June 22nd, 2022
All parties in high-risk or high-value transactions want to have safeguards in place. After all, who would want to pay for a house only to find out later that the terms of sale weren’t honored? Escrow agreements are one of those safeguards – they make sure that transactions are closed only after all conditions set by the parties are met.
But escrow agreements serve a wide range of purposes – from making sure that real estate transactions go through to safeguarding employees’ stocks until they can sell them. In this article, you will learn what escrow is and how it works, and the different types of escrow agreements that exist. However, we should start with the basics.
Escrow is commonly used during any larger transaction and in different contexts, so the term often confuses people. In its simplest form, escrow is a contractual legal arrangement where assets or funds are held by a third party on behalf of two parties involved in a transaction.
The purpose of escrow is to protect the parties in a transaction. All transactions are contingent on specific conditions being fulfilled and escrow is the mechanism that ensures that both parties fulfill their obligations before the transaction is completed.
For example, let’s say that you are buying a relatively large amount of electronic hardware from out of state. The seller needs assurance that you will make the payment, while you will only pay if the hardware arrives undamaged.
What’s the solution? Escrow. You and the seller agree that you will put the money into an escrow account with instructions for the escrow agent that the money will be transferred to the seller once the goods arrive in the agreed-upon condition.
This leads us to the escrow agreement.
An escrow agreement, sometimes referred to as an escrow contract, is a contract that stipulates the terms, conditions, and responsibilities of the parties involved in the transaction.
If we were to go back to the previous example, the terms of the escrow agreement would be that:
The terms would likely be formulated differently and provide more details, but this would be their intended meaning.
Because the escrow agreement is a legal document, it includes other information besides the basic conditions for the transaction to go through. It typically includes:
Three parties are always involved in an escrow agreement:
Each party to the agreement can be termed differently – the depositor could be named ‘Buyer’ in the escrow agreement and the beneficiary ‘Seller’, or other terms could be used. However, the terms used for each party must be clearly defined in the agreement.
Cash is most commonly put into an escrow account, but there is no limitation that an escrow must contain only cash. Many other valuable assets can be put into escrow, including:
The most common use of escrow agreements is in real estate transactions. Short-term escrow accounts are opened by an escrow company to facilitate a sale and are used to store the funds and all the required documents.
The escrow agent ensures that all parties fulfill the obligations stipulated in the escrow agreement and that all contingencies are met. Escrow agreements can be complex legal documents with many conditions.
Let’s simplify it a bit and say that you are selling your house. You find a buyer and agree upon a price, but the potential buyer hasn’t taken out a loan yet. Both you and the buyer have certain conditions for the sale to go through.
You set up an escrow account and deposit the deed to the house. Your condition is that the buyer must secure financing and deposit the necessary amount of money by a certain date, or otherwise, the deal will fall through.
The buyer inserts a contingency clause into the agreement – the sale will only go through if a home inspection is passed. Once the buyer has secured financing and deposited the funds, the home inspection can be performed.
The escrow agent is there to ensure that the buyer has deposited the agreed-upon amount of money and that you have passed the home inspection. After these conditions are met, they will transfer the deed to the buyer and the funds to you.
An escrow agreement can (and usually does) contain many more conditions, but the principle is always the same.
Escrow accounts for mortgages are the other type of agreement related to real estate. Unlike the previous type, these are long-term and sometimes required by a lender. They last for the life of a mortgage.
A lender may open an escrow account and deposit a part of the borrower’s mortgage payment in an escrow – enough to cover future property taxes and insurance. When the levies are due, they are paid from the escrow account.
Escrow agreements are also commonly used during mergers and acquisitions of publicly-traded companies. There are many risks for buyers in these types of deals and escrow agreements are typically used to protect them.
Often, the buyer will put a specific portion of the total purchase price into an escrow account. The funds will remain in the escrow for a specific, negotiated amount of time after the acquisition is completed.
In case the company that is being bought hid crucial information during the sale or didn’t fulfill its obligations from the agreement, the buyer receives the funds back. Conversely, if everything is as it should be, the funds from the escrow account are transferred to the seller.
Stocks can also be kept in escrow. A company may use its shares as payment or as a part of a merger and keep the shares in escrow until the deal has been closed, based on the conditions set out in the escrow agreement. Shares that are issued to employees are also commonly held in escrow.
A company may give its top executives shares as a bonus but put them into escrow for a negotiated period of time. The executive is the rightful owner of the shares, but they are limited in how they can use them until the period expires. Consequently, the shares will be kept in an escrow account until the employee has a right to sell them.
Escrow agreements are used to protect both buyers and sellers. It is the escrow agent’s job to ensure that all parties meet their obligations and that no one is defrauded. Escrow is an added layer of security in high-value or high-risk transactions.
Lightspeed Escrow offers speedy and accurate escrow services. We will make sure that all of your sensitive documents are kept secure and make sure that the terms of your escrow agreement are met. Our job is to make your transaction simple and go through without a hitch.