What Happens to a Real Estate Down Payment in a Bank Failure?

In light of recent instability among financial institutions, many in the real estate community are wondering what happens to a down payment in a real estate transaction.

This alert will highlight the responsibility for a down payment in a real estate transaction and what could happen to the down payment if the bank holding the down payment were to fail.

The Federal Deposit Insurance Corporation (FDIC) is an independent agency of the United States government that protects bank depositors against the loss of deposits if a member bank fails. FDIC insurance covers deposits up to $250,000 per depositor, per ownership category (e.g., retirement accounts, revocable trust accounts), per FDIC-insured bank.

In a typical real estate transaction, 10% of the purchase price is held in escrow, so deposits for most transactions of $2,500,000 or less are likely to be insured.

Funds deposited by a fiduciary, such as an escrow agent, on behalf of another person or entity are insured as the deposits of the beneficiary and not the fiduciary. Therefore, a law firm may have an account balance in excess of the FDIC insurance limit and have each beneficiary’s deposit separately insured, provided each beneficiary’s balance is less than $250,000. However, if the beneficiary has other funds of the same ownership category deposited in the same banking institution, those funds will be added together to determine the insurance limit.

Furthermore, the beneficiary of the down payment can change depending on the performance of the contract. If the purchaser performs all their obligations under the contract, then the seller is the beneficiary of the down payment and would be at risk if the escrowee’s banking institution were to fail. If, however, the purchaser has contingencies in the contract that the purchaser does not satisfy (i.e. a financing contingency) or the seller breaches the contract then the purchaser becomes the beneficiary of the down payment.

Therefore, the parties to a contract and other beneficiaries of funds held in escrow over the FDIC coverage limit may wish to deposit the funds across multiple institutions.

There has been one case where an attorney was sued for malpractice when the depository bank failed. Ultimately the attorney was not found to be liable for the uninsured loss because he didn’t know the bank would fail. In 2005, a transaction involving two cooperative apartments at 50 Central Park West and deposits at a New York branch of the Connecticut Bank of Commerce (CBC) of $1.45 million and $1.28 million, well over the limit insured by the FDIC, resulted in a lawsuit. Bazinet v. Kluge, 14 A.D.3d 324 (2005). Before the transactions could be concluded, and unbeknownst to any of the parties, CBC closed and the FDIC was named as receiver. The buyer sued for return of his down payment, and the attorney was unable to fully recover the funds from the closed bank. The buyer then filed cross claims against the attorney for legal malpractice for not depositing the escrowed funds in a manner which would have been covered by FDIC insurance or taking other steps to ensure protection of those funds. On appeal, the court ultimately found that the attorney was not liable for the losses because he did not know the bank would fail.