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:

Click here to view the table.

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.