Escalation Clauses May Throw Kinks Into Deals

Dear Forms Guy: I need some help! My clients, the Greens, are moving here from another state. They want to make an offer on a hot property that they really like. The property is listed for $425,000 and they are willing to pay up to $435,000. At the suggestion of their lawyer from back home, the Greens have asked me to add an escalation clause to their offer. I’ve heard of escalation clauses but don’t really know what they are or how they work. What should I do? Sincerely, Lola

Dear Lola: Is that L-O-L-A Lola? Sincerely, Forms Guy

Lola: Yes.

Forms Guy: Rhymes with C-O-L-A cola?

Lola: Yes, that’s right. Will you just answer my question, please?

Forms Guy: Question? Oh yes – escalation clauses. An escalation clause is a provision in an offer to purchase that allows for incremental increases in the offering price based on competing offers. An escalation clause in the Greens offer might say something like the following: if the seller receives any other offer with a purchase price greater than the purchase price in the Greens offer, the purchase price will be increased in an amount equal to $1000 more than the purchase price in the other offer.

Lola: What if someone else offers more than the Greens are willing to pay? Would they be stuck with a higher price?

Forms Guy: Great question, Lola. To avoid that possibility, it would be very wise for the Greens to include a maximum amount up to which their offer could “escalate.” That “ceiling” might be $435,000, which is the maximum amount they are willing to pay for the property. However, including a ceiling may compromise their bargaining position because the seller will know that they are willing to pay that amount for the property.

Lola: The seller could just counter at $435,000, couldn’t he?

Forms Guy: Yes, that’s certainly possible.

Lola: Okay, let’s say the Greens include an escalation clause along the lines of what you said. Then suppose that I get a call from the listing agent notifying me that the Greens have a deal at $431,000, which the listing agent says is $1,000 more than another offer that was made. Would the Greens be entitled to see the other offer to confirm that it existed?

Forms Guy: Another great question, Lola! There is obvious potential for fraud in this situation. The seller may be tempted to manufacture a competing offer, or have someone submit a semi-legitimate offer, for the sole purpose of bumping up the amount of the Greens’ offer. To combat this, the Greens would want to consider adding something to their escalation clause, requiring the seller to provide the Greens with a true and complete copy of the competing offer. But of course, just seeing the other offer would not necessarily establish that it is a bona fide or genuine offer.

Lola: Would it be legal for the listing agent to share the other offer with me?

Forms Guy: Real Estate Commission Rule 58A.0115 states: “[a] broker shall not disclose the price or other material terms contained in a party’s offer to purchase, sell, lease, rent, or to option real property to a competing party without the express authority of the offering party.” I am not aware of any definitive opinion on the subject from the Real Estate Commission, but based on informal discussions I have had with the Commission’s Regulatory Affairs Division, the Commission could well take the position that sharing a copy of the competing offer with the Greens would constitute “shopping” the competing offer in violation of the Rule.

However, it could also be argued that in this context, the Greens were not competing with the other buyer because the competition ended when the seller signed the offer from the Greens. If the purpose of the Rule is to prevent a listing agent from being able to unfairly use one buyer’s offer to encourage another buyer to make a higher offer, that’s not what’s happening in this situation. Here, the listing agent would be sharing the other offer with you simply to confirm the existence of the other offer and the price term of the resulting contract between the Greens and the seller.

Lola: I don’t see how the contract could be binding on the parties unless the final price is actually in the contract.

Forms Guy: I am not aware of any statute or case law specifically addressing the legality of escalation clauses in North Carolina. However, there is existing case law supporting the proposition that as long as the price can be readily determined by reference to an ascertainable standard (which in this situation would be the other offer), a contract is not unenforceable simply because the price isn’t in the contract itself. But while I think it is likely that a contract containing a well-drafted escalation clause would be legally enforceable, it is also possible that a court might conclude that there’s no contract unless the offering party signs off on the final price since, at the point in time the seller accepts the offer, only the seller actually knows what the final price is.

Lola: Wow. That’s a lot to think about.

Forms Guy: And that’s not all that needs to be considered. Other things to think about: are the Greens competing with other offers based on gross purchase price, or on net price (gross purchase price less seller concessions)? How about other offers where the purchase price may not be payable in cash at closing or that may be contingent on the sale of the competing buyer’s existing property or that may have a delayed settlement date? And would the Greens be competing only with other offers that may have been presented to the seller prior to the acceptance of the Greens’ offer by the seller, or may a later offer be used by the seller to escalate the Greens’ offer? All of these issues should be considered and possibly addressed in the escalation clause.

Lola: How should I advise my clients?

Forms Guy: The Real Estate Commission discourages the use of escalation clauses and has recommended that agents discourage their clients from using them. A buyer who asks for an escalation clause to be included in their offer should be advised to seek legal counsel for advice and drafting of any such clause. An agent who attempts to draft an escalation clause is engaged in the unauthorized practice of law unless she/he also has an active law license.

Lola: Is there a standard form I can use?

Forms Guy: No. The NCAR Forms Committee recently considered a request to develop a standard escalation clause and decided against it.

Lola: Gosh. It seems like making an offer with an escalation clause would just open up a big can of worms for everybody. Would I even have to present an offer containing an escalation clause?

Forms Guy: Yes. You would need to present it in accordance with NCREC Rule 58A.0106 and Standard of Practice 1-6 of the REALTOR® Code of Ethics. The same would go for the listing agent too. The listing agent in such a situation should advise the seller to seek legal counsel for guidance and should also advise the seller that the listing agent may be unable to share a competing offer with a buyer who includes an escalation clause in their offer.

Lola: Wouldn’t the listing agent have to tell the agent representing the other buyer that the offer from the Greens included an escalation clause?

Forms Guy: No. I think that sharing a term of the Greens offer with the other buyer would clearly violate the Rule prohibiting the shopping of offers that we discussed earlier.

Lola: So what do you think about escalation clauses, Forms Guy?

Forms Guy: Although a well-drafted escalation clause might possibly work in a given situation, as a general rule, I would advise buyers and sellers and their agents to stay away from them.

Lola: Thanks, Forms Guy.

Forms Guy: So long, Lo-lo-Lola! v

By TyLER HELMS TECHNOLOGy MANAGER