What Do Contingency Clauses Do?

Contingency Clauses

What Do Contingency Clauses Do?

In the world of contracts, contingency clauses are critical provisions that provide protections for parties involved in a deal.

These clauses establish specific conditions that must be met for the contract to become legally binding, and if these conditions aren’t fulfilled, the contract may be voided without penalty.

Essentially, contingency clauses function as safeguards, offering a way to manage risk and uncertainty.

Whether you’re involved in a real estate transaction, business acquisition, or even in the context of employment agreements, contingency clauses help ensure that both parties can back out of an agreement if certain conditions aren’t met.

They offer flexibility in the face of unforeseen circumstances that might otherwise result in an inequitable or problematic agreement.

In this article, we’ll explore the function, common types, and importance of contingency clauses, along with tips for negotiating them effectively.

What is a Contingency Clause?

A contingency clause is a condition or provision in a contract that specifies a certain event or condition that must be fulfilled for the contract to proceed or remain valid.

If the condition is not met, the party benefiting from the contingency has the right to terminate the contract without suffering penalties.

For example, in a real estate deal, if the buyer’s financing application is rejected by the bank, the buyer may have the right to cancel the agreement without forfeiting any earnest money or incurring other penalties.

Similarly, a seller may include a contingency that allows them to back out of the deal if they are unable to find another property to move into before closing.

The importance of a contingency clause cannot be overstated—without them, one party could be unfairly locked into an agreement under unfavorable or unexpected circumstances.

Common Types of Contingency Clauses

While the specific types of contingency clauses can vary greatly depending on the nature of the transaction, certain contingencies are commonly included in many types of contracts.

Below, we will delve into some of the most common contingency clauses, with a particular focus on those found in real estate agreements.

1. Financing Contingency

• What it is: A financing contingency is perhaps the most commonly used contingency clause in real estate contracts. It protects the buyer by allowing them to back out of the deal if they are unable to secure the necessary financing to purchase the property, usually in the form of a mortgage loan.
• Why it’s important: Securing financing is a central aspect of most real estate transactions. However, the approval process can sometimes be delayed or even denied due to factors beyond the buyer’s control, such as changes in credit score, unforeseen financial circumstances, or stricter lending policies. A financing contingency ensures that the buyer is not bound to the purchase if they are unable to secure the needed funds.

For instance, let’s say a buyer submits an offer for a home and the seller accepts. The buyer then applies for a mortgage, but the lender denies the loan because the buyer’s credit score has unexpectedly dropped.

Without a financing contingency, the buyer would be legally obligated to proceed with the deal, potentially leading to a financial strain or the need to breach the contract.

With the contingency, however, the buyer can legally cancel the contract without any penalty.

2. Home Inspection Contingency

• What it is: The home inspection contingency allows the buyer to have a professional inspection conducted on the property to identify any potential issues. If significant problems are discovered during the inspection, the buyer can either negotiate for repairs or, in some cases, back out of the deal entirely.
• Why it’s important: Even if a property appears to be in good condition at first glance, hidden problems may not become apparent until an inspection is conducted. Issues such as mold, faulty electrical wiring, or structural damage can result in unexpected repair costs or safety hazards for the buyer. The inspection contingency offers the buyer an opportunity to ensure the property is in acceptable condition before moving forward.

For example, during an inspection, the buyer may discover that the roof needs to be replaced at a cost of $15,000.

The buyer can then either negotiate with the seller to lower the price or request that the seller repair the roof before closing.

If the seller refuses to make repairs or lower the price, the buyer has the right to cancel the contract and walk away from the deal.

3. Appraisal Contingency

• What it is: An appraisal contingency protects the buyer by ensuring that the property’s appraised value meets or exceeds the agreed-upon sale price. If the appraisal comes in lower than the sale price, the buyer can renegotiate the price or walk away from the deal.
• Why it’s important: The appraisal is an essential step in securing a mortgage loan. Lenders typically require an independent appraisal to confirm that the property’s value is adequate to justify the loan amount. If the property is appraised for less than the sale price, the lender may only be willing to offer a loan for the appraised amount, leaving the buyer with a shortfall. The appraisal contingency protects the buyer from overpaying for a property that may not hold its value.

Imagine a buyer has agreed to purchase a home for $500,000. However, the appraisal comes back with a value of $480,000.

The lender will only approve a loan based on the appraised value, meaning the buyer would have to pay the difference.

With an appraisal contingency, the buyer has the right to renegotiate the price with the seller or cancel the contract if an agreement can’t be reached.

4. Sale of Current Home Contingency

• What it is: A sale of current home contingency allows the buyer to back out of the deal if they are unable to sell their existing home before purchasing a new one. This clause is common for buyers who need to sell their current property to fund the purchase of a new one.
• Why it’s important: The sale of a current home contingency offers flexibility to the buyer, allowing them to avoid committing to a new purchase if they cannot sell their current home in time. This contingency provides financial protection, especially in cases where a buyer is relying on the proceeds from their existing home sale to fund the new purchase.

