The article has been written by Ayush Verma, from RMLNLU, Lucknow, and Harsh Kedia, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from lawsikho.com. The article discusses the essentials of a lock-out agreement, its advantages and disadvantages and how to make such agreements work.
A lock-out agreement (sometimes called an exclusivity agreement) is a fundamentally negative agreement wherein the seller is required not to negotiate with the third parties during the lockout period. A seller can only deal with the buyer during such period. The dealings can be in terms of supply of goods, services, etc. However, such an agreement doesn’t guarantee that a sale contract will be entered into.
The agreement provides the buyer with a fixed period of exclusivity which gives the buyer an opportunity to carry out searches, surveys, and investigations before purchasing the property. A property which is the subject of the sale shall also be removed from the market, for the period specified in the agreement. It ensures that the seller does not enter into an agreement with any other person which may cause loss to the buyer.
What are lock-out agreements
Like any other agreements, lock out agreement is legally enforceable. This agreement comes into force when a buyer wants some time to execute a real purchase agreement with the seller. It is not always possible to acquire something at the very first instance. If the amount of the deal is very high, the party paying the amount will check all the necessary documents relating to it and this takes time. For example, A has a property in Bandra, Mumbai which he wants to sell. The demand of that property is huge and many potential buyers are ready to pay the desired amount. B, an individual approaches A and asks him to not sell the property to anyone till B completes all the necessary paperwork and due diligence. In this type of arrangement, lock out agreements come into force which somehow restricts the seller from selling the property to any other party. But it does not actually put a restriction on the seller.
Another distinctive feature of the lock out agreement is that it does not make the seller bound to actually sell the property to the prospective buyer even after the end of the lock out period. In the same way the buyer is also not obliged to purchase it from the seller after the lock out period. Therefore, lock out agreement just allows a buyer to take some time for inspections without the fear of losing the property for a specific period.
Therefore, in this agreement a time period is mentioned in which the seller’s main obligation is to not sell the property to any other buyer and the prospective buyer’s only obligation is to complete all the necessary due diligence within that time period. Though there are not many advantages on the part of the seller as he is somehow restricted to sell the property to any other party during that period but for buyers it is very advantageous as he has some surety that the property will not be sold within the time period.
Enforceability of the lock-out
A lock out agreement will be enforceable if it meets the following requirements:
- Negative in nature – The agreement should restrict the seller from contracting with any other third party within that lock out period either.
- Time period – The time period of the lock out should be fixed. It can be for 2 months or it can be for 6 months but it should be definite.
- Payment – It must be made for the agreement or the agreement must be executed as a deed. However, an obligation on the buyer to incur costs (for example, legal costs in instructing its solicitors to carry out due diligence or surveyors’ costs in carrying out a survey) can amount to “consideration”.
However, to make a lock out agreement enforceable it is not mandatory to execute it in a written format. The parties can enter into a lock out agreement expressly but it is always beneficial for the parties to give it a written form as it will act as a more concrete proof if anything goes wrong.
A sale is not completed when a seller enters into a lock-out agreement with the buyer. After entering into a lock-out agreement, neither the seller is committed to the sale nor the buyer is committed to the purchase. The seller just promises the buyer:
- To not enter into any agreement or negotiations with the third party;
- Restricting the third party from viewing the property (by taking off the property from the market);
- Not to enter into any contractual obligations with the other parties in regards to that property.
The agreement is entered into for a shorter period of time. Otherwise, it may be disadvantageous to the seller; for example, where a third party is offering a higher amount for a property to the seller, the seller might want to accept that offer but he cannot, as he has already made an agreement with the buyer regarding that property. So, the restrictions should be for a shorter period of time.
The purpose of a lock-out agreement is to provide the buyer time to carry out its initial due diligence regarding the property while the parties are agreeing to more detailed terms or the relevant legal documents. Therefore, the seller needs to think about certain specific arrangements that he wants to be put in the lock-out agreement and which needs to be omitted from the arrangements.
The seller may also ask for a non-returnable deposit to the buyer as the consideration for the lock-out agreement. This would help the seller to get some returns for taking his property off the market as per the terms of the agreement. And, it might also incentivize the buyer to proceed with the sale.
Lockout period is the most important clause in any lock out agreement. It defines the time within which the buyer has to perform its obligations and the seller has to restrict himself from selling the property to any other buyer. In most lock out agreements, the period of exclusivity is of short duration.
The time period for which the obligations of the lock-out agreement shall apply must be clearly defined and the period must be fixed, like – two months. The agreement shall specify:
- When does it start?
- When does it finish?
The buyer will always want the lock out period to be long so that he can conduct all the necessary investigations about the property about the seller. He will have sufficient time in his hand to do the necessary tasks. On the other hand, the seller will want the period of exclusivity to be as short as possible. He may not want to miss any other chance better than the present one. If the period of lockout agreement will be long, then he might miss the opportunity to sell it at a higher price if the market value of that property increases.
