This article is written by Arunesh Roy, pursuing a Diploma in Entrepreneurship Administration and Business Laws from LawSikho.com. Here he discusses “Key Insights of an Escrow Mechanism”.
Escrow has basically originated from a French term “Escroue” which means a scrap of paper signifying a deed that is held by a third party on behalf of the underlying transaction. It may be regarded as a third-party account. It is a bank account wherein the asset value is held till the fulfilment of specific conditions related to the transaction. The holder of the escrow account must make sure that the amount deposited with the escrow account is released only on the fulfilment and completion of the specified conditions related to the transaction. Thus, it is a pass through account in which the amount is deposited by the party/parties and is kept intact till the specified conditions have been met. It is highly beneficial to both the parties underlying the transaction as it not only mitigates the risk factors associated with the transaction, but also ensures that the compliance of the conditions is fully met. The third part account holder has an important role to play in these types of transactions and must take of the conditions specified otherwise the transactions go awry.
In this era of voluminous transactions and virtual markets with real transactions, wherein the sellers and buyers and sellers are not able to meet each other physically, a need was felt for an account wherein the parties could put their trust upon. Thus, escrow account bridged this gap and fulfilled the purpose of parking funds upon the trust of the parties, till the satisfaction level of the parties were met upon the successful completion of the transaction.
In India, the escrow account service proceeds as per the guidelines of Reserve Bank of India and is normally used in cases of Real Estate Transactions, Mortgage transactions, Mergers and Acquisitions, in online transactions and a host of other transactions. Escrow account is a type of account used by Bankers to control the underlying transactions associated with it. The amount deposited is withheld till all the specified conditions are met. Thus any party may open an Escrow account with any Bank for the fulfilment and successful execution of the transaction.
The word Escrow depicts “ an account which has been held in trust” or “ an impartial third party account” in a financial transaction between two or more parties. The third-party account or the trust account is generally used to hold cash/ funds on behalf of the parties involved until the transaction is complete or the specified conditions are met.
Status of its use in India
Normally in most of the cases in India, escrow accounts and linked to real estate transactions, but they may extend to other financial transactions too. This is since Real estate transactions involve a voluminous amount of money in addition to the involvement of risks, complexities. Further, it is easier to dupe people with limited means by lobby of big builders. Thus, Escrow account is primarily used across real estate/ property related transactions in India. Further in many a cases guideline to this effect may have been passed by the Reserve Bank of India or the regulating authority that a transaction would move across only through an escrow account. Thus, government intervention may also lead to many transactions moving through an escrow account.
Escrow account in case of real estate/ property-based transactions is used so that a neutral party may be involved in the transaction, thus providing the buyer more comfort in the deal thus mitigating the possibility of transactional bottlenecks. Thus, this account is used as an unbiased mediator that can help resolve and mitigate the complications that may arise in a voluminous transaction with substantial risks.
How to get an Escrow account
Escrow account service is normally provided by all nationalized and private Banks in India. This type of service is provided as per the policy and guidance of Reserve Bank of India. Anyone who wishes to have the services of an escrow account may avail the services of any such banks and open an escrow account.
In order to open an escrow account, both the client and the beneficiary should collectively submit a request letter in this regard. The purpose, terms and objectives of transactions shall be mentioned in this letter. The escrow service provider provides the services of an agent in return for a fee. It also carries out services of dispute resolution if required. In case an underlying transaction fails, both the parties may be given a chance to sort out the dispute by arbitration or any other manner As agreed. The final payment is released only after the resolution of the dispute.
Areas of use of Escrow account
The term escrow may be referring to either of the following: Real Estate Escrow, Online Escrow, Overseas transactions, Project Finance transactions, other Escrow etc.:
Real Estate Escrow
In case of real estate transactions, the Mortgage lenders generally insist for the payments to be routed through an escrow account before the procedural formalities like home inspections, technical and legal compliance are completed. The funds lying in the escrow account is transferred to the beneficiary only on completion of all the basic formalities. It allows the buyer to proceed with due diligence of the potential purchase. It also assures the seller that the buyer is indeed a serious buyer. Thus an escrow account may be used for purchase price as well as in case of monthly payouts aswell.
This process of routing the payments through an escrow account may be beneficial in case of Home Buyers in India, as the payment may be deposited by the home buyers in the escrow account, subject to completion of various levels of the property and thus act as a safety measure in case of dubious builders.
Lease Based Escrow
Similar process is being adapted in case of long term lease based transactions, wherein voluminous loans are availed by the Lessors or Property owners against all future payments to be made in the escrow account by the Tenants/ Lessees, thus providing a safeguard to the banks with regards to the safe repayment of the Loans. This also acts as a two-way measure. This process not only facilitates the property owners to discount the future rentals but also assures the banks for the repayment of the loans availed.
Escrow after Home Purchase
Mortgage lenders prefer escrow accounts with regards to property tax payments, as they do not want a tax lien on the property mortgaged. The same applied to homeowner’s insurance, where the lender does not want to risk lose insurance coverage on the property. Thus, escrow accounts act as a measure of safety shield for the parties as well as Banks too.
In case of High value online transactions also, Escrow accounts are used to ward off any sort of risks in getting the material after making the payments. Thus the supplier dispatches the material only on getting the value in the account. The online buyer also gets a chance to verify the purchase before making the payments. Thus, the escrow account acts as a safeguard to minimize the risks.
Cases of Mergers & Acquisitions
In case of mergers and acquisitions, escrow account services are frequently used across. These transactions are of very high value in general and may involve a lot of risks too till the completion of the due diligence associated with the transaction. Thus the escrow account not only safeguards the buying party, who may not be aware of the intrinsic value of the other party, but also allows a chance to get the due diligence completed to the fullest satisfaction level, thus allowing the buyer a robust deal.
Project Finance Transactions
In case of project finance transactions, escrow account is used to cover performance guarantee through special purpose accounts. These accounts are normally of the nature of long term projects, where the arrangement could be to payback from the cash flow, once the project becomes operational. Thus, these escrow accounts are loan repayments.
Transactions involving overseas market
Escrow accounts are also used frequently in case of transactions involving overseas markets. Since overseas markets are volatile and involve huge risks, hence the seller is ensured of the price before dispatch of the materials. The buyer also would release the price, when he or she is assured that the goods have reached the port of destination.
Benefits of using an escrow service
- Sellers are protected against chargebacks, non-enough funds, possibility of scams, risks of fraud etc
- Useful for intangible services, and for transactions across the country/ overseas markets
- Increased security for both the parties underlying the transaction. Mitigates the likelihood of dispute arising.
- Buyers may inspect the deliverables before the payment is finalized
- Buyers may get the due diligence completed to the fullest satisfaction.
- Buyers reserve the right to return in case of unsatisfactory services/ products
- Lessens the worry out of buying from unknown service providers/ sellers.
How Does Escrow work
Following is the working mechanism for an escrow account:
- The buyer and the seller or two parties agree on the set price and the terms of the transaction.
- The buyer completes the transactions and may choose the escrow account as the preferred payment method for all future transactions.
- The seller will deliver the goods/ services to the buyer once the payment is verified. The escrow service provider will ensure that the buyer has received the merchandise/ product.
- Funds are released from the escrow account once both the parties are satisfied and no dispute has arisen.
Thus, the third-party account or the escrow account is a very useful means to move through a transaction between two or more parties without worrying about the nuisances attached to the transaction. It is indeed a very important means adapted in today’s scenario, wherein a lot of uncertainties are involved.
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