Although expense escrow funds have become increasingly popular south of the border, they still remain relatively uncommon in Canada. An expense escrow account is a separate fund created to pay the legal fees or other expenses of the former shareholders that may arise in defending against claims post-closing. Expense escrows benefit sellers, shareholders and buyers as follows:
- Sellers – by discouraging buyers from bringing a weak or frivolous claim, with the aim of tying-up funds in escrow indefinitely, knowing that the former shareholders will not have the means to fight it;
- Large shareholders – by providing funds to represent the selling shareholders without forcing large shareholders to contribute more than their pro-rata portion of expenses; and
- Buyers – by providing access to funds in the event that the terms of the merger obligate the parties to split costs for items such as audits and arbitration.
Shareholder Representative Services (SRS), a United States based shareholder representative company, recommends a minimum escrow expense fund of $100,000, increasing depending on the size, complexity and earn-out potential of the transaction. According to the 2011 SRS M&A Deal Terms Study, available at the SRS website, the average size of an expense fund for deals with and without earn-out provisions was 0.51% and 0.4%, respectively, in 2011.
Alternatives to establishing an expense escrow fund which may accomplish the same end include adding a provision stating that the selling shareholders’ portion of third party expenses will be paid from the escrow or having selling shareholders establish the funding for a defense of claims by entering into a contribution agreement.
Notwithstanding that the idea of an expense escrow fund makes good sense, expense escrow funds do have practical limitations. Sellers may be reluctant to have a larger share of their funds tied up in escrow, especially when many of the issues can be addressed by entering into a contribution agreement or wording the escrow agreement such that re-payment of legal fees and other expenses paid out-of-pocket by any of the former shareholders will rank in priority to disbursements to all shareholders. However, depending on the leverage of the parties and for whom you are acting, you may be well advised to recommend the establishment of an expense escrow fund in a particular transaction – particularly where there is a strong likelihood of post-closing disputes (based on distrust of the parties, as for example).
Given the apparent downturn in M&A transactions in the current down economy, suggesting an expense escrow fund may be a means of getting parties to – and keeping them at – the bargaining table. The added security afforded by an expense escrow fund may just give the parties the comfort they need to close their deal. Time will tell whether this mechanism catches hold in Canada but for now, we may well take heed from transactions south of the border.