Risk of Loss for Attorney Defalcation
Chris Burti, Vice President and Legal Counsel

In an opinion of a divided panel of the North Carolina Court of Appeals in Johnson v. Schultz, COA08-133, February 3, 2009, the Court considers who bears the risk of loss as between buyer and seller in a residential real estate sale where the closing attorney misappropriates the proceeds due the sellers after recording.  The trial court determined that the risk should fall upon the plaintiff-sellers with the Court of Appeals reversing and remanding the judgment.

In 2005, the defendants entered into a contract to purchase the plaintiffs' property using the North Carolina Bar Association's standard "Offer to Purchase and Contract" form. The buyers hired Donald A. Parker to represent them in the closing of the transaction that was held at his office in January of 2006. He was the only attorney involved in the closing.  He drafted the deed for the sellers and charged them a fee for the service. The defendants provided a substantial portion of the purchase price, obtained a loan for the remainder, and all funds were deposited into Mr. Parker's trust account prior to closing. The deed and deed of trust were recorded after which Mr. Parker delivered his trust account check for the net proceeds to the plaintiff.  When the proceeds check was delivered, Mr. Parker's trust account contained sufficient funds to cover the check, but it was short on the next day after having misappropriated the funds. The plaintiffs did not try to cash the check for over four months whereupon the check bounced and was returned.

The plaintiff sellers sued the buyers, Mr. Parker, the purchase money lender and its trustee. The plaintiffs sought rescission of the deed and recovery of title to the property, or alternatively, damages. Mr. Parker admitted the plaintiffs' material allegations, and the remaining parties respectively moved for summary judgment. The trial court allowed the defendants' motion, and dismissed the plaintiffs' claims with prejudice. The Court of Appeals quoted the trial court where it stated that "the plaintiffs had to ‘bear the risk of loss of the sales proceeds . . .resulting from the escrow agent, Defendant Donald A. Parker, having embezzled the [money] . . . [because] plaintiffs were entitled to receive those sales proceeds at the time of such embezzlement.'" "The court further concluded that ‘Defendants Schultz were lawfully vested with title to the [real] Property on January 3, 2006, the day before Defendant . . . Parker embezzled the . . . sales proceeds. Therefore, Defendants Schultz were entitled only to the [real] Property, [and] not [to] the embezzled sales proceeds, at the time of . . . embezzlement [.]'"

The Court notes that the transaction between the parties can be described as typical for North Carolina. It discusses what it considers to be the "Typical" North Carolina residential real estate transaction as follows:

   
"In a typical North Carolina residential real estate transaction, the buyer and seller execute the standard, pre-printed NCBA contract, which generally is provided to them by a real estate agent who is involved in the transaction. Edmund T. Urban and A. Grant Whitney, Jr., North Carolina Real Estate, § 26-1, at 653 (1996). ‘[I]t is common for only one attorney to supervise and handle the entire closing process.' Patrick K. Hetrick, Larry A. Outlaw, and Patricia A. Moylan, North Carolina Real Estate Manual, at 508 (North Carolina Real Estate Commission 2008-2009 ed. 2008). Although the attorney may be chosen by buyer, lender, or seller, ‘[t]he most common practice is for the closing attorney to represent the [buyer] and lender while performing limited functions for the seller (such as preparation of the deed).' Id.
        [While a]ll parties to the real estate transaction have the right to select their respective attorneys independently and the seller in a residential closing also may choose to have an attorney, . . . this is rare. By comparison, complex real estate transactions, including most commercial and industrial property closings, will involve individual attorneys for the seller and buyer. Id. "

The majority opinion of the Court then goes into what may be characterized as a pointless disambiguation of the difference between a settlement closing and the escrow closing. Arguably, the court's analysis seems to ignore the common practices inherent in legal representation with respect to residential closings. (As an aside, closing practices for smaller commercial transactions are largely common to those of residential closings, a fact seldom acknowledged in the treatment of the subject.) Simply stated, in the vast majority of transactions there are few if any instructions concerning the closing from the parties to the closing attorney. In fact, the contrary may be said to be true. It is typically the closing attorney who instructs the parties as to the standards of practice and what responsibilities the participants bear. Highly organized practitioners will issue engagement letters to the parties explaining the role, responsibilities and limitations or representation by the parties and the attorney.

