M&A Vocabulary – Understanding Experts: “Escrow Agreements”

In M&A transactions, particularly on the buyer’s side, there is regularly a heightened interest in obtaining security for potential future claims against the seller arising from warranty breaches or indemnity obligations, in order to minimize risks from the seller’s payment defaults. After all, a payment claim is only valuable if it can actually be realized.

In M&A practice, it has proven to be a fair and balanced security instrument for both buyers and sellers to “park” part of the purchase price owed on an escrow account (“Escrow Account”) to secure warranty or indemnity claims.

In simplified terms, the amount deposited by the buyer in the Escrow Account (“Escrow Amount”) is held in trust by a third party (“Escrow Agent”) for an agreed period. Neither the buyer nor the seller can unilaterally access the Escrow Amount during the custody period. Only when certain disbursement conditions are met (such as a proven warranty claim by the buyer) or after the expiration of the period does the Escrow Agent disburse the Escrow Amount to the seller or buyer in accordance with the escrow agreement (“Escrow Agreement”) concluded between the purchase agreement parties and the Escrow Agent.

Unlike the agreement of a purchase price retention, where the buyer withholds part of the purchase price owed, with the described route via an Escrow Account, the money actually leaves the buyer’s “sphere of control.” This offers the seller the crucial advantage that he generally does not bear a payment default risk of the buyer, at least with regard to the withheld purchase price.

Furthermore, situations can be avoided where the buyer attempts to prevent the payment of the purchase price retention based on alleged claims against the seller. Practice repeatedly shows that buyers are often extremely reluctant to pay out an amount once withheld to sellers later.

Finally, the route via the described escrow model is usually comparatively easier to enforce in purchase agreement negotiations compared to bank guarantees or warranties as well as warranty and indemnity insurance (“W&I Insurance”) as security instruments, due to the often significantly lower costs.

Details of the escrow relationship are usually set out in a separate Escrow Agreement concluded between the purchase agreement parties and the Escrow Agent. In the share purchase agreement itself, however, usually only the amount of the security, its security purpose, and cost-bearing obligations are regulated.

In addition to the position of the Escrow Agent, the modalities for custody of the Escrow Amount, and investment guidelines, provisions regarding the disbursement of the Escrow Amount to the purchase agreement parties must be regulated in the Escrow Agreement. The disbursement provisions form the core area of every Escrow Agreement.

In German transactions, the notary certifying the share purchase agreement or commercial banks regularly serve as Escrow Agent. Conceivable, but less common in M&A practice in German transactions, is the assumption of this task by lawyers or auditors.

In France, the “conventional” escrow (French “séquestre”) is defined in the French Civil Code as the deposit of a disputed item by one or more persons with a third party. According to the legal provisions, any person who has no personal interest in a subsequent legal dispute between (here) the purchase agreement parties can be an Escrow Agent. In practice, the role of Escrow Agent is mainly assumed by certain officials, bailiffs, notaries, and lawyers. When lawyers act as Escrow Agent, they are obliged to deposit the funds held in trust with the Caisse Autonome des Règlements Pécuniaires des Avocats (CARPA), an institution existing at each French bar association.

The decision for an Escrow Agent is ultimately determined by the trust of the purchase agreement parties in the person or institution as well as the costs associated with appointing the Escrow Agent.

To avoid later disputes, special attention must be paid to ensuring that the disbursement conditions are defined as precisely as possible and are easy to handle in practice. This applies equally in the interest of the purchase agreement parties as well as in the interest of the Escrow Agent, who is concerned with avoiding his own liability risks.

Events or situations that lead to a disbursement of the Escrow Amount to the purchase agreement parties are primarily:

• Final judgments against the seller due to warranty breaches;
• Mutual instructions to the Escrow Agent by the purchase agreement parties; and
• Expiration of a certain period (for the remaining balance of the Escrow Amount).

In the interest of the purchase agreement parties and the Escrow Agent, only proven, final, and enforceable titles should lead to a disbursement claim. A mere out-of-court assertion or still pending judicial pursuit of warranty breaches or indemnity claims by the buyer should not, as long as no final judgment or acknowledgment exists, establish a disbursement claim against the Escrow Agent. Such cases should at most lead to a blocking effect preventing disbursement of the Escrow Amount to the seller.

When choosing an appropriate disbursement date for remaining amounts of the Escrow Amount, the type and scope of the secured claims as well as the timing of a presumed occurrence of the secured damage must be considered. If applicable, alignment with limitation periods from the share purchase agreement may be appropriate. Staggered retention periods are also possible, in which the Escrow Amount is successively released and disbursed after the expiration of time.

In an M&A transaction, the purchase agreement should be prepared in parallel with the escrow agreement to ensure that the mechanisms contained in the purchase agreement are reflected in the escrow agreement. The Escrow Agent should not have to interpret the content of the purchase agreement with regard to the provisions of the escrow agreement.

Last but not least, care must also be taken to ensure that provisions for possible future disputes in connection with the Escrow Agreement are agreed upon (jurisdiction clauses, choice of law clauses, etc.).

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