Buyers unwilling to complete on new-build flats in London’s subdued residential market may have the right to have their whole deposit returned.
Deposits taken over the 10% threshold for new-build property could be deemed an illegal penalty and returned to defaulting buyers. For developers that use the cash from deposits to progress schemes this could be devastating, for buyers that perceive the market to have dropped since they agreed their purchase, it could be a vital loophole.
Developers and lenders are now seeking legal advice.
Much of the residential pre-sales market in London requires deposits of 25% and above. Normally, were a buyer to default, this would be kept by the developer.
However, new legal rulings have found this could be classified as an excessive penalty, and that were a buyer to challenge it, they could be due a refund.
“The recent ruling of the Supreme Court in Cavendish v Makdessi has put the ability of sellers who take deposits of more than 10% at risk of having to repay all of them to a defaulting purchaser, even if the purchaser is wholly at fault,” says John de Waal QC.
What the ruling said
Supreme Court judge Lord Hodge summarised in the Cavendish Square Holding BV v Makdessi case: “I conclude that in both English law and Scots law (a) a deposit which is not reasonable as earnest money may be challenged as a penalty and (b) where the stipulated deposit exceeds the percentage set by long-established practice the vendor must show special circumstances to justify that deposit if it is not to be treated as an unenforceable penalty.”
Under the ruling, developers would have to return the entire deposit, not just the excess.
That key case comes from late 2015, but is only now beginning to ring alarm bells. It was based on the payment of fees for a broken contract, and established that if a fee is extravagant and unfair it is a penalty and can be recovered by the person breaking the contract.
The case itself concerned a commercial contract, with Talal El Makdessi selling a stake of his advertising group to Cavendish, and being required not to engage in competing activities. He alleged clauses in the contract were penalties and not enforceable. A separate case at the same Supreme Court ruling was related to an “overstaying” fine levied at a car park.
The Supreme Court rejected both penalty claims, but still clarified the rules on penalties, and while neither are related to real estate, the principles set out in both cases apply across the board.
“If the sum you have taken by means of a deposit is a genuine estimate of your loss, then there is the possibility a court would decide you can keep it,” says Pamela Hynes, residential conveyancer at Addleshaw Goddard.
The ruling is an update on Workers Trust & Merchant Bank Ltd v Dojap Investments, dating from 1993. Essentially, a bank selling a property at auction took a deposit of 25%, rather than the customary 10%, and was ordered to return the full amount.
Deposits around London |
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Scheme | Developer | Completion (est) | Reservation fee] | Deposit | Balance at completion |
West End Gate, W2 | Berkely | Q2 2020 | £5k up to £1m, £10k up to £2m, £20k over £2m | 20% less res fee on exchange, 10% after six months | 70% |
The Dumont, Albert Embankment, SE1 | St James | Q2 2020 | £2k – £10k | 10% on exchange, 10% after six months, 10% after 18 months | 70% |
Cooper’s Loft, Ram Street, SW18 | Greenland Group | Q4 2017 | £2k | 10% on exchange, 10% after 12 months | 80% |
21 Young Street, Kensington, W8 | Grainger | Spring 2018 | £5k to 2.8m, £10k above | 10% on exchange less reservation, 10% after 12 months | 80% |
Electric Boulevard, Battersea Power Station | BPSDC | 2020 | £5k | 10% on exchange, 10% Sept 2017, 5% Sept 2018 | 75% |
Rathbone Square, W1 | Great Portland Estates | Q3 2017 | £5k | 10% on exchange, 10% after 12 months, 5% after 18 months | 75% |
The Corniche, Albert Embankment, SE1 | St James | Q4 2017 | £5k | 10% on exchange, 10% after 12 months | 80% |
Principal Tower, Upper House, EC2 | Brookfield | Mid-2018 | £5k | 10% on exchange, 10% after 12 months | 80% |
The Music Box, Union St, SE1 | Taylor Wimpey | £5k up to £1m, £10k over | 10% on exchange less reservation, 5% after 6 months | 85% | |
Kings Cross Quarter, N1 | Argent | 43344 | 2500 | 10% on exchange less reservation, 5% after 8 months, 5% at 16 months | 80% |
Vista, Queenstown Rd, SW8 | Berkeley | Q3 2017 | £5k up to £1m, £10k over | 10% on exchange, 10% six months after, 10% 12 months after | 70% |
The Ram Quarter, Ram Street, SW18 | Greenland Group | Q4 2017 | £2k | 10% on exchange, 10% after 12 months | 80% |
The Atlas Building, EC1 | Rocket Investments | Q2 2019 | £2k up to 1m, £5k over | 10% on exchange, 10% after 12 months | 80% |
Elephant Park, West Grove, SE1 | Lendlease | Up to Q1 2019 | £2.5k | 10% on exchange less reservation, 10% after 12 months | 80% |
South Quay Plaza, E14 | Berkeley | 2022 | £2.5k for studios and one beds, £5k for two and three | 10% on exchange less reservation, 10% after 12 months, 5% after | 75% |
The Timberyard, Deptford, SE8 | Lendlease | Q1 2019 | £2.5k | 10% on exchange less reservation, 10% after 12 months | 80% |
The Madison, E14 | LBS Properties | Q4 2019 | £2k up to 1m, £5k over | 10% on exchange less reservation, 10% after 12 months | 80% |
The Residence, 40-42 Ponton Road, SW8 | Bellway | 2018-2019 | £2k | 10% on exchange less reservation, 10% after 12 months | 80% |
The Taper Building, Long Lane, SE1 | Shape/Peveril/Boultbee | Q4 2017 | £2.5k up to 1m, £5k over | 10% on exchange less reservation, 10% after 12 months | 80% |
Aykon London, SW8 | Damac | Q4 2019 | £5k | 10% on exchange, 10% after 12 months, 5% after 18 months | 75% |
Woodberry Down, N4 | Berkeley | Q3 2017 | £2.5k for studios and one beds, £5k for two and three | 10% on exchange less reservation, 10% after 12 months, 5% after 18 months | 75% |
Source: JLL development sales
Levels of deposit have crept up over the past decade as both developers and lenders on schemes look for more certainty from their buyers.
