How can you protect yourself in a transaction when you don’t trust the other party to perform?

In commercial transactions, people like to get paid — and to get what they pay for.

In most transactions, both parties are fairly comfortable because there will be a simultaneous exchange between the party with the cash (the purchaser) and the party delivering the goods or services being purchased (the seller). Both parties may feel minimal risk because they have good reputations or have the privilege of trust due to their prior dealings.

However, there are circumstances where a transaction involves what could be considered a “chicken-and-egg problem.” This is a situation where the purchaser is nervous about delivering funds without full confidence of receiving the expected goods or services, while the seller is similarly apprehensive about fully performing before receiving payment. In such cases, an escrow can be the appropriate solution to mitigate, if not completely eradicate, each party’s concerns about receiving what they bargained for in the transaction. This article examines common situations where such an escrow arrangement would be useful.

What is an Escrow?

It’s best to have a good understanding of what an escrow is in order to understand its utility. 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 party (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, or anything else. The Escrow Agent’s delivery of the escrowed cash or assets to the recipient will be subject to an escrow agreement entered into among the transaction parties and the Escrow Agent (the Escrow Agreement).

How do you choose an Escrow Agent?

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 purchaser completely trusts and has already worked with. For example, this could be the purchaser’s attorney, agent, or other representatives. Conversely, the Escrow Agent most favorable to the seller would be one whom the purchaser finds trustworthy or reliable. For example, this could be the seller’s attorney or agent.

The most equitable option is for the parties to mutually agree upon an independent intermediary to serve as Escrow Agent. This person should 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. 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 purchaser and the seller 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.

How to use an Escrow Agent When Buying and Selling Goods?

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 buy 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 to avoid 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 instruct 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.

Why could an Escrow Agent Hold a Deposit?

Another prevalent scenario where escrows prove useful is when the payor must make a partial deposit of the total 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 seller who must now trust the purchaser to deliver the remaining 80% of the purchase price.

Can Escrow Services be used for transactions of services?

Transactions not only involve the purchase of goods; sometimes they involve services to be rendered. For example, 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.

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 purchaser nor the seller wants to risk being the first one to pull the trigger on performing its obligations.

If you require assistance with opening an escrow fill out the form below to schedule a free consultation.

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