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Option Agreements And Overage Provisions, The Importance Of Accurate Drafting

Option Agreements And Overage Provisions, The Importance Of Accurate Drafting - Saracens Solicitors

Mr Sparks is a forward-thinking clever man. I make this presumption on the fact that over several years he purchased land, ripe for development, parcel by parcel, for the purposes of funding his retirement.

By 2000, Mr Sparks had acquired a decent size plot of land. Save for an access road, the land was surrounded by four rows of terraced houses. In very loose terms (but not in precise shape) Mr Sparks acquisition could be imagined as the hole in a doughnut ring, laid flat. It had situated on it a house (divided into two residential flats) and some garages.

Mr Sparks ran a vehicle repair workshop from a workshop located on the land he had purchased over the years. Although he ran a successful business and had the foresight and gumption to purchase the land, putting it to use was not his expertise.

He needed a developer.

Enter Mr Biden; a developer with some 35 years’ experience. Through his company, Linkwood, he had entered into a number of development agreements over the years. Mr Sparks chose to work with him after talking with several other smaller developers (he did not want to go with a large corporate).

The development proposed consisted of eight new residential houses. The existing houses would stay; however, the garages and workshop would be demolished.

Mr Sparks and Mr Biden entered into an Option Agreement, dated 9 June 2005. By this stage, Mr Sparks was in his late sixties. Both sought independent legal advice from reputable law firms.

The Option Agreement contained the grant of an option to Linkwood to purchase the land. If the option was exercised, the purchase price under the resulting contract for sale was £600,000, together with overage. Linkwood was required under the agreement to apply for relevant planning permission within three years and to use “all reasonable endeavours to obtain” it. Linkwood’s option over the land could be exercised within the same three-year period, subject to one qualification, namely, if the relevant planning permission was formally issued within the three-year period, the buyer had one month from the formal issue of the permission to exercise the option. If the option was exercised and the sale completed, the buyer was required to “proceed as soon as practicable” to construct the development in accordance with the relevant planning permission and subject to obtaining any other necessary consents.

The overage would kick in once the dwellings were sold: Mr Biden would receive 33.3% of the sale price but only regarding sale proceeds in excess of the purchase price of £600,000 (meaning Linkwood did not have to pay overage in relation to the first £1,800,000 received from relevant sales. However, Mr Biden was to receive a minimum overage of £700,000, notwithstanding the aforementioned cap. This became due once the final dwelling had been built and sold.

On 22 July 2008, a supplemental agreement varied the original Option Agreement in the following ways:

  1. The option period, which was expired, was extended,
  2. The purchase price was reduced to £500,000,
  3. The overage provision was altered in accordance with the reduced purchase price, meaning Linkwood was not obliged to pay overage in relation to the first £1,500,000 received from relevant sales (the minimum overage of £700,00 remained).

At the same time, the supplement agreement was completed, Linkwood assigned the benefit of its option to Mr Biden, and he executed the option. Outline planning permission for a development of eight houses had been obtained in about February 2007. The construction of eight houses took place between about March 2012 and February 2015.

So far, so uneventful.

However, Mr Biden never sold any of the houses. Instead, he let them all on assured shorthold tenancies and occupied one himself. He stated to the court there was no express term in the Option Agreement requiring him to sell the dwellings.

Mr Sparks naturally argued that such an interpretation of the Option Agreement “fundamentally undermines its whole working and underlying purpose”.

The judge, His Honour Judge Davis-White, agreed, concluding an express term requiring Mr Biden to market and sell the houses within a reasonable period of time, should be implied in the Option Agreement.

“In my judgment, a clause falls to be implied into the Option Agreement to the effect that the Buyer is under an obligation to market and sell each house constructed as part of the Development within a reasonable time of the Option having been exercised and the planning permission having been obtained. Such a clause is one that is necessary as a matter of business efficacy and without it, the Option Agreement lacks practical or commercial coherence. Furthermore, I consider that the clause is so obvious that it goes without saying”.

The case of Sparks v Biden (2017) EWHC 1994 (Ch) illustrates the importance of clear drafting for both Option Agreements and overage. It is the job of a solicitor to consider all probabilities and outcomes and draft the agreement accordingly.

The Option Agreement – demystified

Option Agreements are the lifeblood of developers. They ensure the right to purchase land ripe for development can be retained while planning permission is sought.

An Option Agreement is entered into by a landowner and a potential purchaser of the land (usually a developer). The developer pays a sum of money in exchange for a contractually binding first option to purchase the property within a certain time period or after a particular event (usually the granting of planning permission).

