Among the things junior associates learn early in their new careers are all the things they didn’t learn in law school. Almost every practice area has practical aspects that were never introduced in class, and nowhere is this truer than in transactional law. While senior attorneys do not expect their younger counterparts to know everything, they are unlikely to provide detailed tutorials about practice terminology that has become second nature to them. One such piece of terminology is the concept of “escrow.”
“Escrow” is used in several contexts in transactional law, and we’ll discuss two of them here. First, it can describe the money set aside as a type of insurance for the buyer in an M&A transaction. This is commonly known as the escrow fund. The escrow fund is one of the key components for an M&A transaction, and traditionally, few transactions closed without some money held in escrow. Second, it describes a unique closing process in a complex legal transaction where executed signature pages are collected while documents are still being negotiated. Until the transaction closes, these signature pages should be “held in escrow.”
What is an M&A escrow fund?
Let’s start by thinking about the escrow you might set up when you buy a house. As part of your mortgage, the bank wants to make sure that you have money available to meet certain future obligations associated with owning your home—namely, your property taxes and homeowners’ insurance. After all, if you default, they could be stuck with the bill. So the bank takes a little bit of money each month and holds it in an escrow account until those amounts are due at the end of the year. The bank uses that money to pay the taxes and insurance on your behalf. If any is left over, you get that money back.
In corporate M&A transactions, the concepts are similar: one or more parties involved in the deal (usually the seller) might owe money to the other (the buyer) at a certain point in the future. The buyer wants to ensure that the funds are set aside to handle those future obligations. To accomplish this, the parties set aside a small portion of the closing proceeds into an escrow fund to cover future obligations. If the funds are not needed after a certain period, they are returned to the seller.
Why the escrow fund is common (though increasingly less so) in M&A transactions
While money might be owed after a deal closes for many reasons, the escrow fund is primarily to protect the buyer from a breach of certain provisions of the purchase agreement by the seller. Sellers will make certain representations and warranties about their company or assets—for example, whether they own certain intellectual property, the condition of the company’s assets, or their relationship with certain customers. When the buyer takes control of the company post-closing, they may discover that some of these representations were misleading or inaccurate. If this results in a monetary impact to the company, the buyer will want to be made whole. The escrow fund will typically reserve 5-10% of the purchase price for a period of time to ensure that, if needed, these funds are available.
A recent trend in M&A deals, however, is the use of representation and warranty insurance (R&W insurance) in lieu of an escrow fund. An R&W insurance policy is typically purchased by the buyer to cover losses resulting from a breach of representations and warranties by the seller—the same losses that would typically be covered by the escrow fund. This may be appealing to both parties. It allows the buyer to make a more attractive offer by paying more upfront, while allowing the seller to hold back a smaller portion of the purchase price in escrow. As an indication of the growth in popularity of R&W insurance, in 2018 an estimated 45% of M&A transactions in North America used R&W insurance rather than a traditional escrow fund.
Who is the escrow agent?
As a junior associate, it is particularly important to understand the role of the escrow agent, who will administer the escrow fund for the 12-to-24 month holding period.
The escrow agent is typically an independent third party—in most cases, a reputable bank or financial institution. Often the escrow agent is recommended by one of the parties or their counsel as a result of a prior relationship, though both parties will need to agree to use that institution. Its primary role is to accept the deposit of escrow funds into an independent account, and distribute those funds in accordance with the instructions of the parties.
While the escrow agent can sometimes be an afterthought as the deal approaches the closing, they will nonetheless be a party to the escrow agreement (discussed below) and have the power to hold up the closing. Here are a few examples of why that might happen:
- The escrow agent has different incentives than the parties involved in the deal. As a result, it often does not operate with the same sense of urgency.
- The escrow agent may require several layers of approval between your contact and the company’s legal team. That means even non-material changes to the escrow agreement may take time (days!) to get approved.
- Finally, escrow agents may have rigid rules, like requiring original signatures from all parties before they will sign themselves. So make sure to find out early what their signing requirements are so your closing isn’t adversely affected!
What do escrow instructions look like?
Enter the escrow agreement. This is an ancillary document you will see in every M&A transaction with an escrow fund. The escrow agreement details the responsibilities of the escrow agent, when they should release the funds in the escrow account and to whom those funds should be issued. Most importantly for the escrow agent, it will want to disclaim any liability it may have for the funds (such as any interest in the funds and responsibility for determining the authenticity of any claims it receives). Instead, it will require that the escrow agreement clearly sets out certain principles:
- How the funds will be invested. Funds are typically invested in a low-risk money market account.
- What is required for the escrow agent to distribute funds. This typically involves a claim to release funds, followed by an opportunity to dispute the claim by the other party.
- Which party will be treated as the owner of the fund for tax purposes. Don’t be surprised if no one wants this responsibility!
- The bank account and notice instructions for the parties. Making sure the escrow agent sends the money to the correct place.
- The escrow fees. Because, of course, the escrow agent wants to get paid.
The “escrow” not like the rest
Aside from the escrow fund, the term “escrow” will arise in another place in the transactional practice. It’s the concept of holding signature pages in escrow. As a junior associate in a corporate, commercial finance or real estate practice, you likely have created signature packets early in your career and had those signature pages signed by your client. The partner or senior associate may then ask you to email the client’s executed signature pages to opposing counsel, adding, “make sure to send them in escrow.”
This request may sound complicated, but it’s straightforward. Rather than an escrow agent holding funds for the parties, attorneys are acting in their fiduciary capacity to hold signature pages in escrow until it’s time for the transaction to close. The attorney wants you to make clear to opposing counsel that they are not authorized to attach the signed signature pages to the underlying documents. Instead, you are giving opposing counsel reasonable assurances that your client has signed all the documents necessary to close the deal. Likewise, you’ll also want reasonable assurances that opposing counsel has the signatures from their client necessary to close, so you should expect to receive their client’s signature pages (also held in escrow).
While the workflow is somewhat complex, there is no magic in actually sending signature pages to opposing counsel in escrow. Simply attach the executed signature pages and include language such as: Attached are the executed signature pages for Jane Doe, XYZ Company and ABC Corporation, each to be held in escrow pending release at closing by their respective parties.
When it comes time to close the transaction, parties will authorize the “release” of their signature pages—this means that they can now be attached to the final versions of the deal documents. This typically occurs verbally on a closing call, or sometimes via an email circulated to all parties involved in the transaction.
About the Author
Sam Beutler is cofounder and chief product officer of SimplyAgree, a leading provider of closing management technology. He previously practiced law as a corporate attorney, where he advised clients on mergers and acquisitions and private offerings. Contact him on Twitter @simplylyagree.