Non-refundable deposits - what’s the problem?

Real Estate monthly digest pebbles

  • Submitted 28 September 2018
  • Applicable Law UK (England & Wales)
  • Topic Real Estate

Overview

In a difficult and uncertain real estate market some participants can search for novel solutions. In the UK market there is an inherent, but usually accepted, risk that there is no certainty to conclude a transaction until formal exchange of contracts. So, what happens in the interim, between agreeing heads of terms and a formal exchange of contracts? For the seller there can be concerns over whether a buyer is really capable of delivering on the transaction, what happens to the other bidders that may be lost in the meantime, what about wasted costs etc.

One solution that can sometimes be suggested is a non-refundable deposit - an amount to be paid on signing heads of terms and granting exclusivity which will not be repaid if the transaction does not result in a successful exchange. This is not something that a buyer would agree to lightly but if they are so keen on securing the transaction they could be tempted.

The concept of a non-refundable deposit (in the true sense of that term) to secure a real estate investment transaction can only work if the party paying the deposit is prepared to lose that money even though they might be blameless for the transaction not completing. If the deposit paying party cannot accept that risk then the deposit will be a refundable deposit.

By the time the parties have appropriately addressed the scenarios in which the deposit is refundable the chances are they will have lost days if not weeks in the process, ended up with an arrangement which neither side is entirely content with (creating tension between the parties that hardly sets them off on the right footing for the forthcoming negotiations on the main transaction itself) and, potentially, additional costs that are unlikely to warrant the aggravation.

In short, a non-refundable deposit can seem a good idea in principle but is either bound to fail or leaves one, if not both parties in an unsatisfactory position.

Why would parties look to a non-refundable deposit?

A property seller can be justifiably concerned that the proposed buyer will fail to perform and in the process they will faced wasted costs, management time and worse still the other bidders may have moved on (or if you return to them they may not be prepared to transact on the same terms). In that situation a seller can be tempted to demand a non-refundable deposit. Similarly, a potential buyer can be tempted to secure the deal by accepting or even volunteering an unsolicited non-refundable deposit.

In practice, what are the challenges?

In most real estate transactions there can often be no or at best limited legal, technical or tax due diligence undertaken before heads of terms are agreed and the real work starts. There are also the detailed terms of the sale and purchase documents to settle with plenty to potentially fall out over. Even in a well managed quasi-auction process where bidders are expected to review detailed due diligence materials and provide a mark up of the sale and purchase documents there usually remains some important matters to be settled. The deal is not done until formal exchange of contracts.

In addition, given the prevalence of SPVs there can often be a practical issue of which entity on the buyer's side will actually be used to enter into the non-refundable deposit agreement? The SPV is unlikely to be set up until close to the formal exchange of contracts, so that tends to be yet another hurdle that takes time to overcome.

Taking the concept of a non-refundable deposit to its logical conclusion, if the parties were so confident that there was adequate due diligence already completed and nothing left to negotiate in relation to the sale and purchase documents then why wouldn't the parties simply go straight to contract and formally exchange? If there are other things to be dealt with (eg funding to be put in place) then a formal exchange subject to conditions precedent would be a more appropriate option than a non-refundable deposit agreement.

A seller who is keen to get to a swift exchange of binding contracts can often find they have wasted time - sometimes days, if not weeks - seeking to settle terms on the deposit and that can play into the hands of the buyer who might be looking to give themselves more time to organise their own affairs and put some distance between the seller and other bidders. Indeed, sometimes buyers can deliberately hide behind the deposit negotiations for this very reason.

When the concept of a non-refundable deposit arrangement is being considered, often the following issues, once raised, can quickly lead to the idea unravelling and the proposal being dropped:

  • If there is missing due diligence information (identified or otherwise) and:
    • once obtained that information is adverse to value or creates other issues;
    • that information cannot be provided within the timescale expected,

then who should take the deposit risk? If the transaction does not proceed because of that information should the deposit be refunded or not? If it is information that is "adverse" what does that mean? If it needs to be ‘material’, what does that mean? Materiality or due diligence issues can often be subjective.

  • What happens if there is a falling out over the terms of the sale and purchase documents? Applying some sort of reasonableness test is just a recipe for further argument. Under English law there is no general duty to negotiate in good faith and it is not possible to enforce and “agreement to agree”. Parties usually reach a sensible compromise on terms because of their overriding desire to conclude the transaction. If the buyer risks losing a deposit over what they think is a perfectly reasonable position they are then compromised and risk having to concede on points that the seller is, arguably, being unreasonable about. For example, if there is a patent defect in title that is identified and the buyer's position is that the seller should resolve it or take out an indemnity insurance policy at its cost - who is right in that scenario?

  • Timing would need to be agreed - a deadline by which if a formal, binding agreement has not been exchanged then the deposit will have to be released to the seller or buyer. How long should that time period be? Parties rarely stick to the timescales set out in heads of terms, because they were never realistic, or unexpected information comes to light that needs more time to assimilate, or due diligence information is not disclosed as promptly as expected (which may or may not be the seller's fault). Should the buyer put themselves at risk of losing the deposit because the deal hasn't been exchanged by a particular date when the cause may be of no fault of theirs? Or more likely, it is a combination of factors where both parties could be criticised for delays.

  • From the buyer's perspective, they may well need to finalise terms for the equity and/or debt arrangements. At the time of agreeing to sign heads of terms these are often, at best, loose, in principle only commitments with plenty of work left to do before funding is certain. If that cannot be concluded there could be a host of reasons why. It is simply not feasible for the parties to cater for allocating risk for each of those innumerable reasons as to what then happens with the deposit.

Are there any other options?

Earnest payments or refundable deposits to demonstrate good faith and commitment to a transaction are a different thing. In these arrangements the buyer is asked to deposit with either their own solicitor or the seller's a sum which is a gesture to demonstrate (a) they have substantial funds available and (b) they are prepared to go to the trouble of transferring the money into a solicitors client account - and why would they do that if they weren't committed to the transaction. From a legal perspective it achieves nothing - it is an entirely refundable "deposit" (it is not actually a deposit at all in the true sense of that word in this context) but there is potentially some commercial value for the seller.

Another variation on this theme is an abortive costs agreement. One party may be sufficiently wary of the other's ability or willingness to complete the transaction that they are only prepared to proceed with the transaction if the other party covers their abortive costs. This is a more sensible option than a non-refundable deposit and one that is more equitable. That said, the buyer should, in any event, be suffering its own wasted costs if the transaction is unsuccessful so to also bear the seller's wasted costs may not seem that fair.

Comment

One of the great benefits of the legal system in the UK is its flexibility and the degree of freedom of contract - the ability to contract on terms with very little intervention from government statute. So, it is technically possible to document a non-refundable deposit agreement but the point is that it is very likely to be a flawed arrangement commercially, often wastes time and is usually futile with the parties abandoning the idea as soon as their advisors start to negotiate the detailed terms of such an agreement.

Indicators of when a non-refundable deposit is a bad idea:

  • The buyer needs to set up an SPV and that will not be available for some time
  • It is not clear how the buyer (and those parties funding the buyer) will fund the deposit
  • There are no draft sale and purchase documents or those that have been drafted have not be settled or are incomplete
  • The amount of the deposit is insufficient to warrant the time and cost involved in negotiating the terms of the non-refundable deposit agreement
  • Timing is uncertain for both parties - particularly if further due diligence is required as part of the process
  • Specifically, in relation to due diligence:
    • Minimal due diligence has been completed; or
    • Some key areas of due diligence have not been completed; or
    • Due diligence material provided is not up to date.

This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.