The word “defalcation” remains one of the more frightening terms in the title insurers’ lexicon. But with the proper training, preparation, and response, defalcations can be managed, and the title insurers’ exposure controlled. A defalcation occurs when a title insurance agent misdirects or misappropriates funds held in trust for the parties to real estate transactions. They can cause liability for title insurers under statutes, common law, title policies, or closing protection letters. But because of that liability, the law gives title insurers all the tools they need to respond. It is just a matter of learning how to use the tools.
Because real estate transactions typically involve hundreds of thousands of dollars in deposits and loan proceeds, even small title agencies can have millions of dollars flowing through their escrow accounts at any given time. Sometimes, the temptation to dip into those funds for improper purposes can prove irresistible. Sometimes, title agents simply cannot manage proper accounting, and negligent defalcation occurs. Either way, the title insurers’ response should secure the remaining escrow funds to cap defalcation liability, then turn to the process of resolving all potential liabilities to the parties to the escrow, then to salvage against those responsible for the defalcation.
Intentional defalcation usually results when a title agent finds itself short of operating funds, or when a third party persuades the title agent to misdirect funds. Typically, a struggling title agency may find itself unable to cover its own operating expenses, such as payroll, payroll tax liabilities, or liabilities to vendors. A title agent may try to “borrow” money from escrow to cover these shortfalls by moving money to the title agent’s operating account. These title agents usually intend to “repay” the escrow account when they become able. But a failing business is a failing business, and they rarely find themselves able to do so. Instead, they become emboldened when the escrow shortage does not immediately come to light. They may move more and more money from escrow to operating until they find themselves in completely over their heads and the title insurer discovers the shortage.
Title agents also sometimes find themselves bent to the will of unscrupulous clients such as mortgage brokers or developers who pressure them to move escrow funds improperly. For example, a developer may demand that the title agent distribute loan payoff funds directly to the developer, rather than to the developer’s mortgage lender, promising to “take care of” making the payoff and obtaining the mortgage loan release. When a large portion of a title agent’s business comes from a small number of significant clients, those clients can often wield tremendous influence over the title agent. Developers, real estate agents, and mortgage brokers have many times used a title agent’s escrow account as a “piggy bank,” leaving the title agent and title insurer to clean up the mess.