Third party approval and due diligence clauses

Commercial | Print Article

[Spring 2013]

Although commonly inserted into sale and purchase agreements by real estate agents and solicitors alike, third party approval and due diligence clauses are not always properly understood, and, unless correctly drafted, are seldom the ‘get out of jail free cards’ that many people think.

The 2013 Court of Appeal decision in Arcadia Homes Ltd v More To This Life Ltd [2013] NZCA 286 highlighted a number of issues surrounding these types of clauses, including:

  • the important distinction between a condition precedent and a condition subsequent;
  • the effect of a correctly drafted due diligence clause; and
  • whether a third party approval or due diligence clause creates a subjective or objective test.

Condition precedent or condition subsequent?

An agreement containing a condition precedent will have no contractual effect until the condition is fulfilled, and if the condition precedent is not fulfilled by the required date, the agreement is void (i.e. it never came into existence). On the other hand, the parties to a contract containing a condition subsequent are bound by their agreement prior to the fulfilment of the condition. If the event on which the contract is conditional does not occur, the contract will be at an end.

This distinction was crucial in the Arcadia Homes case, where a purchaser inserted the following clause into the agreement for sale and purchase and argued that the condition was a condition precedent which effectively converted the agreement into an option:

‘THIS AGREEMENT IS SUBJECT TO AND CONDITIONAL UPON Prime [sic] Approval of the Directors of Arcadia Homes Ltd 4pm on 25th January 2008…’

The purchaser argued that there was no intention to create binding legal relations until the director had notified his approval of the agreement to the vendor. As no such notice was ever given, the purchaser argued that the contract never came into existence.

The Court held that, in fact, the condition was a condition subsequent and that the document was ‘plainly and unambiguously a conditional contract intended to and which did create legal relationships’.

In coming to its decision, the Court noted the existence of clause 8.7 of the agreement (the standard REINZ/ADLS 8th Edition 2006) which reads:

8.7   If this agreement is expressed to be subject either to the above or to any other condition(s), then in relation to each such condition the following shall apply unless otherwise expressly provided:

(1)   The condition shall be a condition subsequent.

(2)   The party or parties for whose benefit the condition has been included shall do all things which may reasonably be necessary to enable the condition to be fulfilled by the date of fulfilment.

[Emphasis Added]

The Court’s view reflected the approach adopted by the courts not to categorise conditions as ‘precedent’ or ‘subsequent’, but to focus on the parties’ intention and the effect of the condition in question. The Court held that the agreement was ‘consistent with a conditional agreement but not with an option’.

Although this case was the first time a ‘subject to director’s approval’ clause had been considered by a New Zealand court, similarities were drawn to ‘subject to solicitors’ approval’ clauses and other clauses that contemplate approval by an external third party.

The Court held that an approving agent must be distinguishable from the contracting agent and that the approving agent must not have been involved prior to signing.

In the Arcadia Homes case, as Arcadia only had one director at the time the agreement was signed and as the sole director had signed the agreement, the Judge held that the conditions necessary for the approval clause to operate (i.e. the existence of another director to approve the agreement) were never present and the contract remained on foot (despite Arcadia’s arguments to the contrary).

Due diligence conditions and options

A due diligence clause can be used to turn an agreement into an option to purchase.

In the Arcadia Homes case, in arguing that the director’s approval clause had converted the agreement into an option, the purchaser sought to draw parallels with two earlier cases:

  • BS Development No 12 Ltd v PB & SF Properties Ltd; and
  • Prime Property Group v Amtrust Pacific Properties Ltd.

The Courts found that the combined effect of the due diligence clauses in each of these cases (which focused on the purchaser investigating and being satisfied about the property) and clause 8.7(2) of the standard REINZ/ADLS agreement, was to give the purchaser an ‘option’, subject to the vendor cancelling the agreement in writing. As the approval clause in the Arcadia Homes case was directed at the purchaser’s director approving the agreement, an option was not created.

Subjective/Objective Test

A number of cases have looked at the question of whether a due diligence clause can give a purchaser an unrestricted option to cancel an agreement.

This question was considered in La Rosa v MacEnnovy Trust Ltd when the purchaser argued that the due diligence clause provided for a subjective determination by him, without any obligation to disclose the reasons why the condition had not been satisfied. The vendor on the other hand argued that any decision made by the purchaser had to be reached fairly and reasonably (i.e. objectively) and solely on matters arising out of the due diligence investigation.

The Courts agreed with the purchaser on the basis that ‘the words of the clause were sufficiently clear, and focused more on an argument that even if the clause was to be construed, in effect, as an option, it was an unrestricted one’. The Court did however go on to clarify that it was still to be confined to matters arising out of the due diligence investigation and excluded matters known to the parties at the time of the agreement.

It appears from the decision that, ultimately, whether a clause will be held to provide for a subjective test will be a matter of interpretation.

The Arcadia Homes case and the other cases discussed above, highlight the importance of fully understanding the legal effects and implications of clauses before they are added to an agreement for sale and purchase and the need to take into account the intentions of both parties at the time the agreement is entered into.