For example, if a buyer is purchasing a new home and has included a sale of current home contingency, they have a safety net if they are unable to sell their old home before closing.

Without this contingency, the buyer could end up owning two homes, which may not be financially feasible.

5. Due Diligence Contingency

• What it is: A due diligence contingency allows the buyer a set period of time to investigate the property thoroughly. This may include reviewing the property’s legal history, zoning laws, environmental hazards, or liens. If the buyer uncovers any issues during the due diligence period, they can walk away from the contract or renegotiate terms.
• Why it’s important: Conducting due diligence helps ensure that the buyer is fully aware of any issues that may affect the property’s value or usability. For example, the buyer may uncover a zoning restriction that prevents them from using the property as planned, or they may discover an unresolved legal dispute over the property title. A due diligence contingency provides a clear path for addressing these concerns without financial penalty.

6. Title Contingency

• What it is: A title contingency ensures that the title of the property is free of any encumbrances, such as liens, disputes, or outstanding debts that could interfere with the buyer’s ownership rights. If any title issues are discovered, the buyer has the option to cancel the agreement or request that the issues be resolved.
• Why it’s important: Clear title is crucial for property ownership. If there are any unresolved legal claims against the property, they could become the buyer’s responsibility once the sale is complete. A title contingency helps avoid this risk by requiring the seller to provide proof that the title is clear before the transaction is finalized.

How Contingency Clauses Work

Contingency clauses generally operate under a straightforward framework: they define a condition, a timeline for meeting that condition, and a process for notifying the other party of the outcome. Here’s a breakdown of how contingency clauses typically function:

1. Condition to Be Met: The clause specifies the condition or event that must happen for the contract to proceed. This could be obtaining financing, passing a home inspection, or resolving title issues.
2. Timeframe for Fulfillment: Contingency clauses include a set period for the condition to be met. For example, a financing contingency may specify that the buyer must secure a loan approval within 30 days of signing the agreement.
3. Notification Process: If the condition is not met, the party benefiting from the contingency must notify the other party, usually in writing, within a specific timeframe. The notification typically explains that the condition was not fulfilled and provides an option to terminate the agreement without penalty.

For example, in a financing contingency, if the buyer is unable to obtain a loan within the agreed-upon 30 days, they can notify the seller in writing. If the seller agrees, the contract is canceled without penalty.

The Importance of Contingency Clauses

Contingency clauses play a crucial role in minimizing risk and ensuring fairness for all parties involved. Without them, one party could be at a significant disadvantage if unforeseen issues arise.

These clauses provide clarity and set expectations, allowing both sides to understand their options should the agreed-upon conditions fail to materialize.

For example, a buyer may feel more comfortable committing to a large investment if they know that they have an “out” if they can’t secure financing.

Similarly, a seller may agree to include certain contingencies, knowing that they are protected from buyers who may back out due to genuine concerns or complications, such as an unfavorable inspection report.

Negotiating Contingency Clauses

The inclusion and terms of contingency clauses can often be a matter of negotiation between buyers and sellers.

Both sides should approach these clauses with careful consideration and clear communication to ensure that they are fair and mutually agreeable.

Buyers:

• Be Specific: It’s essential to clearly define the conditions that must be met. For example, if securing financing is a contingency, specify the exact loan approval requirements and the timeframe in which the financing must be secured.
• Be Realistic: Buyers should avoid imposing overly stringent or unrealistic conditions that may be difficult to meet. For example, demanding a 10-day period for a home inspection may not be feasible in some markets.
• Prepare for Flexibility: While it’s important to protect one’s interests, buyers should be ready to compromise if the seller proposes a reasonable modification to the terms of the contingencies.

Sellers:

• Understand the Buyer’s Needs: Sellers should be aware of the buyer’s circumstances and consider reasonable contingencies, such as financing or home inspection clauses, that can protect the buyer’s interests while keeping the transaction fair.
• Set Clear Deadlines: Establish specific deadlines for meeting contingencies to prevent delays that could extend the transaction timeline unnecessarily.
• Be Ready to Negotiate: Sellers should be prepared to negotiate on terms, such as agreeing to pay for certain repairs identified during an inspection or adjusting the sale price based on an appraisal.

Final Thoughts

Contingency clauses are essential in protecting both buyers and sellers from unforeseen events that could derail a transaction.

By providing a clear framework for canceling or renegotiating an agreement based on specific conditions, these clauses help ensure that both parties are treated fairly and can back out if necessary, without facing financial penalties.

Whether you’re entering a real estate contract, negotiating a business deal, or even working through a personal agreement, understanding the various types of contingency clauses—and how to negotiate them effectively—is key to making informed decisions and safeguarding your interests.

Disclaimer: This article provides general information about contingency clauses and is not intended as legal advice. For advice tailored to your specific situation, please consult with a qualified attorney.