Defining an Escrow Agreement
An escrow agreement is a contract between at least three parties in which one or more of the parties deposit, covenant, or obligate assets. Specifically, an escrow agreement is a deed or instrument whereby an asset or asset for the benefits of a holder is held in custody of a third party. In the common law doctrine of escrow, an escrow is a deed or a bond placed in the hands of a third party pending the occurrence of a specified condition—to be delivered by the third party, to become operative when the condition is met . In other words, an escrow agreement establishes a legal and financial relationship between the parties. The conditions under which the assets will be made available to another party depend upon the terms of the escrow agreement; and may be subject to release upon the next occurring event required by said legal relationship.
Essential Terms in an Escrow Agreement
Generally speaking, an escrow agreement is a contractual arrangement entered into by three parties: the buyer, the seller, and the escrow agent. It sets forth certain conditions under which one or both of the parties are required to perform certain acts, including the payment of money, to the escrow agent in exchange for disbursement of the escrow funds. The buyer and seller generally have to lay out their intentions for the escrow before entering into an agreement with the escrow agent that appropriately addresses their specific needs and business operations.
When negotiating an escrow agreement, it is quintessential to include the following components:
Specificity of Obligations & Conditions to Release The escrow deposit is typically held by the escrow agent subject to the buyers/ investors and sellers obligation to perform certain acts or to indemnify the escrow agent. This "broadly framed condition" should clearly state when and if there are any specific obligations to be performed by either party prior to the release of the funds.
The Disbursements The statements and disbursement provisions are also essential pieces of an escrow agreement. They are closely linked to the specificity of the obligations and generally should include a deadline for distribution after the last party has performed and notified their obligation to the escrow agent.
Common Applications of Escrow Agreements
Escrow agreements are routinely used in several types of transactions. The most common and straightforward use is in the purchase and sale of real property. In most cases, title agents and attorneys will act as escrow agents subject to the terms of an escrow agreement. Commonly the payment of earnest money, the transfer of the deed(s), and the other delivery of a cash or securities such as stock to an agent of the parties and the deposit of such funds with the escrow agent are the common functions performed by an escrow agent on behalf of the parties. The escrow agent is under a duty to pay or deliver a sum of money or a particular instrument to a third person if certain conditions are met.
Real estate that is either listed or being sold by an agent is often subject to earnest money. A real estate agent may receive and hold earnest money from a potential buyer of real property for the benefit of the seller. Escrow agreements are also used in business acquisitions when the corporation has been incorporated but the acquisition is incapable of closing until certain required conditions exist. The seller of the target business may require a deposit to be held in escrow pending the formation of its corporation.
Other uses of escrow agreements include purchases of stocks, bonds, and other financial assets. Online businesses use the contracted Internet payment processor as an escrow agent to receive payment for goods but to postpone payment of the purchase price until a later time to assure that the goods have been received.
These are just some of the many uses for an escrow agreement. The versatility of this document is only limited by the ingenuity of its drafting and the needs of the parties.
How to Write a Successful Escrow Agreement
A properly drafted and legally-enforceable escrow agreement will contain the following sections:
THE PARTIES. The identity of each party, usually, but not always, using the legal names, and the contact information for each party is to be provided here.
PURPOSE OF THE ESCROW. A good escrow agreement will clearly and succinctly explain the purpose of the escrow relationship and the underlying transaction that has created the need for it. How long will the escrow last? Will there be a series of loans or transactions? Will there be one or multiple agreement amendments? Will a contract for purchase/sale be involved?
ESCROW DEPOSIT. The escrow agreement should clearly state what is being held in escrow, content, form (hard-copy, soft-copy, etc.), whether there is any interest earned on what is deposited, identification numbers, amounts (if applicable), name any provisions of law that will apply and/or the section in the contract or agreement that is creating the escrow relationship.
