Escrow refers to the neutral third party that holds funds and/or documents on behalf of a client, to be disbursed once specific conditions have been met. The manner in which escrow acts is based on the conditions of a particular transaction.
In the case of real estate, escrow refers to a third party escrow company holding a buyer and seller’s consideration in a transaction. This is typically a buyer’s funds (i.e. deposit, down payment) and the title/deed to a seller’s property. When all of the required conditions of a purchase agreement are met and the transaction “closes”, both party’s consideration is released to the other party.
In order for escrow to be valid, there needs to be an agreement between a buyer and seller, as well as the delivery of a grant deed or deed of trust.
Section 17003 of the Financial Code defines escrow in legal terms:
“…any transaction wherein one person, for the purpose of effecting the sale, transfer, encumbering or leasing of real or personal property to another person, delivers any written instrument, money, evidence of title to real or personal property, or other thing of value to a third person to be held by such third person until the happening of a specified event or to the performance of a prescribed condition, when it is then to be delivered by such a third person to a grantee, grantor, promisee, promisor, obligee, obligor, bailee, bailor, or any agent or employee of any of the latter.”
Escrow minimizes risk and maximizes the chance of successfully closing a transaction. It protects the interests of both principals in a real estate transaction by enforcing a purchase agreement’s mutually agreed-upon conditions and distributing consideration only when those conditions have been met.
Although escrow is not required for a real estate transaction, it is highly advised that all property sales be executed using escrow to ensure that all components of a transaction are followed.
Escrow Agent
An escrow agent — also known as an escrow holder, or simply an escrow — is the neutral third party whose primary responsibility is to execute the instructions set forth by the principals in a real estate transaction.
An escrow agent’s role is to follow the specific set of escrow instructions. An escrow acts as a depositary for the consideration used in the exchange (i.e. funds, assets, documents) and is responsible for executing the terms of a purchase agreement. This includes receiving and distributing a seller’s property deed in exchange for a buyer’s funds. (Escrow never actually holds the title to a property, however.)
A principal is responsible for dictating instructions to an escrow agent. Typically, this refers to the buyer and seller in a transaction. However, a lender providing a new loan for the purchase of a property may be an additional principal in a transaction. (Lenders are considered principals because they are responsible for executing instructions to the escrow agent for the transfer of real estate.)
Escrows are confidential. An escrow agent must maintain the privacy of all principals and never disclose information to third parties without a principal’s approval. Conversely, an escrow agent must communicate all acquired knowledge relating to the escrow process to the principals. This includes any detrimental or new material information that might affect a principal’s decision regarding the pending transaction.
Authority of Escrow and Escrow Agent’s
An escrow agent does not have discretionary authority. He or she acts on behalf of the principals, rather than in place of them.
An agent must also maintain complete neutrality during escrow. To the extent possible, an agent must not act in a manner that is unfair to another. For this reason, an escrow agent cannot play the role of mediator.
In the event that a dispute arises amongst principals in escrow, the agent must wait for the principals to reach a resolution and give subsequent direction. Should a dispute fail to be resolved in a reasonable time frame, the escrow agent may go to the county court and file an interpleader action. An interpleader action is a civil procedure initiated by one party (escrow agent) which compels two or more other parties (principals) to resolve a dispute. Once the dispute is resolved, the agent will then enforce new instructions.
While an agent may offer advice to principals within the course and scope of the escrow instructions, the agent is prohibited from offering legal advice. Instead, an escrow agent must suggest that disagreeing parties talk to a third party intermediary, such an attorney.
Escrow agents must retain a copy of all vital documents from current and previous transactions.
Case Review: re Marriage of Cloney (200
In re Marriage of Cloney (2001) 91 Cal.4th 429, an escrow agent did not disclose knowledge of a seller’s name change to the buyer.
An escrow agent did not properly disclose all vital information to a buyer. The escrow agent had full knowledge that the seller had changed his/her name, but did not disclose it to the buyer. This seller had a judgment lien on the subject property. The judgment lien on the seller’s property caused the buyer to purchase a property free of liens which meant the buyer did not have full ownership of the subject property.
The Superior Court determined that it was the duty of the escrow agent to disclose information about the seller to the buyer, including a valid judgment lien recorded against a debtor with multiple names.
