The escrow agreement is widely used worldwide as a security measure for the protection of transacting parties' interests in the sphere of M&A. At present, a quasi-escrow mechanism (the so-called opening of an account for the benefit of a third party) is applied in Kazakhstan. This mechanism remotely has some characteristics of an escrow account and is applied by Kazakhstan banks in different ways by virtue of the absence of the legislative consolidation of the escrow term. The result is the triggering of some mistrust of this security on the part of the transacting parties. In this article, we will try to highlight the foreign practice of the legal regulation of escrow agreements, analyse the existing practice and the recent legislative initiatives in Kazakhstan, and make recommendations for improving Kazakhstan laws on escrow matters.
Traditional security measures in Kazakhstan
The practice of rendering services on merger and acquisition (M&A) transactions shows that, in transactions on the purchase and sale of participating interests and shares in Kazakhstan legal entities, the parties always experience some degree of mistrust—the seller cannot always be certain of the receipt of cash from the buyer, and the buyer, in turn, cannot be certain of the fulfilment of all required conditions on the part of the seller. In these cases, the applicable Kazakhstan legislation provides for the appropriate security measures: penalty, pledge, guarantee, etc. However, as practice shows, no such measures offer protection from the situation when a transacting party hides away with the transaction reward received or passes the buck, hiding property from seizure.
The analysis of judicial practice allows one to make the conclusion that the existing security measures are not effective. Thus, the court may invalidate warranty, a security measure if parties failed to comply with certain procedural requirements and formalities, or if the guarantees were issued by designated persons in excess of or in the absence of appropriate powers. As for the pledge agreement, the parties in merger and acquisition transactions do not always resort to such security for obligations by virtue of certain circumstances. First, pledges in merger and acquisition transactions mean the pledger's possession of large property, which is not always practical. Second, various procedures almost always accompany the implementation of the pledge agreement (for example, in the pledging of subsurface use rights). Third, the parties initially waive a pledge as a security in view of the possibility of the enforcement of the pledge only through the courts. In the light of the foregoing, escrow agreements are increasingly used in merger and acquisition transactions in Kazakhstan. This article is devoted to some legal and practical aspects of escrow agreements to consider in M&A deals.
The relevant legislation in the USA has been settled and the escrow agreement used mechanism for the protection of parties' interests in M&A transactions: the experience of foreign countries
А.N. Dontsov has delved sufficiently into the legal nature of the escrow institution: "Classical" escrow mechanism used in international M&A transactions provides that the purchase price is charged to a special escrow account, from which the seller may withdraw the funds only after delivery to the bank (escrow agent) of the documents confirming the transfer of the ownership of the shares to the recipient; the buyer may withdraw the funds only if shares did not pass into its ownership during the period agreed upon by the parties".1 An escrow agreement is a triangular transaction between the escrow agent and the parties under the purchase and sale contract, figuratively speaking, between the seller and buyer2.
The authors of this article consider the necessity of introducing the escrow mechanism in the current Kazakhstan laws. The article does not seek to reveal all the legal matters concerning the subject. The objective of this article is to draw the attention of law-makers, legal authors and legal practitioners to the matters relevant for the adequate introduction of the escrow mechanism into the legal system of the Republic of Kazakhstan.
At the outset, we would like to point to the positive experience of using the escrow mechanism in other countries, especially the countries of the European Union, the United States of America and Russia. The relevant legislation in the USA has been settled and the escrow agreement3 has been applied successfully over the years. Certain laws regulating the escrow mechanism4 are provided for in many states. The main sphere of the application of the escrow agreement in these countries constitutes merger and acquisition transactions.
In its 2011 report, J.P. Morgan underlines the advantages for the seller and for the buyer5 of using the escrow mechanism in merger and acquisition transactions. Escrow is a mechanism for protecting the parties from obligation defaults. It ensures the fulfilment of the aforementioned obligations and, at the same time, sets the procedure for the settlement of payments. In Europe and the USA, large law firms, financial organizations and notaries often act as escrow agents.
The Russian Federation recently made a significant leap in the sphere of the implementation of escrow regulation in civil legislation. On July 1, 2014, the provisions of the Civil Code of the Russian Federation for escrow account agreements came into effect. More specifically, Russian legislation provides that, under an escrow account agreement, the bank (escrow agent) shall open a special escrow account for cash management and trap, received from the account holder (depositor), for the purpose of their delivery to the other person (beneficiary) when grounds arise, covered by the agreement between the bank, depositor and beneficiary6. Further, the article of the Civil Code of the Russian Federation provides that obligations under the escrow account agreement may be contained either in the escrow account agreement or the other agreement under which the bank is an escrow agent. Accordingly, only the bank may act as an escrow agent according to Russian legislation.
