What is "escrow" and how does it work?
By Joseph Hentz
In commercial transactions, the term “escrow” is often used to describe the status of certain documents, instruments, share certificates and funds which are being held by a person but not authorized for use or release. Escrow is a contractual arrangement in which a third party to a transaction agrees to receive and disburse documents, instruments, share certificates and funds in accordance with certain conditions being met. The word derives from the French word escroue, meaning a scrap of paper or scroll that a third party held until a transaction was complete.
The terms of the escrow can be simple or complex. For simple commercial transactions, the lawyers for the parties to the transaction will arrange for executed documents and funds to be transferred amongst each other to enable the other lawyer to complete their review and to assist in the timely closing of the transaction. Once both lawyers are satisfied that all necessary documents have been executed and funds have been provided, they will agree to release the documents and funds from escrow and the transaction will be considered complete.
Complex commercial transactions (such as where funds are being held back for contingent liabilities or until certain conditions or targets are achieved) often require the parties to the transaction to consider more comprehensive terms of the escrow arrangement. These considerations include the following:
- Escrow Agent: A neutral third party escrow agent should be appointed rather than one party’s lawyer.
- Investment of the Escrow Funds: If substantial funds are being held for a long period of time, the parties to the transaction should consider authorizing the escrow agent to invest the funds in an interest bearing account.
- Release Conditions: Clear conditions and notice provisions should be established to enable the escrow agent to release funds from the escrow account to cover liabilities that are realized and for which the escrow account was established, as well as clear conditions to release any excess funds from the escrow account should the liabilities not be realized.
Reporting: The parties to the transaction should receive reports on any distribution of funds from the escrow account.
- Limitation of Liability of Escrow Agent: The escrow agent will likely seek to reduce its liability and seek an indemnification from the parties to the transaction for any claims made against the escrow agent except for those claims from the parties alleging a breach of the escrow agent’s duties.
- Remuneration of the Escrow Agent: The remuneration of the escrow agent should be clearly stated in the escrow agreement, including how the parties will allocate such costs.
In complex escrow arrangements, it is a best practice to have a separate escrow agreement entered into by the parties to the transaction as well as the escrow agent.