The Problem With Escalation Clauses
In this crazy seller’s market, it seems like every property is receiving multiple offers so buyers and buyer agents are understandably trying everything they can to move their offers to the top of the pile. I wrote an article about some of the things they're doing and it can be found at TomGrisaksrealestateblog if you're interested.
One of the things I mentioned was escalation clauses, so that's what I'm going to be talking about here. An escalation clause basically says the buyer agrees to pay a certain amount over the best offer submitted by any of the other buyers. Here's how that would work.
Let's say six offers come in on a home and one of the buyers has an escalation clause. It might even be the lowest offer of the group, but that buyer agrees to pay $10K over every one else's best offer. If the highest offer is $1 Million, the seller shows the buyer with the escalation clause the offer and they agree to pay $1,010,000. Sounds simple enough.
When I first heard about escalation clauses, my reaction was “That’s brilliant. The buyer is going to let all the other bidders fight it out for the highest price, then they'll swoop in and pay $10K over. That way they're guaranteed to get the home and it really doesn't matter what price they made their original offer at”.
Although I couldn't put my finger on it, I had a feeling there would be some ramifications to escalation clauses, I just didn't know what they were. I'm not an attorney so I called one I know and had a very casual conversation with him. I asked how he felt about escalation clauses and what the issues might be.
I'm only summarizing my conversation with him from my notes but what I learned was enough for me to draw the conclusion you have to be very careful with them. The attorney told me he didn't like them but does see them. He pointed out the clause must be written by an attorney and if the buyer agent writes it, they're practicing law.
He went on to say there's a real possibility of contractual illegalities or even downright fraud by using escalation clauses. I asked him to give me some quick examples of problems he's seen just off the top of his head and here's what he said.
First, the buyers who did not win the bid are going to be furious if they find out they were only being used by the seller and listing agent to bid up the price so someone else could come in and buy it. In reality, none of them ever had a real chance to purchase the property. That can lead to hard feelings by all of those buyers which might deteriorate into something worse.
He also said an unscrupulous seller and/or their listing agent can “manufacture” an offer at a much higher price than all the others. The listing agent just shows the bogus offer to the buyer as "proof". Even if the name can be seen on the offer, how would the buyer know if it really was legitimate. It might have come from the seller's friend who was asked to throw out a high number with no intention of ever buying the home. Maybe the listing agent had someone they know submit a sham offer. There’s really no way for the buyer to know if it was a legitimate buyer who had been vetted and qualified yet they're being asked to match it with a $10K cherry on top.
He pointed out when the seller asks their listing agent to present the sham offer to the buyer with the escalation clause, by law, the listing agent is obligated to do so. That means they're also complicit in committing fraud whether they realize it or not.
He mentioned if the buyer with the escalation clause closes on the property and then somehow finds out they were tricked into overpaying with a manufactured offer, both the seller and their listing agent are going to be sued, and rightly so.
He said there might be contractual issues stemming from acceptance of the escalation contract and not defining when the “offer” period ends. What if an even higher offer is submitted to the seller three days before closing? Is the buyer with the escalation clause still obligated to pay $10K over the new higher price? If they refuse and back out of the deal, will they get their earnest money back?
Knowing the risks associated with escalation clauses, we don't use them when we're representing our buyers. If we have a property listed and receive an offer with an escalation clause, we'll encourage our seller to let us ask the buyer agent to resubmit their offer without the clause. That keeps everything clean and everyone out of trouble.