Ten-minute topic: understanding overage

Overage (or “clawback”) agreements are seen as complex and full of hidden traps. Ironically, the commercial rationale for agreeing them is often very simple. Overage is a right to receive additional consideration if a certain trigger or triggers occur in the future. They are particularly useful (and most commonly used) when selling property with development potential. They provide a fair slice of the pie for the seller, ensuring that it gets its part of any upside and avoids the embarrassing (and expensive) scenario of undervaluing its asset or perhaps missing a planning angle that the developer has spotted.  The acquiring developer, likewise, avoids overpaying for a site and can link payment to actual added value rather than hope value. If the payment structure is right, it allows a savvy developer to acquire a site with a speculative aim to enhance the development potential but without overpaying if the optimistic appraisal does not come to fruition. If overage makes commercial sense, how best to ensure that both parties are protected when the agreement is documented? Clarity is the key point for both the developer and the seller. In every aspect of the agreement, the parties need to be clear as to exactly how they intend the agreement to be interpreted. You cannot always accurately predict the future, but exploring the possible scenarios that the overage will operate within is an essential element to agreeing overage. Here are some examples of the points to think about: Length of overage period This will very much be dictated by the circumstances of the transaction. Theoretically, following the change in the rule against perpetuities, overage payments can be secured forever. In most cases, however, it will be a judgment call as to how long the overage obligations should last. Triggers for payment In a development context, the commercial trigger for overage is often the grant of planning permission, either for a change of use or for development. It might also be triggered by implementation of the planning or alternatively it may be linked to first occupation or sale of units on the development. Any of these scenarios bring up more detailed queries that will need to be considered between the parties: Planning: Think about what the parties mean by the grant of planning permission. Is it a general planning consent or a specific development or use or size? Is an outline planning consent sufficient? Or does it need to be a detailed consent? What if the planning consent is unviable? Normally you would expect a definition of an “implementable” planning permission to be agreed, but if the planning permission is quashed following its grant under the judicial review process, overage should not be payable.     Implementation of planning: What do the parties mean by implementation? Is the first spade going into the ground enough?     Triggered by sales: What do the parties mean by “a sale”? Is a short-term occupation to be ignored? Is there a statutory definition of “disposals” that could be used? What about corporate sales? Should a change of control of the owning company be enough to trigger overage? Calculation of the overage Possibly the most critical part of the overage agreement is calculating the overage payable. As a rule of thumb, a numerical equation is normally clearer than describing the formula with words. It is certainly worth considering adding in sample calculations so as to give future readers of the overage agreement an insight into the parties’ intention as to how the overage should be calculated, especially if the formula is not particularly straightforward. Those negotiating the calculation are well advised to run through the formula with example scenarios just to ensure that the outcome is as the parties expect in every conceivable scenario.  If the overage is linked to the sale values achieved, think about whether it is appropriate to include all sales on the development or if indeed the same overage formula applies to every sale? So on a residential scheme, if the overage is a percentage of sale value achieved, then how will affordable units be dealt with? Will they be excluded or perhaps a different formula applied? What about non-arm’s-length sales? You may need a valuation process to avoid circumvention of the payment. On larger developments it is worth ensuring that equalisation of overage is dealt with so that overage is calculated on an equitable basis. For example, if you have overage triggered by sales and the first few sales yield high overage payments but then the sale values drop off, should the overage be based on average price achieved? It is worth considering equalising overage payments over, say, a quarter or six-month period or over the lifecycle of a development scheme. Positive obligations An overage should be clear as to the parties’ obligations. For example: 1. If the overage is triggered by planning, then is there any obligation on a party to positively seek planning consent so as to trigger the overage? It is worth remembering that this needs to be considered from both sides. While a seller will often be attuned to ensuring that its developer has a positive obligation to seek planning consent, this will not always be appropriate. If the commercial motivation for overage is anti-embarrassment (ie a seller wanting to be sure that it has not undersold their asset) then the developer may want an express acknowledgment that it has no obligation to seek planning or otherwise trigger the overage, to avoid any suggestion of that being implied. 2. Similar issues arise if the overage is triggered by sales. Does this imply a positive obligation on the developer to actually sell the units (rather than retain them and let them out)? Sparks v Biden [2017] EWHC 1994 (Ch); [2017] PLSCS 170 suggested that it may do. A developer needs to make its intention clear if it needs flexibility and should not be forced to sell units, especially if its intention is to hold them on completion. Even where a developer is motivated to sell, it is worth agreeing that the developer shall not be forced to sell in a bad market if commercially it wishes to hold for a short term until the market picks up. The seller’s concern about missing out on the overage can instead be addressed by agreeing a longer overage period. Security A clear and precise overage agreement is of little use if the payments are not properly secured. Overage agreements are simply contractual promises to make payment. They do not automatically bind successors in title to the property they concern. Like any promise, they are only as good as the person giving them. Often a seller’s starting position will be to demand a fixed legal charge over the property. Rarely is this a workable solution. A developer cannot usually offer a first legal charge as it will affect its ability to raise funding against the development. Relegating the overage charge to a second legal charge may be unsatisfactory from a seller’s perspective, given the limitations of second charges.  The more standard approach is to rely on the contractual obligation of the landowner to comply with the agreement and to ensure that the developer cannot sell any part of the site without obtaining a deed of covenant from its successor to comply with it. This chain of deeds of covenant is protected by a restriction on title, meaning that any successor in title can not register its acquisition without showing to the Land Registry that the obligation to enter into a deed of covenant has been complied with.  This in itself is not a perfect solution as the restriction on title does not create a mechanism to positively enforce the overage in the event of default. So it does not help if the developer simply refuses to pay the overage, it just makes it more difficult for the developer to extract its development profit. In practical terms, overage payments are usually triggered at the point that the developer has added value to the site and therefore the hope is that the covenant strength should be sufficient to meet the overage obligation. Risks remain if the trigger for overage is not a cash-generative sale.  If there is real concern in relation to the covenant strength, then it can be worth considering imposing rights of re-entry. These are more commonly encountered in relation to leasehold scenarios and are attached to forfeiture clauses but can equally apply in freehold scenarios.  Essentially, a right of re-entry would give the seller a right to step in to a property to dispose of the whole or part in order to recover the monies due. While this is not a common approach, it has its place when a seller is concerned about how the developer will pay any overage due. Developers (and their funders) are likely to resist, but as rights of re-entry are commonplace in 999-year leases there should not be a conceptual reason why they could not live with their inclusion in a freehold scenario.  Overage agreements can be complex, but this highlights the need to ensure the agreement is as clear as possible as to the extent of obligations on the parties and how and when the overage should be payable. Dominic Whelan is a partner at Goodman Derrick LLP