One in the freezer

We have recently seen the emergence of a new clause in option agreements and promotion agreements for residential development sites. The clause is being agreed regularly enough that in a few years it may well be considered to be a standard clause. I will talk generally from the perspective of option agreements here, but the principles are the same with respect to promotion agreements.

This new clause is usually known as a “freezer clause”, or “market failure clause”. The clause states that in the event of a significant market downturn, certain provisions of the option agreement which would otherwise lead to the termination of the agreement, in the event that the developer did not purchase the site, will be postponed (or frozen) for a certain period of time (usually two years).

Where would a freezer clause apply?

The two situations where a freezer clause would be useful are:

(a) The developer has obtained planning permission for residential development on the option site, but there is a market downturn before they exercise the option. Either (i) the option agreement may have provisions stating that the landowner can terminate if the developer has not exercised the option within a certain period after planning permission has been obtained, or (ii) we may simply be near the expiry date of the option. The freezer clause would operate to extend the period within which the developer had to exercise the option (so, if there were only six months left in the option period, the freezer clause would operate to extend this to a maximum of two years and six months).

(b) The developer has exercised the option and is purchasing the site in tranches at the time of the market downturn, and the option agreement provides that the agreement will come to an end in the event that further tranches are not acquired within a certain period (so, for example, it may say that a further five developable acres have to be acquired every 18 months). In this instance, the freezer clause would postpone the 18-month period (so, if the freezer clause was to operate for two years, it could postpone the 18-month period to a maximum of 42 months).

In either situation the developer will have invested significant time and money in promoting the site through the local plan process, site investigation costs, planning application fees (and possibly appeal costs) in obtaining detailed planning permission, as well as the costs of contractors and consultants. The developer will not wish to lose the site, but if there were significant downturn in the market it could, for a period of time, make the site unviable (particularly in the light of a high minimum price). Without the freezer clause, the developer would need to make the difficult decision whether to purchase the site (or continue to purchase tranches) despite the market downturn, or potentially lose a site they had invested significant time and money in. The freezer clause operates to postpone this difficult decision and, hopefully, at the end of a two-year period the market will be back on track and the developer will be able to proceed with the purchase.

Arguably the freezer clause is also for the benefit of the landowner. In the vast majority of option agreements the purchase price is calculated on the basis of the market value of the site, so there is a clear benefit to the landowner not to sell at the bottom of the market. The principle is the same with promotion agreements, where the landowner will not wish to sell at the bottom of the market.

Having said that, every freezer clause we have entered into has been purely at the instance of the developer (meaning that the developer has the option whether to use the freezer clause to extend the relevant periods, or disapply the freezer clause and purchase despite the market downturn). I think this has to be correct, as it is important for the developer that they are able to ensure continuity of sales on the site, or to purchase the site if it is in their business plan, even if there is a market downturn.

Generally, we have found landowners in favour of the market failure clause as they are tying up a long-term option agreement or promotion agreement, so they know that they are in for the long haul with the developer and are relatively comfortable with an extension as a result of an issue which is outwith the control of the developer.

What is a market downturn?

While we could all recognise a market downturn as deep as the 2008 recession, the question of how to define a market downturn (and therefore what should trigger the freezer clause) is relatively tricky. I have seen various different definitions or attempts to define a market downturn in different option agreements and promotion agreements.

I have seen definitions as simple as that there is a market downturn if the price (after deduction of abnormal costs) is less than the agreed minimum price. However, it may not be a market downturn that triggers this outcome, as this could simply be due to there being significant abnormal costs in respect of the site.

Other ways to define a market downturn that we have seen are (a) where the headline market value (i.e. prior to the deduction of abnormal costs) is lower than an agreed minimum headline value, or (b) with reference to one of the house price indices (if the relevant house price index is, say, 5% lower than it was when the option agreement was entered into, this would constitute a market downturn).

Possibly a better (if less definitive) approach is to define a market downturn as a demonstrable reduction in house prices in Scotland (or the relevant part of Scotland), which leads to the price being lower than the agreed minimum price.

This is slightly less definitive and leaves some room for debate further down the line, but then this is a relatively difficult concept and it may be that it is best for there to be some room for debate in order that both parties are protected.

Length of extension

Generally, we have seen freezer clauses permitting an extension of two years. It is generally thought that any period of less than two years is not long enough for the market to recover if there is a downturn.

While, in reality, the market may not have recovered fully after two years if there is a significant financial downturn, there has to be a balance here in that the landowner cannot have the land tied up forever with no firm commitment from the developer to purchase. Therefore, on balance, we have found that two years is an acceptable compromise.

What to call the clause itself

We have often seen freezer clauses referred to as “market failure” clauses or “market downturn” clauses. However, we have had some comments that certain landowners and developers do not like this terminology and think it a bit negative. In these cases, the terminology “freezer clause” has been used. 

Not Brexit-related

It is worth pointing out that the rise of freezer clauses is not related to any current concerns about how Brexit will affect the market. The length of option agreements and promotion agreements, and the amount of time it takes to promote a site and obtain planning permission, mean that it is likely that any freezer clauses agreed now will not operate until a number of years in the future.

And, in the future, I think it is likely that the inclusion of freezer clauses in option agreements and promotion agreements will be seen as standard practice.