The Journal of The DuPage County Bar Association

Back Issues > Vol. 17 (2004-05)

Deconstructing Insurance Proceeds Escrows to Get Your Contractor Client Paid
By Edward N. Tiesenga

General Rule:

Escrow agents can’t take sides among claimants.

3 Main Points:

1.In the insurance reconstruction business, you can’t avoid working with escrows.

2.Document what’s going in and from whom it came.

3.Make sure the escrow rules fit the deal.

The escrow is a commonly used, very effective payment tool. It is used to ensure that all parties to an insured loss involving reconstruction of damaged property are protected. In the construction context, funds are held in escrow until the contractor reaches some level of completion, as decided by either a third party or by agreement of both parties. However, sometimes the parties to an escrow don’t agree as to what the final disposition of the property should be. How done is "done?" In such a case, the dispute may germinate into litigation2.

A property owner’s mortgage lender will usually require that all funds paid pursuant to a property insurance policy be payable jointly to the contractor, owner, and mortgagee. This check is typically indorsed by both owner and contractor, then placed in escrow by the mortgagee until all mechanics lien claims are released.3 This allows the mortgagee to protect the property from any encumbrances and prevent any foreclosure actions. This practice is clearly for the benefit of the mortgagee, and the contractor has little leverage to refuse cooperating with it.

This is not to say that the lender is free to administer the escrow without obligation to the contractor. In fact, by acting as an escrow agent, the mortgagee takes on a fiduciary duty to the parties to the escrow agreement (in this example, the property owner and the contractor).4 Judge Cardozo famously defined fiduciary duty as the "punctilio5" of highest honor, far above the mere "morals of the market place."6 Escrow holders are right in the middle of the market place, and yet, they are above it. Therefore, they may not sink to the level of playing favorites among claimants to escrowed money. "[A]n escrowee, like a trustee, owes a fiduciary duty to act only according to the terms of the escrow instructions, and […] an escrowee may become the trustee of both the party making the deposit and the one for whose benefit it is made."7

In McBride, Plaintiffs Bruce and Ruth Ann McBride contracted to purchase property from F.R. and Ruth F. Inskip.8 The Defendant bank was to act as an escrow agent for the McBrides and Inskips during the term of the purchase agreement.9 The bank was to hold all documents related to the property sale (including the warranty deed) until, according to the escrow agreement, the purchase agreement was "fully performed by the McBrides, or otherwise terminated."10 First, the bank received a letter from the McBrides requesting the documents, claiming that they had fully performed the purchase agreement.11 About two weeks later, the bank received a letter from the Inskips requesting the documents, claiming that the McBrides had defaulted and that the agreement had been terminated.12 For unknown reasons, the bank chose to take sides, believed the Inskips, canceled the warranty deed, and sent the documents to the Inskips.13 The McBrides filed suit against the bank, claiming that the bank breached its fiduciary duty as an escrow agent, and that the breach damaged the McBrides by depriving them of their interest in the property.14 The trial court granted summary judgment in favor of the bank, dismissed the complaint, and the McBrides appealed.15 The appellate court reversed the trial court’s decision,16 holding that when the bank, acting as an escrow agent, responds to a demand of one of its principals at the expense of another, it does so at its own peril.17 In other words, the bank should not have been so hasty to believe one party when a legitimate conflict existed. Escrow agents cannot take sides.

What, then, is an escrow agent supposed to do when confronted with a situation like McBride? The McBride court suggested that the bank should have filed an interpleader action, where the bank brings a suit against both parties, deposits the documents with the court, and lets the court adjudicate the rights of the parties.18 This clearly imposes a substantial burden on escrow agents.

More complications occur when the property owner pays off the mortgage while the funds are still in escrow.19 At this point, the former mortgagee, most likely a bank, would ordinarily no longer have any interest in holding the funds in escrow. This would be true if only the mortgagor alone had an interest in the insurance reconstruction proceeds that were escrowed under the authority of the now-released mortgage. After all, the tendency of a bank is to wash its hands of anything related to a paid off mortgage. However, when the funds in escrow were originally payable to and indorsed by the contractor on their way into the escrow, the bank’s duties as an escrow agent do not terminate just because the bank’s self-interest in the mortgage has ended. The bank’s punctilio of fiduciary duty to the remaining claimants to the insurance proceeds escrow continues unabated by the release of the mortgage.

A recent fact pattern 20illustrates the above issues. The names have been genericized to keep the parties anonymous. The home of Ms. Doe suffered substantial damage due to an electrical fire. The structural repair estimate was adjusted to about $90,000. Ms. Doe contracted with Local Restoration Company, Inc. (LRC) to restore her home. The insurance company issued a check payable to Doe, LRC and Ms. Doe’s mortgagee, Fiduciary Bank, Inc. (FBI). Doe and LRC indorsed the check and turned it over to FBI. FBI cashed it an placed those funds into escrow. According to FBI’s policies concerning such escrow accounts, FBI would release thirty percent (30%) of the money up front, thirty percent (30%) at the halfway point, and forty percent (40%) once the work was completed and FBI received mechanics lien waivers. All funds paid out of the escrow were to be paid to the owner and contractor jointly, requiring the signatures of both parties to cash the checks.

