Rebecca Pedersen: What Is An “Escalation Clause?”

TorontoRealtyBlog

Some of you just read the title of this post, and your stomachs are already churning.

The market is frenetic enough without nonsense like escalation clauses being brought into the mix.

I have never seen an escalation clause in an Agreement of Purchase & Sale in Toronto before. Never. Not once.

And yet RECO released a bulletin on Thursday showing agents how to "deal with" the clause.

Let's look at the bulletin, and then I'll tell you why these clauses will never, ever be entertained…

Man confirm mortgage contract (estate agency client sign contract)

The following article appeared on the Real Estate Council of Ontario's website, and was emailed to all registrants on Thursday.

You can find the original article HERE.

What You Need TO Know Before Using An Escalation Clause

FOR THE RECORD
May 31st, 2017

As the housing market continues to sizzle, buyers often feel tempted to offer more for a property, or remove conditions that are intended to protect them. One tool buyers are considering is an 'escalation clause'.

Escalation clauses, also known as 'escalator clauses', are designed to edge out competing offers by automatically raising the offer price by a pre-set amount when a higher bid comes into play. There are numerous variations of this type of clause. Some identify a maximum price, others may not. It can become particularly cumbersome if more than one offer contains a form of this clause. Escalation clauses are certainly on RECO's radar, and we've been receiving a number of questions from registrants about how to deal with them.

An escalation clause may seem like an effective way to get a leg up on the competition. Although there are no specific regulations related to escalation clauses, there are general rules and regulations which still apply.

RECO will review and investigate complaints related to escalation clauses and, if warranted, will take appropriate action.

How it works

Let's say for example you have two buyers: Stan and Fred. Stan's initial bid is $550,000, while Fred's offer is $600,000.

However, Stan's offer also includes an escalation clause, which will increase Stan's offer by increments of $2,000 over any competing offer that comes in. Stan's bid rises to $602,000. Stan's representative also included a cap, which means when a competing bid reaches a certain number – in this case $700,000, the escalation clause won't increase the offer price any higher. So if a third buyer named Richard put in an offer of $750,000, Stan's offer would stand at $700,000. It's then up to the seller to decide which offer to pick.

Multiple clauses

That's a simple example, but if two buyers who have both included escalation clauses in their offers, there could be additional issues.

Imagine that both Stan and Fred included escalation clauses in their offer, with $2,000 increments. If Stan has a cap of $700,000 and Fred's cap is higher, then there's no problem—Stan's offer would stand at $700,000 while Fred's would escalate to $702,000.

But what if they both have the same cap, or both have no cap at all? In this case the seller's representative may ask both Stan and Fred to remove the escalation clause and submit a final, best offer.

Protecting your buyer

The rules and regulations that govern your conduct apply when you recommend an escalation clause or submit one as part of an offer.

You have a duty to look out for your clients' best interests, and to provide conscientious and competent service, while demonstrating reasonable knowledge, skill and judgment. Before submitting an offer with an escalation clause, the buyer must fully understand the implications and provide informed consent. There are a number of questions you should ask before you proceed.

For example, are you confident that the home will receive multiple offers? Does the buyer have flexibility in their budget to allow for a higher purchase price? Be sure your client understands that when this clause is in effect, they could be locked into a bidding war until their maximum bid has been reached.

Here are some other key tips when dealing with escalation clauses:

-You must take all practical steps to verify your client's approved borrowing limit. Ideally they would be able to provide a commitment or pre-approval letter from a financial institution. Make sure your client understands that the lender may require an appraisal after the offer is finalized. There is no guarantee that financing for the purchase price will be approved.

-A cap or provision for stopping the escalation is required to protect the buyer's interest.

-A seller may choose not to accept an offer that includes an escalation clause.

-The seller may not always choose the highest offer.

Escalation clauses can cause added stress to a buyer during a bidding war, especially if they don't fully understand how it works. Communicate with your client to make sure they know what to expect, and always remember that your first duty is to the client's interest.

This may be the dumbest bulletin ever released by RECO.

