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 considered 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. The case was appealed to the North Carolina Supreme Court. The Supreme Court handed down an opinion on April 15, 2010 holding that the Court of Appeals ruled correctly with two justices joining in a dissenting opinion. The Court determined that, ordinarily, the buyers controlled the choice of attorney and equitable principles dictate that they must bear the loss caused by the misconduct of their own attorney. However, in this case, there was evidence of a prior relationship with the attorney by the sellers, and the matter was remanded to determine whether this attorney also represented the sellers during the closing process.
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 his misappropriation of the funds. The plaintiffs did not try to cash the check for over four months whereupon the check bounced.
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:
'[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).'
[While all 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 Supreme Court, without analysis, then adopts what may be characterized as a pointless disambiguation of the difference between a settlement closing and the escrow closing set out in the Court of Appeals opinion. Arguably, that court's analysis seems to ignore the common practices inherent in legal representation with respect to residential closings. (As an aside, closing practices for residential closings are also largely common to those of smaller commercial transactions, 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 Court of Appeals attempted to parse these definitions in a way that supported its conclusion without apparently understanding the practical distinctions as opposed to semantic ones. The Supreme Court swallows the supposed significance of these distinctions whole. 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 the Court attempts to describe is that the former usually have at least a minimalistic written 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 because the obligations of the attorney in a settlement closing and those of an escrow agent are, in substance, identical.
Quoting the North Carolina Real Estate Manual, the Court of Appeals noted 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 an 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 well reasoned Supreme Court dissenting opinion summarizes the majority's position as follows: "Unable to cite to any authority that supports its reasoning, the majority concludes that buyers should be held responsible for sellers' loss because "buyers are normally in a better position than sellers to bear the loss that results from embezzlement by the closing attorney." Buyers are better positioned to sustain the loss, the majority asserts, because of the availability of insurance coverage to buyers. This Court has long held, however, that evidence of insurance coverage is irrelevant to the substantive inquiry of a case." (citations omitted).
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 Supreme Court, without any real analysis summarily disposes of the application of the entitlement rule by categorizing the transaction as settlement closing and not an escrow closing.
The majority in the Court of Appeals 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..." and 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 an 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 of Appeals recites a description of a typical "deed and
"[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."
That 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 of Appeals 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 in the Court of Appeals 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."
The dissenting Supreme Court opinion goes more correctly into an agency analysis and in the interest of conciseness, we quote:. "The United States Supreme Court stated that, '[a]s between two innocent persons one of whom must suffer the consequence of a breach of trust the one who made it possible by his act of confidence must bear the loss.' Id. at 462, 74 L. Ed. at 967. Because the plaintiffs 'saw fit to entrust [the certificate of title] to Napletone . . . they took the risk,' id. at 461, 74 L. Ed. at 967, and the Court affirmed judgment for the buyers, id. at 452, 74 L. Ed. at 967. Thus, as was the case in Barnes, the Court was not faced with two truly "innocent" parties, but determined rather that the plaintiffs' 'conduct . . . contributed in some way, which reasonable care would have avoided, to the perpetration of the wrong." 1 Mechem § 749, at 532."
The dissenting Supreme Court opinion analyzes this relationship and points out that it "is well established in North Carolina that an attorney-client relationship is based upon principles of agency. E.g., Dunkley v. Shoemate, 350 N.C. 573, 577, 515 S.E.2d 442, 444 (1999). A universal rule of agency provides that a principal may not be held liable for the torts of his agent unless the agent's act is (1) expressly authorized by the principal, (2) committed within the scope of his employment and in furtherance of the principal's business, or (3) ratified by the principal. See, e.g., Snow v. DeButts, 212 N.C. 120, 122, 193 S.E. 224, 226 (1937). Mere employment of an agent is insufficient to impose liability upon the principal for the agent's wrongful acts committed outside the scope of employment. See id. at 122-24, 193 S.E. at 226-27; Salmon v. Pearce, 223 N.C. 587, 589, 27 S.E.2d 647, 649 (1943) (citations omitted)."
"Clearly, the acts of embezzlement by attorney Parker far exceeded the scope of his employment or any apparent or actual authority invested in him by either party, and the majority concedes as much. The majority nevertheless determines that the innocent buyers may be held liable for their employment of Parker under the principle that '"'[w]here 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.'"' Virginia-Carolina Joint Stock Land Bank v. Liles, 197 N.C. 413, 418, 149 S.E. 377, 379 (1929) (quoting Wilmington & Weldon R.R. Co. v. Kitchin, 91 N.C. 39, 44 (1884)). This principle, taken out of context and presented without analysis by the majority, may perhaps appear at first blush to support the majority's proposition that an innocent, non-negligent party may be nonetheless held liable for the malfeasance of an agent. Careful examination of the legal precedent, however, including all the cases relied upon by the majority, quickly reveals that the principle is simply inapplicable to the facts of the present case." (footnote omitted).
What Court of Appeals majority 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  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 Court of Appeals 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 Supreme Court states a new rule "after considering the procedures customarily used for residential real estate closings and applying long-standing principles of equity, we hold that buyers must bear the loss caused by the misconduct of their own retained attorney. We stress that it is the buyer alone in most residential real estate transactions who is legally deemed to repose confidence in the closing attorney through the existence of the attorney-client relationship. In the present case, however, there is evidence that ... sellers had a prior relationship with him. Thus, a factual inquiry must be conducted to determine whether Parker also represented sellers during the closing process. Therefore, we remand this case to the trial court to determine if an attorney-client relationship existed between sellers and Parker. "
The Supreme Court is implicitly adopting the stated rule of the Court of Appeals which can be restated as: 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 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.
We note that Judge Wynn, dissenting in the Court of Appeals opinion, 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.