The Escalation Clause: The Escalator to Nowhere?
Going up? Or Down?
Or Nowhere?
Do you remember the episode of The Simpsons where, at the end, there was an escalator to nowhere in Springfield? You can check out the clip here. There's been a new topic of conversation brewing among agents in the past week or so that reminded me of that episode. It's called the Escalation Clause. Here's how it works and why it's so controversial:
The Escalation Clause (or Elevator Clause) is used by buyers and their agents in a bidding war situation where Buyer A offers an initial offer amount (let's say $625k) but then adds a clause to their offer allowing him to increase his offer by a fixed amount above any other higher offer, up to a certain cap.
So let's say Buyer A and Buyer B are in a bidding war on offer night for a property listed for $599k. Buyer B writes up an offer for $640k. Buyer A writes up an offer for $625k and includes an Escalation clause allowing him to increase his offer by $2k above any offer higher than his, but his max price will not exceed $650k. So in this example, Buyer A would (or should) win the bidding war with a price of $642k.
Apparently this tactic was used frequently enough in the past couple weeks for RECO to issue a bulletin to all agents about how to handle these situations. First, let's talk about the issues with allowing this process:
1 - According to RECO guidelines, agents are not permitted to disclose the details of any competing offer to any other buyer offering on a property. This includes conditions, closing date, and especially price. What does this have to do with anything? Well, in my example above, if Buyer A wins the bidding war with his offer of $642k, then he knows that Buyer B bid exactly $640k. Which to me is no different than the listing agent disclosing to Buyer A what Buyer B's offer was.
2 - Even if Buyer A wins the bidding war for $642k, s/he still has no guarantee that the next highest offer was in fact $640k. Why? Because again, the listing agent is not permitted to disclose what price the other offer was and although one would pressume that the next highest offer was $640k given Buyer A's winning bid, how can Buyer A be sure of this? I mean, I trust people and everything but how can you really be sure that the listing agent and/or the seller are being truthful? Look, I'm not saying anyone would be untruthful but the reality is, without the proper controls or regulations in place for these exact situations, there is nothing from stopping the listing agent from telling Buyer A's agent that he won the bidding war for $650k. I mean, who would ever know? Besides, Buyer A was willing to pay $650k anyway, right? Seems a little too sketchy for me.
3 - Buyer B will never know that Buyer A has an Escalation clause, which puts Buyer B at a disadvantage. Buyer A's bid is pegged to Buyer B's bid giving Buyer A an unfair advantage on the bidding process. That in itself contradicts RECO regulations.
4 - What if there are multiple buyers who use this Escalation clause? Does the seller automatically accept whoever has the highest cap in their clause? A unit recently sold at Theatre Park with around 40 offers on offer night. Imagine the nightmare trying to deal with the logistics if Escalation clauses were used by a bunch of those bidders.
I'll be honest, I don't know how often this clause is really used. I've personally never encountered it on either the buying or listing side. Would I ever use it? Seems to me that if my buyer wanted to use this strategy, I would have to caution them about all the pitfalls I described above (and I'm sure there are many more). And if my buyer client won a bidding war using this clause, I would want proof of what the next highest offer actually was before letting my client agree to the final price. Will that proof ever be provided before the deal is done? Who knows. Is it a RECO requirement? Nope. At least not yet. In fact, agents (and their brokerages) are not required to keep a full copy of all offers submitted on a property once a deal is done. They are only required to keep what's known as a Form 801 - Offer Summary Document, which only confirms that an offer was actually submitted by a buyer and when. It is not required to detail anything about the price that was offered. So even during a RECO audit (which would only happen after the deal is already done), there would be no way to confirm whether a buyer who used an Escalation clause actually paid the price he was "supposed" to. Or if he got played.
RECO's response to the use of this Escalation clause is that (and I'm paraphrasing) "agents must act in their client's best interest and guide them accordingly". So no concrete regulations around how agents are supposed to handle these very dicey situations. I personally think this clause should not be allowed until there are very strict rules around how they are implemented. Until then, it will only result in more confusion and more frustration among agents and their clients.
If you have a comment, feel free to leave it below. And remember, if you haven't already, please "like" my Facebook page and check back regularly! Your Toronto condo lover, Adil Dharssi
