The use of Escrow accounts as building works enablers

Posted by Edward McMullen, 12th December 2016
The redevelopment of one part of a building poses obvious construction risks to the remaining parts.  For example, basement excavations in expensive London enclaves, fancy penthouse conversions to the top of a block, or a ground floor face-lift of commercial retail space. Where the different building parts reflect the legal title of different owners the situation is ‘complicated’.

Leaving aside engineering challenges, overlapping legal interests first need to be stress-tested.  Landlord and service company consents will be required and necessitate a delicate dialogue concerning the cost of putting things right if a grand design should run into delay or out of money – typically, if the party proposing the project (the developer) becomes insolvent midway through.

How should those with an ownership stake in the property seek to ensure that their interest is protected? How should the main contractor ensure that it gets paid for work carried out; and is prepared to complete the project?   With some innovative thinking the developer may be able to offer reassurance through the use of legal security.

Familiar examples of legal security such as guarantees and bonds may not be practical for residential or small-scale developers.  They may lack a parent company (many are private individuals), and a parent may yet be brought down by difficulties encountered elsewhere in the group – the domino effect of late payment on a different project, for example.

Nor will the use of bank bonds necessarily plug the risk gap.  Construction bonds are normally for only 10% of the build cost and intended to fund finding a replacement contractor, rather than for replacing a developer. The bank/bond provider will likely charge a crippling cost; expect a charge over the developer’s other assets, and pose tricky questions concerning the trigger for the bond money to be paid out.

Is there a further option with fewer side-effects?  Escrow agreements may be an answer.

Holding money ‘in escrow’ means putting those funds beyond the immediate reach of the party supplying it.  It is most often encountered at the sharp end of a conventional property conveyancing transaction.  One firm of solicitors will act as the neutral third party, constrained from dealing with the money other than in accordance with the strict instructions agreed in advance by the parties concerned (such as mortgage providers, a property seller and its buyer).  The arrangement is over quickly.

In construction scenarios, however, a longer term escrow agreement (EA) may be settled between a developer and a contractor hesitant to commit to a project for fear of not being paid.  Under the EA, the developer is obliged to pay either all or a percentage of the total build cost into an escrow bank account.  Typically escrow bank accounts involve only two or three transactions: an initial payment in by the developer, a pay-out on expiry (to either the developer or the contractor depending on the position) and possibly a pay-out in an emergency.  A third party funder can be accommodated too, conceivably, to shore up the developer’s position.

An escrow account is not a project bank account.  Project bank accounts (PBA) similarly ring-fence funding, but ensure payment is channeled throughout the supply chain on the contractually agreed dates. Whilst an admirable set up encouraged by commentators, PBA’s are unpopular with main contractors reluctant to cede cash flow control, and who may not welcome the open-book nature of such arrangements.  PBA’s also involve much more management and need to be provided by a regulated member of the banking sector. Critically, a PBA may not suffice if it is the developer that goes bust.

How does a construction escrow agreement operate?

EA set-up always includes very prescriptive terms to minimise the chance of conflicts arising and money being improperly released. The account operator (an escrow agent, bank or firm of solicitors) must detail its obligations carefully to avoid any uncertainty – even if there is a disagreement between the parties themselves (e.g. regarding the work performed/payments due).  If a proposed payment out is disputed, the operator should be unable to act until provided with a court order or equivalent or a consent signed by all parties.

EAs are inherently risky without careful drafting.  Fair access must be enshrined, but the EA must safeguard against any party becoming unjustly enriched.  For example, if other title holders could draw down from the escrow account sums greatly in excess of value of the works yet to be completed. This scenario would see the freeholder, say, with a greatly enhanced (albeit incomplete) asset, plus cash far in excess of the cost required to finish the project.

Feasibility for the developer

If the developer has enough capital available, perhaps using a third party funder, escrow funds totaling the full projected build cost can be deposited. The developer pays for the works separately – which is considerable assurance to other title holders in the property. However, few developers will have such capital available and/or be content to freeze access to the escrow money until it is returned at the successful completion of the project.

In more sophisticated set-ups payment out of the escrow account can be triggered against site progress: against contract administrator certificates, say, or according to sections, stages or a predetermined percentage of the contract sum. The aim here is to minimise the sum on account.  However, those taking comfort from the EA must at all times remain satisfied the sums left on account are sufficient to cover the cost of the developer abandoning the project for whatever reason.

Complications to be wary of

Banks rarely operate escrow accounts for amounts smaller than £1 million and also often require several weeks’ notice to set up unorthodox services.  A residential or small-scale developer with tight deadlines may be frustrated, and turn expectantly to their trusted advisor at the local solicitors firm.

For solicitors, opening a bespoke client escrow account is achieved swiftly and with relative ease, once the parties have agreed the terms of the escrow agreement. However, solicitors are regulated tightly.  They must always operate a separate ‘client account’, conduct strict anti-money laundering checks, insure against negligence and abide by undertakings – such as those contained in the EA.  Conceiving and managing escrow accounts must be handled particularly carefully. The Solicitors Regulation Authority (SRA), states:

The use of escrow accounts is a serious risk if they do not have a reasonable connection to an underlying legal transaction (which you are advising on) or are not in association with the recognised “professional duties” of a solicitor.

In order to advise on or manage an escrow account, therefore, the solicitor must be sufficiently connected to the underlying legal transaction – able to justify the rationale for the EA setup and understand the transaction as a whole and their legitimate legal service within it.  That is distinct from a ‘mere’ banking facility, provision of which would contrary to the SRA rules.

Simplistically, if the solicitor has been involved deeply in the wider transaction then the provision of the EA is more likely to satisfy this test.

Is an EA appropriate for you?

To conclude, some projects fail to get out of the ground because those with an affected interest will not buy into the vision of the project proposer.  Providing legal security, backed by hard cash, may be the comfort those parties require.  It’s not easy, but using an escrow agreement may be the best of a small number of viable options.

A solicitor may, in certain circumstances, set up and manage an escrow account in order to bring the agreed arrangement into life.

If you would like to talk to someone about procuring construction works and/or the feasibility of employing an escrow account, then please contact the authors of this blog piece.


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