Breaking a lock-up

Following the close of an exit, it sometimes happens that a buyer will bring a claim that the seller believes is either invalid or so tenuous as not to warrant tying up escrow funds indefinitely. 

The point of an escrow account is to reserve a percentage of a deal price with a third party (such as a bank) so that buyers can make claims against the seller in the event certain terms of the purchase agreement are not met. Private equity firms typically agree between five to ten percent of the deal price to be held in escrow.

Paul Koenig

Recently a growing number of private equity firms (acting as sellers) have been more carefully reviewing the terms of their escrow agreements as a way of mitigating the risk a buyer will make an unwarranted escrow claim post-exit. 

The risk of a tenuous or invalid claim post-closing can be even greater if the merger agreement allows the buyer to bring an indemnification claim for any damages that it “reasonably anticipates” it might suffer. In that case, the buyer may assert a claim based on a theory of hypothetical losses that it 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. And until the risk is eliminated completely, the money must remain in escrow.

Sellers have a thorny problem in these cases. The escrow bank is not going to weigh in on this, since it will only release the money either on receipt of a court order or on joint instructions. The buyer does not care if the money stays in the account indefinitely. It either effectively gets a no-cost insurance policy against a hypothetical risk, or it can try to use this as a tactic to attempt to re-cut the deal that was agreed to at closing. 

Put simply, tying up as much money as possible for as long as possible is, all else being equal, a good thing for buyers (ignoring the impact on future relationships between the parties) and a very bad thing for sellers.

In these situations, the sellers 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. Fighting to compel the release of money can be expensive, which can eat up a good portion of the money the sellers are hoping to recover. If there is no expense fund set aside in the escrow for disputes, the sellers may have to write cheques  to fund the litigation. 

Mark Vogel

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

Define what constitutes a third party claim (and what does not): A claim from a third party (which in turn can be used by buyers to lock up an escrow) should be a live lawsuit or a written threat stating that the party has a specific grievance against the sold company and will sue if it does not get adequate satisfaction of that grievance. Questions from third parties that are answered without any subsequent communications are not claims.

Require the buyer to accrue for the potential loss on its balance sheet: If the buyer truly has a reasonable anticipation of loss, it should be accruing for that loss on its balance sheet. If it does not think that there is a reasonable anticipation of loss under GAAP, then arguably there should not be a reasonable anticipation for indemnification purposes either.

Allow legal representatives of the seller 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 sellers will sometimes prefer to pay out a little to settle even a frivolous claim rather than having 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. We note that this approach is tricky and may not always work, 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: If the sellers feel strongly that there is no real claim, allow for a resolution without going to court. Require the loser to pay the winner’s fees, so that the sellers 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 sellers 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 it knows the sellers 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 sellers 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. 

The above piece is an extract from the latest edition of Tales from the M&A Trenches, a best practices guide to mitigating post-closing risks authored by SRS co-founders Paul Koenig and Mark Vogel.