A term of confidentiality is important for lock-out agreements which may include termination. When a party enters into a business relationship, it may obtain and have access to highly confidential information and other sensitive information that may be helpful to the competitors. Therefore, there should be a well-drafted agreement incorporating both the immediate and future needs of all the parties involved, in order to maximize business synergy. A confidentiality provision is required because, if the sale is not completed, the seller does not want the market to get a wrong impression as to the value of the property.
Change of heart
If a party loses its interest in the transaction, the other party would never want to be locked into a pre-contract agreement in order to save time and cost. So, lock-out agreements often include a clause asking both parties to notify each other if, during the lock-out period, they choose not to proceed.
Good faith Agreement
A lock-out agreement may include a clause where both parties agree to act in utmost good faith towards each other, in relation to the agreement and the transaction. An act of good faith means that:
- The parties will be observing reasonable commercial standards of fair dealing;
- Being faithful to each other for the purposes of the agreement; and
- Acting consistently with the reasonable expectations of the other party.
A clause is more likely to be enforceable if it is more detailed and clear, so both parties need to specify what they expect from the other party to progress the transaction.
There are certain obligations that buyers have to abide by. These obligations may be imposed by the seller. The buyer needs to carry out its due diligence (for example, submit searches, carry out environmental investigations and measured surveys) within the time specified in the agreement. It may be suitable to specify in the agreement that if the specified time limits are not met, the seller shall have the right to determine the conditions of the agreement.
The buyer or its solicitors need to comment quickly on the draft documents submitted and raise
preliminary queries regarding the information supplied to them, and carry out the due diligence properly.
If the seller is carrying out environmental or survey tests, the seller can ask the buyer to produce copies at the completion of the lock-out period, if the buyer decides not to continue with the transaction, although these will not be particularly directed to the seller. The copies may include useful background information (in specific circumstances, a seller might insist that the reports must be directed to the seller as well as the proposed buyer).
Other types of Seller’s obligations
The seller may agree that his solicitors will dispatch the draft documents within a specified time period, to quickly deal with the proposed amendments in the documentation by the buyer and to make reasonable efforts to answer the preliminary queries raised by the buyer. If the seller has committed to allow the buyer to carry out surveys, the seller needs to ensure that the consent of the occupational tenant is obtained, if necessary, and also allow the proposed investigations (for e.g. – the seller might want to be informed about where the boreholes may be sunk; allow the proposed reinstatement works and look over buyer’s public liability insurance).
Breach of the agreement
As in other types of agreement, in case of breach of contract, the party breaching the contract has to pay a certain amount of money to the other party as damages or compensation. In addition to this, the suffering party may choose other methods to protect his rights. In lock out agreements, if the seller breaches the agreement, for example the seller within the lock out period transfers the property to some other buyer which in turn violates the provisions of the previous agreement. In this case, the seller shall be liable to pay the damages to the previous buyer. Though like every other contract, it is not the same the seller is required to pay limited damages up to the expenses incurred by the buyer in conducting his investigations or legal expenses. The buyer cannot ask a court to grant a permanent injunction and to restrict the seller from selling the property to any other buyer. Why such an injunction is not granted is because of the nature of the lock out agreement which is discussed later in this article.
The seller shall also be required to return the non-refundable deposit which was deposited by the buyer before executing this agreement. In many circumstances, some amounts are paid to the seller as a non-refundable deposit for securing the property from getting purchased by any other buyer.
If we look at things practically, generally this type of agreements is entered into for the interest of the buyer. There is very little chance that the seller will get some benefits and that too when the buyer actually purchases the property after the lock out period. It may happen that the buyer after some time refuses to carry out the investigations or breaches the agreement. For example, the buyer may come into a contract with any other seller without informing the seller in advance. In such a case, the seller will be at the liberty to claim damages from the buyer which in this case he can claim the legal expenses incurred during the term of the agreement. Also, he can forfeit the deposit which was given by the buyer. Generally, the seller does not face any such problems in the event of termination of the contract as the seller does not guarantee the actual transfer of property to the buyer even after the lock out period.
Liability of Breach
There is a possibility that a buyer may not proceed with the sale. If the seller gets convinced during the lock-out period about such happening, he may want to proceed with another offer immediately, in order to complete his sale. This would lead to the seller breaching the lock-out agreement. So, let’s discuss the potential liabilities that may arise from such breach:
- Firstly, a buyer may obtain an injunction to restrict the seller from contracting with another interested party. However, the courts have emphasised on various occasions that an injunction should be granted for a short period (reflecting the nature of the lock-out agreement itself). An injunction would stop the seller from negotiating with another party during the lock-out period but would still not commit the seller to any succeeding transaction with the original buyer.
- Secondly, a buyer shall be entitled to get damages for the breach. Typically, the Courts have always emphasised on the buyer’s wasted costs while deciding the damages. However, there is an argument that the damages should be further restricted. A transaction may not have completed even if the lock-out agreement is not breached and the buyer would have suffered losses. Therefore, it can be said that the damages should be limited to the additional wasted costs which were caused to the buyer by the seller’s breach.
A buyer may also ask the seller to pay a non-refundable deposit if the transaction is not completed. It can also be used to pay off buyer’s wasted expenditure and would also act as a warning to the seller to not sell the site elsewhere. Nevertheless, it will depend on the negotiating position of both the parties but it will be difficult to foresee that other sellers will also want themselves to be put in such a situation.
