M&A Vocabulary - Experts explain: Escrow Agreements

In M&A transactions, the buyer is often interested in obtaining security for any of its possible subsequent claims against the seller arising from i.a. breaches of warranties or indemnities in order to minimise risks arising from any shortfalls in payment on the part of the seller. Indeed, a payment claim is only worth something if it can actually be enforced.

In the M&A practice, “placing” part of the purchase price into an escrow account has proven to be a fair and balanced way of securing warranty or indemnity claims for both the buyer and the seller.

In simple terms, the amount deposited by the buyer in the escrow account (“escrow amount”) is held in escrow by a third party (“escrow agent”) for an agreed-upon period of time. Neither the buyer nor the seller can unilaterally dispose of the escrow amount during the escrow period. The escrow agent will only pay out the escrow amount to the seller or the buyer in accordance with the escrow agreement concluded between the parties to the purchase agreement (SPA) and the escrow agent, if certain conditions for the disbursement are met (e.g. in case of a substantiated warranty claim of the buyer) or after the escrow agreement expires.

In contrast to a simple purchase price retention where the buyer retains part of the due purchase price under the SPA, the above-mentioned escrow mechanism leaves the funds actually “out of the buyer’s reach”. This gives the seller the decisive advantage that he/she/it basically does not bear any risk of payment default on the part of the buyer, at least with regard to the retained purchase price.

Furthermore, this mechanism allows to avoid situations where the buyer attempts to prevent the pay-out of the retained purchase price on the basis of alleged claims against the seller. Practice has shown many times that once they already retained an amount, buyers were often extremely reluctant to disburse it to the seller later.

Finally, security claims are usually relatively easier to enforce under the escrow mechanism described above than from bank guarantees and warranty and indemnity insurance (“W&I insurance”) due to the often significantly lower costs in SPA negotiations.

Modalities of the escrow relationship are usually agreed upon in a separate escrow agreement that is entered into between the parties to the SPA and the escrow agent. The SPA itself, on the other hand, usually only regulates the amount of the security, its purpose and obligations regarding the bearing of costs amongst parties.

In addition to the position of escrow agent, the terms and conditions of retention of the escrow amount and investment principles, the escrow agreement must above all contain provisions on the disbursement of the escrow amount to the parties to the SPA. The provisions on disbursement form an essential part of every escrow agreement.

In transactions conducted in Germany, it is the notary notarizing the SPA or commercial banks that usually act as escrow agents. The assumption of this task by attorneys at law or auditors is conceivable, but less common in the M&A transactional practice in Germany.

In France, the “conventional” escrow (French: “séquestre”) is defined in the French Civil Code as the depositing of a disputed thing by one or more persons in the hands of a third party. Pursuant to applicable legal provisions, an escrow agent can be any person who would have no interest of their own in a subsequent legal dispute between the parties to the SPA. In practice, the position of escrow agent is mainly carried out by certain public officials, court enforcement officers, notaries and attorneys at law. If attorneys at law act as escrow agents, they are required to deposit the funds held in escrow with the Caisse Autonome des Règlements Pécuniaires des Avocats (CARPA), an institution existing within every French bar association.

The decision to involve an escrow agent ultimately depends on whether the parties to the SPA have the confidence in the person or institution as well as on the costs associated with  the appointment of the escrow agent.

In order to avoid later disputes, special attention should be paid to ensuring that the disbursement conditions are defined as precisely as possible and are easy to handle in practice. This is intended to safeguard the interests of both the parties to the SPA and the escrow agent, for whom it is very important to avoid his/her/its own liability risks.

Events or situations that lead to the disbursement of the escrow amount to the seller (or purchaser) include mainly:

• Final judgments against the Seller due to warranty breaches;
• Instructions mutually given to the escrow agent by the parties to the SPA; and
• Expiration of a specified period of time (for the remaining balance of the escrow amount).

In the interest of the parties to the SPA and the escrow agent, only proven, legally binding and enforceable titles should lead to a claim for disbursement. On the other hand, if the buyer merely asserts the breach of warranty or indemnification claims on an out-of-court basis or the legal proceedings regarding such claims are still pending, this should not give rise to any claim for disbursement against the escrow agent as long as there is no legally binding judgment or acknowledgement. In such cases, this should at most result in imposing a blockade on disbursing the escrow amount to the seller.

When selecting an appropriate date for disbursing the remaining portions of the escrow amount, the type and scope of the secured claims and the date of a presumed occurrence of the secured loss event should be taken into account. In some cases, it is advisable to synchronise the date with the limitation periods arising from the SPA. Instalment-based retention periods are also possible, in which case the escrow amount is released and disbursed successively.

In an M&A transaction, the SPA should be drawn up in parallel with the escrow agreement in order to ensure that the mechanisms laid down in the SPA are reflected in the escrow agreement. In this regard, the escrow agent should not have to interpret the content of the SPA in light of the provisions of the escrow agreement.

Last but not least, care should also be taken to ensure that provisions are included to regulate possible later disputes in connection with the escrow agreement (agreements upon the place of jurisdiction, choice of law clauses, etc.).