Escrow is the term used when funds or assets are held by a neutral, jointly-appointed third party on behalf of two contracting parties, subject to a transaction being completed between them (typically a contract of sale), until certain predetermined obligations or conditions under the agreement have been met.
More simply put, an escrow account is a bank account with defined conditions for the release of funds. Etymologically, the word derives from the French word escroue, which refers to a scrap or roll of parchment that served as a written instrument that could be delivered to a third person until a future condition was satisfied. An 'escrow agent' acts as the neutral third-party intermediary, whose role is to ensure that all parties to a transaction perform as the contract or agreement requires.
Escrow is therefore a useful tool that provides security and comfort to both contracting parties in a transaction and can be used in relation to virtually any contract involving the transfer of money or property. It is a preferred way to mitigate risks against the non-performance of an obligation by your counterparty.
Specific transactions that you may consider using an escrow service for include:
|Transaction type||Risk / reason for escrow|
For an ongoing JV, funds can be pooled in an escrow account and released as and when certain milestones are met.
Escrow mitigates against the risk of a party not supplying funding and affecting a set timeframe for the release of funds.
|Mergers and acquisitions||
Escrow helps assure the performance of each party's obligations when their deliverables in an M&A transaction cannot be executed immediately upon signing of the transaction documents.
For example, delays can occur in the transfer process from seller to buyer in the registration of title transfers or the issuance of tender offer announcements; and from the buyer's side when it seeks to defer payment of the purchase price until confirmation of transfer.
Escrow can also be used in a transaction as a 'retention' or hold-back of part of the purchase price for a warranty period, during which the buyer can confirm that the representations and warranties made by the seller in the sale documents are true and correct. This time can act as a buffer to ensure that any undisclosed liabilities come to the fore during the process of annual audits, tax filings, licensing applications or legal proceedings etc.
|Real estate transactions and leasebacks||
Escrow services can be used in real estate transactions, especially in respect of any deposit payments, because it allows the buyer to carry out due diligence of any potential purchase and, if dissatisfied with the findings, to withdraw from a deal without fear of recovering the deposit.
Funds in escrow also provide the seller with assurance that a potential purchaser has the financial means. This can save on save transaction time and costs by discouraging frivolous parties.
Funds can also be held on deposit until improvements or maintenance to the property that have been agreed on are complete.
Shares, secured by a third party, can be held in escrow to reduce counterparty risk pending the completion of a corporate action or a specific time period leading up to an event.
Shares can be placed into escrow in three common cases:
|Asset sales||Funds can remain in escrow as part of a Sales and Purchase Agreement (SPA) subject to their being no claims against them while the transaction is in process. In the event of such a claim, the funds would remain held in escrow until the claim was determined. If the claim was determined in favour of the purchaser, the claim would be satisfied out of the escrow amount.|
|Crypto currency exchange||Using escrow in crypto exchanges can significantly reduce the counterparty risk when making a large crypto purchase. By depositing the crypto currency in an escrow, a seller can prove both the existence of the coins and distribute control over the coin to reassure the buyer of a settlement in the case of a dispute.|
|Inter-insurer disputes||Providing without prejudice funding to an insured party where the policy indemnity has been accepted in principle but primary and excess layers are still in dispute|
|Construction projects||An escrow account may be used to help to mitigate the risk of employer and / or contractor insolvency during construction projects. The construction escrow account will effectively ring-fence an element of an employer's money in a place where the contractor can see and use the money as security for interim payments.|
- Timing – escrow terms should be concluded as close as possible to the completion of the underlying facility documentation in order to give them the best prospects of encapsulating all of the finalised, underlying terms and completing relevant KYC requirements. It can also take time to agree upon the terms of the escrow itself and this should be factored in once it has been decided to use an escrow service to avoid post-completion delays. Bear in mind that escrow terms that are established too early might need to be modified once the underlying transaction documentation is finalised.
- Segregated accounts – escrow funds should be held in a segregated account to avoid any mixing of funds with the trustees or other party's assets, so a sufficient level of segregation must be met. If there are multiple obligations being secured by the escrow agreement, it may be prudent to hold funds in separate accounts with different escrow amounts and disbursement dates.
