Large Deposits In Land Transactions: Are They Penalties?

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...