An escrow agreement defines the arrangement by which one party deposits an asset with a third person (called an escrow agent), who will in turn make delivery to another party if and when the specific conditions of the contract have met.
They can be used widely, including in mergers and acquisitions (eg, indemnification or withholding part of the purchase price pending performance of the seller’s pre and post-completion obligations), property (eg, buyers’deposits, leasehold improvement funds), inter-insurer disputes (eg, providing without prejudice funding to insureds where policy indemnity has been accepted in principle but primary and excess layers have an aggregation dispute) and lending (eg, where the lender wishes to monitor borrower performance and reduce risk).
An escrow is the process by which a document, real estate, money, or securities are deposited with a neutral third party to be delivered upon fulfillment of certain conditions. The neutral third party is known as an escrow agent or depositary. In the creation of an escrow, there must be a depositary with instructions from the parties. Instruments are deposited with a depositary by an agreement between the parties. Instructions to the depositary constitute the rules governing an escrow agreement. An escrow agreement is different from the instrument placed in escrow. It contains conditions agreed upon by the parties. A depositary accepts an instrument upon the terms of the agreement.
For an escrow to be valid there must be a binding contract between the parties to a transaction, and conditional delivery of transfer instruments or money to a third party.
Generally, there are two or more underlying transactions, and two or more related escrows in an escrow transaction. An escrow agent is a limited agent of the parties to the transaction in that he or she acts as the agent but only for a specified purpose as directed in the escrow instructions. His/her position is like that of a trustee.
The primary duties of an escrow agent are duty to follow the escrow instructions, duty to use good faith and reasonable skill and duty to redeliver goods on the completion of conditions.
Escrow instructions are written directions to an escrow agent which state the duties of the parties and the escrow holder. An existing agent or an attorney of grantor or grantee cannot act as an escrow agent due to the conflict of interest in the duties.
The escrow relationship gives rise to two specific fiduciary duties are to comply strictly with the terms of the escrow agreement; and to disclose facts that a reasonable depositary would perceive as evidence of fraud committed on a party to the escrow.
The selection of the escrow holder is normally done by an agreement between the principals. An escrow agent who breaches duties to the parties to the escrow agreement can be held liable in tort and for breach of contract.
When an instrument is deposited in escrow, the instrument passes beyond the control of the depositor. A depositor cannot recall it. Upon the performance of the condition, the depositary must deliver the property to the grantee. A deposit in escrow amounts to a conditional delivery.
An escrow is not invalidated by the death of a depositor prior to performance of the condition of the escrow. The parties can substitute another depositary for the same purpose. A substituted depositary will be bound by the terms of the original contract.
As the duties of a depositary are governed by the terms of the escrow, care is to be taken in drafting depositary instructions. An escrow agreement must include the names of the parties submitting the instructions and the name and address of the depositary. Agreement shall include the date of the instructions. A list of the items or documents deposited or to be deposited with the depositary must be included in the agreement. Conditions for the delivery of the escrow property are to be included in the agreement. Additionally, default provisions can also be included in an escrow agreement. A good idea is to include an arbitration clause plus an attorneys fees clause.
In private M&A transactions, the buyer often requires that a portion of the purchase price be held back until a later date to satisfy the seller’s post-closing obligations. These obligations are most commonly either potential indemnification claims, a purchase-price adjustment payable to the buyer, or both. In return for agreeing to a holdback, sellers typically prefer that these amounts be placed into escrow with a third-party escrow agent, rather than being retained by the buyer.
In M&A Escrow Agreements:
- Issues negotiated between the buyer and seller before involving the escrow agent, including, among others:
- the obligations covered by the escrow;
- whether or not the escrowed funds should be held in one account, even if they are securing multiple obligations;
- the amount of the escrow and length of the escrow period; and
- the release of escrowed funds.
- Issues for negotiation often raised by the escrow agent, such as:
- the buyer and seller’s indemnification of the escrow agent;
- the compensation of the escrow agent;
- the governing law and venue for disputes.
- Non-negotiable issues for the escrow agent, including:
- disclaimers of any obligation or duty to advise, recommend or make investment decisions;
- disclaimers of liability for losses sustained by the parties related to their investment choices;
- a requirement that all instructions to the escrow agent to be in writing and signed by designated authorized representatives of the applicable party or parties; and
- disclaimers of any fiduciary or other implied duties or obligations or any knowledge of terms of other agreements between the parties.
