The New South Wales Court of Appeal has given a needed to refresher on the nature of a deposit and in doing so confirmed as worthless the typical “reduced deposit” clause.

Iannello & Anor. v. Sharpe [2007] NSWCA 61 involved a contract for the sale of a house for $4.5 million where $224,000.00 was paid as deposit but including a special condition as follows.

“Notwithstanding anything else herein contained, the Vendor shall accept, on exchange of this Agreement, payment of $225,000.00 being part of the deposit. The parties expressly agree that if the Purchaser defaults in the observance or performance of any obligation hereunder which is or has become essential the balance of the deposit, namely $225,000.00, shall become immediately due and payable and the Purchaser shall forfeit the whole of the sum of $450,000.00 pursuant to Clause 9 hereof to the Vendor.”

The Court of Appeal cited Luu v. Sovereign Developments Pty. Limited [2006] NSWCA 40 as a case with similar facts because on the front page of the contract in that case the price was $6.6 million and provided for a deposit of “$65,000.00 [followed by] 10% of the price unless otherwise stated” coupled with a special condition as follows.

“In the event that the Purchaser pays less than ten percent (10%) of the purchase price as deposit then if the Purchaser commits a default hereunder the whole of the 10% deposit shall become due and payable notwithstanding that this Contract is not completed. This clause shall not merge on completion and the Vendor shall be entitled to sue for recovery of so much of the 10% deposit that remains outstanding as a debt due by the Purchaser to the Vendor.”

Of course, in the Luu case, the purchaser defaulted and the vendor claimed the full 10% as damages. While allowed in the first instance, the Court of Appeal overturned that, holding that this “balance of deposit” amount was not part of the deposit but really a penalty. Bryson JA’s leading judgment on the relationship between deposits and penalties was quoted.

“.. Where parties make an agreement for a sale which is to be completed at some time in the future it is unremarkable and only to be expected that the vendor will require the purchaser to pay some part of the purchase money straight away so as to show that the purchaser is in earnest in committing himself to pay the rest, on the understanding that the purchaser will not get his earnest money back if he does not complete the sale. For contracts of sale of land it has long been customary practice and established law that the purchaser pays a deposit on account of the purchase money when the contract of sale in writing is made, and cannot recover that deposit if he later fails to complete the bargain and pay the rest; whether or not the vendor’s losses are actually more or less than the amount of the deposit. Notwithstanding the apparent inconsistency, the invalidity of contractual penalties does not apply to contractual provisions for forfeiture of reasonable deposits in sales of land. … The exception from the law relating to penalties relates and relates only to deposits, that is, to payments which truly have the character of earnest money paid on or in relation to entering into the Contract, and although provisions of contracts almost always establish what the deposit is, it is not open to parties to avoid the operation of penalties law by designating a payment or an obligation as a deposit if it does not otherwise have that character.”

In summary, calling it a deposit did not make it a deposit. An essential characteristic of a deposit is payment in earnest and this element was absent once the purchaser was in default and could not complete the contract.

If not a really a deposit, the question remained whether the so-called balance of deposit was a genuine pre-estimate of damages. In both the Luu case and in Iannello & Anor. v. Sharpe, it was concluded the claimed “balance of deposit” amounts greatly exceeded the vendors’ losses and was a penalty and not enforceable.

While the Court’s analysis on deposits and penalties was welcome, there was no convincing analysis on the interaction of the issue of liquidated damages, only a perfunctory note that a genuine pre-estimate of damages clause would overcome the rule against penalties.

The upshot: Do not rely on the enforceability of a payment described as a deposit payable on default. Payment (and forfeiture) of a good faith deposit due in instalments is fine, but upon a default, unless claiming actual damages, any further amount payable must on proper construction be liquidated damages (i.e. a genuine pre-estimate of damages) in which case proof of actual losses is not required. It is worth mentioning here too that a self-described liquidated damages clause may be found to be, in substance, an unenforceable penalty where it is extravagant and unconscionable compared to the maximum possible loss.