Escrow Licensing
California real estate law defines an escrow agent as an individual or entity that holds a valid, unrevoked escrow agent license. It is unlawful for any individual or entity to engage in escrow activity without a license issued by the Real Estate Commissioner (California Financial Code Section 17200).
Escrows are licensed as companies, not individuals. Escrow companies are either licensed or controlled.
Licensed Escrow Company
A licensed escrow company is considered “independent”. The requirements to be become a licensed company are much more difficult than becoming a controlled escrow company.
A company must be licensed by the California Corporations Commissioner. Each licensed escrow company must have at least one agent with a minimum of five years of responsible escrow practice at the primary branch. Each additional location must have an escrow agent with a minimum of four years experience.
Potential agents must pass rigorous tests to ensure proper knowledge of the escrow process. A licensed escrow company must also perform extensive background checks on all of its employees and take fingerprints.
All agents who have access to money or securities must have a bond indemnifying them against loss of money or property (Business and Professions Code 17203.1). Licensed escrow companies must have a $10,000 surety bond and must purchase a minimum $125,000 bond for each employee.
Controlled Escrow Company
A controlled escrow company — also known as a non-licensed or “non-independent” escrow company — is exempt from being licensed.
The process of becoming a controlled escrow requires less time and money than becoming a licensed escrow. Unlike licensed companies, controlled escrows are not required to purchase bonds for their employees, do background checks, or take fingerprints.
License-exempt agents may include:
A broker
An attorney
A title insurance company
Other real estate professional
Controlled escrow companies do not require a minimum amount of experience to be licensed. However, as brokers have the right to act as escrow agents without being required to purchase fidelity or surety bonds, the Department of Real Estate does maintain a victim’s fund for principals who are defrauded by escrow brokers. The maximum payout for victims of escrow fraud is $50,000.
A broker-controlled escrow refers to when a broker is also the escrow agent. Brokers can only perform escrow services in a real estate transaction where a principal is already using the broker to buy or sell a property. If a broker advertises escrow services, it must be in addition to his or her primary real estate business. Brokers also cannot use a fictitious name with the word “escrow” in any forms, publications, or sign-offs.
Should a broker solicit escrow business outside of his or her primary real estate business, the broker may be subjected to a cease and desist order from the Bureau of Real Estate.
The Escrow Process
Finding Escrow Agent
As a buyer typically initiates a real estate transaction, he or she is generally responsible for finding an escrow agent. However, principals may select an agent together if they choose.
Real estate brokers and/or agents cannot select an escrow agent on behalf of their principals. They also may not require either principal to buy or sell a property contingent on which escrow company is used. However, if both principals cannot agree on a suitable escrow company, an agent may recommend one.
In a refinance situation, brokers or lenders generally choose the escrow company.
Opening Escrow
Typically, escrow opens immediately after the seller accepts the buyer’s purchase agreement. The broker will send the details of the transaction to the escrow agent. Upon verification of these details, the escrow agent will prepare escrow instructions.
Escrow Instructions
Escrow instructions indicate the obligations required of a buyer and a seller in order to close escrow. Any party who submits escrow instructions is considered a principal. This includes lenders who are providing buyer financing; they will send their own instructions to escrow.
Unless given authorization by the principals, an escrow agent may only accept claims, funds, or documents laid out in the escrow instructions.
In California, principals typically use a form called the California Purchase Agreement and Joint Escrow Instructions, which include all components of a transaction on a single form. It is possible, however, to have a purchase agreement and escrow instructions that are separate from one another.
There are two types of escrow instructions: unilateral and bilateral. Unilateral escrow instructions refer to separate instructions for each principal, while bilateral escrow instructions refers to the same instructions being signed by both principals. Both instructions bind each principal to the terms of the agreement. Both the escrow instructions and purchase agreement are used to provide escrow with the specifics of the transfer.
If either principal wants to amend an aspect of the escrow instructions, both parties must consent. Any alteration is referred to as an amendment to escrow instructions. The escrow agent must be made aware of any changes immediately.
Should any aspect of either the escrow instructions or the purchase agreement be in conflict with one another, the most recent document generally supersedes the other. Therefore, as escrow instructions come after the purchase agreement, they typically take precedent. However, a purchase agreement may stipulate that in the event of such a conflict, the terms of the purchase agreement should supersede the terms of the escrow instructions.
To make escrow valid, both the buyer and seller must sign escrow instructions.