The Buyer will desire that holding all escrow funds in one account, even if they are securing multiple obligations, to ensure all escrow funds are available to satisfy the seller’s obligations.
If the buyer agrees to multiple accounts, ensure that escrow funds from one account can be used to satisfy obligations that may be secured by another account.
For example, if there are separate accounts for purchase price adjustment and indemnification claims, the buyer may want escrow funds in the indemnification escrow account available to satisfy any purchase price adjustment in excess of the amount held in the purchase price adjustment escrow account.
The Seller will logically desire that holding escrow funds in separate accounts with different escrow amounts and disbursement dates if there are multiple obligations being secured by the escrow and the Seller will explicitly state that escrow funds held in one account are not available to cover liabilities that are covered by another account.
Deal parties establishing an escrow account must negotiate an escrow agreement with an escrow agent outlining the account’s terms and conditions and the agent’s duties and expectations. Key terms of the escrow agreement include scope, representations and warranties, and management of the escrow funds. The escrow agreement must be strategically negotiated and drafted to avoid conflicting with provisions of the acquisition agreement.
With lending, there are obvious benefits for both parties (the“Depositors”). The lender can monitor and reduce his counterparty risk; if the requisite release obligations are not satisfied or the loan defaults, he retains better prospects of recovering funds that are protected in a segregated account, and which has been administered by a neutral third party (the “Escrow Agent”) – than from a distressed borrower. Equally, the borrower has the comfort that the funds have been earmarked and will be made available to him upon satisfaction of certain pre-agreed conditions. So far, so good – at least, in principle. But, an escrow is only as valuable as the agreement governing its administration.
Drafting the release and contingency provisions may not be straightforward, depending on the complexity of the underlying deal. The efficacy of an escrow can also be affected by the Escrow Agent selected. There is now a welcome trend for banks, rather than solicitors to provide third-party escrow products. They do not run into as many of the potential conflict issues that the solicitors instructed on an underlying deal will face, if the solicitor acts as Escrow Agent. Banks are also far better placed than solicitors to track the receipt and investment of funds, report on payments and interest accrued, execute investment instructions (particularly where multiple currencies and onshore/offshore and cross-border transactions are involved), liaise with loan administrators to monitor performance and turn around standard documentation.
The disadvantage lies in their standard escrow terms. These will invariably need considerable input from the Depositors (as well as, increasingly, the Escrow Agent’s own legal Butterworths Journal of International Banking and Financial Law advisors), to ensure that the escrow terms mirror and respond to the underlying transaction as appropriate, given that the Escrow Agent is seldom, if ever, a party to the underlying finance documents.
Points to check when reviewing a standard term escrow agreement
––Choose your agent carefully: they should have appropriate expertise and resources to understand the underlying deal and administer the ancilliary escrow fund.
––Timing: factor in that your agent will need to carry out KYC checks. How soon after completion of the underlying documentation will you need the escrow fund to be operational? Negotiating escrow terms post-completion may take time.
––Certainty: set out the deposit terms, pre-conditions to drawdown from the fund and the Escrow Agent’s duties in full. Do not just cross reference to the facility agreement.
––Scope: if there are ancilliary facilities/documentation, ensure that the fund and agent’s duties catch these and are not just limited to the main agreement.
––Segregated accounts v trusts: the Escrow Agent’s standard terms will almost certainly expressly state that escrow monies are not being held on trust. This is because the escrow funds will be held in a segregated account. However, there are different levels of segregation and it is usual for parties’ monies in an escrow fund to be commingled to some extent, given that the Escrow Agent is usually an institution providing similar services to others. For those reasons and depending on the parties involved, the Depositors’ previous experiences and the nature of the underlying deal, the Depositors may still insist that the Escrow Agent hold the cash expressly to the Depositors’ order. Where this is the case, the lenders will ideally require the borrower to declare itself as your trustee in respect of any right to receive escrow monies and to hold all amounts received for your benefit up to the amount of principal (and interest) due under the underlying transaction.Conversely, borrowers should seek to ensure that any trust created for the benefit of the lender terminates automatically upon a valid release notice.