A seller cannot be said to be bound by the terms of the sale, therefore, it is plausible to use a mechanism whereby the seller can end any positive obligations, if the negotiations have broken down or where the seller decides not to proceed.
Such a mechanism would involve serving the ‘withdrawal notice’ to the buyer upon receipt of which such obligations would directly terminate. However, negative obligations on the part of the seller (not negotiating with other parties etc.) would remain alive until the exclusivity period lasts.
Contrastly, in many cases, a withdrawal notice from the buyer will logically operate to bring the exclusivity period to an end instantly upon receipt by the seller.
Recovery of the buyer’s costs
In the lock-out agreement, the seller is liable to pay the costs to the buyer, if the buyer serves a written notice (during the lock-out period) confirming that he is ready, willing and able to exchange contracts. It the seller then fails or refuses to do the exchange, he shall pay to the buyer, an amount which may be equal to the total costs, fees and expenses incurred by the buyer during the lock-out period. This may or may not be subject to a cap. Since an exclusivity or a lock-out agreement is intended to protect the buyer from having incurred substantial costs while getting ready for the completion of the sale, and at the last moment if he losses property because the seller decides to proceed with someone else, payment of damages by the seller is to be regarded as a suitable alternative.
Lock-out agreements: exclusivity, but not a right to buy
By thorough reading of the above paragraphs, one will understand what lock out agreements are and when it is executed. But there’s one unique feature of this agreement. As from the heading of this paragraph, one must be thinking what is “but not a right to buy”. The lock out agreement is executed to protect the property and for the interest of the prospective buyer. The seller’s obligation is to hold the property and not to sell to any other potential buyers. If we look at the things practically it is the seller who actually faces the risk. One problem is that the seller will still have to protect the property just for the prospective buyer even if the market price of the property increases in the meantime.
The reason why the nature of the lock out agreements is different because if the seller is made strictly bound to protect the property for some period without any guarantee that the buyer will purchase it from him after the lock out period then the chance of risk increases for the seller. Although the seller has some obligations to protect the property, it does not mandate him to sell the property to the prospect buyer. Thus, by mere execution of the lock out agreements, the buyer does not get any right to buy the property. As mentioned above the buyer cannot ask a court to pass an injunction order against the sale of the property. If the seller gets an offer within the lock out period then he can sell the property to any other buy provided that he may have to provide damages to the previous buyer. Therefore, ultimately it is the seller who will decide the actual owner of the property. This shows the nature of the lock out agreements and why it is said that such an agreement does not give the buyer a right to buy.
Advantages of a lock-out agreement
- A lock-out agreement can help in achieving financial security as it provides a stable stream of revenue. This revenue stream can further help in expanding the company once the exclusivity period expires.
- It provides a better business focus. It can help a company focus on the long-term goals as the distributive issues and other logistical issues are dealt with, by the provider.
- It also helps in networking as such agreements give you access to the provider’s network of business owners. It also helps in establishing a stronger business and personal bond with the parties involved that could persist beyond the term of the contract itself.
Disadvantages of a lock-out agreement
- A lock-out agreement may hamper the creativity and flexibility in the business.
- Violating a lock-out agreement can bring fines and penalties, as a result of which parties might miss more advantageous business opportunities.
How to make such agreements work?
- The most important thing for the parties is to agree to both the principles and the terms of an agreement before agreeing to the sale of the property i.e. it should be included as one of the terms of the sale and preferably, a draft of the agreement should have been viewed and accepted by the parties beforehand.
- It is also important to distinguish those cases where using an exclusivity agreement may be inappropriate. This will be where one or other party is not committing to exchange within the definite time period.
- Lawyers of both parties should be familiar and passionate about the use of an exclusivity agreement. Some lawyers think that such agreements are not a good thing and the time spent on putting such agreement in place should be utilized in trying to achieve unconditional exchange of contracts.
- The agreement should be promptly exchanged and a date by which exchange must be completed should be fixed as a term of the property’s sale.
- It is also recommended that, in every case, the seller’s title to the property be provided to the buyer’s lawyer before the exclusivity agreement is exchanged. Now, that title to 90% of the properties being registered, it is easy to identify the major defects in the title. It also helps to check that the owners of the property and the seller are the same.
- It is also recommended that, if possible, the buyer should get the survey done before exchanging of the agreement. It is beneficial for both parties because it indicates that the other important reason why a buyer may wish to withdraw from an exclusivity agreement will have been dealt with. However, it is not easy to achieve because surveys can take time to arrange which will delay the timeframe for getting the agreement in place.
A lock-out agreement aims to secure a pre-contract ‘lock-out’ period for a buyer to enable him to carry out searches, surveys and investigations before proceeding with the sale. However, the agreement doesn’t bind the parties to proceed with the sale. A lock-out agreement should be entered into for a shorter period of time so that the ‘lock-out’ period doesn’t harm the seller. Its terms should be definite and straight-forward in order to avoid any confusion.
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