What is the Escrow Account?
The escrow account is a temporary account held by a third party (usually a bank or an escrow agent) on behalf of two parties in a transaction and its purpose is to reduce the risk of failing to oblige the transaction by either of the parties involved. It is a temporary account and operates until a transaction is completed and all the conditions between the buyer and the seller are settled.
From an escrow account, the amount is not transferred to the seller until the terms and conditions are met. This type of account is mostly used in real estate projects, business deals, issues of shares and project financing.
How does Escrow Account Work?
- Let’s take a simple case of buying/selling between two parties A & B. Party A wants to buy some goods from party B and the transaction amount involved is huge. Party A has a risk of making payment but not receiving the goods. Party B has a risk of supplying the goods and not receiving the payment.
- So, in this case, Party A and B will enter into a contractual agreement to open an escrow account. It is a central account where the funds are parked by the buyer and will be transferred to the seller only when the transaction is completed i.e. goods are finally received by party A.
#1 – Real Estate
It is the most common transaction where this type of account service is required. While buying any property it is often the area of concern that the buyer will make the full payment but will not get the possession of the property on time. So, in order to mitigate this risk, an escrow account will be opened where the buyer’s money will be deposited. This money will be transferred to the builder only when the possession of the property is fully transferred in the name of buyers.
#2 – Mergers and Acquisitions, Business Deals
Suppose Company A takeover Company B. Now the company A does not want to make complete payment to B till the time full handover is completed. In this case, company A will deposit the payment in an escrow account. Company B will make the complete handover of all the assets, properties, documents, etc. as per the agreement. Once it is done, the payment will be transferred to company B.
#3 – Project Financing
In the case of project financing, banks often have the concern that the loan amount is diverted to other projects instead of the one mentioned while entering the agreement. In this case, the Bank and the Company will enter into an agreement where the bank will transfer the loan amount in an escrow account. The amount will be paid to the company as per the stage of project completion i.e. first 20% on completion then again 20% on further completion and so on.
#4 – Issue of Shares
As per SEBI, India guidelines, there has to be a 90% subscription of shares by the general public. If it is less than 90%, the application money received by the company has to be returned to the public. Hence, in this case, an escrow account is opened where the application money paid by the public for the subscription of shares is deposited. If the total subscription is 90% & above, the money transferred to the company and if it is less than 90%, the money is returned back to applicants.
#5 – Public-Private Partnerships
There are certain projects where both government and private agencies are involved. In such cases, revenue sharing/profit sharing models are used. For example toll plazas, coal extractions.
Suppose the government enters into an agreement with company A for coal extraction project, terms of the agreement include full expense by company and revenue sharing ratio 30% to government and 70% company. In this case, all the expenses for coal extraction will be borne by company A. Once the revenue starts generating, it will be deposited into a central account i.e. escrow account from where the revenue will be distributed amount government and company A in the agreed ratio.
Why do we Need Escrow?
- Reduces transaction risks and trust issues.
- In the event of any of the parties fails to adhere to the terms of the escrow agreement, it will be easier to settle the escrow than it would be if both the parties are directly transacting with each other.
- Helps protect the interest of both parties.
- Ensures that the funds, assets are kept safe till the time the transaction is not settled.
Who Manages It?
An escrow account is managed by a third party who can be an escrow agent, Bank, a financial institution or a company providing such services.
Conclusion
This can be used under various arrangements. It helps to protect the interest of all the parties involved in the agreement. It is not only used to hold funds, but there can also be a financial asset or any other security. It reduces the transaction risk and provides fair treatment to all the parties involved.
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