Legal Breakdown: Escalation Clauses

IAR Legal Counsel Gabe Walsh sits down with IAR Instructor and attorney Jorge Gomez, Jr. to discuss escalation clauses. 

If you like to read the transcript, please scroll below the video to read through the transcript of this Legal Breakdown video. 

Hello, everybody. It's good to be back for another legal breakdown video. My name is Gabe Walsh and I'm the legal counsel here for the state association. I have with me back again in the studio today Mr. Jorge Gomez. He's a founding partner with the Gomez Lay, or excuse me, with the Gomez May Law Firm, and has offices in both Iowa and Illinois. And he is also the founder of the Gomez Title Company, which has offices in Illinois.

Gabe, thanks for the invite. Legal breakdown, always a pleasure to do these with you. And for those of you watching, I'm sure you would agree that this is a great service that the Iowa Association has for its members.

Absolutely. And Jorge, we're just always happy for everything you do for our membership and just appreciate you being here today.
Well, I appreciate the opportunity again. Thank you.

Absolutely. So today we've got a pretty good topic coming your way, and it's one that all of a sudden has been coming up in a lot of conversations. And the topic we're going to talk about today is escalation clauses. Jorge, do you want to just give us a little background on this topic?
Gabe, I couldn't agree with you more. Escalation clauses are getting more and more questioned, if you will. And I get more and more phone calls from Realtors concerning escalation clauses. I call it the escalator. The great escalator. We're going to talk about the escalator.
Let me give you a brief definition of an escalation clause or the escalator, if you will. They exist when a buyer makes an offer on a property at a specific price and attaches the escalator, the escalation clause, to that offer, which generally says in simple terms that if any other competing bona fide, key bona fide offer, is higher than the offer, that offer automatically increases by a certain dollar amount up to a maximum dollar amount.

And we're starting to ... I don't know what it is. I don't know if it's the markets. I don't know if it's the inventory or what it is exactly, but we're seeing more and more of these types of offers being made all across the state. And suddenly I keep getting the question on the legal hotline, is this permissible? Are escalation clauses submitted with offers legal in Iowa?

Gabe, I don't think there's anything illegal about them. My concern is this. I'm not sure they're understood as fully as they need to be understood by the Realtors who are suggesting to their clients or buyer clients that they put escalation clauses in the offer. And that's why I think it's important for the Realtors to know what they are, know the ramifications of them.

So again, to answer your question directly, they are not illegal from what I could find. However, what's very important is how they are worded in the purchase agreement.

Absolutely.

The contract language. When I talked about contract terms, I talk about certain and definite terms, especially when you have escalator clauses. Certain and definite terms are so important. Those will be key.

And I think with these escalation clauses, what I tell people is like you said, there's nothing that makes them illegal or unlawful. It's important to word them correctly. But I think it's almost as much of a question of strategy as much as anything. Because with these escalation clauses, a lot of times what you're seeing is properties where somebody's saying, "Submit your highest and best." And maybe it's going to be a multiple offer situation. You don't know what the highest and best is going to be. So you submit an escalator clause on a $100,000 house. You say, "We'll buy it for a $100,000, but we'll go up to $110,000." It maybe gives you a shot to get something you wouldn't have otherwise gotten. But on the flip side, the other argument is that by submitting an escalation clause and going maybe even above the asking price, you're showing as a buyer all your cards. You're laying everything out. Now the seller knows exactly what your financial situation is and what you're willing to pay.

Yeah. So I think we have to talk about this from two different perspectives. One is if you represent a buyer. When do you advise your buyer that an escalation clause may be appropriate in this particular transaction? And I find those to basically come into play when there's multiple offers on a property, like you stated. Inventory is low. Person wants that property. So buyer, when do you use it?

On the other side of that, Gabe, is from the seller's point of view. So you're the listing agent. You represent that seller. Do you advise your seller to accept escalating clauses in the offers presented to them or not? Or do you just want that buyer to come and say, "This is what I have. This is my top dollar."

And I think it's a case by case basis. My biggest thing is what I tell our members when we deal with these kinds of issues is, escalation clauses should never be something you tell your buyer that you should absolutely always use an escalation clause. It's kind of a calculated gamble in a way.

Now, I don't think you should use escalating clauses carte blanche. I think you have to look at that particular transaction, because they could come back, as you rightfully pointed out, to harm you as well as they could help you. So you have to know when and how to use them.
And I think buyers' agents as a best practice need to be sure to advise their buyer clients that, "Hey, look. This is what an escalation clause generally is. If you submit one, there might be a chance that you're going to get something that you might have not otherwise gotten. But there's also a risk that this is going to put your cards on the table and maybe it's not going to help you. It's sort of a gamble." And I think you need to explain both sides and ultimately let your client make that decision.