There are four types of Option Agreements:

  1. Call option – where a buyer has the right (but not an obligation) to buy the property from the seller.
  2. Put option – where the seller has a right (but again, not an obligation) to sell the property to the buyer.
  3. Cross option – the buyer receives a call option and the seller, in return, gains a put option.
  4. Reverse option – occasionally these types of options are used to secure an overage payment. The seller receives an option to purchase the property back after the ‘trigger’ event occurs if the overage payment is not forthcoming.  The resale price will reflect the increase in the value of the land because of the ‘trigger’ event (e.g. planning permission being granted).

There is no restriction on how long an Option Agreement can last for[1].

Option Agreements are not without criticism. The housing crisis gripping England and Wales has been partly blamed on developers ‘land banking’. A 2015 Guardian investigation found Britain’s biggest housebuilders had enough land to create more than 600,000 homes, but none were in the process of construction[2]. Option Agreements have been criticised for tying up land for many years, preventing others, who may be able to begin building sooner from purchasing it[3].

However, Pete Jefferys, policy manager at housing charity Shelter told the paper that Britain’s dysfunctional housing market, not developers were to blame for ‘land banking’.

“Developers have to buy land upfront at a very high price,” he stated. “Then they have to get a return for their shareholders, so of course they are only going to build at a speed that keeps prices high.”

The advantages of an Option Agreement

Property development is a risky business. And like any risk, if it comes off, huge rewards can be claimed. For example, the High Street Group of Companies, who developed Newcastle’s tallest building, Hadrian’s Tower, recently acquired a site in Birmingham for £120 million. The site, which has planning permission, will be developed into 500 one, two and three bedroomed apartments, with a proposed project value of £600 million[4].

Option Agreements mitigate some of the risks of property development for both developers and landowners. Developers know the landowner cannot sell the land if obtaining planning permission takes longer than anticipated. Furthermore, the final purchase price of the land may be negotiated as part of the agreement, preventing the developer from having to pay market value if the option is not exercised for many years.

Landowners also benefit. Not only do they have a guaranteed interested buyer, they also receive a non-refundable payment for the benefit of the option.

Then there is the possibility of overage – the vehicle which can provide enormous profit to savvy landowners.

An overview of overage

Overage is a seller’s right to recover additional payment(s) from a buyer at some point in the future, usually after completion of a sale. It allows the seller to receive additional payment if the land turns out to be more valuable than projected. Overage is usually triggered by the occurrence of an event which increases the value of the land. Common ‘trigger events include:

  • the grant or implementation of planning permission
  • completion of development
  • disposal of the property or part of the property
  • on-sale of the property within a specified period

Savvy landowners will ensure multiple events trigger the overage provision, such as the granting of each planning permission, or sale of every individual plot, thereby maximising the potential for payment. Multiple trigger events also protect the landowner if there is a sudden downturn in the market and several properties fail to sell. In such circumstances, they will still receive overage from the initial sales.

‘Overage’ and ‘clawback’ are interchangeable expressions. Overage may also be referred to as a ‘deferred consideration’, ‘uplift’ or ‘kicker’.

Often overage provisions may act in both parties’ interests because a seller can share in future receipts or uplift in value and a buyer can defer payment until the occurrence of the trigger event.

Sellers will usually protect their right to overage via:

  • legal charge
  • restriction on title
  • restrictive covenant
  • guarantee
  • ransom strip

The importance of meticulous drafting in option and overage agreements

Many disputes arising from Option Agreements and overage provisions result from ambiguous drafting. Both are highly complex matters, and experienced legal knowledge is required to ensure the agreements cover every possible outcome.

The recent, long-running case of Burrows Investments Limited v Ward Homes Ltd [2017] EWCA Civ 1577 highlights this point.  

The facts of the case

In 1993, Burrows Investments Ltd, a property investment company, sold land to Ward Homes, a development company. The land had been sold with a 1993 planning permission for 62 residential units.

Overage provisions in the sale agreement between the parties contained a prohibition on any disposal of the affected land unless this was by ‘permitted disposal’. There were several categories of permitted disposal, but those of relevance to the dispute were:

  1. at paragraph (c) of the definition, ‘the transfer…of land…for roads footpaths, public open spaces or other social/community purposes’ (for the purposes of this article a ‘Community Disposal’)
  2. at paragraph (a) of the definition, ‘a disposal by the buyer of one or more Individual Market Units (whether to an individual private purchaser or a third party investor) in the open market at arm’s length by way of the sale of the freehold or long leasehold estate in such Market Unit or Market Units’ (a ‘Residential Disposal’)

In 2011, when almost half of the units had been built, the Ward Homes Ltd obtained revised planning permission which increased the total number of permitted units to 75. Under the accompanying section 106 agreement, it had to provide five units of affordable housing to one of several registered social housing providers. This was not negotiated with Burrows Investments.