LRC and Ms. Doe had an extremely conflicted and tumultuous relationship. Ms. Doe erroneously claimed that most of LRC’s work was defective. LRC offered to repair any defects, but neither LRC nor the adjuster could find any. LRC alleged that Ms. Doe demanded a large number of change orders, caused unnecessary delays, and that Ms. Doe’s friend(s) stole some of LRC’s equipment off the site.21 At a meeting to attempt resolving difficulties between the parties, Ms. Doe went so far as to steal the original signed copy of the work authorization. At this impasse, LRC quit the property and filed a mechanics lien claim for about $70,000, having completed ninety percent of the scoped work, but only having been paid thirty percent of the value of that work.22

Six months later, following repeated and intense badgering of local bank personnel by Ms. Doe over the escrow, Doe took insurance funds she had separately received for the destroyed contents of her house, and paid off her mortgage to induce FBI to release the remaining restricted escrow funds to Ms. Doe, made payable to Ms. Doe alone. FBI then did so, reasoning that since it was no longer the mortgagee, it had no further interest in holding the funds due the contractor in escrow. However, doing so violated FBI’s duty to LRC as an escrowee. LRC sued both FBI and Ms. Doe, alleging breach of fiduciary duty.

The trial court ruled squarely in favor of LRC and against both Ms. Doe and FBI. The court also entered judgment against FBI for the full amount FBI paid out to Ms. Doe, finding that FBI breached its fiduciary duty to LRC, a party to the escrow, by releasing the funds to Ms. Doe in breach of both its policies and, more generally, its duties as an escrow agent. FBI paid its portion of the judgment and Ms. Doe’s appeal was unsuccessful. Doe neglected to post an appeal bond and LRC foreclosed on her mortgage-free house and then re-sold that house to a neighbor, in order to create the funds to compensate LRC for the attorney fees expended over six years, as awarded by the trial court.23

The long shadow of Judge Cardozo looms over each escrow arrangement covering insurance proceeds generated by a contractor who has agreed to repair property that an owner has encumbered with a mortgage. To the extent any party or claimant to such an escrow acts sloppily, carelessly, or deviously to the detriment of another claimant to escrowed funds, the damaged claimant may decisively assert its rights. Banks caught in the middle of these kinds of contentious escrows may not wash their hands in the amoral rinseate of mortgage releases, which will not remove the punctilio mark made by the money in escrow.

1 The author gratefully acknowledges the writing and research assistance of Nathan Hamstra (B.S. with honors, Univ. of Illinois 2001; J.D. expected 2005, Univ. of Michigan)

2 Perhaps the descent into litigation could be viewed as a deconstruction of the contractor’s relationship with the owner. "Deconstruction is not synonymous with ‘destruction’, however. It is in fact much closer to the original meaning of the word ‘analysis’ itself, which etymologically means ‘to undo’ — a virtual synonym for ‘to de-construct.’ ... If anything is destroyed in a deconstructive reading, it is not the text, but the claim to unequivocal domination of one mode of signifying over another. A deconstructive reading is a reading which analyses the specificity of a text’s critical difference from itself." [First paragraph of a four-page definition of the term deconstruction in J.A. Cuddon, A Dictionary of Literary Terms and Literary Theory, third ed. (London: Blackwell, 1991)]. Skilled deconstructive analysis of the duties that are found enmeshed in escrow relationships is part of the job description for commercial lawyers working in this area.

3 In addition to whatever verification and appraisal procedures the lender may reasonably impose on the reconstruction process in the interest of protecting the lender’s collateral interest in the property.

4 See, e.g., Patel v. Lacey, 203 Ill. App. 3d 1048 (1990); Meyers v. Rockford Systems, 254 Ill. App. 3d 56 (1993); McBride v. Commercial Bank of Champaign, 101 Ill. App. 3d 760 (1981).

5 Webster’s College Thesaurus defines "punctilious" as synonymous with "exact, precise, correct, meticulous, painstaking, proper, scrupulous; exacting, rigid, strict, fussy, particular, demanding, finicky, picky, rigorous." It is the opposite of "casual, indifferent, negligent, careless, slipshod."

6 Meinhard v. Salmon, 249 N.Y. 458 (1928)

7 Bescor, Inc. v. Chicago Title & Trust Company, 113 Ill. App. 3d 65, 446 N.E.2d 1209,
1983 Ill. App. LEXIS 1555, 68 Ill. Dec. 812 (citations omitted)

8 McBride, 101 Ill. App. 3d at 762.

9 Id.

10 Id.

11 Id.

12 Id.

13 Id.

14 Id.

15 Id.

16 Id at 766.

17 Id at 765.

18 Id at 766.

19 The owner will do this either because they are debt-averse, or in a devious attempt to dislodge the escrow. An owner’s claimed motive for such action might not be true, and can also be deconstructed through discovery. Many banks keep communication logs that can be very revealing. When looking at these, the assistance of an expert can help decode bank jargon and abbreviated syntax. Words don’t always mean what they appear to say. Bank employees themselves are sometimes inexplicably attached to wooden terminology that can be demonstrated to have multiple meanings. See generally,; or In other words, money does not always properly slosh through a bank.

20 From the 18th Judicial Circuit, Chancery Division, aff’d on appeal to the 2d Dist. (but under Rule 23, causing this author to question whether it can be cited).

21 A tough relationship highlighting the need to keep insurance proceeds properly in escrow.

22 The first payment from the bank escrow having been made pursuant to a written bank policy requiring all checks out of the escrow to be made payable jointly to the contractor and the owner.

23 According to personnel at the DuPage County Sheriff’s office (where this kind of judicial sale is conducted in the lobby) , mechanics liens rarely lead to the extremity of actually taking possession of the subject real estate.

Edward N. Tiesenga is a partner in the law firm of Tiesenga & Tiesenga P.C. located at 1200 Harger Road, Ste. 830 Oak Brook, IL 60523.

DCBA Brief