And I would agree with you. But let me throw something in here and get your opinion on this. In order for that escalation clause to kick in, that seller has to have received a bona fide offer.

Absolutely.

So do you see any questions about what is a bona fide offer and how does one Realtor representing the buyer who has this escalation clause, how can they be certain that there is a bona fide offer?

That's a great question. What's so important is you have these escalation clauses that it's going to trigger your higher offer, but you've got to make sure that the seller's not just getting some bogus sham from their brother-in-law offer in there to try to kick in the escalator and drive up the price. Which is why in most of these clauses, they should always have some kind of a provision which says the buyer's entitled to see whichever offer kicked their escalator clause in.

That's exactly on point. And that's why I said earlier that the language of the contract is so important. The language of the escalation clause is so important, because that dictates, that outlines what each party can expect from the other side.

Absolutely. And I think it's critically important when we talk about Realtor code of ethics, it's important that Realtors are honest and truthful in all their communications with other real estate professionals. You have to treat all parties to a transaction honestly, and fairly. So don't ever, ever, ever be a part of a practice where you're basically letting sham offers come in.

No, exactly. And you have several articles, ethical articles, that come into plain escalation clauses. Not only Article Nine, which talks about writing your contracts in clear and understandable language, you have Article Three, cooperating with other Realtors. You have Article One, honesty to all parties in the transaction, honesty to the public. If they all come in together, that's why these are so important. And Realtors should not hesitate to ask for help in offering these escalation clauses.

Absolutely. And Jorge, we've talked a lot about some different best practices for buyer Realtors and buyers' agents dealing with their clients. But I think on the seller side, what you need to consider is a seller doesn't have to accept an offer with an escalation clause. It's still totally 100% the seller's option what offer they're going to accept on their property.

Correct.

But what's really important is let's say that you have a listing agreement with a client for $100,000 on your property. And let's say two buyers come along and they both submit $100,000 offers. One of them has an escalator clause up to 110, one's got an escalator up to 115. I mean, obviously a seller has an option to counter both those or counter one of them and try to drive up the price without accepting one of those offers. But if one of them, if those buyers get upset and leave, that does run the seller at risk of having to pay commission.

I would agree. And that's where the Realtor has to educate that seller. You turn this down, you don't know if they'll come back or not. So at the end, because that seller received an asking price, a good faith offer, they may be obligated to pay some compensation to the Realtors.
It is. And based on the multiple listing service, the selling agent may also have an obligation to pay cooperative compensation to a cooperating broker who brought a buyer.

Exactly.

So again, it's important on the seller side as a Realtor to have those conversations with your seller, inform them of that listing agreement, and that if they turn those down, they still might be on the hook for a full price offer.

I would completely agree.

Exactly.

So let's summarize this a little bit, Gabe. What are some of the things we can tell the viewers, we can tell the Realtors, maybe some best practices, things that maybe they should keep in mind when determining whether or not to use escalation clauses.

Yep. Again, I just think it's a case by case basis. I think you need to sit down with your clients, look at the situation, determine what you think there's going to be for activity on the buyer side on that property, and determine whether it's better to just throw out your best price or whether an escalation clause might provide you a safety net. But again, I think it's important to always consider the positives and negatives that can be associated with that.

I would agree. And I think it's very important. And I stress this to all Realtors is to inform your client as to the process, as to the procedure. Educate your client as to the process, as to the procedure. They don't know this. That's why they come to you. They're relying on you. At the same time, remember the client makes the ultimate decision. But they need to make that decision based on good information that you have given them.

Absolutely. And again, if there's a question as to the terms of the escalation clause, what legal obligations that creates, I think it's always important too to remember your Article 13 Code of Ethical Obligations, to make sure clients seek the advice of an attorney if a legal opinion is sought or legal advice is needed.

So I think that wraps up this topic.

Yeah, absolutely. And Jorge, I think you might be teaching something about this going down the road a little bit, right?

Actually, I have submitted a two-hour class. Hopefully it'll be approved here shortly, and I'll be offering a two-hour class solely on escalation clauses, talking about the pros and cons and when to do it, when not to. Some contract writing escalation clauses and how to advise your client on those processes.

Absolutely. And I think our members should sign up. That will be a much more detailed view on this subject. But this gives you a little bit of idea.
But thank you very much for watching. Jorge, thank you for being here with us. And always feel free to call our legal hotline here with questions. So thank you very much.