In commercial transactions, people like to get paid — and to get what they pay for.
In most cases, both parties to a transaction are fairly comfortable because there will be a simultaneous exchange between the party with the cash (the payor or buyer) and the party delivering the goods or services being purchased (the payee or seller). Even when the transfer doesn’t happen concurrently, both parties may feel minimal risk because they have good reputations or enjoy a degree of trust due to their prior dealings.
However, there are unique circumstances where a transaction involves what is often described as a “chicken-and-egg problem.” This is a situation where the payor is nervous about delivering funds without full confidence of receiving the expected goods or services, while the payee is similarly apprehensive about fully performing before receiving payment. In such cases, an escrow can be an elegant solution to mitigate, if not completely eradicate, each party’s concerns about receiving what they bargained for in the transaction (sometimes referred to as consideration). This article examines common situations where such an escrow arrangement would be useful.
In its simplest terms, an escrow is a compromise where something being transferred from one party to another in a transaction leaves the hands of the sending party but is held in trust buy an intermediary (the Escrow Agent) before being delivered to the receiving party. Typically, the escrow consists of cash, but realistically almost anything of value being transferred from one party to another can be put into escrow, whether it be cash, an asset, an instrument, or anything else. The Escrow Agent’s delivery of the escrowed cash or assets to the intended recipient will be subject to an escrow agreement entered into among the transaction parties and the Escrow Agent (the Escrow Agreement).
Depending on the relative bargaining power of the parties, the selected Escrow Agent can take various forms. Most favorable to the payor would be the selection of an Escrow Agent whom the payor completely trusts and has already worked with. For example, this could be the payor’s attorney, agent, or other representative. Conversely, the Escrow Agent most favorable to the payee would be one whom the payee finds trustworthy or reliable. For example, this could be the payee’s attorney or agent (or, in the instance of a real estate transaction, the payee’s title agent or broker).
The most equitable option is for the parties to mutually agree upon an independent intermediary to serve as Escrow Agent. Ideally, this person would be someone completely unbiased towards the parties in the transaction. For this reason, an attorney who has no prior relationship with either party can be an optimal solution. Most attorneys already have an escrow account (also known as a trust account) for the purposes of holding client retainers. However, only certain attorneys are willing to enter into escrow arrangements, due to liability concerns. Once you are able to find a lawyer willing to serve as the Escrow Agent for your transaction, the parties will sign the Escrow Agreement, which will include a stated fee to be paid to the Escrow Agent (the Escrow Fee). The Escrow Fee can take many forms, but will usually be a percentage of whatever amounts are deposited with the Escrow Agent, plus expenses. The payor and the payee would also have to agree between themselves whether one of the parties should be fully responsible for the Escrow Fee, or if the Escrow Fee should be split between them.
A common situation where an escrow can be useful is in the purchase and sale of goods. Typically, the payment mechanics of buying and selling a product is not an issue in our daily lives. For instance, when you do the groceries or buy something at the mall, you’re able to pay for the product and then walk away with it in the next moment. However, this simultaneous exchange of consideration is not always possible.
For example, take the situation where an American wants to buy a rare painting from a seller in Germany. Clearly, the seller will have to ship the painting to the buyer in the United States. Unfortunately, because the parties have no prior relationship, they have no trust that the other party will perform to satisfaction. More specifically, the buyer doesn’t want to send any money to the seller without certainty that the painting will be delivered. This is quite reasonable from the buyer’s perspective, because once the buyer has paid the seller, the buyer no longer has any leverage to compel the seller to perform in a timely fashion or at all. If the seller fails to perform, the buyer would prefer avoiding having to chase down the seller for payment, whether it be through a lawsuit or otherwise. On the other hand, the seller does not want to run the risk of shipping the painting to the buyer without any guarantee of being paid. This is a common chicken-and-egg scenario.
In this situation, both parties could alleviate their concerns by having the purchase price held by an Escrow Agent. The Escrow Agreement could stipulate that the Escrow Agent will hold the purchase price until the delivery of the painting is confirmed. Upon that confirmation, the Escrow Agent would then deliver the funds to the seller. If the seller fails to deliver the product within a specified period of time, then the Escrow Agent would be required to return the funds to the buyer. The use of the Escrow Agent gives both the buyer and the seller comfort in knowing that a third-party has a contractual obligation to honor the expectations of the transacting parties.
Another prevalent scenario where escrows prove useful is when the payor must make a partial deposit of the aggregate purchase price (for example, 20%) with the seller. Unlike the example described above, in these cases only the 20% deposit would be placed with the Escrow Agent. For example, if the seller of the painting would be willing to ship the item upon the receipt of a 20% good faith deposit, then the deposit could remain with an Escrow Agent until the product is shipped; then, the Escrow Agent would deliver the deposit to the seller once the painting is in transit. Then the buyer would be under a contractual obligation to deliver the remainder of the purchase price directly to the seller after the painting had been successfully received. Note that in this example, placing a deposit with the Escrow Agent (rather than the entire purchase price) lowers the Escrow Fee, but also increases the ultimate risk to the payee who must now trust the buyer to deliver the remaining 80% of the purchase price.
Transactions not only involve the purchase of goods; sometimes they involve services to be rendered. Consider an example where a concert promoter wishes to hire a performing artist to hold a concert at a particular venue. Here, a chicken-and-egg issue could easily arise because the artist would be unwilling to perform without any guarantee of payment, and the promoter would be unwilling to advance payment directly into the artist’s bank account without having any guarantee that the artist will perform as agreed. This is a particularly high-stakes situation because concerts involve many upfront costs including rental of the venue, ticket sales, staff preparations, and so on. As such, concert promoters and musical artists regularly proceed with the use of an Escrow Agent to hold either a deposit or the artist’s entire fee. Note that this situation serves as a good example of when relative bargaining power can have much influence on the Escrow Agent selected. In most cases, artists with increasing fame and popularity can demand the use of an Escrow Agent that they fully trust or is within their employ (their booking agent, for example). In such cases, the promoter has little leverage to demand an alternate Escrow Agent.
The examples discussed above involve situations that are quite common for the use of escrow services. However, you should keep the escrow solution in the back of your mind for any situation in which the only roadblock to getting a deal done is that neither the payor nor the payee wants to risk being the first one to pull the trigger on performing its obligations.