In its analysis of the closing practice in North Carolina as discussed in treatises on the subject, the majority attempts to parse these definitions in a way that supports its conclusion without apparently understanding the practical distinctions as opposed to the semantic ones. Simply stated, all closings involving an attorney can fairly be said to be escrow closings. The fundamental differences between the escrow closings and settlement closings that he Court attempts to describe is that the former usually have at least a minimalistic escrow agreement, and the latter are usually closed in accordance with the custom of the trade. Where the Court goes astray is in missing the crucial point that the similarities are more significant than the differences.

Quoting the North Carolina Real Estate Manual,  the court  notes the following with respect to escrow closings: "When both parties have complied with the escrow agreement [terms] . . . the escrow agent will complete the transaction after first verifying by an updated title search that the seller's title conforms to the contract terms and that the [buyer's] check is valid." With respect to settlement closings it quotes as follows: " There will be no disbursement of funds at the closing meeting. The closing attorney will place all funds in his trust or escrow account and will not disburse any of the funds until he can perform a final title search." Ultimately, the same function is performed in either case.  Whether there are written instructions or merely implicit ones by custom of trade, the process is essentially the same. In both circumstances, the closing agent holds the documents and funds in trust until the title and conditions of the closing are fulfilled. Once the conditions are met and the documents are recorded, the closing has occurred, and the agent then disburses the funds accordingly. The opinion implicitly concedes this when it treats the definition of an escrow.  "At the outset, we note that our research has failed to yield a single North Carolina case which defines an escrow. A leading encyclopedia on escrow provides:
       

An ‘escrow,' as a general rule, is created when the grantor parts with all dominion and control of a instrument or money by delivering it to a third person or a depository with instructions to deliver it to the named grantee upon the happening of certain conditions." Unfortunately, the Court wanders away from this basic premise by focusing on further language dealing with instruments evidencing escrow. "It is an instrument which by its terms imports a legal obligation, and which is deposited by the grantor, promisor or obligor, or his agent with a stranger or a third party, the depositary, to be kept by him or her until the performance of the condition or the happening of [a] certain event and then to be delivered over to the grantee, promisee, or obligee. "Escrow" by definition means "neutral," independent from the parties to the transaction . . . . Thus, when, pursuant to an agreement, money is left in [the] hands of the attorney or agent of one of the parties, an escrow is not created; however, in some jurisdictions, one may be the escrow agent of both parties to an escrow if there is nothing inconsistent or antagonistic between his acts for the one and the other." The Court ignores the fact that there is far more at play than merely an agreement to leave money in the hands of an attorney. They are relying on the attorney to close in accordance with a contract whose form evolved in conformity to long-established closing practice. This widespread custom of practice has its own set of implicit instructions and explicit rules that are well understood by practitioners and just as immutable as any contained in a written agreement.

The trial court based its decision and judgment by placing the risk of loss on the party entitled to the funds, the seller in this case. This is characterized as the "'entitlement rule'" by the Court of Appeals and it notes "has been ‘adopted in all jurisdictions that have considered' how ‘to allocate losses of money deposited in escrow.'" (citation omitted) The entitlement rule generally places the risk of loss as to escrow monies on the depositor-buyer under the theory that the escrow holder is the buyer's agent "even if the escrow holder was the seller's . . . attorney[The Court looks to GE Capital Mortgage Services v. Avent, 114 N.C. App. 430, 442 S.E.2d 98 (1994), as the only North Carolina appellate case to apply an entitlement theory…"

"‘In the absence of fault, the entitlement rule shifts the risk of loss solely to the party holding ‘title' to the funds at the time the misappropriation occurred, a determination based on whether the escrow conditions have been fully performed at the time of embezzlement. Id. at 344-45, 352. If all escrow conditions have not been performed, the risk of loss remains solely with the buyer. Id. at 352. If all conditions have been performed, the risk of loss shifts solely to the seller. Id. In other words, the risk falls squarely on either the buyer or seller.'"
       

