Escrow Agreement Explained
Escrow agreements are legally binding contracts that set forth the rules for a holding and delivery device to be used for the actual exchange of money between parties. Parties use escrow agreements almost exclusively in connection with the real estate sales, but the parties can also use escrow agreements in other cases where money is exchanged. One of the main reasons why escrow agreements have become popular in real estate transactions is that these agreements create a neutral third party to hold the money pending closing. Thus parties do not have to worry about dilly dallying with each other over whether funds are on deposit or worry about missing payment dates. In addition, escrow agreements are flexible and allow the parties to provide for certain contingencies that will require an evaluation or judgment to be made by the escrow agent.
Parties enter into escrow agreements when the nature of a deal requires the money being paid to be set up in advance and for the payment to have to be made later. For example, parties use an escrow agreement when an earnest money deposit will be made and placed in a trust account pending a closing. The parties will then provide for a return of the deposit in certain circumstances or the application of the deposit to the purchase price. There are endless variations on this concept. For example , if a seller has an existing home equity line secured by a mortgage on a property being purchased, the seller may enter into an escrow agreement to deposit an amount in excess of the mortgage to ensure that the buyer gets good title at closing.
An escrow agreement is designed to provide the straightforward delivery of money providing comfort to both sides. However, it is important to keep in mind that there may be some situations where it is more advantageous to wait until closing to exchange the funds. For example, if the buyer can get a price reduction for paying cash, it may make sense to forego using an escrow agreement where the buyer has the available cash to close without financing.
Importantly, an escrow agreement defines an optional self-help remedy much like the right to cure that many states provide by default. That is where the seller has the right to cancel the deal and keep the deposit on default by the buyer. Thus, notwithstanding the possible flexibility of the flexibility of this concept, the parties must be careful to exclude application of the statute by specifically providing for factors such as the state of title, removing the right of either party to cancel the deal and by providing for a process for curing a failure to meet a condition.
Escrow Agreement: How It Works
Once the escrow agreement is signed by the parties, the escrow agent will follow a set process to carry out the terms of the agreement. Because various parties can be involved in an escrow agreement, these steps can vary depending on whether the escrow agreement is MRTA or a reverse escrow agreement.
In MRTA scenarios with only the lender and borrower, the following describes a typical timeline:
- Lender disburses the security deposit amounts.
- Borrower complies with the terms of the escrow agreement.
- Lender has the security deposit funds returned and/or returned to two party or three party escrow agreements within 60 days and/or as otherwise specified in the escrow agreement.
- The escrow agent will remit to the lender the amount of the security deposit within 60 days and/or as otherwise specified in the escrow agreement.
In MRTA scenarios with three or more parties:
- One or more parties place funds with the escrow agent.
- If there are specific terms, the escrow agent monitors for the conditions to be met as set forth in the escrow agreement (ie. evidence that the remediation was completed and approved by the lender).
- The escrow agent will disburse funds according to the terms of the escrow agreement (i.e returned to the borrower or lender).
In reverse escrow agreements, the security deposits reverse the roles so rather than the borrower depositing funds, the lender must deposit funds into the escrow account until the terms are satisfied.
The parties, in consultation with one another, can set a timetable for each step of the escrow agreement based on the specifics of the transaction and the escrow agreement.
The Benefits of Using an Escrow Agreement
Escrow agreements benefit both parties in a transaction, and they help to provide security and assurance for both the buyer and seller. In particular, escrow agreements provide:
· Eventual money transfer – a seller wants the money from a transaction; a buyer wants security that they have received what they are paying for. An escrow agreement provides the answer to both of these issues: A seller stands to not get paid until the terms of the agreement are carried out, and the buyer can be assured that they are only paying for the completed product or service.
· Third party assurance – especially for larger transactions, it is reassuring to both the buyer and seller that a neutral third party is holding onto the money until the proper transaction terms are met.
· Clarity – both buyers and sellers have their interests protected by a contractually binding agreement. Both parties are able to have their terms met.
Common Uses of Escrow Agreements
Escrow agreements are commonly used in a wide range of applications. Real estate transactions involving the sale or lease of property (particularly where closing costs or other fees are contingent upon an event), business acquisitions , and development projects are a few examples of situations where escrow arrangements have been used. Online commerce has seen the development of its own breed of escrow companies that serve as a middleman in the sale of goods over the Internet; when the buyer receives the goods as promised, the escrow company releases the money to the seller. This has greatly reduced the risk of fraud in this burgeoning method of buying and selling.
Legal Requirements in Escrow Agreements
In the context of an escrow agent acting in a fiduciary capacity under a true escrow agreement (as opposed to an agency contract), as a matter of law, the agent does not have the same type of authority or discretion as an agent and is bound to strict instructions given by the contracting parties as set out in the escrow agreement.
While parties may submit a dispute to mediation and/or arbitration as part of the escrow agreement, the banks or other depositaries may be contractually entitled to require that a dispute be resolved through litigation, although most escrow agreements allow for the possibility of resolving a dispute without court intervention. Parties should be aware that an escrow agent may not be subject to the jurisdiction of the court or mandatory disclosure orders for various reasons.
Escrow agents are not required to return the deposit to either party (or both) until the conditions of the escrow agreement have been met or until the escrow agreement has been terminated by the parties. In addition to clearly articulated instructions, the parties to an escrow agreement should consider what happens in the circumstance where there is no dispute and the escrow agent believes it is entitled to release the funds or property but one or both parties disagree. If a party refuses to consent to the release, the escrow agent may only be able to release the funds or property upon receipt of judicial or arbitral permission. This can be an expensive and time-consuming process, although sometimes the mere commencement of a proceeding will be enough to get either party to change his/her mind.
Conversely, if there is a dispute, the escrow agent is not authorized to deal with the deposit until the parties resolve their differences. The parties may be bound by a deadline to resolve the dispute, for instance, if there is an immediate need for the funds or property, or may want to wait until a later date to give them more time to resolve the disagreement. Either way, if the parties are not able to agree, they must submit their dispute to the appropriate forum for resolution. Most escrow agreements provide that, should a dispute arise, jurisdiction is in some specified manner, whether a particular court or another alternate dispute resolution mechanism.
Choosing an Escrow Agent
If the parties agree to utilize an escrow agent to hold funds or some other property, they should consider the following in selecting an agent:
- The escrow agent must be a neutral third-party. If either party is designated as the escrow agent, it would no longer be an independent third party. An independent third-party escrow agent is considered to be impartial and free of any interests , relationships and circumstances that could cause an individual to not be able to balance the interests of both parties.
- The escrow agent must have experience holding the type of funds or property to be placed into escrow.
- The escrow agent should have a sufficient office staff that can manage large sums of money and will be able to handle issues between the parties.
- If there are specific provisions regarding the "prudent investment" of the escrow funds, the escrow agent should generally be an investment company or bank.
- Select an escrow agent who will be available to answer questions of the parties, accounting firms and others.
- Select an escrow agent that will have time to do the accounting work in a timely manner.