In the current transactional market, there is increasing pressure for deal speed as well as heightened sensitivity to assess and mitigate against risk (particularly when funding with debt). Whilst the range of legal and practical solutions can often be helpful, it is the commercial solutions that can often move matters forward quickly. The return of the escrow account is significant because it’s often at the centre of a compromise solution between buyer and seller.
What are the issues that arise on transactions?
Acquiring commercial real estate assets invariably gives rise to a range of legal, practical, and commercial issues during the due diligence process. Common issues that can surface include unregistered land, title defects such as restrictive covenants or unknown rights, planning issues (including breaches of planning conditions, incorrect planning permissions, or outstanding obligations under planning agreements), and occupational lease terms that may not be institutionally acceptable or where there are concerns over tenant or guarantor covenant strength. Buyers should also be alive to the risk of arrears, ongoing or historic disputes, TUPE transfers of employees, matters revealed by building surveys, potential contamination, flood risk, outstanding insurance claims, absent or insufficient EPCs, and construction-related concerns such as a lack of collateral warranties or the insolvency of a warranty provider.
Assessing the risk
Where concerns arise it is helpful to:
- Quantify the risk level in monetary value.
- Confirm if the risk has crystallised or remains unknown/contingent on a future event.
- Apportion the risk between buyer and seller.
We can then explore different solutions through use of a variety of “toolboxes”:
The Legal Toolbox:
- Indemnity insurance. Used to mitigate risk raised by potential title defects, lack of or age of real estate searches and/or breach of planning permission conditions. It is particularly helpful to mitigate technical issues which may be very low risk in terms of likelihood of being crystallised but high impact in the unlikely event this happens. An example might be a very old covenant on the title not to use a property for a specific use which conflicts with the existing use of the property (although obvious that it’s historic and very old, the impact of a successful injunction claim being brought would prevent use of the property for the existing use and an associated impact on the property value). The benefit of indemnity insurance is that lenders (depending on the issue) are largely comfortable with accepting it as adequate risk mitigation. The downside with indemnity insurance is that it prevents a property owner taking steps in the future to resolve the issue (such as getting a neighbouring owner to release the relevant covenant) because this correspondence will invalidate the policy.
- Additional diligence. Sometimes initial investigations flag potential concerns but a more involved review can lead to the risk level being lowered or even the concern being resolved. An example would include potential employment liability arising through TUPE (which could be resolved by further diligence confirming the numbers of employees, their employment terms and more specific information about the nature of any potential employment liabilities to quantify the potential financial impact and therefore risk level).
- Reliance letters. Diligence can lead to key reports being produced by a seller to help provide comfort to a buyer (such as a phase 2 environmental report or flood risk assessment). A buyer will want to be able to rely on key reports and the report provider issuing a reliance letter to the buyer enables this.
The Practical Toolbox:
- Site inspection. Physical and virtual site inspections can help to provide practical context to technical legal issues. It is often possible to evidence that issues are historic by a site inspection.
- Liaising with your surveyor. This can be helpful in assessing the risk level of an issue by understanding the practical impact. An example would be where there is a lack of warranties for works but the surveyor confirms that the main aspect of the works where liabilities could arise is tanking works. A potential solution could be to have the tanking works inspected by a specialist to provide additional comfort.
- How much time has passed? This helps assess whether any time periods relevant to an issue arising have passed and in analysing how likely it is that an unknown risk will crystallise.
- Commercially, does it matter? In the TUPE example mentioned above the buyer may say they need to have the employees transfer across to be able to operate the property, and they were therefore expecting to assume any employment liabilities that go hand in hand with the commercial benefit of retaining those employees.
Whilst legal and practical solutions can often reduce the “issues list”, commercial solutions are inevitably more appropriate when it comes to the most significant concerns.
The Commercial Toolbox:
- Price chip. For a known and crystallised risk, a price chip is the most obvious solution for a buyer. However, unless it is very clear a risk has crystallised a seller is likely to argue that an unknown potential issue should not reduce the upfront price.
- Retention. Where a known risk has not yet crystallised or is contingent on a possible future event occurring, the parties might want to negotiate a retention. However, if funds remain with the buyer (as opposed to a solicitor or in an escrow account), the seller is left with a contractual claim to enforce payment in court if the buyer defaults on the retention becoming due. For the same reason, a buyer will not want to pay a retention on completion to a seller to be repaid if the retention becomes repayable to the buyer. Enforcing contractual obligations takes time and is expensive in terms of legal and court costs. Increasing Law Society regulation over use of solicitors’ client accounts has led to most law firms being unable to hold retention sums.
- Guarantee. Where either buyer or seller has a strong covenant (or a parent company within its structure), a guarantee of payment obligations for retention and contingent sums might provide additional comfort. However, enforcement still has a time and cost consequence, in the event a guarantee is not honoured.
- Escrow account. A third party escrow account can be used to hold a retention sum from completion until a liability crystallises or a time period expires. Comfort is provided to both buyer and seller that the retention and interest accruing will be held securely and applied in accordance with an escrow agreement. There are now a number of third party providers who offer cost effective escrow services and can open accounts very quickly (to avoid holding up a live transaction).
The rise and return of the escrow account
So, having analysed what the risk is, whether there are legal or practical solutions, and then quantifying the risk, often the most palatable solution to buyer and seller is to have a retention placed into an escrow account. Escrow arrangements have become increasingly uncommon due to law firms struggling to accommodate them within the client accounts, putting pressure on other, typically more initially contentious, solutions like retentions and price chips . The rise of low cost third party escrow services with accounts that can be opened quickly allows the return of escrow arrangements and easier allocation of risk between buyer and seller. In turn, this will likely allow transactions to proceed at a faster pace even when concerns are raised during the diligence process which is particularly valuable in the current transactional climate.