The court wanders from this bright line and notes that the "Plaintiffs and the North Carolina State Bar ("the State Bar") argue that the transaction here is not an escrow. Consequently, they contend the entitlement rule does not apply and that the Schultzes as principals should bear the risk of loss due to the defalcation of their attorney or agent Mr. Parker. The Plaintiffs further argue that even if the arrangement here is an escrow, this Court's decision in GE Capital Mortgage Services v. Avent, 114 N.C. App. 430, 442 S.E.2d 98 (1994), which is the only North Carolina appellate case to apply the entitlement theory, establishes that in the absence of fault, the risk of loss is then allocated based on the attorney-client relationship."

The majority agreed with the Plaintiffs that the arrangement did not constitute an escrow, "and consequently, in accordance with equity, the risk of loss here should fall on those parties who had an attorney-client relationship…" a further declaring that their "holding is consistent with the equitable principle that ‘where one of two persons must suffer loss by the fraud or misconduct of a third person, he who first reposes the confidence or by his negligent conduct made it possible for the loss to occur, must bear the loss.'" The court notes that it could not find "a single North Carolina case which defines an escrow" and looks to a dictionary definition. "An escrow,' as a general rule, is created when the grantor parts with all dominion and control of a instrument or money by delivering it to a third person or a depository with instructions to deliver it to the named grantee upon the happening of certain conditions. It is an instrument which by its terms imports a legal obligation, and which is deposited by the grantor, promisor or obligor, or his agent with a stranger or a third party, the depositary, to be kept by him or her until the performance of the condition or the happening of [a] certain event and then to be delivered over to the grantee, promisee, or obligee. ‘Escrow' by definition means ‘neutral,' independent from the parties to the transaction . . . . Thus, when, pursuant to an agreement, money is left in [the] hands of the attorney or agent of one of the parties, an escrow is not created; however, in some jurisdictions, one may be the escrow agent of both parties to an escrow if there is nothing inconsistent or antagonistic between his acts for the one and the other."

The Court recites a description of a typical "deed and money" escrow,
        "[s]oon after entering into a contract for the sale of the realty, or perhaps simultaneously, the buyer and seller agree upon a person to serve as escrow holder. The parties agree that the buyer will deposit with the escrow holder some portion of the purchase price, and the seller will deposit an executed deed and related documents. Jointly or separately the parties set forth instructions for the escrow holder. Ordinarily the buyer instructs the holder to release the purchase price to the seller when a valid deed has been recorded and a title insurance policy has been issued, after a title search has shown that the seller has marketable title. The seller instructs the holder to record and deliver the deed to the buyer when the purchase price has been deposited."
    

The Court concludes ( we believe erroneously): "In the instant case, the record is completely devoid of any evidence tending to establish the creation of an escrow between the parties, including any escrow instructions to Mr. Parker from the buyers (the Schultzes), the sellers (the Plaintiffs), or the lender (State Farm Bank). Furthermore, here, the only ‘conditions' that appear in the record are those provided in the parties' ‘Offer to Purchase and Contract[.]' In contrast, in Avent, the Court explicitly mentioned that there was an ‘escrow agreement,' requiring the ‘escrow agent,' who was the buyer's closing attorney, to deliver the remaining sales proceeds to the seller once the seller cancelled the prior lender's deed of trust. Avent, 114 N.C. App. at 431-32, 442 S.E.2d at 99. Hence, based on the above definitions and law, the arrangement in the instant case does not appear to be a formal escrow." We feel that the Court's imposition of a requirement for a written escrow agreement to establish an escrow is in error. There is no requirement for a written agreement in order to establish a trust, either under the common law or as explicitly codified in N.C.G.S. Section 32C-4-407.  There should not be one judicially imposed for what is an analogous arrangement, an escrow.

The Court then, without specifying a rule for transactions not deemed an escrow, goes on to interpret Avent as establishing a rule that the risk of loss "should be allocated based on the attorney-client or agency relationship in accordance with equity."

It is important to note that the escrow in Avent was not a "deed and money escrow", but rather a "‘set-aside' escrow . . . typically [is] used to salvage the closing of a sale which otherwise would be canceled due to the discovery of a minor physical defect of the realty, or the failure . . . to have cleared all liens or other encumbrances on the title to the realty. The sale goes forward and the deed is delivered to the buyer and [typically] the bulk of the purchase price is delivered to the seller. A portion of the price is placed in escrow, to be released to the seller after the seller, for example, . . . clears the title by paying the overdue tax assessment or mortgage lien."

