts in other provinces have applied the factors in Redstone  when refusing to grant relief from forfeiture.

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.