When both principals have signed escrow instructions, the escrow is perfected. The following are included in escrow instructions:
Names of the buyer and seller
Subject property’s purchase price
Transaction terms and contingencies
Buyer’s deposit
Vital documentation, including:
Title insurer & preliminary title report
Beneficiary statement
Deed of reconveyance
Structural reports and inspections
Lender information
Closing statements & costs
Form of title transfer
Audit
Closing
Buyer’s Deposit
The first instruction in escrow instructions is typically for the buyer to put forward an initial earnest deposit. This deposit is a percentage of the purchase price for a subject property, and serves as a good faith indicator of the buyer’s intent to purchase.
Escrow will hold the buyer’s deposit in a trust account until the property title is released to the buyer. An agent must maintain the trust account with extreme care. Overdrawn accounts are strictly forbidden.
Escrow typically requires buyers and sellers to sign a cancellation agreement. In the event that escrow is terminated by either principal, the cancellation agreement will dictate the terms of the deposit and how payment will be refunded. However, as an escrow company’s responsibility is to follow the instructions of the principals, it cannot refund a deposit until all parties have mutually agreed.
Should the buyer and seller disagree about who is entitled to the deposit, an escrow agent may initiate interpleader action in order to resolve which principal has valid claim to the deposit.
Civil Code 1057.3 states that any party involved in the purchase of a 1-4 unit building may be subject to a penalty if he or she refuses to execute the demands of the other party within the specified time period. The penalty for a principal who has not met his or her agreed-upon obligations is potentially losing his or her deposit and, if applicable, the cost of attorney fees.
Preliminary Title Reports
Prior to any funds or documentation being received or distributed, an escrow agent will order a preliminary title report. A title company — also known as a title insurer — is responsible for issuing title insurance policies and the preliminary title report.
A title company will conduct a title search to thoroughly research public documents for any relevant information regarding a subject property. This includes all known liens/encumbrances, easements, and ownership in the property.
Many title searches uncover liens that must be addressed before a title insurer will issue a policy, or the buyer purchases the property. Buyers almost never purchase properties with junior liens, particularly when they are personal in nature. Typically, properties are only exchanged when personal liens and debt (minus a loan on the property) are removed from the transaction.
A title company will then issue a preliminary title report. This “prelim” is not a policy; rather, it is a report that states which terms and conditions a title insurer is willing to offer in a policy.
Liens and encumbrances will be listed as “exceptions” on a title insurance policy and will not be covered. A title report also includes all current title agents, land records, and parties who claim to have an interest in the property.
Beneficiary Statement
A beneficiary statement is a written disclosure from a lender to a borrower that includes the loan balance, interest rate, terms, and conditions of the loan secured for the transaction.
The lender is required to supply the borrower with a beneficiary statement. The borrower has the right to receive one free statement per year. Additional requests for the statement cost money. Borrowers have the right to receive the statement within 21 days of their request. Should the lender not provide the statement within the 21 day period, the borrower is entitled to a $300 credit towards their mortgage or a refund of $300.
Deed of Reconveyance
Unlike a deed of trust, which formalizes a borrower’s mortgage debt from a lender, a deed of reconveyance states that a borrower’s mortgage debt has been paid off. When a mortgage debt has been satisfied, a deed of reconveyance releases the title to the subject property back to the borrower. This shows that they are the sole interest holder of the property.
A deed of reconveyance must be provided by a lender within 30 days of a request.
Case Review: Pintor v. Ong (1989)
The case, Pintor v. Ong (1989) 211 Cal.3d 837., involved a lender who refused to provide a borrower with a deed of reconveyance after the borrower paid off a loan.
A borrower (Pintor) paid off a loan to a lender (Ong). However, Ong refused to execute a full reconveyance. As a result, Pintor was prevented from refinancing because of the existence of Ong’s lien. Pintor sued for emotional distress.
The Superior Court ruled in favor of Pintor on the grounds that the “underlying debt was in tort, rather than in contract” which meant that Pintor could recover for emotional distress. Ong appealed. He contended that damages stemming from a violation of the Business and Professions Code are contractual in nature and that Pintor could not recover emotional distress unless he brought forth evidence of substantial damages, in addition to emotional distress. The Court of Appeals disagreed and upheld the lower court’s ruling on the basis that not being able to refinance one’s property when one has the opportunity to do so as a result of a lender’s negligence is grounds for emotional distress.