- Jurisdiction of the courts – An escrow agreement often foresees dispute resolution by arbitration in the country of the escrow agent instead of ordinary court proceedings. Arbitration is often preferred for confidentiality reasons, because the public and the media may find interest in disputes over a significant asset.5
- Responsibility for loss – Determining which party should bear the loss when the funds are embezzled by the escrow holder is often a difficult and troublesome task. The one who is responsible for the hardship has typically either disappeared or become insolvent, so the two parties to the transaction are left to battle between themselves over the missing funds. An equitable remedy seems impossible in such a situation as both parties are generally innocent of any wrongdoing. The inevitable result is that one blameless party will suffer a substantial loss while the other will still reap the benefits of the deal.6
- Absolute clarity – any 'milestones' that should trigger a transfer or settlement need to be established with absolute certainty, so that there is no room for interpretation. Such actions should be capable of immediate execution or, if that is not possible, then within a pre-determined time frame. The consequences of missing a milestone should be agreed upon by the counterparties to the underlying contract, as well as the escrow agent.
- Limitation of liability – Liabilities should be strictly limited to those arising out of a specified, named agreement and, if possible, a total limit should be implemented together with appropriate insurance cover.
Recent examples of the use of escrow: purchases of Personal Protective Equipment
The Covid-19 pandemic brought about an alarming increase in scams involving the sale and purchase of personal protective equipment (PPE) as governments and private companies around the world competed on the open market to secure much needed stocks.7
PPE transactions are risky by their very nature because they are usually conducted on a global scale across great distances making the comoletion of appropriate due diligence challenging, especially under the restrictive conditions of the pandemic.
The scams usually involve either the representation of PPE product that simply does not exist or underperformance on the quality of the PPE promised. Although there are some legal recourses available to someone that has been defrauded, these remedies are available after the fact, take time and money to initiate and do not always restore the victim to full financial parity, if any at all. This is often made more difficult by conflicting legal systems and laws in the transacting jurisdictions.
Rather than relying on equitable remedies, the preferred approach is to anticipate and mitigate against these risks by using a qualified and trusted escrow agent. This service offers the buyer protection and peace of mind as to the performance of a contract because payment can be suspended until the product ordered is delivered and the items have been inspected to confirm that their quality conforms to the standards agreed upon by the parties. Provided the escrow agreement is set up clearly and correctly, the risks of non-performance can be substantially decreased.
How Sovereign can help
Legitimate escrow services are supposed to protect users from fraudulent activity. An 'escrow agent' acts as the neutral third-party intermediary, whose role is to ensure that all parties to a transaction perform as the contract or agreement requires. If there is a problem with a transaction, the funds/assets can simply be refunded.
It is therefore essential that an escrow agent should be jointly-appointed by all parties to a transaction and that the escrow agent should be trusted by all parties to a transaction.
Criminals who commit escrow scams warp this model to convince consumers that their money will be protected, while requesting that consumers send money by unconventional methods. potential problem of an escrow arrangement is that an escrow holder might take advantage of the position of trust and embezzle the money under his custody so it is vitally important to deal with a firm that you can trust.
Sovereign Trust (Hong Kong) Limited is licensed as a Trust and Company Service Provider (TCSP) by the Hong Kong Monetary Authority. Professional trustees are required to apply for a licence from the Registrar of Companies and satisfy a 'fit-and-proper' test before they can provide professional trustee services in Hong Kong.
We provide a Hong Kong-based escrow service for a wide range of transactions. We employ a robust compliance review in order to minimise risk to our clients. As escrow agent, Sovereign will hold funds, in accordance with the terms and conditions under a particular escrow agreement, at a reputable bank in Hong Kong where we have a pre-established, segregated banking facility. This ensures that there can be no co-mingling of client funds.
Sovereign is one of the world's largest, independently owned trust and corporate service providers. We offer a simple, safe and flexible facility to hold funds, instruments, share certificates or documents in escrow. We can facilitate a variety of transactions in multiple jurisdictions and currencies.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.