To summarize:

1) These clauses are not being used. I have never seen one, and a quick poll of my office shows nobody else has.
2) RECO has sent out a bulletin about them – giving bad agents, a bad idea.
3) RECO admits they have no clue how to handle this.
4) RECO suggests there "could be additional issues."

Having never seen one of these clauses before, and never even thinking about using one, I have to think very few, if any agents, have done so.

For RECO to bring this to the attention of the growing percentage of agents who work outside the lines is like showing your 10-year-old son where you hide your pellet-gun and then saying, "But I don't ever want you to play with this."

In my opinion, these clauses are illegal. There is no debate about that.

In order to entertain an escalation clause, you would have to divulge the terms and conditions of a competing offer to the agent who has presented the clause.

To do so is unethical, but more to the point, illegal.

And to try and think about how this would work in practice is insane.

So there are multiple offers on a property, listed at $649,900, and a buyer agents submits an offer with an escalation clause with a $5,000 increment.

What would that agent's offer be? What price would that agent offer?

How about $649,900? Why offer anymore than that, if you're "automatically" going to bid $5,000 more than the highest?

Why wouldn't that agent bid $0? Why bid anything if you have the clause?

And how does this "automatic" escalation work?

If a $649,900 bid, with a $5,000 escalation clause, is "automatically" bid up to $705,000 because the highest bid is for $700,000 even, then what paperwork do the listing agent and the buyer agent fill out?

Do they bother changing that $649,900 offer price to $705,000?

Is the bid communicated verbally, or on paper?

How much weight does that clause hold?

If the $649,900 bid price must be crossed out, and $705,000 need be written into the offer, then does the clause really hold any weight?

And how "automatic" is this escalation clause?

What if the highest offer was $900,000, and the listing agent came back to the agent with the escalation clause in their bid, and said, "Good news, we're ready to take your $905,000 offer." What's to stop the agent with the escalation clause from saying, "Not a chance," turning around, and walking out?

The seller isn't going to sue the buyer. That happens in theory, on TV, and probably in Buffalo, New York.

The seller wouldn't be able to sell his or her house to anybody else, without a mutual release from that so-called deal anyways, so they would never chase it. They would just say, "That clause was weird," and move on to accept the $900,000 offer.

So in the words of Bob Ross, let's get crazy here….

What if there were five offers on a property, and two had escalation clauses?

What if those two offers were for $1?

Or what if there were five offers on a property, and all five had escalation clauses?

What would the listing agent do then?

What would the law say regarding this?

I picture the listing agent standing in a room with all five buyer agents, and saying, "You all have escalation clauses, so you're basically 'automatically' bidding each other up to infinity. So we are happy to accept John's offer of $inifnity. Please sign here."

This whole idea makes no sense.

It's utterly ridiculous.

And if I was on the receiving end of an escalation clause, I would tell the buyer agent, "We're not working with this offer."

As far as I'm concerned, it contravenes existing RECO rules regarding disclosure of terms and conditions of competing offers, and you cannot contract out of law. Remember that – you cannot contract out of law.

Now, I'm sure one or two of you reading this, whether you have a legal background, or you're just practical, will tell me that I'm wrong, and that escalation clauses are used in other markets, in other industries, in other places around the world. You'll show me an example of how it can be done, and maybe point out the merits.

But in practice, in Toronto, and in our industry – it's a nightmare waiting to happen. Complaints, lawsuits, and legal and ethical breaches all over the place.

My colleagues will take issue with my following statement, but I've said this before many times: real estate agents are not all rocket-scientists. In fact, some of the most useless humans I have ever come across in society happen to work in my industry. Yes, there are some geniuses among us, and a lot of capable, hard-working, intelligent individuals.

But there are a lot of people who don't do the job well, and never will.

And they're already cutting enough corners, and/or fumbling their way through the most complicated market on the planet.

To throw escalation clauses into the mix would be a disaster.

If the public thinks that under-listing properties, holding back offers for offer nights, blind bidding, and listing and re-listing are frustrating, I can't imagine how anybody could stomach buying a house in this market if seemingly-illegal escalation clauses were introduced into our market…

Addendum –

I finished this blog on Thursday morning.

And then at 9:21pm on Thursday night, RECO emailed us:

RECO Email