Private Equity

While it is becoming increasingly common for parties in the private equity arena to negotiate “walk-away” public-style deals—it is still common in many deals to allow post-closing indemnity claims and for parties to place a portion of the purchase price into escrow in order to fund such post-closing claims.

It’s no surprise that drafting the terms of an escrow agreement does not garner as much attention as other aspects of negotiating a private equity M&A transaction, but the fact remains that the language used in an escrow agreement has very real consequences on how, when and even if escrow funds will be released to the parties. So, it is incumbent on all private equity professionals to draft escrow agreements with care, lest they lose the ability to access coveted escrow funds post-closing.

Two recent cases exemplify the importance of careful drafting when it comes to escrow agreements: the New York District Court decision in American Securities LLC v. E.I. DuPont De Nemours & Company and the Delaware Court of Chancery decision in i/mx Information Management Solutions, Inc. v. Multiplan, Inc. and HMA Acquisition Corporation.

In American Securities LLC v. E.I. DuPont De Nemours & Company, the private equity firm was unsuccessful in its attempt to release $12.5 million of escrow funds, which DuPont claimed should be kept in escrow past the initial escrow term to fund a potential tax liability, notwithstanding the fact that taxing authorities had yet to assert that any liability even existed. The court relied on the plain meaning of the words used by the parties to find that a “liability” included “contingent, asserted or unasserted, known or unknown, liquidated or unliquidated, due or to become due, fixed or unfixed” liability (emphasis added) and as such, DuPont was justified in blocking the release of escrow funds, even though the impugned tax liability may never come to exist. The result: American Securities lost the ability to collect the escrow funds, which would be tied up until the unclaimed and unripened tax liability is settled or until the statute of limitations on the potential tax liability expires.

In i/mx Information Management Solutions, Inc. v. Multiplan, Inc. and HMA Acquisition Corporation, the court held that multiple notifications from a third party to private equity-backed Multiplan of an “issue” was not sufficient grounds to block the release of escrow funds, notwithstanding that the “issue” could have evolved into a legitimate claim. Again, the court turned to the plain meaning of the words used by the parties to conclude that in order for an “Action” to exist, the “Action” had to be commenced or threatened – the mere notice from a third party of an “issue” without the threat or commencement of litigation was insufficient on its own. The result: Multiplan lost the ability to tie up escrow funds to finance a likely claim because of the language used by the parties.

These cases serve as a sober reminder to private equity professionals that the language used in all agreements, including the sometimes overlooked escrow agreement, have very real consequences when it comes to who has access to the cash held in escrow. Buyers should strive to include language in an escrow agreement that provides for the most opportunity in blocking the release of escrow funds – which should include the ability to block the release of escrow funds on facts that could potentially give rise to a claim, even if such a claim has yet to be asserted or yet to materialize in a meaningful way. Sellers, on the other hand, should try to limit the situations where a buyer can tie up escrow funds as much as possible, and they would want to provide that escrow funds will be released in all cases unless an indemnifiable claim has actually been commenced.