Escalation Clause To Win A Bidding War

by Jim the Realtor | Jul 5, 2020 | Bidding Wars, Jim's Take on the Market, Realtor | 2 comments

I don’t accept these when I’m the listing agent because it’s not fair to the rest of the bidders.

Here’s what C.A.R. has to say:

Introduction

Q1. What is an escalation clause?

A1. An escalation clause (also called a relative bid or “sharp” bid) is a provision added to an offer or counter offer where the buyer offers “X dollars more” than the next highest offer.  For example, an offer that states, “The purchase price shall be $1,000 higher than any other offer,” contains an escalation clause.

Q2. Why make an offer with an escalation clause? 

A2. The escalation clause allows the buyer to make the highest offer but only by the minimal amount necessary to beat out other offers. At first blush, it seems to be a savvy strategy.

II. Enforceability

Q3. If accepted, do such offers create enforceable contracts? 

A3. Mostly likely, yes. Although no published case addresses escalation clauses in the context of a typical real estate offer/counter offer situation, the 1991 case of Carver v Teitsworth involved the enforcement of an escalation clause in the context of sealed bids for real property, one of which the seller was bound to accept when the bids were opened. The Court stated, “A relative bid may be valid, but only where a party expressly solicits relative bids or such bidding is objectively reasonable as being customary in a particular trade or industry.”

Based on this case, escalation clauses may create binding real estate contracts, depending upon custom in a particular trade or industry.  While sealed bidding is not common, in many areas of the state, particularly those experiencing a “hot” or competitive market, it is not unusual or unexpected to see an offer with an escalation clause.  Accordingly, there is a good chance if a seller accepts an offer with an escalation clause it would be considered objectively reasonable and will be enforceable.

Of course, unlike in the sealed bid situation present in the Carver case where the seller may have been surprised by the escalation clause, in a typical real estate offer/counter offer scenario, the seller is not bound to accept any particular offer and may accept, reject or counter any offer received.  Further, in the absence of a confidentiality agreement, the seller may disclose one buyer’s offer to another in an effort to generate a higher sales price.  These factors further favor the enforceability of an offer with an escalation clause voluntarily accepted by a seller in the typical context.

III. Contractual Considerations

Q4. Should there be a cap indicating the maximum price? For example, should the buyer offer “XXXX dollars more” than any other offer but “not to exceed” a certain maximum price?

A4. On the face of it, this seems like a good idea since it limits the buyer’s exposure to paying an exorbitant price in the event another buyer makes an outrageously high offer. But, on reflection, in the typical real estate scenario it has a fatal flaw. Once the buyer makes known the cap amount, the buyer has given away the maximum price at which they are willing to buy. If the seller has not received an offer as high as the maximum set by the escalation clause, the seller, armed with this information, can then simply counter at that maximum price or use it as leverage to get more from other prospective purchasers.

Either way there is a problem for buyers. Without the cap, they risk being bound to an outrageously high price. But with the cap, they’ve given away critical information to the seller about how much they are willing to pay.

Q5. Should there be a floor price establishing the minimum amount the buyer is offering to pay? For example, should the buyer offer “XXXX dollars or $1,000 higher than any other offer received, whichever is greater”?

A5. There are pros and cons to such a provision. On the plus side, in the event there is no competing offer, then the buyer’s offer, if accepted, would still create a binding contract. Thus, by including a floor price the buyer adds certainty to the offer that is the equivalent of an offer without an escalation clause. On the other hand, if no other offer matched the buyer’s floor price, the buyer will wind up paying more than if the buyer had only included an escalation clause.

There are different ways a buyer could make such an offer.  It is not recommended to say, “$XXXX or $1,000 higher than any other offer received” since it is unclear which is being offered, the fixed price or the escalation price? Such an offer could be interpreted as ambiguous and be unenforceable.  Instead, the offer might state, “$XXXX or $1,000 higher than any other offer received, whichever is greater.”  Or another way to say this is, “$1,000 higher than any other offer received, but no less than $XXXX.” With this type of wording the buyer is more clearly committing to a minimum price while at the same time more clearly indicating a willingness to pay more, but only if needed.

Q6. Should the buyer include a provision that allows for verification of the next highest competing offer?

A6. Yes. Since the buyer is making an offer dependent upon the offers of other buyers, it makes sense that the buyer should be able to verify that those other offers were in fact bona fide offers. The buyer may include language such as:  “Seller shall, upon acceptance, provide buyer with a copy of the highest offer received.  Buyer has a right to contact that prospective purchaser making that offer, or his or her agent, to verify the validity of that offer and that the other offer is in fact a bona fide offer.”

While the listing agent may be uncomfortable handing over another buyer’s offer to the accepted buyer with the escalation clause, the NAR Code of Ethics provides that, in  general, offers are not confidential, and both the price and terms may legally be disclosed to other buyers unless all parties and their agent have signed a written confidentiality agreement (such as C.A.R. form CND). Even a listing agent acting as a dual agent might be able to reveal details of an in-house buyer’s offer where the in-house buyer has consented to such by signing C.A.R. form PRBS (“Possible Representation of More Than One Buyer or Seller – Disclosure and Consent”) or form SBSA (“Statewide Buyer and Seller Advisory”).

Q7. What happens if all buyers, or even two or more buyers, make offers with escalation clauses at the same time?

A7. In this situation,  there is a chance that the seller’s acceptance will not result in the creation of a binding contract. A contract can only be created where there is an objective way of arriving at a discernable price.  If more than one buyer includes an escalation clause, it is unclear which offer is used as the basis for calculating the escalation clause. It could be the next highest fixed price offer, or it could be the other escalation offer.  If the latter, then there is a never ending escalation (where neither escalation offer has a cap or maximum price).  Should this situation arise, rather than accept one of the multiple escalation offers, the seller would be well-advised to issue multiple counter offers.

IV. Risk Management Approach

Q8. Should the buyer be cautioned against making an offer with an escalation clause?

A8. Yes. Given that the enforceability of such a contract is not 100% assured, and given the potential pitfalls as discussed in the previous questions, the buyer should be advised to speak with their own legal counsel prior to making such an offer.

Q9. Can a broker adopt a policy discouraging the use of escalation clauses since such offers may lead to disputes, especially in light of the complications in drafting such a provision?

A9. Yes. State law requires brokers to adopt policies and procedures for their office. Certainly, there would be nothing improper for a broker to adopt a policy discouraging the use of escalation clauses in offers. Another possibility is that a broker could adopt a policy prohibiting their agents from writing such a provision thereby placing the onus upon the buyer directly, or more appropriately, on the buyer’s attorney to draft this type of offer.

Q10. Where can I obtain additional information?

A10. This legal article is just one of the many legal publications and services offered by C.A.R. to its members. For a complete listing of C.A.R.’s legal products and services, please visit car.org/legal.

Readers who require specific advice should consult an attorney.