INSTRUCTIONS. This is the heart of the escrow agreement. It is critical that parties spell out the specific instructions the escrow agent must follow when releasing the deposit. If there is no agreement, there can be no escrow and you will pretty much have the same problems with one as if you had no escrow. It is best to avoid overly broad language and absolutely essential to avoid unclear terms. Leave no doubt as to the meaning of the instructions. Are there any requirements for the contracts to be executed and delivered to a specified party? Are there any specific circumstances under which the escrow agent can make payment from the escrow? Know exactly what you want the agent to do with the deposited items and the conditions that must be met, and then be certain the agent thoroughly understands those instructions.
RELEASE OF ESCROW. This is the day-to-day administration aspect of this document. Be specific and detailed about how the escrow agent is to pay interest on a deposited item. Is there a specific way or means by which the interest is to be paid? Is there a specific date each month or quarterly for such payments? In some cases, the payment of interest may be part of the escrow agent’s fees. If not, be specific about the method of payment and how payment will be demonstrated.
FEES. First, is the escrow fee to be paid by the buyer, seller, or both? State the actual fee amount, and be clear about any fees assessed at closing or settlement. Also, be explicit about when the fee is to be collected, and what happens if the closing or settlement does not occur. Does the escrow agent have to wait for the closing to occur before collecting the fee?
BINDING PARTIES. Parties need to be advised that the escrow agreement binds them and in the event that they are to be jointly bound with respect to future performance such as, a notto- be-exceed amount of payments they will comply with this escrow agreement. Additionally, encourage them to consult an attorney if they have questions regarding their obligations. Furthermore, allocate the duties and responsibilities outlined in the escrow agreement to the appropriate parties making certain they understand them.
Legal Aspects to Bear in Mind with Escrow Agreements
The legal considerations involved when entering into an escrow agreement with an escrow agent are multifold. From a legal perspective, consideration must be given to the standards that an escrow agent must meet in order to comply with applicable state and federal regulations. The state regulatory requirements governing escrow agreements vary from jurisdiction to jurisdiction. Escrow agents may be licensed under the laws of the individual states in which they do business. Many states require escrow agents to meet bonding and insurance requirements, have minimum capital requirements and submit to financial statement audits, among other things. Escrow agents must also comply with Treasury Department regulations requiring them to report both cash transaction reporting and suspicious activity reporting. Certain transactions which constitute money laundering or other illicit acts may be reported under anti-money laundering prohibitions. Some states also require the escrowing party to obtain a license to use an escrow agreement.
For example, the Department of Corporations ("DOC") in California regulates mortgage-related and cooperative loan-related escrow transactions under the Escrow Law (Financial Code Sections 17000 et seq.). (For additional details on this subject, see my post at California Corporate Escrow License.) The laws apply to persons offering commercial or residential mortgage-related escrow services in the state of California and also to individuals who are holding funds pending the close of escrow, regardless of the source of the funds . The DOC has indicated that it has taken a more aggressive approach toward enforcing its laws in this area. The applicable financial code sections include: Section 17400 – Unlawful activities; Section 17401 – Application for escrow agent license; Section 17410 – Denial of escrow agent license; Section 17420 – Condition of escrow agent license; Section 17423 – Escrow transaction must be in compliance with escrow agent’s license; Section 17450 – Keeping records; Section 17451 – Public inspection of records; Section 17454 – Transactions exempt from license requirements; Section 17459 – Exemptions; Section 17452 – Notice of delay in the performance of escrow agreement. In addition, if the escrow agent does not follow the specific requirements of California Financial Code Section 17413, this can constitute grounds for denying escrow agent’s application for license, or for revoking or suspending such license. However, sometimes, depending on the jurisdiction and/or the escrow agent, a different set of escrow licenses are required for a particular type of transaction, or the transaction may even be exempt from the licensing requirements. In California, for example, real estate purchase transactions are exempt from escrow licensing requirements and a "closing agent" can act as the escrow agent. (For additional details on this subject, see my post at California Real Estate Closing Agent Provisions.)
