For most people, transactions are as simple as paying and getting what’s paid for. But, not all transactions are that straightforward. Sometimes, you may need an extra layer of security for a transaction to scale through successfully. That’s where escrow comes in.
As a rule, every transaction is based on trust. The buyer trusts the seller to fulfil their end of a bargain, and vice versa. But, some other transactions need more than just oral assurances or blind faith. Sensitive and really expensive transactions, especially real estate, commerce, and other high-stakes transactions, need an extra layer of security besides mere faith that the parties will fulfil their obligations. That is where escrow comes in.
Escrow services protect all the parties in a transaction. This layer of security prevents any party from enjoying benefits without fulfilling their obligations.
This article will cover:
What an escrow is, and how it works
The different types of escrow agreements
The legal implications of escrow agreements
How to create an escrow agreement for your next transaction
What Is Escrow?
An escrow is a legal safety net that withholds the enjoyment of certain transactional benefits until certain conditions are satisfied. It could either be in the form of a legal document i.e. an escrow agreement, or it could be a third-party service via an escrow agency or software application.
Simply put, an escrow is an agreement where the parties to a transaction decide to hand over the payment for a particular product or service to a third party for safekeeping until the product or service is fully delivered or completed. For instance, a buyer would pay money into an agreed escrow account, while the seller delivers the agreed product or service to the buyer. Once the delivery is confirmed and satisfactory, the money paid into the escrow account will then be released to the seller.
Historical Context And Evolution Of Escrow Arrangements
Historically, escrow agreements date back thousands of years. It was quite a common practice for merchants and buyers to use it to protect themselves from uncertainties. Escrow even predates the use of money. During the barter trade system, parties could approach a third party to witness their trade agreement and act as a guarantor. Afterwards, each party would bring their items for barter to the guarantor who would then oversee the exchange.
When money was introduced, escrow agents became keepers of the monies paid for a product or service. They could either wait to be jointly informed by the parties that the contract has been completed, or they could directly monitor the progress of the contract by making enquiries.
Seeing that most transactions were simple and direct, escrow gradually became a safety net that was mostly used for property transactions. At the time, property transactions required an exchange of title documents for money. As such, both the title documents and the money were kept with an escrow agent, usually local courts, pending the necessary verification of the title and inspection of the property.
Once there's a hint of fraud or misrepresentation during the verification process, the court could cancel the contract and return the title documents and funds to their respective owners. The court could even go as far as barring the errant party from ever engaging in any property transaction. Ultimately, the strict verification process and consequences made the escrow system very tight but fair to both parties. You had nothing to lose if you were honest.
As legal systems evolved, so did the escrow system which allowed for less stringent consequences. Rather than going to local courts, parties could choose neutral third parties such as a trusted mutual friend, specialised escrow agency, or even banks to serve as escrow agents.
How Does Escrow Work?
Like all contracts, escrow agreements are legally binding on the parties. It automatically gives the third party who is known as the escrow agent, legal control over the money, consideration, or valuables clearly stated in the escrow agreement. As such, it is only after the contract is completed that the escrow agent would release the stashed valuables to the seller or receiving party.
For instance, when parties approach an escrow agent concerning a service contract, the parties could deposit the payment price with the escrow agent. Once the contract is complete with proof, the escrow agent can then release the stashed money to the receiving party. In this case, the money goes to the service contractor.
Where there's a disagreement about the completion of the contract, the escrow agent being neutral, would assess the progress of the contract, and determine who's meant to make amends. As such, neither the buyer nor seller can collect the funds held in escrow until the contract is completed.
Here’s a quick breakdown of how an escrow arrangement works:
Parties approach each other for an exchange of products or services for payment or some other valuable consideration.
The parties agree to create an escrow agreement.
The parties approach a neutral third party that’s trusted by both of them
The parties alongside the third party draft an escrow agreement.
The escrow agreement clearly states the scope of the transaction, including the price and declares the third party as the escrow agent.
