The Pitfalls of Using Escalation Clauses

Published Monday, April 5, 2021 9:30 am
 

In an effort to gain a competitive advantage, some prospective buyers may ask their agents to include escalation clauses in their offers.  An escalation clause is one in which a prospective buyer expresses their willingness to pay a specific amount more than the highest competing buyer. The escalation clause may or may not indicate a maximum amount that the prospective buyer is willing to pay.

The Commission discourages the use of escalation clauses but does not prohibit them.  Commission Rule A .0115 reads as follows: “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.” Therefore, in the unlikely event that a buyer consents to allow a broker to share the price and terms specified in their offer with another prospective buyer, then and only then may the broker do so.

Pitfalls of escalation clauses:

  • If a buyer submits an offer containing an escalation clause without knowing the price and terms of the other offers and without specifying a maximum price, the buyer may end up paying much more for the property than desired.
  • If a buyer includes a maximum price in an escalation clause, the seller will immediately know the buyer’s top price thereby compromising the buyer’s bargaining position.
  • An offer containing an escalation clause may not become enforceable until a specific price is entered into the contract and the buyer sees the price the seller has specified.
  • The seller may fabricate a fictitious offer in order to drive up the sales price for a buyer who uses an escalation clause.
  • Real estate brokers are prohibited from drafting escalation clauses because doing so would constitute the unauthorized practice of law. Hiring an attorney is recommended but will increase the buyer’s costs. The seller should also have an attorney review an offer containing an escalation clause to protect the seller’s interests.
  • If multiple buyers were to include escalation clauses in their offers, a bidding war may follow. If no buyer is willing to commit to a specific price, then no contract is ever formed and no property is sold.
  • Since the use of an escalation clause implies that a prospective buyer is willing to pay more than other buyers, it may motivate sellers to seek higher prices, a disadvantage to the buyer using the escalation clause. 
  • While the use of escalation clauses may lead to higher sales prices, a benefit to the sellers, they could also discourage buyers who do not want to use escalation clauses.  The use of escalation clauses may also lengthen the negotiation process, a potential disadvantage to sellers and buyers.
  • The buyer who is unsuccessful in a negotiation where a competing buyer used an escalation clause may feel that they were treated unfairly.  The perception of unfair treatment may discourage the buyer from purchasing property in the future and may lead the buyer to file complaints against the brokers involved in the transaction.
  • A broker who discloses the price/terms of an offer without the buyer’s consent or otherwise gives one party an unfair advantage over another risk disciplinary action by the Commission.

              A seller’s best response in a multiple offer situation where one or more of the buyers is using an escalation clause will likely be to invite all buyers to make their highest and best offers.  That way, each buyer is given an opportunity to buy the property at the price and terms he or she is willing to pay and the seller will receive the best offer from each buyer rather than an incremental offer from a buyer who wants to offer slightly more than a competing buyer.

            Escalation clauses tend to focus on price.  Listing agents should exercise care to advise seller-clients to consider more than the sales price in an offer.  An offer from a well-qualified buyer who offers a lesser amount may be a wiser choice than a higher offer from a less-qualified buyer. Similarly, an offer from a buyer who has visited the property may be preferred over one who offers a high price sight unseen.

            Brokers who choose to use escalation clauses should proceed with extreme caution.  Real estate transactions are complex even without such clauses. Real estate transactions in busy markets with low inventory can be even more frantic. The use of such clauses may introduce confusion, anxiety, frustration, and fraud.  For these reasons, the Commission discourages their usage and the disclosure of the terms of competing offers even when authorized by buyers.

 
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