Wednesday, March 18, 2009

Keep Your Eye on the Details of the Escrow Agreement

Escrows are common in many real estate transactions, and they are sometimes agreed to and established without a great deal of documentation in the rush to complete a closing.

In the 2005 case Davis v. Holsten, the Virginia Supreme Court provided some guidance on how escrow agreements will be interpreted.

In light of the Holsten decision, buyers and sellers of real estate should exercise caution and diligence when agreeing to escrow funds. In particular, they should be careful in negotiating and documenting the terms and conditions of the escrow.

Background: Substantial compliance

The principle of substantial compliance, asserted most often in construction contracts, compels a party who has "substantially" received the benefit of a bargain to complete its part of the bargain by paying for the benefit received. This principle frequently enables contractors to recover payment from disgruntled buyers even when there has not been total and complete performance by the contractor.

The Holsten decision:

The issue addressed in Davis v. Holsten was whether substantial -- instead of strict or complete -- performance was required under an escrow agreement signed by a seller and buyer as part of a residential real estate transaction.

The case arose when the buyers of a home coated with Exterior Installation Finishing System (EIFS) discovered water damage to the home. They included a provision in their sales contract, which was accepted by the seller, which required the seller to have the stucco replaced with hard coat stucco. The contract provided that if the repairs were not made prior to closing, the seller would escrow $50,000 from the sale proceeds, to be held until the repairs were made and the stucco was replaced, along with any rotted or damaged wood.

The work had not been completed by closing and, therefore, an escrow agreement was entered into among the parties and a third party escrow agent.

The escrow agreement incorporated the provisions of the sales contract, and required the seller to deliver $50,000 (from the proceeds) to the escrow agent and have the work completed within a certain time after closing. Upon completion, the escrow agent would release the escrowed funds to the seller. If not completed within the time period, the funds were to be released to the buyer upon their written notification that the repair and replacement were not completed.

The seller hired a contractor to do the work, but there was an ongoing dispute as to whether it was being done satisfactorily.

Eventually, the seller informed the buyer that he considered the work to have been completed and demanded the escrow. He acknowledged, however, that there were matters of disagreement between himself and the buyer, but contended that the escrow agreement did not allow withholding release of the escrow "over a few very small details."

The escrow agent refused to release the funds, and the seller filed suit against both the escrow agent and the buyer. He contended that he had performed -- or at least had substantially performed -- all his obligations, and the escrow agent and buyer had breached their duty by failing to release the $50,000 in escrow.

The issue before the trial court and the Supreme Court was whether substantial performance was sufficient for release of the escrow. The evidence showed that all of the rotten wood under the synthetic stucco had not been removed, and control and expansion joints necessary for the repairs had not been installed.

Although the escrow agreement did not contain any reference to substantial completion, the seller contended that substantial compliance applies to all construction contracts. The Court disagreed with this contention, stating that the escrow agreement was not a construction contract; the construction contract was between the seller and the contractor he engaged.

The Court went on to say that the escrow agreement set out specific conditions for the release of the escrowed funds and made no reference to or provision for substantial compliance with those conditions. Although lacking in prior precedent in Virginia, the Court agreed with the clear weight of authority that, unless the agreement provides otherwise, substantial performance will not be applied to an escrow agreement and compliance must be strict.

A lesson from the Supreme Court's decision in Holsten is that the specific terms incorporated into an escrow agreement can significantly affect the rights and obligations of the parties to the agreement.