A Sample Analysis of an Escrow Agreement
Irrevocability of Escrow Instructions
The next three highlighted sections discuss the irrevocable nature of the escrow instructions. The Buyer is unable to change deposit instructions without notifying the Seller or without a written instruction with both parties’ signatures. Similarly, the Seller also has a clear and irrevocable escrow instruction, and the deposits are "non-revocable."
Plaintiffs hope that the Seller can still recover the funds based on the fact that he discharged his obligations under the agreement.
The effect of the provisions is that neither party can revoke the Escrow without paying the one percent prescribed in the Revocation section, which states:
A. The parties hereto may, jointly, upon notice to Escrow Holder and payment of One Percent (1%) of the aggregate sale price deposited into Escrow, direct Escrow Holder to revoke its appointment as Escrow Holder. Upon the written request of either Buyer or Seller under paragraph 22(a), above, Escrow Holder agrees to deliver the Subject Documents to the demanding party. Without notice to Escrow Holder, Escrow funds may only be released as provided in the Subparagraphs below:
Although this can be used to party’s advantage, it can also be used to a party’s disadvantage, based on the facts of the particular situation.
Deposit Release
This section explains how the Deposit is paid to the Seller. It references Item 2 of the Escrow Instructions, which provides a variety of options from which the Seller can choose. These are:
The fact that this method of payment replicates the methods of payments allowed in the sales contract is important to ensure that deposit funds can be freed up as quickly as possible.
Disputed Funds
This section defines the process to release funds if there is a dispute. It states:
C. Right to Interplead. In addition to the provisions of Subparagraph 22(b) (above), Escrow Holder reserves the right to interplead disputed funds with the Clerk of the Superior Court in the county where Escrow Holder’s office is located. In the event Escrow Holder elects to interplead the funds, Seller and Buyer shall jointly reimburse Escrow Holder for fees charged by the court and/or the costs and reasonable expenses incurred by Escrow Holder in connection with the interpleader action, including funds for costs and reasonable attorney’s fees.
Escrow Holders will often file an interplead action as opposed to waiting for a party to initiate a lawsuit against them. This provision is not dependent on whether the deposit funds are disputed, but serves to release the Escrow Holder from potential liability.
It is important to review raise such concerns prior to opening escrow and to address them to avoid secondary litigation.
Questions and Answers Regarding Escrow Agreements
Q: Does the escrow agreement define the relationship among the parties?
A: It depends, but typically it does not unless the agreement states that it does. A parties’ use of terms like "escrow agent" or "third party" in the agreement can suggest an intention that the escrow agreement has some purpose beyond being a simple holding agreement. Notably, there is no single standard definition of the term "escrow agent." We have seen such contractual interpretation done both ways. This is an area where careful drafting of the escrow agreement can work towards a preferred contractual interpretation.
Q: What is the legal status of an escrow agent and an escrow agreement?
A: Many states define an "escrow agent" as an agent for both the buyer and seller, and the escrow agent has equitable ownership of the subject matter of the escrow to the extent of the escrow agent’s charges, costs, etc. The escrow agent has to dispose of the subject matter according to the terms of the escrow agreement . This more technical legal characterization of the position of the escrow agent is almost always best found in case law, while the parties’ particular intentions are found in the escrow agreement itself.
Q: Does a court have the right to redirect or gain possession of funds held in escrow?
A: Perhaps. An escrow agent is ranked among the class of property custodians, meaning a property custodian must either return the funds or the property within the custodian’s possession, or he may face a court order requiring that specific performance of the court order. Thus, an escrow agent can be subject to a court order, including to transfer funds, and have the power to enforce the court order without being in contempt of court. The escrow agent could enter into a separate agreement with the court or a party, beyond that of the escrow agreement itself, to be compelled to act by a court order. So long as that agreement meets contractual requirements of mutual assent and an exchange of adequate consideration among the parties, such an agreement would be enforceable as long as the escrow agent complied with the order.