Escrow

The arrangements for managing and making payments in commercial transactions are often very complex. One reason for the complexity is the risk associated with payments. For example, in a sale and purchase transaction, the purchaser will not be willing to pay the seller unless it is confident that it can obtain clean title to the asset it is purchasing, and that any risks are reduced to the extent possible. Consequently, it is necessary to ensure that the purchase price is paid to the seller only after the relevant conditions have been paid and clean title can be transferred.

This article examines the use of an escrow account to reduce risks in corporate merger and acquisition (M&A) transactions, and how the concept is structured and implemented. It outlines the position in common-law jurisdictions and in China, and considers a number of important issues including the role lawyers perform in facilitating escrow arrangements in corporate M&A transactions.

WHAT IS AN ESCROW ACCOUNT?

Escrow account arrangements are common in many corporate M&A transactions, particularly share-purchase agreements. In a share-purchase agreement, the parties commonly agree that a certain portion of the purchase price paid by the purchaser will be retained in an escrow account. The purpose of the escrow account is to ensure that funds (the escrow funds) are available to compensate the purchaser for any loss they might incur as a result of a breach of a warranty by the seller (for a discussion about representations and warranties, see China Business Law Journal, volume 1 issue 3: Warranties and misrepresentations). In some jurisdictions, such as France, it is more common to use bank guarantees as security for warranty claims than to use escrow accounts.

Typically, the parties agree that the seller’s warranties will remain effective for a specified period of time (e.g. 12 months) and that the escrow funds will be held in the escrow account for that period. At the end of the period, if the purchaser has not made any claim against the seller under the warranties (or does not have any outstanding claims against the seller), the escrow funds will be released from the escrow account and paid over to the seller. Most share-sale agreements provide that if any amount is paid to the purchaser to compensate it for a claim under the warranties, the amount will be treated as a reduction in the purchase price rather than as a repayment of part of the purchase price. The reason for this is to reduce the tax on the purchase price to which the parties are subject (e.g. income tax in the case of the seller, and stamp duty in the case of the purchaser).

The English word “escrow” derives from the old French word escroue, which means a piece of paper or a scroll, and came to be used to describe a document that would be held by a third party until a transaction was completed. In fact, escrow arrangements can apply in respect of both payment amounts and documents (e.g. share certificates or land title documents).

IN A COMMON-LAW JURISDICTION

An escrow account will always need to be held by an account-opening institution such as a bank. In circumstances where only three parties are involved – namely, the seller, the purchaser and the bank – the escrow account arrangement will usually be structured and implemented as follows:

• The escrow account is opened in the name of the seller;

• The purchaser agrees to pay the escrow funds into the escrow account;

• The escrow bank agrees that it will only deal with the escrow account in accordance with the terms of the escrow agreement. Accordingly, it will only release the escrow funds to the seller on the relevant release date (i.e. at the end of the warranty period) or, if earlier, the date on which it receives an instruction to release the escrow funds signed by both the seller and the purchaser. However, if it receives a retention notice from the purchaser, indicating that the purchaser is making a claim under the warranties and there is a dispute between the seller and the purchaser, it will only release the escrow funds in accordance with a final court judgment or arbitral award that is issued to resolve the dispute.

• The escrow agreement provides that the escrow bank will have only those duties, obligations and responsibilities as expressly specified in the escrow agreement and will not have any duties, obligations or responsibilities that are implied by law or otherwise. For example, the escrow bank will not want to be treated as a trustee for either the seller or the purchaser, as this would impose fiduciary duties on it (for a discussion about fiduciary duties see China Business Law Journal, volume 3 issue 1: Duty or obligation?).

A former partner of Linklaters Shanghai, Andrew Godwin teaches law at Melbourne Law School in Australia, where he is an associate director of its Asian Law Centre. Andrew’s new book is a compilation of China Business Law Journal’s popular Lexicon series, entitled China Lexicon: Defining and translating legal terms. The book is published by Vantage Asia and available at law.asia.