Avoiding Improper Lock-up of Escrow Money

Most sophisticated buyers would prefer not to have to bring an indemnification claim after closing a merger transaction. It sometimes happens, however, that a buyer will bring a claim that the selling shareholders and their representative believe is either invalid or so tenuous as to not warrant tying up escrow funds indefinitely. This risk can be even greater if the merger agreement allows the acquirer to bring an indemnification claim for any damages that they “reasonably anticipate” they might suffer. In that case, the buyer may assert a claim based on a theory of hypothetical losses that they may someday suffer, even if such theory is far-fetched. Some buyers simply take the position that the risk, even if remote, is not their problem or theirs to assume. They may assert that the money must remain in escrow until the risk is eliminated completely.

Tying up as much money as possible for as long as possible, all else being equal, is a good thing for buyers and a bad thing for sellers.

Selling shareholders have a thorny problem in these cases. The escrow bank is not going to weigh in on this since they will only release the money either on receipt of a court order or on joint instructions. The buyer might not care if the money stays in the account indefinitely. They either effectively get a no-cost insurance policy against a hypothetical risk, or they can try to use this as a tactic to attempt to re-cut the original deal. Put simply, tying up as much money as possible for as long as possible, all else being equal, is a good thing for buyers (ignoring the impact on future relationships between the parties) and a bad thing for sellers.

In these situations, shareholders are left with two unattractive options: sue the buyer to compel release of the funds or wait for the statute of limitations related to the claim to run out. Waiting for the statute of limitations to expire is tough, but suing the buyer is not an appealing option, either. The buyer is usually a much larger company with greater resources. Fighting to compel the release of money can be expensive and eat up a good portion of the funds the shareholders are hoping to recover. If there is no expense account set aside for disputes, the shareholders may have to write checks to fund the litigation.

What options do the former shareholders have when the escrow period ends and claims have been made that the former shareholders believe are either invalid or of little merit?

What options do the former shareholders have when the escrow period ends and claims have been made that the former shareholders believe are either invalid or of little merit? No agreement can guarantee that a buyer will not lock up funds unnecessarily. The following suggestions, however, may help mitigate the risk:

  • Define what constitutes a third-party claim (and what does not). A claim from a third-party should be a live lawsuit or a written threat stating that the party has a specific grievance and will pursue legal remedies if they do not get adequate satisfaction of that grievance. Questions from third parties that are answered without any subsequent communications generally should not be considered claims.
  • Require the buyer to accrue for the potential loss on its balance sheet. If the buyer truly has a reasonable anticipation of a measurable loss, they typically should be accruing for that loss on their balance sheet. Sellers may argue that if the buyer does not think that there is a reasonable anticipation of a concrete loss under GAAP, then arguably there should not be a reasonable anticipation for indemnification purposes either. Buyers may respond that potential claims do not meet the accounting standard for accrual but still are real threats for which indemnity is required.
  • Allow the shareholder representative to assume the defense of third-party claims. If the representative thinks a third-party claim is frivolous, let the representative try to settle it quickly. The shareholders will sometimes prefer to pay out a little to settle even a frivolous claim rather than have the escrow funds tied up indefinitely.
  • Include a time period during which the buyer must have heard from the third party before the claim is deemed dormant. If the third party grumbled about something a long time ago but has said nothing since, it may be time to conclude that the risk of the issue becoming a claim is small enough that the parties should consider the issue dead. This approach is tricky and it may be difficult to agree on a reasonable time period to establish repose, but it is a question of where to draw the line with risk allocation. At some point, it does not make sense to continue to tie up funds to protect against issues that have become remote risks with the passage of time.
  • Provide for arbitration or mediation with the loser paying the winner’s fees. To address the circumstance where the former shareholders feel strongly that there is no real claim, allow for a resolution of the question of whether the claim is still an indemnifiable risk by an arbitrator and require the loser to pay the winner’s fees, so that the shareholders do not have to deplete a meaningful chunk of their escrow balance if they are right.
  • Establish an expense escrow. An expense escrow is a separate fund that is created to pay for legal fees or other costs or expenses the former shareholders may incur in defending against claims or otherwise protecting their rights after the merger closes. When such a fund exists, the buyer may be less likely to bring a weak or frivolous claim because they know the former shareholders have the means to fight it.
  • Provide for conditional releases. If certain conditions have been met (such as the passage of a specified amount of time), provide that the shareholders can compel that the escrow money related to that claim be released to them so long as they agree to refund that money to the buyer in the unlikely event that the issue resurfaces and results in losses that would have been indemnifiable.

Buyers may not agree to many of these suggested alternatives, although they generally will not be able to object to the establishment of a separate expense escrow.

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