Escrow Provisions in a Commercial Purchase and Sale Agreement

A commercial real estate Purchase and Sale Agreement (“PSA”) typically requires the buyer to make a good faith deposit concurrently with or shortly after signing the agreement. This deposit plays an important role in the transaction.  Typically the deposit will initially be refundable to the buyer if the buyer elects not to proceed with the transaction, but after a specified period of time, the deposit will become nonrefundable or “go hard” and will be paid to the seller if the buyer elects to back away from the deal. Understanding how a deposit is treated within the context of a typical commercial real estate sale is important for both buyers and sellers alike.

The Role of Escrow in a Commercial Real Estate Transaction

Once the PSA has been executed by the buyer and seller, if the parties will be using a third party escrow provider, the agreement will then be sent to the escrow holder for the transaction. The escrow holder then issues wire instructions to the buyer, who transfers the agreed-upon good faith deposit into escrow to be held until the transaction closes.

Due Diligence and Refundability of the Deposit

During the due diligence period, the buyer has the opportunity to conduct thorough investigations of the property. This includes physical inspections of the property, reviewing financial and legal documents provided by the seller, conducting environmental assessments, evaluating zoning and title reports.  Typically, the deposit remains fully refundable during this period and the buyer will have the right to terminate the PSA “for any or no reason,” meaning that if they decide not to proceed—whether due to unfavorable inspection results, changes in market conditions, or simply a change of mind—they can cancel the agreement and have their deposit returned.

The Deposit “Going Hard” and Additional Deposits

Once the due diligence period expires, the buyer’s deposit typically “goes hard,” meaning it becomes non-refundable except under specific circumstances. These exceptions may include:

• Seller’s default,
• Failure of a contractual condition benefiting the buyer,
• A casualty or condemnation event affecting the property.

At this stage, it is also common for the buyer to make an additional deposit into escrow. This additional deposit is generally treated the same as the initial deposit, meaning it will be nonrefundable when made.

Application of the Deposit at Closing

If the transaction proceeds to closing, the deposit will be credited toward the purchase price. For example, if the purchase price is $10,000,000 and the buyer has placed a $200,000 deposit into escrow, the buyer will only need to provide an additional $9,800,000 at closing. The escrow holder will then release the full purchase price to the seller.

Independent Consideration and Enforceability of the PSA

PSAs sometimes include a concept known as independent consideration. This provision typically states that a nominal amount—often $100—of the deposit is non-refundable under any circumstances.

The rationale behind this provision is to ensure that the PSA cannot be terminated by the seller. Courts in certain jurisdictions have held that a PSA in which the deposit remains fully refundable effectively grants the buyer an unpaid option to purchase the property, and where a person has granted a “free” option, meaning they have not received any payment for the benefit of the option itself, the person granting the option has the right to terminate the option at anytime, whereas someone who has “sold” an option, meaning they were paid for the value of the option itself, cannot terminate the option they have sold.  By designating a portion of the deposit as non-refundable, the buyer is deemed to have paid for the option to purchase the property, thereby preventing the seller from terminating it at will.

Escrow Instructions and Disbursement of Funds

A key function of the PSA is to govern the escrow arrangement between the buyer and seller. Upon signing, the buyer deposits funds into escrow, where they remain until closing or termination of the agreement. The PSA typically outlines instructions for how the escrow is to be handled.

Some PSAs include detailed escrow instructions within the agreement itself, while others provide for separate escrow instructions issued by the escrow holder.

Buyers should be aware that even if the PSA specifies that no additional instructions are needed for the release of funds, escrow holders frequently require joint written instructions from both parties before disbursing funds. This practice minimizes the escrow holder’s risk and ensures that the parties mutually agree on the disbursement.  However, if a dispute develops between the parties over the release of the deposit, that dispute will often need to be resolved before the deposit is ultimately returned.

Supplemental Escrow Instructions and Closing Procedures

At closing, the escrow holder typically requires the execution of additional escrow instructions from both the buyer and seller. These instructions may:

• Confirm the closing details,
• Outline the final distribution of funds,
• Specify the documents required for closing.

While the PSA governs the overall escrow arrangement, these supplemental instructions help facilitate a smooth closing process and ensure that all parties are aligned on the final steps of the transaction.

Conclusion

Escrow plays an important role in commercial real estate transactions, ensuring that funds are securely held and properly disbursed according to the terms of the PSA. Buyers and sellers should carefully review escrow-related provisions in their agreements and understand the implications of deposit refundability, independent consideration, and escrow instructions. By doing so, they can navigate the escrow process with confidence and minimize potential disputes.