The parties deposit the payment or valuables stated in the agreement in an escrow account managed by the escrow agent.
The parties go ahead with their transaction e.g. rendering services or delivering products.
Once the transaction is complete, including quality checks, the parties approach the escrow agent with proof that the transaction is complete.
The escrow agent then releases the payment or valuables to the appropriate receiving party.
Types of Escrow
An escrow arrangement is usually determined by the transaction involved. As such, there are different types of escrow arrangements. These include:
Property Escrow
This is arguably the earliest form of escrow. It is used to transfer property ownership from one person to another. Property escrow covers transactions like home purchases, mortgages, and leases. It usually involves the solicitors of both the buyer and seller.
Here, ownership or title documents and the payment are kept in an escrow account that is managed by the escrow agent. Afterwards, the buyer would inspect the property and also verify the ownership claim of the seller. If everything is in order, the parties will complete the sale. The escrow agent would then oversee the exchange of the title documents to the buyer, and the payment to the seller.
For mortgage transactions, an escrow agreement could be used to protect both the buyer and the lender, ensuring commitment to paying the mortgage. In this case, down payments are secured from being arbitrarily claimed by a seller due to mortgage payment defaults. What's more, a portion of the mortgage payment is held in escrow to cover insurance and tax payments.
Business Transactions
Escrow payments are popular for high-stakes transactions in the corporate and commercial sectors. Transactions like mergers and acquisitions, and procurement usually include an escrow arrangement to ensure that both parties keep their end of the deal.
Conditions like transfer of intellectual property, representation of assets and liabilities, and consideration either as shares or premiums, are usually listed in the escrow agreement. Where there are breaches in a merger, for instance, the buyer is protected against losing all invested funds completely to the seller.
Software Escrow
Escrow agreements are important for tech companies, especially when contracting software developers. At face value, software Escrow agreements are like service-level agreements. The software developer only gets access to the payment in escrow after developing, testing, and handing over control access of the software to the company that paid for this service.
While preparing a software escrow agreement, conditions like transfer of intellectual property, licensing, publication, and control access, are included to ensure that the buyer (tech company) is protected from fraudulent moves such as backend hacking, delayed delivery, poor testing and outrightly poor software performance. The seller (software developer) is also protected from false claims by the buyer. The funds in escrow remain locked until the parties resolve transactional issues.
Other Business Transactions
Escrow cuts across all sectors that involve any form of commercial transaction. It works for the transfer of intellectual property rights, property sales, stocks, and even regular online buying and selling.
There are escrow agencies that offer escrow services for online transactions. These agencies receive payments for online purchases and withhold them until the products are delivered. Some e-commerce platforms like Amazon have escrow arrangements in place as well. That's why e-commerce platforms don't immediately pay sellers after purchase. Payments made by buyers are usually held in escrow for a period of time during which complaints, returns and refunds can be made.
In some cases where returns are fraudulent e.g. damages caused by buyers, refund requests are denied to protect the seller. The goal is to ensure fairness to all parties in a transaction.
What Should Be Included In An Escrow Agreement?
Like all contracts, an escrow agreement needs to be clear in its terms and conditions. It must provide a reasonable covering for both parties to the transaction.
Some of the things that should be included in an escrow agreement include:
Parties: the parties involved in the transaction must be clearly identified
Identity of the Escrow Agent: the escrow agent must be identified with necessary details such as name, qualifications, and contact information.
Escrow instructions: the escrow agreement must provide detailed instructions on how the funds or valuables should be held, managed, and disbursed. An escrow agent must not convert the items in escrow for personal use.
Conditions for disbursement: an escrow is only as good as its conditions. The conditions that must be fulfilled before disbursement must be clearly stated.
Dispute resolution: the agreement should state the means through which disputes would be resolved. This could include negotiation, mediation, second chance attempts at peacefully fulfilling the escrow conditions, and litigation.
Escrow fees: the payment terms and fees for the escrow agent must be clear.
