Classification of Option Fees and Deposits

In the recent decision of J & Z Holding (Aust) v Vitti [2022] NSWSC 1718, the New South Wales Supreme Court considered whether an option fee paid by a prospective buyer, which became the deposit under the contract, was to be:

• retained by the seller as the option fee paid by the buyer for the grant of the option; or
• refunded to the buyer as the deposit, upon the contract (arising from the exercise of the option) coming to an end.

Background

On 17 August 2018, the plaintiff as grantee entered into a put and call option agreement with the defendants as owners for the right to purchase land in Ultimo, New South Wales for $10,250,000 (Option Agreement), for a period of 22 months expiring on 17 June 2020 (Option Period).

The plaintiff offered to purchase the land if the offer was accepted by the defendants during a period of 5 business days following the Option Period (Put Option Period).

In consideration of the parties entering into the Option Agreement, the plaintiff paid an option fee of $2,050,000 (Option Fee) by four equal instalments of $512,500.

The Option Agreement stated that if the call option and the put option is exercised, the first and second instalment of the Option Fee would:

be taken to form and constitute the deposit payable under the contract and shall be subtracted from the purchase price payable at completion of the contract.

This represented 10% of the purchase price, being $1,050,000.

On the expiry of the Option Period, the parties entered into a deed of amendment by which:

• the plaintiff paid two extension fees totaling $220,000 in addition to the Option Fee;
• the Option Period was extended to 17 January 2021; and
• the Put Option Period was extended for 5 business days after 17 January 2021.

The plaintiff paid the Option Fee on 17 June 2020.

The plaintiff did not exercise the call option.

On 22 January 2021, the defendants exercised their put option creating the contract.

Settlement under the contract was due on 30 June 2021.

The plaintiff failed to settle by that date and, as a result, on 2 July 2021 the defendants served the plaintiff with a notice to complete under the contract by 16 July 2021.

The plaintiff failed to settle by 16 July 2021 and the defendants issued a termination notice on the plaintiffs.

The plaintiff disputed the validity of the defendant’s notice to complete and termination notice and claimed to terminate the contract pursuant to the defendant’s wrongful repudiation.

The contract came to an end in August 2021 by way of the acceptance of allegedly repudiatory conduct by each party.

Arguments

The plaintiff sought to recover the Option Fee on the following grounds:

• the sum of $2,050,000 was characterised, in form and substance, as the deposit paid under the contract;
• the plaintiff was entitled to the deposit, given the plaintiff had rescinded the contract due to the defendant’s alleged repudiation of the contract; and
• the deposit was a penalty, as it was an amount equivalent to 20% of the purchase price, which the defendants were not entitled to, and the plaintiff is entitled to recover under the law of restitution.

The plaintiff did not raise any arguments as to the extension fees and it was established that the defendants were entitled to retain those fees.

The defendants argued that:

• the sum of $2,050,000 was the Option Fee under the Option Agreement (as amended) which ‘vested in them’;
• the Option Fee was not to be characterised as a deposit; and
• the Option Fee was no more than a credit to be allowed against the purchase price upon completion of the contract.  

When the contract came to an end, the defendants sold the property at a loss and did not seek to recover any compensation for that loss of profit.

Consideration and Determination

Option Fee

The Supreme Court considered:

whether, upon the proper construction of the contract read in the context of the option agreement, the disputed sum is to be characterised as an amount (a “conventional deposit”) notionally paid by the plaintiff as a purchaser to the defendants as vendors in earnest to provide security for the defendants that the plaintiff would perform the contract.[1]

The court considered the intention of the parties which required consideration of the text of the Option Agreement (as amended) and the contract, and the context and the purpose of the transaction.

The terms of the Option Agreement (as amended) provided for the disputed sum (of $2,050,000) to:

vest in the defendants…as consideration for the call option and for it, upon completion of the contract, to be credited against the balance of the purchase price ($10,250,000) payable by the plaintiff on completion ($8,200,000).[2]

The contract imposed no obligation for the plaintiff to pay the disputed sum nor did it identify a sum as the deposit.  The Option Fee was paid as “the price for the grant, and extension, of the call option”.[3]  It was not paid “in earnest of its performance of the contract created upon the defendants’ exercise of the put option”.[4]

The court stated that simply labelling the disputed sum as a deposit does not determine its legal character.[5]  It was a ‘credit in favour of the plaintiff’ towards the purchase price payable by the plaintiff upon completion of the contract.[6]

Given the court’s findings that the disputed sum was not a deposit but a credit:

• the deposit could not be characterised as a penalty; and
• therefore, the plaintiff was not entitled to recover the deposit.

The defendants were entitled to retain the Option Fee of $2,050,000.

Termination of the Contract

Separately, whilst no party claimed relief for wrongful termination of the contract, the court still proceeded to consider the validity of the notice to complete issued by the defendants on 2 July 2021.

The notice incorrectly included the weekend in calculating the time for the plaintiff to rectify the default, being the failure to settle.  The notice should have specified a revised settlement date of no earlier than 19 July 2021, in compliance with the notice provisions under the contract.  The notice was to require the plaintiff to complete within a period of at least 14 days after service of the notice, excluding the day on which the notice was served from the calculation of the 14 days.

The defendants argued that an incorrect interpretation of the contract should not constitute repudiation of their obligations under the contract.[7]

The court determined that:

• repudiation is an objective inquiry as to the conduct of a party and that party’s unwillingness to perform its obligations under the contract;
• the defendants did not demonstrate a willingness to reconsider their position, even after the plaintiff issued a letter to the defendants highlighting that the defendant did not provide the contractually agreed notice period for completion; and
• the defendants’ wrongful termination of the contract constituted repudiation of the contract by the defendants.  

Key Takeaways

The Treatment of the Option Fee

When documenting an option to purchase land, it is important that the parties clearly specify the nature of the payments to be made under the option contract and the resulting sale contract.

The option fee is paid by the grantee (the potential purchaser) for the grant of the option.

Generally, when the option is exercised and the sale contract comes into existence, that option fee is credited against the purchase price under the sale contract.

If the sale contract specifies that the option fee then becomes the deposit under the sale contract, the nature of the option fee becomes blurred.  Arguments can arise (as they did in this case) that the option fee ceased to be an option fee and became a deposit.  The treatment and entitlement to the option fee is very different to the treatment and entitlement to the deposit.

Unless the parties clearly require otherwise, the sale contract should credit the option fee against the purchase price, rather than classify the option fee as the deposit under the sale contract.

Getting the Notice to Complete Correct

An incidental lesson from this case is the consequence of getting the notice to complete correct.

The issuing of a notice to complete is often regarded as a clear intention by the issuer to end the contract if the contract is not completed as specified in the notice.  The courts have consistently held this to constitute a repudiation of the contract.  If the notice is incorrect, the other party can accept the repudiation and sue the issuer for wrongful termination of the contract.  This can be catastrophic for the issuer.

This was an observation of the court, but the court was not required to rule on this issue.

The Property and Leasing Team at Lavan regularly assist clients with purchasing property assets through option agreements.  Please contact us if you have any queries on these matters.