“The comfort sought by a developer and their funding partners has become more important,” says Dominic Grace, director of residential sales at Savills.
“Rewind the clock 20 years ago, 10% was the norm, now in recent years the 10% on exchange is followed by 10% a year later. That is to give everyone comfort that the buyer is well and truly locked.”
This, and the ruling, has become troublesome since jitters have entered the London new-build market.
“It’s perhaps a pretty dry point of law, but one that is now becoming of greater interest and may take on even more importance,” says Jonathan Northey, partner at DLA Piper.
“It’s not something that would probably be questioned in a rising market, but when economic circumstances change, that’s when you might see someone potentially challenging this.”
For the moment, while there has been some discomfort in London’s new-build residential market, there is no danger of a large crash and large numbers of defaults. However, after the 2008/09 fall, levels of default were anecdotally between 20% and 30% of buyers.
More of a risk could be investors looking for an excuse to leave, perhaps because of the inherent risk now in the London market following the EU referendum or to recoup cash due to currency shifts.
A further complication is that returning that funding could be difficult. Anything over 10% should not be used by developers for build out, but returning all of the deposit will be complicated depending on how financing, and different vehicles for buying assets such as SPVs, have been arranged.
“When I act for buyers, I advise not to [go above the 10%], because they should be cautious regarding the finances of the developer, and generally under the warranty scheme offered by the developer only up to 10% of the price is protected under the scheme,” says Hynes.
“My concern is from the buyer’s perspective, and I would want the amount over 10% held by solicitors.”
What could happen now?
If a buyer were to be successful in recouping their deposit using this ruling there is the potential for a precedent to be set and the floodgates to open, thus the reason developers and lenders have started taking legal advice.
“In that type of market [rising], you will probably not get to the stage where you cannot complete,” says Northey.
“But once the market starts to dip and you find you cannot flip anything on, and you are not able to complete, you will find that’s when people start exploring every avenue to get that 25% back.”
According to de Waal, the process awaits a test case. But there is enough concern already for developers to consult on it.
Wider macro shocks could have an impact on the performance of the residential market, as could new regulations – for instance it is unclear how the new cap on Chinese capital – $100,000 a year – will affect completing buyers.
Currency plays may also have some impact. Despite London property value increases over the past few years, buyers from China and the dollar-pegged countries, which include the Middle East, have all essentially lost money, due to the strength of their own currency,
“To be perfectly frank, if I had been acting for any of these people during the recession where they had paid a deposit exceeding 10% of the price and the person was not in a position to complete the purchase due to lack of available funds, I would have said its worth going for a punt,” adds Hynes.
House price growth % | 2017 | 2018 | 2019 | 2020 | 2021 | (2017-21) |
---|---|---|---|---|---|---|
Central London developments | 0 | 1 | 2.5 | 6.5 | 5 | 15.8 |
Greater London | 1 | 2 | 3 | 5 | 7 | 19.2 |
UK | 0.5 | 1 | 2 | 4 | 5 | 13.1 |
Rental growth forecasts % | 2017 | 2018 | 2019 | 2020 | 2021 | (2017-21) |
---|---|---|---|---|---|---|
Central London developments | 1 | 1 | 3 | 3.5 | 4 | 13.1 |
Greater London | 2.5 | 3.5 | 4 | 4 | 4.5 | 19.9 |
UK | 2.5 | 3 | 3.5 | 3.5 | 4 | 17.6 |
Source: JLL
Opinion: Deposits and penalty clauses
So what is too high, and what are special circumstances? There is no decision yet in England or Wales where the courts have answered that particular question, but there are decisions from other jurisdictions which are relevant.
In a Jamaican case, Workers Trust & Merchant Bank Ltd v Dojap Investments Ltd [1993] 2 WLR 701, a bank which had sold a property at auction taking a deposit of 25% – more than the customary 10% -17.5% – was ordered by the Privy Council to repay the whole amount (not just the part of the deposit in excess of 10%) to the defaulting purchaser.
And in the Hong Kong case of Polyset Ltd v Panhandat Ltd [2002] 5 HKCFAR 234, a defaulting purchaser was able to recover the whole of his 35% deposit on a purchase of commercial property when he failed to complete for much the same reasons.
What these cases tell us are two things. Firstly, that it is going to be difficult for developers to hang on to deposits of greater than 10% if they are challenged by defaulting purchasers. Secondly, that, if the deposits have to be repaid, all of the sum must be repaid, not just the proportion that is ‘excessive’.
What we don’t yet know, however, is what ‘special circumstances’ are that could persuade a court to allow the seller to keep the deposit.
One argument on behalf of a developer might be that its business model requires high deposits from purchasers of off-plan properties – who are willing to pay this sum and take the risk because they are gambling on increase in value in the property market and maybe a quick sale at a profit – and that this justifies taking a higher deposit than normal.
A test case is awaited.
John de Waal, QC, barrister and mediator