Your escrow period is nearing its end. Moments before the expiration, the acquirer informs you that they want the bank to continue to hold a significant portion of the escrow beyond the expiration date because they believe one or more potential claims could still come. In some cases, the potential claim is really tenuous – hypothetically:
Customer X complained six months ago about a late delivery. Nothing has happened since then. Customer never threatened to sue. The Buyer, though, is concerned that Customer someday might, so they want to hold back part of the escrow to cover potential losses; or
A former stockholder had a question at Closing about the amount of they were receiving. That question was answered, and nothing has happened since. The Buyer, though, fears the stockholder might bring a claim someday that they held additional shares and wants to reserve against this.
There are dozens of other examples, and the terms of many merger agreements allow Buyers to do this. It’s understandable that the Buyer wants this term because there are also lots of examples of situations where the Buyer hasn’t suffered an actual loss at the time of the escrow expiration, but a real “live” claim is outstanding.
Determining the line between legitimate claims and issues unlikely to ever become actual losses is problematic. It’s a real problem for the former stockholders who want that money released, but the escrow bank won’t release it without joint written instructions or a court order. They have no idea how long they’ll have to wait before the Buyer agrees that the highly tenuous “claim” is now dormant. If a year passes and you still haven’t heard anything from the third party with a hypothetical claim, is that long enough? Two years? Five years? Expiration of the statute of limitations? That is a hard pill to swallow if you’re talking about significant money tied up for indefinite periods. To make matters worse, the Buyer has no incentive to agree to a release. In fact, some buyers would prefer that the money sit there for as long as possible as a security blanket and it costs them nothing.
This situation can be avoided. There are a few options:
Set rules in the merger agreement about how long money can continue to be tied up if you haven’t heard from the applicable third party. For instance, if there has been no communication with that party for 18 months, the “claim” is deemed dormant and the money reserved for that claim is released.
Put terms in the merger agreement that allow the shareholder representative to work with the third party to settle the claim. If the rep believes it’s meritless, allow it the option to offer a small settlement to wrap up the issue quickly. Any settlement payment would come from the escrow, so the Buyer shouldn’t care, and the former stockholders are sometimes willing to forego a small amount of the escrow to settle the issue. If only the Buyer is allowed to control this process, you might be left with no attractive options.
Have terms that say that the Buyer can only continue to reserve funds in escrow following the escrow expiration for losses that are “reasonably anticipated and ascertainable and for which a claim, lawsuit or threat of a lawsuit has actually been made by the third party in writing.” This will hopefully cut down on the number of frivolous claims submitted by Buyer.
Define what constitutes a “claim.” Is a question from a third party asking if they are entitled to more money a claim, or do they have to make a written demand? Consider having a requirement that the buyer has to have accrued the claim as a loss on its balance sheet and taken it as a loss on its income statement. That should help filter those claims that are reasonably likely of eventually becoming an actual loss from those that are too tenuous to justify a continued escrow holdback.
We’re sure there are other fixes if anyone else has ideas.
