What Is An “Escalation Clause?”

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

They never should have sent the first email…

29 Comments

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  1. […] On his website torontorealtyblog.com, Toronto broker David Fleming wrote, “This may be the dumbest bulletin ever released by RECO.” […]

  2. Jack says:

    Escalation clauses and other flavours of modified bids by buyers are used in transparent markets, such as open auctions or stock markets, and work without much harm there.

    The problem is that the residential housing market as currently practiced in Canada is not transparent. Houses are sold by what amounts to a blind auction controlled by the agent for the seller. Sales data are controlled by real estate boards, and they only publish selected statistics.

    The confusion about escalation clauses by itself doesn’t mean much, since hardly anyone uses them anyway. But it is another symptom of the big underlying problem, the lack of transparency in housing markets.

    1. downtown says:

      Totally agree. I expect that for an escalation clause to work, the process would have to be very transparent. The mere fact that there is no disclosure of the competing bids (and no requirement for the seller to accept the highest bid) would seem to make this type of bid unworkable from the start. If a buyer submitted, say, a $650k bid with escalation clause up to $1m, what’s to stop the seller from simply saying “we accept your $1m bid”. They don’t have to disclose the other bids. And as a seller divesting of my most important asset, I would be very wary about accepting a bid which automatically put the price far above the buyers initial offer.

      The only function this clause would seem to serve is a signal from the buyer to seller that this is not their best and final price.

  3. SallyFiver says:

    Escalation clauses are not the problem. The issue is that RECO has no policy on how to legally and ethically manage them. Escalation clauses are no different than auctions with stop-limits. Admittedly Sellers would not be averse to escalation clauses, and at least Buyers have a mechanism to up-the-ante (up to their stop limit). Would like to see RECO’s “greater level of detail”. Good luck all.

  4. Libertarian says:

    This topic is also in the Globe & Mail today. Other agents discuss their concerns. Some say the same as David, others that because bidding wars are dying down, these clauses won’t be necessary. We shall see.

    https://secure.globeadvisor.com/servlet/ArticleNews/story/gam/20170602/RBCDRECOESCALATIONCLAUSE

  5. Condodweller says:

    David, with all due respect I don’t know if you are too busy with your day job, not getting enough sleep or if you have other distractions but during the few years of following your blog, I have never seen a post with so many logical and factual errors. You have also sunk to a new low with your useless human comment WRT your colleagues.

    1. McBloggert says:

      With all due respect. Stop reading the blog. Plenty of other blogs on the interweb for you to read.

      1. Condodweller says:

        Thank you captain obvious.

    2. Chris says:

      He’s not wrong. Not saying all real estate agents are useless, but some certainly are.

      Case in point:

      http://www.cbc.ca/news/canada/toronto/realtors-amber-alert-hashtag-1.4020652

      1. Condodweller says:

        There is a difference between a useless agent and a useless human being.

        1. Chris says:

          Yes, but some of those useless humans work in Real Estate, and are probably useless agents. I think that was David’s point. He’s not saying all, or even most agents are garbage. But some certainly are, and would exploit this new rule in unethical (and possibly illegal) manners, for their own benefit.

          1. Condodweller says:

            I am sure many agents are gready, unscrupulous, unethical who would love to take advantage of this clause which makes them useless agents. However, calling someone a useless human being is an extremely nasty and hurtful thing to say. It is possibly one of the worst things a person can be called and I take great offense at it even though I’m not one of them.

          2. Chris says:

            Ehh, I guess I can think of worse things to be called than useless.

            I would also say not being very good at your job makes you a useless agent.

            Being unethical, unscrupulous, etc., well that goes beyond just being a useless agent, into being a person of low morals (possibly a useless human).

            For example, using an active Amber Alert situation to drive traffic to your real estate twitter feed goes well beyond simply being incompetent.

    3. Ralph Cramdown says:

      Me, I try not to be too negative all the time. I don’t think I’m succeeding. But don’t crap on the dude TOO much. His blog provides a valuable service, even if you don’t agree with much of it.

      Thank you David.

      1. Condodweller says:

        Agreed. I meant the “with all due respect” part of my comment as constructive feedback, however, captain obvious managed to turn it into sarcasm.

  6. Ralph Cramdown says:

    “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.”

    At the risk of stating the blindingly obvious, REBBA applies to BROKERS and AGENTS, and the contract is between the BUYER and SELLER. REBBA does not apply to the contract between buyer and seller. And, as we’ve seen, RECO apparently sanctions the practice.