Structural Reports and Inspections
Common reports and inspections — including soil, mold, plumbing, and other specific reports that relate to the property — should be included in the escrow instructions.
Lender Information
Escrow instructions must include instructions from a lender on how to satisfy a loan and be signed by the buyer.
Closing Statements & Costs
An escrow closing statement states all the fees and costs necessary to closing escrow.
Closing costs are the costs that either a buyer or seller are required to pay in addition to a property’s purchase price. The costs associated with closing a real estate transaction vary based on the terms of a transaction, purchase price, location, and/or local customs. All fees and costs can be found in the escrow closing statement.
Typical fees include:
Title fees
Recording fees
Agent commissions
Property taxes
Loan fees
Escrow fees
Escrow Fees
Escrow companies have the right to set the price for services provided. Escrow fees are dependent on the complexity of a transaction, the time and effort spent, and the costs incurred by the escrow company. Therefore, there are no standard escrow charges or fees and there is no formal measure dictating them.
Additional escrow fees may be incurred when agents must work with lenders on the transaction. Such lenders may include a seller’s lender, junior lien agents, and the lender for a buyer’s financing.
Both principals should agree on how much they are willing to pay in escrow fees before they look for an escrow agent. As it is against the law for a real estate agent/broker to require the use of a specific escrow company, principals have the right to research the most suitable escrow for their needs.
In California, buyers and seller oftentimes split the cost of escrow. However, they do have the ability to negotiate how much each principal is responsible to pay. In some real estate transactions, for example, a seller may have to undergo repairs as a contingency of the purchase. Thus, the seller may request that the buyer cover all escrow fees.
In the case of a refinance, a lender will almost always require the borrower to pay the escrow fees.
It is illegal for an escrow to discount one principal’s fee in exchange for a referral or the promise of future business. Escrow must provide each principal with the same discounts and savings opportunities; however, escrow can split escrow fees differently for principals based on the principal’s negotiations with one another.
Prorating
Prorating is the process of distributing property expenses amongst principals at the close of escrow. Expenses that are typically prorated include: property taxes, deposits, HOA fees, rental income, interest, and insurance. Individual prorations can be negotiated between principals.
The purpose of proration is to make expenses more equitable between principals in accordance with the buyer and seller’s respective periods of ownership. For example, if a transaction closes in the middle of the month, escrow may prorate the costs of the property taxes between the buyer and seller.
Proration is based on a 360 day calendar year and a 30-day month.
Impound Account
An impound account is a type of escrow account managed by a lender for the purpose of collecting a borrower’s property expenses, including property taxes, title insurance payments, and H.O.A. fees that are required to maintain property ownership.
Property expenses are expensive, especially if a borrower is expected to make large annual payments. Lenders use impound accounts to divide a borrower’s annual payments (mortgage payments, taxes, insurance, H.O.A. fees, and others) into more manageable monthly payments. This increases the likelihood that a borrower will stay current on all payments and not be subject to foreclosure.
In California, it is illegal for lenders to require single family residence borrowers to have impound accounts, except in the following circumstances:
A borrower has failed to make two consecutive tax payments
The loan is a government-backed loan, such as a FHA or VA loan
Lenders may impose impound accounts on high risk borrowers, including those with low income, bad credit, or lower down payment borrowers to offset the risk of funding loans to lower income or less credit worthy applicants.
Lenders particularly require borrowers to have impound accounts for low down payment borrowers because such borrowers have “less skin in the game” or a lower stake in the property thereby reducing the borrower’s incentive to make payments.
The California Civil Code states that a lender cannot require a borrower to pay more than the federal maximum, or to contribute more than is needed to pay off property expenses. A lender also may not create circumstances that force a borrower to fall behind on property expenses.
In the event that a lender miscalculates property expenses, it must refund the overpayment back to the borrower within 30 days.
It is a lender’s responsibility to inform a borrower of the steps required to maintain an impound account. This includes providing accurate payment deadlines so that a borrower doesn’t fall behind on property taxes or insurance payments.
Failure by a lender to adhere to the aforementioned standards may allow a borrower to bring legal suit against the lender and recover for damages.
Form of Title Transfer
Any and all documents that signify ownership interest must be docmunted immediately. This may be a grant deed or trust deed/deed of trust.
Copies are to be furnished to appropriate and concerned principals or third parties, so that the validity of the document can be determined.
