Benefit of an option contract over a conditional contract
An option contract is different from a conditional contract. Both types of contract are used in similar situations e.g. for the purchase of development land, where applications for the various consents are to be made, and site investigations are to be done, after the contract has been concluded. However, there is a key difference between the two types of contract. With an option contract, you have total control over whether or not to exercise the option. With a conditional contract, if the pre-conditions are satisfied then you must buy the property. Of course, many conditional contracts do give the buyer plenty of discretion as to whether or not the conditions have been satisfied - but at the end of the day, if there is no doubt that they have been satisfied, then the buyer will have to pay up.
Buyers in option agreements do have to bear in mind that these contract are not quite as watertight as they might expect and that there are a surprising number of pitfalls and traps that can catch out the unwary. The bottom line is that option contracts, unless carefully drafted and backed up with the relevant security, can be surprisingly fragile.
Seller breaches the option and sells, leases or grants a security to someone else
In Scotland (unlike in England), there is no ability to register an option agreement in the Land Register. As a result, a Scottish option is a type of personal right (enforceable against the other party to the option agreement) rather than a real right (enforceable against anyone and everyone).
In practice, this means that if the landowner subsequently sells the property to a third party at a higher price (or grants a lease or standard security over it), your right to exercise the option and purchase the property may not be worth a great deal. (The same risks apply to a conditional contract - but the risks can be less worrisome if there is a short time to satisfy pre-conditions and/or no up front money is paid to the seller.)
If the option agreement is drafted correctly, such a sale to a third party will be a clear breach of contract. However, once the sale to the third party has completed, your only remedy might be a claim for damages against the (former) landowner - subject to the later comments about a possible reversal of the sale if the third party is in bad faith. As anyone who has been through a court action knows, undertaking litigation can be a costly business and would involve having to prove the loss that you have suffered as a result of the breach of contract.
Even if you're confident of success in any court action, careful consideration needs to be given to whether the (former) landowner has any assets to satisfy an award of damages against them. By selling the property, they may just have divested themselves of their only asset (with the sale proceeds no doubt disappearing into the ether) making any court decree in your favour a particularly hollow victory.
In any event, what most people really want in that situation is what they originally contracted for - i.e. the ability to purchase the property at the pre-agreed price.
Third party buyer in bad faith - possibility of reversing the sale?
If the third party purchaser is in good faith, the grantee of the option won't have any remedies against the third party. As mentioned earlier, the grantee in an option agreement generally doesn't have a real right in the property. It would also be pretty unfair on an (innocent) third party purchaser if their purchase of the property could be nullified, leaving them to try to recover their cash from the unscrupulous former owner.
However, there's a long-established rule of Scots Law known as the "off side goals" rule. In essence, this provides that if a purchaser is in bad faith, there may be scope to have the transaction voided. In other words, if you can prove that the purchaser knew about the option agreement prior to their purchase of the property, there may be a way to unravel the sale.
In practice, of course, things aren't quite as straightforward and there is currently some debate as to whether unexercised options benefit from the protection of the off side goals rule (or whether that right has to be capable of conversion into a real right). Also, there is the issue of proving that the third party knew about the pre-existing option agreement (thereby putting them in bad faith).
Seller becomes insolvent or defaults on its secured loan
It's not just the case of a duplicitous landowner you need to watch out for (as in the example above).
If the owner gets into financial difficulty during the option period (still a common occurrence in today's market), it's worth flagging that the insolvency practitioner (liquidator, administrator, receiver, trustee in bankruptcy) or the heritable creditor (mortgage holder) is unlikely to be bound by the option agreement. Instead, he will simply wish to get the best possible price for the property (and in fact, may have a duty to do so). The best price might not be your pre-agreed option price, especially if you've done something to enhance the value in the meantime (like obtain planning permission).
Ways to minimise the risks for the grantee of the option
So what can be done to protect the grantee of an option? There's no perfect solution that will guarantee that you will definitely still have the ability to acquire the property, but the best available protection is to take a standard security (fixed charge) over the property to secure the option. This security (ideally first ranking) would secure the landowner's obligations under the option agreement and should be drafted in such a way that makes clear that the landowner is prohibited from selling the property (or granting a lease, charge, etc).
A standard security, even a first ranking one, doesn't guarantee that you'll get your hands on the property, but it does put something on the public record (i.e. the Land Register of Scotland). This not only assists with putting any third party in bad faith (see above), but also assists in any claim for damages. Having said that, the security should be carefully drafted to ensure that the maximum protection is achieved.
The real benefit of a standard security over the property is that most third parties (whether they are purchasers, lenders or tenants) won't wish to go ahead with an acquisition or loan without getting a discharge or consent from the holder of the standard security. In this way, the option holder achieves a level of control over the property that should ensure that they are able to exercise their option in due course.
Of course, a standard security doesn't solve all issues, particularly where you're dealing with an insolvency practitioner. Again, however, careful drafting can ensure that the maximum level of protection is achieved.
Conclusion
In short, options are a valuable tool that offer great flexibility in terms of making a particular property deal stack up, but you should be well aware of their potential shortcomings. These can be mitigated to a certain extent, but it's always best to take legal advice on the option at the heads of terms stage, so that suitable protection and security can be negotiated and agreed alongside the other commercial terms.
If you would like to discuss these issues further, please contact our Real Estate team.
