Legal Definitions - escrow account

An escrow account is a special type of financial account held by a neutral third party, known as an escrow agent. This account temporarily holds funds or assets on behalf of two other parties involved in a transaction. The money or assets are released from the escrow account only when specific conditions, agreed upon by both parties, have been fully satisfied. Its primary purpose is to provide security and ensure fairness for all parties until a transaction is complete or certain obligations are met.

Here are some examples to illustrate how an escrow account works:

• Mortgage Payments for Property Taxes and Insurance:

  When an individual buys a home with a mortgage, the lender often requires an escrow account. The homeowner makes monthly payments that include not only the principal and interest for the loan but also an additional amount for property taxes and homeowner's insurance premiums. The mortgage lender acts as the escrow agent, holding these additional funds in the escrow account. When the property tax bill or insurance premium is due, the lender pays it directly from the escrow account on behalf of the homeowner. This arrangement ensures that these crucial payments are made on time, protecting both the homeowner's asset and the lender's collateral.

• Purchase of a Custom-Built Item:

  Imagine a small business commissions a specialized manufacturing company to build a unique piece of machinery for their production line. The total cost is substantial, and the machinery needs to meet specific performance criteria. To protect both parties, they agree that the business will deposit a significant portion of the payment into an escrow account managed by a bank. The manufacturing company will receive the funds from escrow only after the machinery has been built, delivered, installed, and successfully passes a specified performance test, as verified by an independent engineer. This ensures the manufacturer gets paid for their work, but only after they've met their contractual obligations, and the buyer is protected from paying for a non-functional product.

• Sale of a Business with Post-Sale Conditions:

  Consider a scenario where a buyer agrees to purchase a small consulting firm. As part of the agreement, there's a clause stating that the seller must resolve a pending client dispute within 90 days after the sale is finalized. To ensure the seller fulfills this obligation, a portion of the purchase price is placed into an escrow account. The funds will remain in escrow until the 90-day period has passed and the client dispute is confirmed to be resolved to the buyer's satisfaction. If the dispute is not resolved, the buyer may be able to claim a portion of the escrowed funds as compensation, providing a strong incentive for the seller to meet the condition and protecting the buyer from inheriting unresolved issues.