The dissent correctly notes that the Court's analysis in Avent involves a straightforward application of the general entitlement rule establishing in North Carolina that the risk of loss should be allocated based on who held title to the funds at the time of defalcation. The majority disagreed placing great importance on the fact that the Court in Avent "specifically noted, ‘the parties agree that generally when property in the custody of an escrow holder is lost or embezzled by the holder, as between the buyer and the seller, the loss falls on the party who was entitled to the property at the time of the loss or embezzlement.' Avent, 114 N.C. App. at 432, 442 S.E.2d at 100. In other words, the parties agreed to resolve the issue based on the entitlement rule, and the Court analyzed it as such."
    

The majority observes that the holding in Avent resulted from the conclusion that the parties at fault should suffer the risk of loss but the loss in this case did not occur as the result of either party's fault. Somehow the majority comes to the conclusion that "Avent and the equitable principle highlighted within it establish that in the absence of fault, our courts should consider the attorney-client relationship and impose the loss on those parties whom the attorney represented." Adding: "Furthermore, in residential real estate transactions such as in the case sub judice, the closing attorney typically does not represent the seller, and by law, the attorney is not permitted to distribute funds to the seller until the deed is recorded." And concluding: "Hence, given the lack of fault here, in accordance with equity and the "entitlement" rule as articulated in Avent, the risk of loss here should have been allocated based on which parties reposed confidence in Mr. Parker, i.e., which parties had an attorney-client relationship with him."

What this opinion ignores is the fact that, regardless of which party employs the attorney in a common representation, that attorney undertakes a limited representation of the other party by performing tasks for that party and actions that constitute the practice of law. The attorney is as  determined by the North Carolina State Bar to be a fiduciary for both parties, 2008 Formal Ethics Opinion 7, adopted by the North Carolina State Bar on July 18, 2008. This opinion addresses a lawyer's obligation to record or to disburse closing funds when directed otherwise by one of the parties. The position of the State Bar is unequivocal and creates a bright line in this regard.

"Normally, a client's decision not to proceed with a transaction must be honored by the lawyer and, if necessary, the lawyer must restore the status quo ante by returning documents, property, or funds to the appropriate parties to the transaction. Comment [1] to Rule 1.2 of the Rules of Professional Conduct states, "[t]he client has ultimate authority to determine the purposes to be served by legal representation within the limits imposed by law and the lawyer's professional obligations." However, a closing lawyer must also comply with the conditions placed upon the delivery of the deed by the seller absent fraud. If the seller delivered the executed deed to the lawyer upon the condition that the deed would only be recorded if the purchase price was paid, the lawyer has fiduciary responsibilities to the seller even if the seller is not the lawyer's client. See, e.g., RPC 44 (conditional delivery of loan proceeds). Because title has passed to the buyer, the lawyer must satisfy the conditions of the transfer of the property by disbursing the sale proceeds. The lawyer must notify the buyer and the buyer can then take appropriate legal action to seek to have the sale rescinded…" This opinion clearly recognizes the implicit escrow nature of a typical residential closing notwithstanding the position advocated by it in its amicus brief in this case. And as the majority notes in its own analysis where it says:  "'[T]he relation of attorney and client may be implied from the conduct of the parties, and is not dependent on the payment of a fee, nor upon the execution of a formal contract.' N. C. State Bar v. Sheffield, 73 N.C. App. 349, 358, 326 S.E.2d 320, 325 (citation omitted), cert. denied, 314 N.C. 117, 332 S.E.2d 482, cert. denied, 474 U.S. 981, 88 L. Ed. 2d 338 (1985)."

The Court, in conclusion, states a new rule that where: "(1) one attorney is used to handle a residential real estate closing, (2) the attorney misappropriates the remaining balance of the purchase price owed to the seller, and (3) the risk of loss must be allocated to one or more parties, courts should first consider the existence of fault. However, if fault does not exist and the risk must be allocated between essentially "innocent" parties, courts should then consider which parties had an attorney-client relationship with the wrongdoing attorney and impose the risk of loss on those parties. Where multiple parties to the transaction have an attorney-client relationship with the offending attorney, the risk of loss should be shared among them."
The case was then remanded to the trial court for findings in conformity with this rule.

