In M&A transactions, it’s routine for the seller to put a portion of the purchase price into an escrow to provide a secure source of recovery for the buyer’s post-closing indemnity claims. Today, however, private equity sellers are, with increasing frequency, taking this concept a step further by making such escrows the sole source of recovery for these claims.1 While this structure is attractive, particularly for financial sponsors who are “winding down” an older fund, there are a number of issues that should be considered.
How Much?
Limiting future indemnity exposure can come at a price. When faced with a request for an escrow-only indemnity structure, buyers will argue, often successfully, that the escrowed amount should be larger than a typical indemnity escrow because it’s the buyer’s sole source of recovery. In those circumstances, private equity sellers will need to balance escrow size versus the greater certainty provided by the escrow-only approach.
In determining the proper balance, private equity sellers should consider the following factors. First, private equity sellers are in the business of providing their investors with a healthy return on their investment. Dollars placed in escrow typically are excluded from IRR computations and some investors view purchase price placed in escrow as money they will never receive. Second, amounts placed in escrow could be considered purchase price taxable to the sellers for federal income tax purposes. Therefore, a larger escrow could result in taxes being paid by the seller and its investors on money not yet received. Finally, depending on the age of the private equity fund, selling and limitations in the fund’s organizational documents on its ability to call additional capital, investors in a fund may, as a practical matter, already have limited exposure regardless of the escrow, and thus will want to minimize the escrowed amount.
How Long?
When an escrow is the sole source of recovery for a buyer’s post-closing indemnity claims, the escrow’s duration becomes the maximum period that these claims may be brought. Buyers, however, are accustomed to getting longer survival periods for tax, ERISA, environmental and certain other claims. Also, buyers typically expect to always be able to bring certain claims, like those relating to title to shares or assets acquired. Therefore, buyers will typically resist escrow-only indemnities on this basis or, alternatively, will push for a longer escrow period to help address these concerns or push to carve-out certain claims from the escrow-only limitation or both. Again, the private equity seller will need to balance escrow duration versus greater certainty.
How Enforceable?
The Delaware Chancery Court enforced an escrow-only indemnity structure in Abry Partners V, L.P. v. F&W Acquisition LLC, decided on Feb. 14, 2006. Abry involved a private equity buyer seeking to rescind its purchase of a company from a private equity seller based on alleged misrepresentations by the seller and the target company’s management. In essence, the buyer wanted to give back the target company in return for the $500 million it paid.
The stock purchase agreement in the Abry case contained three key provisions:
A non-reliance provision (i.e., an acknowledgement by the buyer that the target company and seller made no representations other than as expressly contained in the stock purchase agreement).
An exclusive remedy provision (i.e., a provision stating that the indemnity in the stock purchase agreement was the sole and exclusive remedy of buyer with respect to the agreement).
An escrow-only indemnity provision (i.e., a provision that purported to limit the liability of seller for any misrepresentation of fact contained in the stock purchase agreement to a claim for damages not to exceed the amount of a contractually established indemnity fund – $20 million or 4% of the $500 million purchase price in the Abry/F+W case transaction).
In response to the buyer’s recission claim, the seller in Abry asserted that (i) the non-reliance provision precluded the buyer from asserting any alleged misrepresentation outside of the stock purchase agreement, and (ii) with respect to any misrepresentations in the stock purchase agreement, the exclusive remedy provision and the escrow-only indemnity provision effectively limited buyer’s remedy to a claim for money damages up to the amount in the escrow-$20 million.
The court in Abry held that the non-reliance provision was effective in precluding buyer’s ability to assert misrepresentations outside the stock purchase agreement. The court then stated that the combination of the exclusive remedy provision and escrow-only indemnity provision effectively limited the buyer’s recovery for negligent or innocent misrepresentations contained in the stock purchase agreement. However, the court stated that, as a matter of public policy, this combination of provisions was not effective to limit seller’s liability if (i) seller knew the target company’s representations and warranties were false or (ii) the seller itself lied to the buyer about a contractual representation or warranty.
Although no caselaw other than Abry was found specifically addressing the enforceability of an escrow-only indemnity structure, the Abry result was not surprising in light of the general enforceability of limitation of liability provisions. Limitation of liability clauses restrict the amount of damages recoverable upon a breach, regardless of the actual damages suffered. The courts analyze these provisions flexibly because they represent the parties’ agreement on how risk of economic loss should be allocated upon a breach. The courts have indicated that imposing a reasonableness or other standard would restrict the parties’ freedom to contract. The courts have also stated that it is immaterial whether a limitation of liability clause provides a reasonable estimate of probable damages resulting from a breach.
How “bullet” proof?
As evident from Abry, while the courts should respect the parties’ allocation of risk reflected in the escrow-only indemnity structure, an escrow-only provision may not foreclose a buyer’s non-contractual claims. Consistent with Abry, other courts have also rejected contractual limitations on fraud claims.
Consequently, as a seller, it is important to draft an escrow-only provision so that it attempts to cover all claims, including tort and fraud claims. Buyers, on the other hand, should, even in light of Abry, attempt to expressly exclude fraud and willful conduct from an escrow-only provision to avoid even an argument that these claims are limited to the amounts placed in the sole source escrow.
How to structure to suit both parties?
Is there an escrow structure that works for buyers and sellers? A combination of indemnity solutions may be the best way to provide seller with certainty without a larger and longer escrow and provide buyer an adequate, secure source of recovery. For example, an exclusive escrow could be coupled with an indemnity insurance product. Indemnity insurance provides buyers with post-closing protection for breaches of representations and warranties and helps bridge the gap between the indemnity protections a buyer wants and those a seller will provide. Policy periods tend not to exceed three years but longer periods may be negotiated for certain representations and warranties like tax and environmental. Policies may be issued to either the buyer or the seller and premiums generally range from 3% 6% of the amount of coverage purchased.
Before jumping on the sole source escrow bandwagon, buyers and sellers should carefully consider the advantages and disadvantages of these escrows. If a sole source escrow approach is pursued, it should be carefully tailored based on the specific facts and circumstances of the transaction.
Denise Carkhuff and Patrick Leddy are partners in the Cleveland office of international law firm Jones Day. Both have extensive experience with buyout and private equity funds and transactions. Associate Katherine M. Serevitch helped research this article.
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