Split-Payment of a Deposit: Enforceable Deposit or Unenforceable Penalty?

Usually, a contract to purchase real estate will require payment of a 10% deposit on entry into the contract (or ‘exchange’).

When the purchaser settles, the deposit is deducted from the purchase price.  If the purchaser defaults and the contract is terminated by the vendor, the deposit is forfeited.

It is not uncommon, however, for purchasers to request a lesser deposit, usually 5% of the purchase price.  Vendors commonly add a split-payment clause in the contract providing that 5% would be accepted on exchange and the remaining 5% would be payable either on settlement or on termination of the contract by the vendor.

If a purchaser defaults and the vendor terminates the contract, is such a split-payment clause enforceable? 

In Iannello & Anor v Sharpe (1*) the NSW Supreme Court of Appeal considered a typical split-payment clause.  The vendor accepted a 5% deposit being $225,000 on exchange with the remaining 5% to be paid on settlement or termination.  The purchaser defaulted and the contract was terminated by the vendor.  The vendor then sued for payment of the remaining $225,000 but was unsuccessful.

The Court considered what a ‘deposit’ is and whether a payment following termination fits the criteria of a deposit.  A deposit is a payment made by the purchaser which is (1) a part-payment in advance of the purchase price and (2) a display of earnest to the vendor of the purchaser’s intention to comply with its obligations under the contract.   

Forfeiture of a deposit has long been an exception to the rule prohibiting penalties.  A penalty is a specified payment required to be made under a contract by a party in breach to the innocent party.  Such payments (penalties) are usually unenforceable.

The Court found that it was impossible for any payment required following the termination of the contract due to the purchaser’s breach to demonstrate an earnest to comply with the contract – it is impossible for a purchaser to comply with a contract that has already been terminated. 

As the second payment did not fit the criteria of a deposit, it was a penalty (an unenforceable payment required on breach of a contract) and the vendor was unable to recover the second instalment of the deposit, leaving the vendor $225,000 down!

In Cloud Top Pty Limited and Anor v Toma Services Pty Limited and Anor (2*) the split-payment clause differed slightly.  In that case, the vendor agreed to accept an initial 5% instalment of the deposit with the remaining 5% of the deposit payable on the 42nd day after the contract date.  The 42nd day after the contract date was also the date on which settlement was due, however, the balance of the deposit was to be paid on that date irrespective of whether settlement took place or not.

The Court found that the second instalment of the deposit was not a penalty and was enforceable.  The purchaser was ordered to make payment of the remaining 5% of the deposit to the vendor.

It is clear from these two cases that any payment, even if it is described as a deposit, required on the default, breach or termination of the contract is at risk of being unenforceable as a penalty.  To minimise this risk, it is important that the requirement to make any payment is not linked in any way to the default, breach or termination of a contract.  Rather, payment may best be linked to a date, timeframe or event.

Even where a split-deposit clause is enforceable, vendors should still be wary of the risks involved in accepting a smaller deposit.  For example, a common reason why purchasers request a smaller deposit is because they do not have the full 10%.  Accordingly, enforcement may prove difficult, lengthy and expensive.  If a vendor obtains judgment in their favour, there is still a risk that the vendor may not be able to recover the debt from the purchaser if they simply do not have the funds or assets to make payment.

1* [2007] NSWCA 61 (23 March 2007)

2* [2008] NSWSC 568 (28 June 2008)

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