––Limit liabilities: check your duties and liabilities are limited to those arising out of specified, named agreements. Seek a cap on liability where appropriate. Seek E&O cover. Resist holding escrow funds on trust; rely instead on the standard market practice for this term to be excluded and on the segregated nature of the escrow fund providing sufficient protection.
––Certainty: as above. Uncertainty as to the terms for release of monies and your duties in the event of certain contingencies amount to scope for potential legal action. By ensuring the escrow agreement gives express instructions (for as many specified eventualities as possible) you protect yourself and your Depositor principals.
––Freedom to perform duties: ensure that events of default occurring under the facility agreement do not inhibit you from carrying out escrow duties or exercising remedies under the escrow agreement.
Material Adverse Effect” (“MAE”) or “Material Adverse Change” (“MAC”) Clauses
MAE clauses offer the buyer an “out” in the event that the business, operations or prospects of the target company is adversely affected in a material way before the transaction closes. The seller will want the application of the MAE clause to be as narrow as possible. In general, buyer proposes a broad MAE clause that allows her to exit the deal if the target company’s results of operations deteriorate before closing. Seller will attempt to qualify this to say the exit is only available if the cause of the deterioration uniquely affects the seller and not the whole industry, or that the poor results are not unusual when viewed in the context of historical results of the seller or its competitors in the industry.
- Closing Conditions
If the signing and closing of the deal are not on the same day, each party will require the fulfillment of certain conditions for closing to occur. Common closing conditions include obtaining necessary government approvals (for example, early termination of the waiting period under the Hart Scott Rodino anti-trust act), obtaining stockholder approvals, and no material adverse change in the company. In connection with the closing conditions buyer will generally negotiate to include a “bring down” of the seller’s representations and warranties. The bring down is usually included when signing and closing do not occur on the same day, thus leaving a possibility that all the representations and warranties will not be accurate through the closing date. With a “bring down”, the buyer does not have to close if the representations are not true on the closing day or if they were not true on the signing date. Seller typically negotiates to have this limited by materiality or material adverse change. The “bring down” is a mechanism that mostly benefits the buyer but it also benefits the seller since the buyer’s financing representations and warranties would be brought down at closing as well.
Covenants normally take the form of pre-closing and post-closing covenants. Common Pre-closing covenants include the seller operating the business as usual until closing,
- not entering into any material contracts (sometimes a dollar value threshold is used to specifically determine materiality here),
- not incurring any indebtedness,
- not issuing shares,
- not declaring or paying any dividends,
- not disposing of any assets or making any acquisitions,
- and not making any capital expenditures beyond a certain amount.
Post-closing covenants govern the behavior of the parties after the deal is done, and depending on the industry, the seller agreeing
- not to compete with the target company for a certain period of time and
- not soliciting any employees of the target company. Seller will typically require the buyer to maintain director and officer indemnification insurance to outgoing directors and officers of the target company, on a basis no worse than what they had prior to the acquisition.
Termination and Break-up Fees
Termination provisions allow the parties to walk away from the deal under certain circumstances. Some common reasons for termination include failure to obtain regulatory approvals, breaching a no-shop clause, failure of one party to satisfy closing conditions or, in some cases, if the seller has a fiduciary duty to accept a better offer from another buyer. Associated with the termination provision is what is referred to as a “break-up fee,” used to compensate the party who is not in breach if the deal is terminated. The break-up fee is typically a percentage of the deal value. While there is no bright-line rule the market standard is generally somewhere between 3% and 4% of the deal value.
Indemnification is a post-closing remedy that covers a non-breaching party in the event of a breach by another party of a covenant or representation made in the purchase agreement or other deal documents. The agreement will normally include procedures for notifying a party of an indemnification claim and other requirements associated with indemnification such as any requirements to cooperate in settling a third party claim.
- Indemnification claims are limited to a cap (the maximum amount a party can recover on any indemnification claim and a basket or deductible (the indemnifying party does not have to pay for a party’s losses until they exceed a certain amount, at which point the indemnifying party is liable for all losses). This is sometimes referred to as a “tipping” or “dollar one” basket.
- Certain breaches will have no limitation in terms of a cap on recovery. These include: (i) legal authority to complete the transaction; (ii) title to shares; (iii) capitalization of the target company; and (iv) certain matters that are set out in disclosure schedules.