The Problem with Deficiency Holdbacks and What You Should Do Instead
Updated: Oct 11, 2021
Holdbacks are often taught as a mechanism used to protect clients, and they sound appealing in theory; if there are things to be fixed, or issues unresolved, and your client is in a hurry to remove subjects, just state that there is a holdback, and the issue will be resolved... right?
Unfortunately, rarely anything in life resolves by itself, and holdbacks are complicated mechanisms to be used in limited circumstances. When it comes to deficiencies, a holdback will most likely only cause headaches and increased legal fees for your clients, and by extension, problems for you down the line as a realtor.
The most important aspect of understanding holdbacks is that the triggering event for the holdback release must be clearly defined and non-contentious. In other words, it should be very clear whether or not the "matter" on which the holdback clause is based, has been satisfied. To illustrate this point, take a look at the following:
The Holdback Amount is released upon the issuance of the Occupancy Permit from the City of Vancouver.
The Holdback Amount is released upon the Seller fixing the refrigerator.
The first example works well. Occupancy permits are provided by the municipality, and it should be clear to anyone whether the same has been issued. The second example, which is a deficiency holdback (meaning it is a holdback relating to some form of physical deficiency of the building) is highly problematic.
In our previous example with the refrigerator, the drafting raises several questions to a third-party reading it for the first time:
What was the problem with the refrigerator in the first place?
At what point is the refrigerator considered fixed?
if there is a dispute about whether the refrigerator is "fixed" or not, how would the lawyer know who is right?
In addition, consider the following:
Lawyers are not Judges and are not able to "judge" or ascertain whether a specific physical deficiency has been remedied. Even if we do have an opinion on the matter, our opinions are not legally binding and would not be determinative on whether the deficiency has been remedied.
Lawyers generally do not want to make any on-site visits to the Property and clients are generally reluctant to pay the high hourly rate of lawyers to deal with holdbacks.
For illustrative purposes, let's say that the original refrigerator is a model DX Maymair brand refrigerator but the cooling unit only goes as low as 10 degrees celsius. The Seller learns that the cost to replace the cooling unit is $800 dollars, and they see that there is a sale going on for a model AB Peare brand refrigerator with almost exactly the same specifications as the DX Maymair model, on sale for only $700 dollars. They decide to replace their DX Maymair model with a brand new, AB Peare. The Buyer sees this and claims that there was a breach, and the holdback should be released to the Buyer. The Seller claims they have fulfilled the holdback, and it should be released to the seller. The two parties state the following points:
A new DX Maymair retails for $2000 dollars, and the AB Peare which the sellers used to replace the original refrigerator was only $700 dollars;
The contract says "fix"; and since the Seller did not "fix" the DX Mairmair model, the Buyer should get the holdback amount.
The DX Maymair is not exactly the same as the AB Peare; there are differences between the reputation of the companies, and the parts within are manufactured at different countries.
The original DX Maymair model is an old model, and even if the cooling unit is fixed, a used DX Maymair in such condition sells on the market for approximately $1100 dollars.
Although the AB Peare model was purchased for only $700 dollars, the regular, non-flash-sale price would retail for $1200 dollars, which is actually worth more than an old DX Maymair. As such, the Buyers has not suffered any loss, and instead received a windfall of $100 dollars as a result of the replacement.
While the Seller recognizes the two refrigerators are not exactly the same, the specifications of the two refrigerators are in essence, the same.
The point of the holdback was to ensure that the Buyer has a working refrigerator, and that has been fulfilled.
So in this situation, can you determine who is right or wrong? or to make matters more complicated, perhaps there should be partial releases? Consider the following options:
Release the entire holdback to the Seller;
Release the entire holdback to the Buyer;
Release partial holdback to the Seller, being the difference between the holdback amount, and the normal retail price of the AB Peare;
Release partial holdback to the Seller, being the difference between the holdback amount, and the flash-sale retail price of the AB Peare;
Release partial holdback to the Buyer, being the difference between the value of a new DX Maymair and the normal retail price of the AB Peare;
Release partial holdback to the Buyer, being the difference between the value of a new DX Mairmair and the flash-sale retail price of the AB Peare.
Every lawyer will have an opinion on which option would be the "correct" one, but as we have stated before, we cannot give a legally binding decision on the matter. Experience tells us that the result of this situation is that the holdback amount remains sitting in the lawyer's trust account, until the parties reach a resolution, or in the worst-case scenario, is paid to the court for the parties to settle in court. You can imagine that neither the Buyer nor the Seller is going to be happy with the arrangements made by the Realtors on their behalf in those circumstances.
Sometimes, Realtors are taught that they can put in an "Arbitration Clause" and that will resolve any issues which may arise out of the holdback. It usually says something along the lines of "If a dispute occurs between the parties with respect to the Holdback, the parties will seek arbitration and the decision made by such arbitrator will be binding upon the parties."
There are a few problems with this:
Do any of the related parties have experience in arbitration? It is more expedient than going to the courts, but it is not necessarily cheaper. Does it make sense to go to arbitration over $2000 dollars if the arbitration cost is going to be $3000 dollars or more?
Who picks the arbitrator? What if there is a difference in opinion on which arbitrator to use?
who pays for the arbitrator? Even if you say "the parties will split the cost evenly", what if one party refuses to pay?
There's nothing inherently wrong with arbitration clauses; but rather, a well-crafted arbitration clause needs to be very concise and should address the above issues 2 and 3. It is also only appropriate once the monetary value of the "matter" that is in dispute is sufficiently high to justify such costs.
Personally, I have always advised all the realtors that work with me to deal with all deficiencies PRIOR to subject removal. I generally advise against removing subjects where there are still outstanding matters. Drafting which states that the parties will go through a deficiency list or settle upon a dollar amount post subject removal usually has a high likelihood of ending up with problems later. All this type of drafting (including deficiency holdbacks) manages to achieve, in most residential real estate cases, is push the problem to a further date. Experience has also shown that if clients are unable to agree on something definitive prior to subject removal, they are also unlikely to agree on the same matter after a few weeks have passed.
My suggestion is that if there are physical deficiencies with a property that has been discovered, agree to bring on a third-party contractor to come in and give an appraisal of the rectification costs prior to subject removal, and such amount should just be credited to the Buyer through closing adjustments so that the buyers can fix the deficiencies themselves. While this may be a lot of work to be done prior to subject removal, it will save a lot of headaches down the line, and may very well save the Realtor's reputation with their client. If you MUST use a holdback, please remember to:
be concise as possible when describing the issue to be remedied;
be concise as possible when describing the trigger for the holdback release (replacement with a new part of the exact same brand? repairs from a manufacturer-approved technician?);
consider whether an arbitration clause is appropriate in such circumstances;
have a realistic expectation of what may follow, and communicate with the client to set such expectations; and
most importantly, seek help from a trusted real estate lawyer, of course.
If you are a Realtor and would like to work with us in the future, give us a call at 604-242-1578.