Ward Homes subsequently disposed of five ‘affordable’ units to a social landlord as was required under the section 106 agreement. Ward Homes argued at first instance the sale of affordable units to a housing association amounted either to a Residential Disposal under paragraph (a) or, in the alternative, to a Community Disposal under paragraph (c). The judge held the second ground was established.

The Court of Appeal overturned this finding. In giving the judgment, Lord Justice Henderson referred to the well-established principles of contractual interpretation which were not in dispute between the parties and quoted Lord Neuberger in Arnold v Britton Arnold v Britton [2015] UKSC 36, [2016] 1 All ER 1, [2015] 2 WLR 1593:

“When interpreting a written contract, the court is concerned to identify the intention of the parties by reference to ‘what a reasonable person having all the background knowledge which would have been available to the parties would have understood them to be using the language in the contract to mean’. And it does so by focussing on the meaning of the relevant words in their documentary, factual and commercial context. That meaning has to be assessed in the light of the natural and ordinary meaning of the clause, any other relevant provisions of [the contract], the overall purpose of the clause and the [contract, the facts and circumstances known or assumed by the parties at the time that the document was executed and commercial common sense but disregarding subjective evidence of any party’s intentions”.

In considering whether the sales of the completed units amounted to a Community Disposal, the court agreed the sales of affordable units to a social landlord did achieve social and community purposes, and that changes in planning policy towards affordable units forming part of development was a factor likely to have been in the parties’ minds when the agreement was entered into. However, the court bore in mind the ‘ejusdem generis’ (Latin for “of the same kind”) principle or as Henderson LJ put it:

“The words “or other social/community purposes” in the second part of paragraph (c) have to be read in the light of the three specified purposes which precede them, and with at least a provisional inclination to interpret the social and/or community purposes which the parties had in mind as being purposes akin to the provision of land for roads, footpaths or public open spaces”.

The parties did not dispute that even if the ‘affordable’ units been sold at market value, no overage would have been due as the price per square foot did not exceed the overage threshold. Burrows Investments, therefore, could not have claimed damages for the overage it would have received had the affordable units been sold at market value, as there would have been no overage payable. It, therefore, claimed damages based on ‘negotiation damages’ (i.e. what Ward Homes would have agreed to pay to be released from the restrictions on disposal). Therefore, once it was established the sale of the five properties was not a ‘permitted disposal’, the court had to decide whether Burrows Investments Limited was entitled to damages when, under conventional analysis, it had suffered no loss.

Lord Justice Henderson concluded:

“The simple fact is that Ward transferred the five properties to Amicus Horizon in breach of an express term of the Sale Agreement, namely clause 4.9. Burrows had a legitimate interest and expectation that Ward would not breach the Sale Agreement, reinforced in the present case by the fact that Ward had negotiated with Burrows for three months on the footing that the proposed transfer was prohibited by the Sale Agreement, and had then effected the transfer behind Burrows’ back and without Burrows’ consent. Burrows is not now seeking to extract a ransom from Ward, but merely to be compensated for the loss of the opportunity to negotiate a reasonable price for releasing Ward from its contractual obligations. The benefit of the contractual restriction was a potentially valuable piece of property in its own right, and Burrows was deprived of the opportunity to exploit it, for what it was worth, by Ward’s unilateral action”.

Planning for every eventuality

What Sparks v Biden and Burrows Investments Limited v Ward Homes Ltd emphasise is the importance of ensuring your solicitor makes provisions for every foreseeable eventuality when drafting Option Agreements and overage provisions. For example, if there are section 106 requirements for affordable housing, the drafting solicitor should make sure there is provision for their disposal within the sale agreement, and that this can be done without the seller’s permission. And when it comes to the actual sale and marketing of properties, if a developer wants the choice to rent out properties (and wait for more favourable market conditions before disposing of them), this should be clearly provided for in an Option Agreement.

These two examples are only a taster of the intricate analysis which must go into drafting Option Agreements and overage provisions. When entering into such an agreement, both developers and landowners may wish to be mindful of the wise words of Benjamin Franklin – “An ounce of prevention is worth a pound of cure.”

 

Saracens Solicitors is highly experienced in drafting and negotiating Option Agreements and overage provisions for both landowners and property developers.  If you have any questions regarding points that have been mentioned in this article, please call us on 020 3588 3500.
[1] Perpetuities and Accumulations Act 2009.  Option Agreements signed before 6 April 2010 must be exercised within 21 years

[2] https://www.theguardian.com/society/2015/dec/30/revealed-housebuilders-sitting-on-450000-plots-of-undeveloped-land

[3] https://www.theguardian.com/cities/2017/jan/31/britain-land-housing-crisis-developers-not-building-land-banking

[4] https://www.chroniclelive.co.uk/business/commercial-property/newcastle-developers-snap-up-birmingham-14586922

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