Termination clause: the escrow agreement may be terminated by mutual consent, transaction completion, or breach of contract.
Governing laws: this is important especially if a dispute arises. The agreement should specify the laws that would oversee its application.
Signatures: an escrow agreement is incomplete and unenforceable without the signature of all parties involved. Hence the buyer, seller, and escrow agent must sign the document in the presence of witnesses.
How Secure Is An Escrow Arrangement?
Generally, escrow agreements are legal and secure. They're enforceable and ensure that parties are committed to fulfilling their transactional obligations. But, the security of an escrow arrangement depends on some factors:
Reputation of the escrow agent: Choosing the right escrow agent is the main determiner of how secure an escrow arrangement could be. Reputable agents act with integrity and within the bounds of law. As such, parties have to be careful in choosing an escrow agent.
License: While being an escrow agent in the United Kingdom isn't regulated, most agents fall under a professional body. Lawyers, realtors, trustees, accountants, and payment service providers typically act as escrow agents. You'll be better off choosing a licensed professional to serve as your escrow agent.
Escrow terms and conditions: A well-drafted escrow agreement protects the parties involved. Parties need to spell out rights, obligations, and conditions for disbursing valuables held in escrow. Each party should individually review the agreement to ensure that they're not short-changed.
Security measures: An escrow is only as good as its security. The vault or location where valuables are held in escrow must be verifiably secure. While physical vaults like bank vaults may be secure, funds held electronically need to be within secure firewalls that can counter potential malware or phishing attacks.
Jurisdiction: The jurisdiction in which the escrow agreement is governed can also impact its security. While some jurisdictions have stricter regulations and legal protections for escrow transactions, some don't. As such, it's safer to research the governing laws and jurisdictions before creating an escrow agreement.
Who Can Act As An Escrow Agent?
An escrow agent is a neutral third party whose primary duty is to hold funds or valuables until the disbursement conditions are met. While anyone can technically act as an escrow agent, it's safer to choose persons who are reputable and can ensure the security of the funds or valuables. The categories of these persons include:
Professionals; lawyers, accountants, trustees, realtors, and other licensed professionals under a regulatory body.
Escrow companies; including banks, finance and payment service providers, and registered companies who offer escrow services.
Independent agents; unlicensed persons may serve as escrow agents depending on their track record.
What Happens If The Conditions Of An Escrow Are Not Met?
As a rule, the items held in escrow are not released until the conditions for disbursement are met. It all boils down to the conditions listed in the escrow agreement.
Where the conditions of an escrow are not met, the escrow agent typically holds on to the items in escrow until the conditions are met. Sometimes though, the parties can approach the escrow agent with an agreement to modify the conditions for disbursement. This usually involves secondary documentation that's then attached to the original escrow agreement.
For ease, the modification clause must be included in the escrow agreement, allowing the parties to modify the conditions for releasing the items in escrow.
Where issues like dispute or defaulting a condition arise without any hope of resolution, the escrow agreement may be terminated and both parties restored to their default position. This usually means that the escrow agent returns a part of the payment to the buyer and the seller receives reasonable compensation for services rendered.
Can Escrow Be Used For Online Transactions?
Yes, escrow can be used for online transactions. This can be created using online escrow agencies and payment service providers.
Most e-commerce and contract service platforms already offer escrow services. However, parties can choose an independent escrow service provider for their online transaction.
Conclusion
Escrow is a safety net for commercial transactions. Whether you're buying something online or engaged in a high-stakes transaction like mergers and acquisitions, having an escrow agreement protects your interests. It ensures that both parties to a transaction fulfil their obligations for a smooth deal.
While it's up to the parties to choose who should be their escrow agent, it's often better to seek out reputable professionals. At Lawhive, we connect you with top-tier solicitors who specialise in managing your transactions with the utmost care and precision. Whether you’re dealing with real estate, business agreements, or any legal transaction, our network of expert solicitors will guide you every step of the way.