Daily Development for
Wednesday,January 29, 1997

by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law

ESCROW; DUTIES OF ESCROW AGENT; VERIFICATION OF CONDITIONS: Escrow agent for public offering of condominium development subject to "minimum subscription level" requirements has no duty to verify that minimum subscription level has been met in accordance with offering statement before releasing deposits to developer.

Schultz v. Rhode Island Hospital Trust National Bank, N.A., (No. 95-1997)(1st Cir. 1996).

Bank operated as financier and escrow agent in connection with a public offering of condominium units and rental contracts in connection with the rehabilitation of a resort hotel in Rhode Island. The terms of the escrow agreement for each unit required as follows:

"The Deposit shall be held by the Bank until the Seller shall verify to the Bank that (a) $6,000,000 in aggregate purchase price for Hotel Interests have been subscribed for and received as required under the Registration Statement (the "minimum Subsciption Level") and therefter disbursed . . . or (b) such Minimum Subscription Level has not been achieved within 210 days of the effective date of the Registration Statement with the Securities and Exchange Commission. [in this even the deposits would be returned to buyers.]"

The Registration Statement required that every investor would be required to "pay a down payment of 10% of the purchase price of the Hotel Interest (the `Escrow Deposit'), . . . "

The Developer did obtain subscriptions for $6,000,000 in unit interests by the deadline and submitted those contracts to the Bank, which disbursed to the Developer the monies that it held in the escrow. The Developer, however, had accepted notes rather than cash for the deposits on more than half of the units, a fact that either was known to the Bank or readily verifiable, as the Bank held all of the cash deposits in the escrow.

Subsequently, the deal failed, and those parties who had subscribed and lost their deposits sued everyone in sight. All the alleged really bad actors (the Developer, etc.) settled for no cash payment to the plaintiffs in exchange for their agreement to testify in the case against the Bank, which likely was the only deep pocket. The court takes pains to point out this fact, and it is likely that it was an influential factor in the court's final decision to absolve the Bank of liability as well.

The claim of most interest against the Bank was the claim that it breached its responsibilities under the Escrow Agreement by releasing the funds when it knew or should have known that cash deposits on many of the contracts had not been paid as required by the Registration Statement.

The court concluded that there was no material issue of fact, and that the Bank was entitled to summary judgment. Its holding on the escrow issue is brief, and is set forth below:

"Thus, although the fact that [Developer] sold a number of Sea Crest units without taking a ten percent deposit from the purchaser was arguably at odds with the prospectus, there is no language in the escrow agreement conditioning the release of any escrowed funds upon [Bank's] having received deposits totalling a full ten percent of the six million dollar minimum sales amount. . . [W]e find no support for plaintiff's broad arguments that [Bank], which is not alleged to be in a conflict of interest, was required, in effect, to actively root out fraud of which it had no knowledge and to police [Bank's] conduct in the . . . offering."

Comment 1: The editor believes that the court has made a more egregious error than a mere split infinitive in the above holding. At least there was a close question of fact as to whether promissory notes were an acceptable form of deposits, since clearly they did not result in any deposit with the Bank, which was the intended recipient of all deposits under the papers. Most likely, in any other context, a court would have read the prospectus and all other documents together to conclude that there was a ten percent cash deposit requirement.

If there was such a requirement, then the Developer's tendering sales contracts that, under the facts known to the Bank, did not meet the qualifying standards of the Prospectus. Therefore the release of funds to the Developer was a breach of the Bank's duties as an escrow agent.

Drafting Tip: Although the editor views the court's opinion here to be result oriented, and an irresponsible setting of precedent, the fact is that the opinion is precedent. It obviously is a warning to drafters that a requirement for a non refundable escrow in a specified amount might not be read as a requirement for a cash deposit. Everyone will hate you for being a "nit picker," but here's one more reason that you have to be just that.

Items in the Daily Development section generally are extracted from the Quarterly Report on Developments in Real Estate Law, published by the ABA Section on Real Property, Probate & Trust Law. Subscriptions to the Quarterly Report are available to Section members only. The cost is nominal. For the last six years, these Reports have been collated, updated, indexed and bound into an Annual Survey of Developments in Real Estate Law, volumes 1-6, published by the ABA Press. The Annual Survey volumes are available for sale to the public. For the Report or the Survey, contact Stacy Walter at the ABA. (312) 988 5260 or stacywalter@staff.abanet.org

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