An escrow account is a contractual arrangement where a third party holds money or property in trust until the contracting parties meet a set of conditions. The third party is referred to as an escrow agent. They are neutral to the parties and the agreement and are responsible for the safekeeping and distribution of the money or property in trust upon satisfaction of the conditions.
Why are escrow proceedings important?
Escrow proceedings are a safeguard to prevent parties from being tempted to abscond with all of the deal's benefits, double-cross a party by selling goods out from under them, or avoid payment altogether. Most often, escrow accounts are utilized to prove that the paying party can afford the transaction, has the liquidity to complete the transaction, and isn't using promised funds in alternative transactions.
Escrow is most useful when the subject of the contract is highly valuable – escrow isn't especially useful to a retailer who sells shoes. An escrow is a more appropriate shield for selling a home or a business, for example.
Types of Escrow Accounts
There are several types of escrow. The most common are real property escrows, mortgage escrows, and business escrows. Property escrows occur during the purchasing process of real property – an escrow agent collects any down payment, loan documents, and deeds and holds them in trust until the sale formally closes. When the deal closes, the escrow agent will distribute the deed and the mortgage documents to the buyer and the payment to the seller. Property escrows are functionally essential because of the length of the contracting process of real property sales.
Mortgage escrows are established by mortgagors (e.g., the bank) to hold money in trust to pay property taxes and insurance. This form of escrow is selected so that a lender can ensure the property purchaser pays the required property tax and insures the property. Lenders are concerned about taxes and insurance because their collateral (the property) is exposed to liability if the homeowner doesn't comply with these requirements.
As the mortgagee makes payments on the mortgage, a portion of each payment is deposited into the escrow account. The mortgagor will release the escrow funds to apply to the principal of the loan balance once the homeowner makes the annual payments, and then the process begins again for the next year's payments. Often, these accounts are audited annually by the lender itself to be sure that the amount collected is appropriate.
Business escrows help protect business entities from unnecessary risk when purchasing supplies, placing merchandising orders, and contracting for long-term projects. What makes a business escrow specifically useful. It mitigates risk when large quantities of money or property are at stake, when there are long-term contracts, or when contracts include payment components that are guaranteed and contingent.
Why Business Escrows are Important
An escrow account assures both contracting parties that the outcome of the agreement will match the expectations. A business escrow account works like property and mortgage escrow accounts – a third-party escrow agent holds money or property in the trust. Once they are notified by both parties of satisfactory performance, they release the account to the appropriate party.
What kind of escrow agent should you choose?
It is important to note that escrow agents and agencies should be neutral third parties. However, they can still have a pre-existing relationship with either contracting party.
The agents cannot be under the control of either party – an escrow agent shouldn't be directly employed by either party. A company may have an escrow agency or agent they frequently do business with, but the company should not directly influence their chosen agent. For example, if the CEO of a small business tells their fellow contracting party that their son is an escrow agent, it's probably best not to use his services.
Downsides to Using an Escrow Account
There are some downsides to using an escrow account, the first being the cost. Escrow agents require some sort of compensation for their work, and most often, that comes in the form of a small percentage of the overall cost of the transaction.
Typically, an escrow agent would charge between one and two percent for the safekeeping and distribution of collateral. Otherwise, escrow agents may charge flat fees or offer a single client a package deal. For example, if a single client uses an agent regularly, they may offer to pay a lump sum upfront for a year's worth of the agent's services.
There is also the opportunity cost of putting money or property into an escrow account. Those who use escrow accounts, individuals and corporate entities alike, lose the opportunity to spend, exploit, enjoy, or invest whatever they are safekeeping. The opportunity cost can be high in larger transactions, where escrow amounts rise into six- and seven-figure territories.
What does the escrow agent do with the collateral?
This brings about an important consideration when choosing an escrow agent – what does the agent do with the collateral? In the case of capital collateral, the depositing party will want to search for an agent who keeps funds in an interest-bearing account.
This way, if the money is held in trust for any significant amount of time, there will be a small return on the investment. It's important to note one large red flag in particular when searching for an escrow agent – if they claim to invest your funds. This defeats the purpose of holding funds in escrow and would violate state escrow agent regulations.
Verifying An Escrow Agent's License
It is even more important that potential depositors verify a potential escrow agent's license. Most states have public records databases that anyone can check to see if an individual is licensed and in good standing. If an agent purports to be a member of an escrow agency, be sure to verify their employment with the agency and check that the agency is a registered entity with the state. Especially when it comes to keeping large amounts of funds in escrow, finding a trustworthy, state-licensed, well-reviewed escrow agent is the most important consideration.
Banks' In-House Escrow Services
Most banks offer in-house escrow services. If an individual or a business entity chooses to use their bank's escrow services, their money will likely be safe and distributed effectively. Typically, businesses have good working relationships with their banks, individual bankers, and loan officers – these relationships can offer peace of mind about collateral placed in escrow.
Business Escrow Examples
An example of a common situation where business escrow accounts are utilized is when a business contracts with a supplier for frequent, large deliveries of products over a long period. For instance, a large computer company like Apple may contract with manufacturers who produce keyboard panels.
Apple does an extremely large volume of business in selling laptops, so they may contract with large and small manufacturers to meet their demand. It is possible that at least one of these manufacturers does not have the liquidity necessary to carry out a project like this over the span of a year. Apple may agree to put the lump sum payment into an escrow account, with directions to the agent to disperse installments of the funds upon periodic product deliveries.
This would allow Apple to contract with smaller manufacturers, protect their investment from exploitation, and make a small return on their investment in the form of interest. The small manufacturer also benefits – they can take on a larger product with a reputable company without securing a loan, they can be certain that Apple doesn't take their product and run, and they can avoid any sort of litigation over payment against a company with infinitely more resources.
Escrow Accounts for Online Transactions
An escrow account can also be useful in the case of online transactions. Anyone who has purchased something from eBay, Craigslist, or Facebook Marketplace knows the uncertain feeling of sending a payment off into the void and anxiously awaiting the arrival of a package on their doorstep. In the case of larger transactions, escrow accounts remove that anxiety. If someone purchased a custom-made guitar for $2,000 from a craftsman's website, they might feel safer depositing that money into an escrow account until the delivery of the instrument.
NFL Business Escrow Example
A real-life example of a business escrow comes from standard practice in the National Football League. Teams that sign players under contracts with guaranteed payout provisions must deposit portions of that guaranteed payout into an escrow account. This is an old rule, originating from the days when football was not as lucrative and widely adored as it is now, but it is still in effect to protect players from exploitation. In March 2023, the Browns owner had to deposit $169 million in escrow as promised in a contractual agreement with DeShaun Watson.
Overall, an escrow account can ease the anxiety of contracting parties regarding their counterpart's performance. The most important things to remember when searching for an escrow agent are licensure, good standing, and stable returns on a short-term investment. Always do your own research to protect your assets.
If you have any questions about escrow accounts and agents, contact our experienced business lawyers today.