Cash collateral for warranties and indemnities (M&A)

The acquisition of a company's shares almost always comes with a set of warranties and indemnities. Through this undertaking, the seller promises to compensate the buyer if a liability predating the sale surfaces after completion. But a promise is only worth as much as the solvency of the person who gives it. How can the buyer be sure the seller will pay, sometimes several years after banking the price and reinvesting the funds? Cash collateral offers a simple and robust answer: block part of the price to secure that obligation.

The problem: a guarantee with no guaranteed payment

The warranties and indemnities protect the buyer against the company's past: a tax reassessment relating to an earlier financial year, a latent employment dispute, an unrecoverable trade receivable, an overstated asset. When such a risk materialises, the buyer notifies a claim and the seller must indemnify it. Provided, of course, that the seller has the means to do so.

Yet several years may pass between completion and the moment the guarantee is called. The seller may have reinvested the price, moved abroad, run into difficulty, or even ceased to exist where it is a company that has been wound up. The buyer would then hold an indemnity claim against a debtor who cannot be found or is insolvent — a theoretical guarantee with no practical effect. It is precisely this risk that the parties seek to neutralise by arranging a guarantee of the guarantee: a mechanism ensuring that, on the day the warranties are called, the necessary funds are genuinely available.

Cash collateral: a fraction of the price blocked

Cash collateral means earmarking a sum of money to secure an obligation. Applied to a share sale, the principle is as follows: at completion, the buyer does not pay the whole price to the seller. A fraction is handed straight to a third-party escrow agent, held on a dedicated account and earmarked to cover the warranties and indemnities.

These funds occupy an in-between position throughout the guarantee period: they are legally due to the seller, but unavailable for as long as the warranties run. If the guarantee is called, the escrow agent draws from the account the amount of the agreed indemnity and pays it to the buyer. If no claim is made — or for any balance remaining after indemnification — the funds revert to the seller on expiry. The buyer thus holds a real and immediately available guarantee, without having to pursue a reluctant seller through the courts to recover what it is owed.

Cash collateral, price holdback or bank guarantee?

Three mechanisms can secure warranties and indemnities. They do not offer the same protection, nor the same balance between the parties:

• The price holdback: the buyer itself retains part of the price and pays it only on expiry of the guarantee. Simple, but the seller then bears the opposite risk — never being paid by a buyer that has become insolvent or acts in bad faith. The funds stay within the buyer's sphere;
• The bank guarantee (often an on-demand guarantee): a bank undertakes to pay the buyer if the guarantee is called. Protection is strong, but issuing it has a cost, ties up a credit line of the seller and requires the bank's agreement;
• Escrowed cash collateral: a fraction of the price is blocked with a neutral third party, which neither buyer nor seller may access unilaterally. The funds are real and available, without tying up any credit line.

Escrowed cash collateral occupies a particularly balanced position. Unlike a price holdback, it removes the funds from the buyer's sphere: the seller no longer has to fear the buyer's insolvency. Unlike a bank guarantee, it depends on no financial institution and ties up none of the seller's credit lines. It is quick to set up and moderate in cost, which explains its frequency in mid-market M&A transactions.

How much should be placed in escrow?

The amount of cash collateral is a matter for negotiation. It is not meant to cover the entire cap on the warranties, but to represent a share considered sufficient in light of the risks identified during due diligence. In practice, the escrowed fraction often corresponds to a portion of the price — in the region of ten to twenty per cent depending on the deal, and sometimes more where significant tax or employment risks have been spotted.

That amount may be fixed for the whole period, or tapering: it then decreases as the main risks become time-barred, gradually releasing the seller from a lock-up that has ceased to serve any purpose. The escrow agreement sets the initial amount, any tapering and the release timetable.

A duration aligned with the warranties and indemnities

The duration of the cash collateral tracks that of the warranties and indemnities. The warranty period is itself set by reference to the limitation periods for the main liabilities: tax and employment limitation, the principal sources of unpleasant surprises. A three-year period is common; certain risks, such as an ongoing tax dispute, sometimes justify a longer window.

The agreement may provide for staged releases: an initial partial release after a set period, then the balance on expiry. This sequencing avoids locking up, for too long, funds that now cover only a residual risk. As with any escrow of the price paid for a share sale, it is the agreement that fixes these dates precisely, consistently with the warranty clause of the sale contract.

Release of the funds

Release is governed strictly by the conditions set out in the escrow agreement. The escrow agent carries out only what is provided for, never deciding alone the merits of a disagreement between the parties:

• Where no claim has been made by the expiry date, the balance is released to the seller;
• Where the guarantee is called, the agreed indemnity — settled by agreement of the parties or by court decision — is drawn from the account and paid to the buyer;
• Where a claim is notified shortly before expiry, the corresponding fraction may be kept in escrow until the dispute is resolved, the undisputed balance being released to the seller;
• At each partial release date, the share that has ceased to serve any purpose reverts to the seller.

This mechanism calls for careful drafting: definition of the triggering event, the form and time limit for notifying claims, and the fate of the funds in the event of a dispute. It is the care taken over these clauses that makes the arrangement robust and stops a block from turning into litigation.

The escrow agent: keystone of the arrangement

Cash collateral is only worth anything if the funds are genuinely ring-fenced and managed by an impartial third party. Entrusted to a lawyer, the escrow relies on the CARPA account: the funds are held on a sub-account dedicated to the matter, separate from the lawyer's own assets, every movement is checked and traced, and the whole operation is covered by professional secrecy. Neither buyer nor seller can touch the funds outside the agreed conditions.

Are you structuring a share sale backed by warranties and indemnities? Fidens sets up the cash collateral on a dedicated CARPA account, aligns its duration with the guarantee and releases the funds in line with the agreement. Let us discuss your transaction.