Compensation Trust Accounts – What Are They and How Should They Be Used?

Indemnity clauses are used by parties to business acquisitions to provide protection against losses that may arise after the transaction closes. Indemnity obligations require one party to compensate the other party for costs that arise from the performance (or lack thereof) of the terms agreed to in the transaction documents.

The sources of compensation funds may come from a number of sources: an indemnity escrow account, a withholding or deferral of payment of the purchase price, or a right to offset future payments to which a party is entitled under the terms of the purchase agreement, e.g., payment for work performed.

Indemnity escrow accounts are often used to provide security that the selling party in a transaction has sufficient funds to meet its indemnity obligations. Because the buying party is more likely to make indemnity claims after closing, it typically has a greater interest in ensuring that these funds exist prior to closing.

The parties will agree on the amount to be placed in escrow, usually as a percentage of the purchase price of the transaction (a highly negotiated matter), and the period of time the escrow account will remain open to satisfy future claims for damages. Decisions on these matters will depend on a variety of factors, including the extent to which the parties are concerned that liability claims will be filed after closing, the willingness of the selling party to waive receipt of the entire purchase price at closing, and whether representation and warranty insurance is obtained as part of closing.

The parties may elect to establish a single escrow account to hold all funds needed to cover all potential claims, or to establish multiple accounts, each holding funds to cover a specific category of claims.

The period of time that the escrow account remains open is typically tied to the survival period of the representations and warranties contained in the purchase agreement. The release of indemnity escrow funds may also be broken down into different stages so that portions of the funds are released at different times or upon the occurrence of negotiated post-closing transaction milestones.

The parties may agree to include limitations on the types of claims covered by the indemnity deposit amount, as well as the amount of indemnity funds available to settle the claim. In some cases, all potential indemnity claims will be subject to a dollar limit. However, certain categories of claims are not subject to such limits, and the entire purchase price may be at risk in order to settle the claim. This is typical for claims based on fraud or fraudulent misrepresentation by a party. The parties may also elect to waive the limit on certain claims, such as breaches of certain “fundamental” representations and warranties (i.e., claims deemed most important to the transaction). Fundamental representations and warranties typically relate to ownership of the purchased assets and the capitalization of the selling party, the authority of the parties to enter into the contract, and the good standing of the parties to the transaction.

In general, indemnity escrows are a highly negotiated risk-sharing tool. A good indemnity escrow is consistent with the rights defined by the parties and allows for a smooth and hopefully litigation-free resolution of matters after closing. Practitioners should take great care to ensure that indemnity provisions are aligned with their client’s priorities.