Judge Wynn, dissenting, quotes Avent thusly: "Ordinarily, the determination as to which party is entitled to the escrow property depends upon whether the conditions of the escrow were satisfied prior to the loss or embezzlement. For example, if the escrow agent embezzles the purchase price prior to the seller's performance of the escrow condition, the buyer has retained title to the money and must therefore bear the loss. Conversely, if the embezzlement occurs after the seller has performed the escrow condition, then the seller must bear the loss because he was entitled to it at the time of the embezzlement. Id. at 432-33, 442 S.E.2d at 100 (internal citations omitted)."

 "Thus, in this case, as was done in Avent, we should ultimately allocate the risk of loss to the party that held title to the funds in escrow at the time of the embezzlement. We should also follow the conclusion of Avent and hold that "[h]aving obtained title to the property [at closing], the [buyers] no longer held title to the funds in escrow. Thus . . . [the sellers] must bear the loss resulting from [the attorney's] embezzlement of the escrow funds." Avent, 114 N.C. App. at 434-35, 442 S.E.2d at 101.

Such a rule comports precisely with 2008 FEO 7 and its predecessors, comports precisely with the general understanding of the role of an attorney in such closings and with the requirements of the Good Funds Settlement Act. It also comports with the risk of physical loss to improvements upon the property as is set out in the North Carolina Bar Association's standard "Offer to Purchase and Contract" form. As such it is a far more consistent and reliable rule than the one promulgated in this opinion.

Dirt Tales From the Deed Vault - Episode 23
John Dillard, Vice President and Legal Counsel

This month's edition of Dirt Tales examines a fact situation wherein a deed of trust was recorded without the benefit of a bring-down title examination.

Commercial Developer is getting a new loan and has put up as collateral tracts of land located in two counties.  The loan closed on Friday, and the deed of trust was recorded in County A the same day.  Also the same day, the bank disbursed the loan proceeds although the deed of trust had not been yet recorded in County B , a rural county some distance away.  The following Tuesday the deed of trust had been returned from County A and it was sent to County B to be recorded.  When the attorney brought the title down he discovered a lien had been filed of record the previous day, Monday.  The attorney called the bank and advised them of the problem and was told to go ahead and record since they had "gap" protection. 

What is this "gap" the banker was referring to and does it in fact afford the lender protection against this intervening lien?

In North Carolina any purchaser of value who records their instrument will have priority over all subsequent recorded conveyances regardless of whether that person has notice of any unrecorded conveyance.  This concept is typically known as a Pure Race recording doctrine.  In the majority of states this is not the rule. 

Most states are what is known as Race Notice, which means that conveyances that get recorded first will have priority over subsequently recorded conveyances provided the prior conveyance was recorded in good faith without knowledge of the unrecorded conveyance.  In those states the "gap" or the time period between the closing and recording is protected by the title insurance commitment so long as no knowledge of any other unrecorded instruments, judgments or liens exist.  The risk that is presented to the title company in insuring this gap are that the grantor may sell or mortgage the property to another purchaser or lender for value without disclosing the unperfected interest or an intervening lien or encumbrance may be recorded, granting priority or, the grantor may file bankruptcy, whereupon the trustee may invoke the avoidance powers set forth in §544(a)(3)) of the Bankruptcy Code and set aside your conveyance or mortgage.

Because these risks are real and pose a substantial threat to purchasers for value as well as those holding security interests, it is imperative that the title be brought current before recording the deed or deed of trust.  In fact, the Good Funds Settlement Act dictates this be done before the closing attorney may disburse closing proceeds.

The case of Hardy v. Fryer 194 NC 420 (1927), (applied in Terry v. Brothers Investment Co. 77 NC App 1 (1985) discusses the elements of applying notice requirements in a Pure Race jurisdiction and an exception that may be applied when the grantee does have notice of a prior encumbrance and their instrument is in fact made subject to that encumbrance.  The principle set out in Hardy is not derived from a Race Notice application, but rather from the theory that a reference to a prior encumbrance in the grantee's instrument creates an equitable trust.