Audit
Before closing escrow, an escrow agent must hire a CPA to do an independent audit of all files. Escrow companies’ files are subject to random inspection by the Department of Real Estate. These audits ensure that a company is not committing fraud or misrepresenting any information.
Closing
Closing is final step of the real estate selling process, whereby title is transferred to the buyer. This is where principals sign all closing statements and pay closing costs.
Terminating Escrow
The most common way terminate escrow is by cancelling escrow instructions or the residential purchase agreement. However, while cancelling escrow instructions may terminate escrow, it does not terminate the purchase agreement.
Legal Cases That Relate to Escrow
Case Review: Lee v. Escrow Consultants, Inc. (1989)
In Lee v. Escrow Consultants, Inc. (1989) 210 Cal.3d 915., a buyer sued an escrow company for accepting a forged document.
A buyer (Monty Lee) entered into the escrow process with an escrow agent (Escrow Consultants, Inc.). At some point during the transaction, Escrow Consultants, Inc. accepted a forged escrow amendment. This led to the improper withdrawal of $100,000 of Lee’s deposited escrow funds. Lee sued.
The Superior Court ruled against Lee. Lee appealed. The appellate court ruled in Lee’s favor, indicating that the escrow company had a duty to verify the signatures used to authorize the withdrawal of Lee’s escrow funds.
Case Review: Christenson v. Commonwealth Land Title Insurance Company (1983)
In Christenson v. Commonwealth Land Title Insurance Company (1983) 666 P.2d 302., a principal sued a title company for providing inaccurate information regarding the liens and claims about a property.
A title company (Commonwealth Land Title Insurance Company) provided incorrect information to a buyer (Christenson) regarding a property he was purchasing. This inaccuracy resulted in a financial loss for Christenson. To recover losses, Christenson sued for negligent misrepresentation.
The Superior Court ruled in favor of Christenson. It contended that Commonwealth Land Title Insurance Company had provided information that Christenson relied on and assumed to be accurate, when in fact, it was not.
The fact that the title company acknowledged providing inaccurate data made them liable for Christenson’s losses.
Case Review: Summit Financial Holdings, Ltd. v. Continental Lawyers Title Co. (2002)
In Summit Financial Holdings Ltd. v. Continental Lawyers Title Co. (2002) 27 C.4th 705, involved a severe blunder of wrongful payment by an escrow company that ultimately that took over 10 years to resolve.
A borrower, Dr. Furnish, secured a loan with his property in the amount of $425,000 from Talbert Financial. During the loan process, Talbert Financial transferred the loan to Summit Financial Holdings without notifying Dr. Furnish. When Dr. Furnish refinanced his loan, another company (Continental Lawyers Title Co.) acted as his escrow agent. However, Continental Lawyers created escrow instructions that led to loan being paid to the original lender, Talbert Financial, rather than Summit Financial.
Once payment was transferred, Talbert Financial did not pay the loan proceeds to Summit Financial. Summit Financial sued Continental Lawyers to recover damages. Summit Financial contended that Continental Lawyers was responsible because they knew Talbert Financial had assigned its rights to Summit.
The case began in Superior Court, where judgment was awarded to Summit Financial. Continental Lawyers appealed. The Court of Appeals reversed the lower court’s ruling, on the grounds that an escrow agent owes no duty of care to a nonparty to the escrow. Therefore, Continental Lawyers owed no duty of care to Summit Financial. The case was appealed again and heard in the California Supreme Court. The court upheld the appellate court’s decision. Continental Lawyers were not held liable.
Case Review: U.S. v. Cloud (1989)
The case, U.S. v. Cloud (1989) 872 F.2d 846., involved a real estate seller who was accused of bank fraud.
An experienced real estate entrepreneur (Cloud) put his hotel and casino on the market for $18 million. A potential buyer (Perroton) presented falsified documents to the bank — including a forged sales agreement — in order to obtain the $20 million loan. Cloud had knowledge of this fraudulent behavior, but did not report it. Instead, he manipulated the escrow instructions to inflate hotel and casino’s sales price in order to cash out on the property. After the sale’s execution, the loaning bank lost in excess of $24 million.
The U.S. Government sued Cloud for conspiracy to commit bank fraud, and aiding and abetting bank fraud. The Superior Court and appellate court found Cloud guilty.
