Should the Rep Indemnify the Escrow Agent?

The escrow agreement in most M&A deals contains a section that says that the buyer and the rep jointly and severally indemnify the escrow agent against all acts performed by it absent gross negligence or willful misconduct. Many reps assume they have no choice but to accept this. Our view is the rep should start with the position that indemnification should just come from the buyer. The typical buyer is a major corporation with significant assets. The typical rep is an individual or a comparatively small entity. Adding the rep to the indemnification clause gives the escrow agent little, if any, additional protection. Additionally, the rep is just an agent in the transaction. It’s not one of the principal parties. Generally it is not appropriate to ask a party who is just acting as an agent to some of the parties to the transaction to take the risk of providing indemnification to an escrow bank.

If it’s absolutely necessary for the rep to provide this indemnification, the rep should make clear that he or she is acting in his or its capacity as the agent of the stockholders and, in such capacity, is committing the stockholders to the indemnification terms. The rep should not give that indemnification individually. As mentioned above, it should be the principals to the deal, who are benefiting from the transaction, who provide any indemnification to the escrow bank.

In response to this position, we’ve heard arguments that the rep receives indemnification from the selling stockholders and so they really aren’t taking any risk by indemnifying the escrow bank. We don’t think that’s right. If the rep has to pay the escrow bank and then try to recoup the money from the former stockholders, it’s definitely not in a risk-free position. If the indemnification amount is significant, this gap could cause significant cash flow problems for the rep. Additionally, many of the major stockholders on most deals are private equity or venture funds with limited life cycles. This means a major stockholder may have ceased to exist when the rep seeks reimbursement or may no longer have any assets. Smaller stockholders may simply default on this obligation, but none of this relieves the rep from his or her obligations to the bank if the rep made that commitment.

We’ve also heard that the risk associated with this is minimal since escrow banks are rarely sued for anything. We don’t disagree, but that should also minimize the need for the rep’s indemnification in the first place. Also, even if small, it’s not far fetched to imagine a scenario in which money gets wired to the wrong account for some reason and is lost. The rep shouldn’t be on the hook for this when he or she is really just acting as an agent to allow the principals to consummate their deal.