The Problem of Locked Up Money: The PayQuik.com Dispute

Nothing is more frustrating than expecting a check and then not getting it, and no one knows that better than the former shareholders of PayQuik.com.

In a complaint filed in Delaware federal court recently, the representative of the former stockholders of PayQuik sued Citibank )PayQuik’s acquirer) and U.S. Bank (the escrow agent) to compel the release of the balance of the escrow. At the closing of the transaction, Citibank placed 10% of the merger consideration in an escrow account with U.S. Bank. Near the end of the escrow period, Citibank brought an indemnification claim, but the stockholder representative asserted that Citibank submitted this claim one day after the escrow period had expired. As is typical, the escrow bank took no position on the dispute, so the stockholder representative decided to seek a court order directing release of the funds.

This raises an interesting question that we have come across on other transactions: What options do the former stockholders of an acquired company have if the acquirer brings a claim near the end of an escrow period that the stockholders believe is either invalid or of little merit?

It is not unusual for the former stockholders to believe that these last-minute claims are invalid or so tenuous as to not warrant tying up escrow funds indefinitely. Some merger agreements even allow the acquirer to bring an indemnification claim for any damages that it “reasonably anticipates” it might suffer, creating a heightened risk that the escrow could be tied up indefinitely.

Selling stockholders have a thorny problem in these cases. The escrow bank is not going to weigh in on this, since they will only release the money either on receipt of a court order or joint instructions, and the buyer has no real incentive to negotiate. It does not care if the money is tied up; having the money remain in escrow works as a free insurance policy. Put simply, tying up as much money as possible for as long as possible is, all else being equal, a good thing for buyers and a very bad thing for sellers.

We note that most buyers don’t behave this way for a variety of reasons, including general consideration of business ethics, protection of business reputation, having more important issues to focus on, and a basic desire to not become a party to unnecessary lawsuits.

In situations such as PayQuik, however, the stockholders are left with two unattractive options: sue the buyer to compel release of the funds or wait for the statute of limitations related to the claim to run.

Waiting for the statute of limitations is a tough pill to swallow, but suing the buyer is not an appealing option either. The buyer is usually a much larger company with greater resources. Fighting to compel the release of money can be expensive, which can eat up a good portion of the money the stockholders are hoping to recover. If there is no expense fund set aside in the escrow for disputes, the stockholders may have to write checks to fund the litigation.

While you can never ensure that a buyer will not lock up funds for unnecessary reasons, we have a few tips on how to mitigate this possible risk.

Define what constitutes a third party claim (and what does not). A claim from a third party should be a live lawsuit or a written threat stating that they have a specific grievance and will sue if they do not get adequate satisfaction of that issue. Questions from third parties that are answered without any subsequent communications are not claims.

Require the buyer to accrue for the potential loss on its balance sheet. If the buyer truly has a reasonable anticipation of loss, they should be accruing for that loss on their balance sheet. If they do not think that there is a reasonable anticipation of loss under GAAP, then arguably there should not be a reasonable anticipation for indemnification purposes either.

Allow the stockholders’ representative to assume the defense of third party claims. If the representative thinks a third party claim is frivolous, let the representative try to quickly settle it. The stockholders will sometimes prefer to pay out a little to settle even a frivolous claim rather than having the escrow funds tied up indefinitely.

Include a time period during which the buyer must have heard from the third party before the claim is deemed dormant. If the third party grumbled about something a long time ago but has said nothing since, maybe it is time to conclude that the risk of this ever becoming a claim is small enough that the parties to the merger agreement should consider the issue dead. We note that this one is tricky and may not always work, but this is a question of where to draw the line with risk allocation. At some point, it does not make sense to continue to tie up funds to protect against issues that have become remote risks with the passage of time.

Provide for arbitration or mediation with the loser paying the winner’s fees. If the former stockholders feel strongly that there is no real claim, allow for a resolution without going to court, and require the loser to pay the winner’s fees, so that the stockholders do not have to deplete a meaningful chunk of their escrow balance if they are right.

Include an expense escrow. An expense escrow is a separate fund that is created to set aside money to pay for legal fees or other costs or expenses the former stockholders may have to incur in defending against claims or otherwise protecting their rights following closing of the merger. When such a fund exists, the buyer may be less likely to bring a weak or frivolous claim because it knows the former stockholders have the means to fight it.

Provide for conditional releases. If certain conditions have been met (such as the passage of a specified amount of time), then provide that the stockholders can compel that the escrow money related to that claim be released to them so long as they agree to refund that money to the buyer in the unlikely event that the issue does ever resurface and result in losses that would have been indemnifiable.

Not all of these possible resolutions are going to work in every deal, but the parties should consider whether the potential for abuse of this issue is one they want to address.

Paul Koenig is co-founder and managing director of Shareholder Representative Services (www.shareholderrep.com), which serves as a professional shareholder representative following the acquisition of a VC-backed portfolio company. View his past posts here.