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What legal classification applies (and what are the effects) when a sum of money is deposited at the bid stage?

24/05/2017

As part of a sale process, and before the seller gives any undertakings or even grants a period of exclusivity, it will sometimes want to ensure that the potential buyer is serious about proceeding. For this purpose, the seller could ask it to deposit a sum of money at the bid stage.

In the seller’s mind, such a request will in some cases be made with no intention other than to seek a level of reassurance. In other cases, the parties’ intention will be to give this deposit a specific legal classification, the scope of which may vary. What are the potential legal classifications of such a deposit?

1. Dédits, break-up fees or rights to exit

According to this first classification, the sum deposited is deemed to be compensation for terminating discussions (a ‘break-up fee’), a ‘dédit’ (a sum payable by a promisor who avails himself of a right not to perform an obligation) or a ‘right to exit’. Such a classification means, for the potential buyer, that it can perform its obligation either by paying the compensation if it terminates the discussions, or by signing the sale agreement. In principle, such dédit compensation cannot be revised by the courts, unless it is reclassified as a penalty clause (please see below). Furthermore, if the potential buyer decides not to proceed with the purchase, in principle the seller has no possibility of obtaining any remedy for breach of contract as paying the compensation is, for the potential buyer who changes its mind, one of the ways of performing its obligations in full.

2. Penalty clauses

The second conceivable classification is that the deposit is treated as a penalty clause. A penalty clause – referred to as ‘security for performance, a penalty for breach’ – is the mechanism by which parties agree a fixed amount in advance for the compensation that a party in breach must pay to the other party as a remedy. In principle, it cannot be revised. ‘Nevertheless, the courts [may], even of their own motion, vary or increase an agreed penalty, if it is manifestly excessive or inadequate’ (Article 1152 of the French Civil Code; Article 1231-5 of the future Civil Code). To limit the risks of the courts changing the penalty, the parties must therefore have first estimated the losses faced by the seller if the buyer breaches its obligations, in order to ensure that the difference compared to the proposed penalty remains a moderate one.

3. Remuneration for exclusivity or earnest money

A third classification involves treating the deposit as remuneration offered to the seller for it to cease any discussions with other potential buyers. In return for this sum, the seller agrees to suspend the sale process with third parties and to give the potential buyer chosen a period of exclusivity. In this case, it is no longer a matter of penalising a breach of contract. In practice, the risk of the indemnité d’immobilisation (earnest money) being reclassified as a penalty clause (and being varied by the courts) cannot be ruled out, especially in cases where the amount of the indemnité d’immobilisation appears disproportionate in comparison to market practice and in light of the short period for which the asset in question is off the market.

4. Cash collateral for any compensation

A fourth possibility is to take the approach that this deposit is used solely as a financial guarantee (‘cash collateral’), as security for any compensation obligations on the potential buyer who is in breach.

In other words, if the potential buyer breaches its obligations, the courts will define the amount of damages and the deposit shall be allocated towards payment of those damages (with any excess payment being reimbursed to the potential buyer).

There is nothing to stop parties from using several mechanisms at the same time, although they must not forget that the courts have the power to reclassify deposits. For this purpose, the parties must try and ensure that a certain consistency is maintained between the classification chosen and the underlying reality. This analysis will not change for contracts entered into as from 1 October 2016, this being the date on which the provisions of French Order No. 2016-131 of 10 February 2016 (reforming the law of contract) will come into force.

What legal classification applies (and what are the effects) when a sum of money is deposited at the bid stage? – Legal analysis published in the magazine Option Finance on 16 May 2016

Authors

Picture of Alexandre Morel
Alexandre Morel
Partner
Paris