    You can do this in the stock market, and you can do it on Ebay. You can do it at an art auction. Buyer agents (and some of their clients) are going to love it. Is it stupid? Probably in most cases, but it isn’t any stupider than bidding $300k over asking for a crackerbox semi on a 15′ lot with no inspection or financing clauses, and everyone seemed just fine with that.

    Besides, haven’t you heard stories where a house sat on the market for three weeks, and somebody put in an offer, and the listing agent called back to say there was suddenly another offer in play? Yeah, that wasn’t a coincidence.

  7. Paully says:

    “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.”

    It would seem to me that inserting a clause that basically tells the vendor that the buyer is so desperate to own right now, that they will pay just about any price for that privilege, is a crazy-stupid idea.

    Looks like another horseman of the Real Estate Apocalypse.

  8. Kyle says:

    With zero transparency into what others are offering, a buyer would have to be super-trusting or super-naive to ever submit an offer with such a clause. If the seller has an offer with an escalation clause in hand, there’s really nothing stopping him from asking one of his buddies to submit a fake competing offer just below the cap.

    1. Ralph Cramdown says:

      You’re right. But there’s already so many games played, e.g. the CBC exposé on listing agents who’d “work with” buyers to reveal other bidders’ numbers so the buyer gets the house and the agent gets both ends. This wasn’t exactly a surprise to industry followers — if I I’ve never actually heard of someone (seller or agent) having a few extra “bidders” show up on offer night to drive up the bids of the bona fide buyers, but I have no doubt it has happened.

      It is an open question whether, with all the games played in real estate excluding escalator clauses, things would get any worse with them.

  9. JC says:

    Clauses might not be enforeceable under Ontario law anyways.

    1. Ralph Cramdown says:

      Yeah, right. If you put in an escalator without a cap and the seller’s agent has some joker submit an offer for ONE BILLION DOLLARS, the court isn’t going to hold you to $1,000,005,000. But otherwise, real estate contracts are done “under seal,” you are assumed to know what you are doing, and to mean what you sign your name to. And the escalator wouldn’t be a clause that the seller wrote; it would be one that you — the buyer — wrote. Unless there is ambiguity, why shouldn’t the court, if asked by the seller, require you to keep your promise or pay damages for the consequences of breaking it?

      1. JC says:

        Ther’s this thing called the Statue of Frauds.

        1. JC says:

          *Statute. Cofveve.

        2. Ralph Cramdown says:

          Probably the shortest law on the books. Boils down to “for real estate, it has to be on paper, there are no enforceable verbal real estate contracts.” Pretty abstruse legalese, though, since it goes back such a long way.
          Ontario, current: https://www.ontario.ca/laws/statute/90s19
          The original, England, 1677: http://www.languageandlaw.org/TEXTS/STATS/FRAUDS.HTM

          1. JC says:

            Well aware.

  10. Real Estate Millennial says:

    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.

    If a cap is required, then it’s really not that complicated you can tell the other offers you’re not the highest offer without disclosing the price and terms of the other offers, agents already do that now. Provided all the offers submitted were real it’s not that hard to pick out the offer with the highest escalation cap and highest offer. Sure it’s a little more work but it’s not that serious the cheque is still over 10k most likely, you actually have to work a little for it now. Buyers walk away from deals without an escalation clause adding the clause doesn’t change much. Clearly there is a smart person who is looking out for their clients and trying to win in this market, cudos to that guy/girl for being innovative and using the tools given to them especially when buyers don’t have very many in this sellers market. I agree with a lot you say but this one is a stretch David.

  11. Ralph Cramdown says:

    ‘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.”’

    Unless you’re talking about selling your own property (and the “we” suggests you aren’t), that’s not your call to make. These things aren’t that complicated, and they are used literally billions of times per day in other markets. You sound like the ancient first real estate agent who was presented a cheque instead of gold coins, and said “what is this abomination of creation, mere paper and ink?”

    They might be a good idea, they might be a bad idea. No surprise that RECO is behind the curve, but they wouldn’t have sent the memo for purely theoretical reasons — somebody has obviously been using them, recently, in Ontario. By the sounds of things, you may not have to worry about seeing one for another few years. But be prepared, if you do, to work in your client’s best interest.

    1. Art says:

      I believe Reco updated there stance on the use of escalation clauses because I put in a complaint after losing a house to someone who used this clause. The sellers realator as well as the escalating buyers realator were both represented by the same brokerage. I don’t think it’s right and would love to take them to court but am going to have a lot of trouble proving the behind the scenes collision between the realators, anyone have any suggestions?

      1. Art says:

        If someone using an escalation clause with a$1000 increment wins the bidding war on a house, does that not imply that the winner knows what the second bid was. Naturally it’s $1000 less than their winning bid. How does this not violate the code of ethics?

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