Escrow mechanism: Kazakhstan realities and our recent experience of its application in transactions
Alongside the legal regulation of escrow agreements in foreign jurisdictions, we would like to review the Kazakhstan laws and analyse the extent to which the applicable legislation is ready to implement this mechanism. As per Article 292 of the Civil Code of the Republic of Kazakhstan, fulfilment of obligations may be secured by penalty, pledge, lien, suretyship, guarantee, deposit, guarantee fee, and other means, as provided for in the legislation or the agreement. Thus, theoretically, the parties may provide for other mechanisms, including escrow, as a security for obligations on a contractual basis.
The present-day reality of Kazakhstan legislation is that it does not even feature the term "escrow". An analogue of sorts of the escrow account that currently exists is the structure whereby a party opens up a bank account for the benefit of a third party. So, as per Article 764 of the Civil Code of the Republic of Kazakhstan, when making a deposit in escrow in favour of a third party, such party is entitled to operate an account only subject to compliance with the bank deposit terms and conditions. Before these conditions take shape, the third party may operate the account only by written permission of the party that has made a deposit. Although this structure reproduces the advantages of the escrow account to some extent, it does not create the analogous legal and economic effect to the full extent.
Based on our practice, the escrow agreement in Kazakhstan is not legislated and is used more as a functional business scheme. Moreover, it serves as a special procedure for the fulfilment of obligations under transactions regulated by foreign law where only an element of Kazakhstan law is present. We served merger and acquisition transactions using the escrow services of foreign or Kazakhstan banks on several occasions. In this regard, we would like to pay special attention to our experience of dealing with Kazakhstan banks.
Within the framework of one of our recently closed transactions for approving a draft of an escrow agreement with a Kazakhstan bank, we had to spend about four months with our client. In our opinion, the conservative approach of the bank officials to the execution and the subject matter of the escrow account opening agreement resulted from the uncertainty concerning escrow as a separate legal concept with a well-functioning mechanism. As a result, time delays in the approval of drafts of the escrow agreements on the side of the banks in practice gave rise to certain disadvantages for the clients who had decided to use Kazakhstan banks, thus causing a mistrust of foreign investors to escrow mechanism in Kazakhstan in whole, and forcing a wide application of foreign law (mainly, English law) to escrow agreements in our country. In this case, it should be noted that the application of foreign law and engagement of foreign escrow agents may result in cost increases of the M&A transactions in Kazakhstan. Consequently, with the implementation of escrow agreements in Kazakhstan law, we see possibilities for the removal of parts of transactions involving Kazakhstan assets from regulation by foreign law and the increase of foreign and Kazakhstan investors' degree of trust in Kazakhstan civil legislation.
Escrow agreement implementation in our legal system – recent legislative initiatives
At the present time, the Draft Law "On Payments and Payment Systems" provides for a bank account as the "escrow account". Thus, as per the Draft, the escrow account is a current or savings account that the client opens in the name of a third party with the limitation of the rights of this party to perform debit transactions on bank account until occurrence or fulfilment of the terms and conditions as stipulated by the client. In the case of the non-performance by the party in whose name the escrow account was opened of the terms stipulated by the client and the expiration of the occurrence or observation of such terms under the bank account agreement, the bank refunds cash to the client that opened the escrow account. The seizure of cash from the escrow account is not allowed other than by decision of the court. However, in our opinion, for the purpose of the durable fixation of this mechanism in Kazakhstan legislation, and to provide the civil transaction parties with the possibility of effectively using this mechanism in practice, an escrow agreement must be provided for in the Civil Code itself as a separate civil law contract.
In our opinion, among all existing security measures, the mechanism included in the escrow agreement enables the parties to guarantee the fulfilment of the transaction to the maximum extent possible and to minimize the risks. With the fixation of the escrow agreement as a special civil law contract with a well-functioning mechanism at the legislative level, Kazakhstan will have the chance to significantly increase the level of trust it inspires in Kazakhstan businesses as a whole. In particular, the parties in merger and acquisition transactions will be able to resort to the services of Kazakhstan escrow agents, promoting business development and the attraction of foreign investment to the country. In our opinion, a number of factors should be taken into account for the purpose of implementing the escrow mechanism in the applicable law of Kazakhstan.
First, it is necessary to deal with the legal nature of this agreement. The escrow agreement is similar to an agency agreement. However, compared to the classical agency agreement, in this case, the escrow agent is an agent for both parties. That is not typical for agency relations. The classical agency agreement has clearly defined agent-principal and agent-third party relations. Thus, the escrow agreement is an unusual agency agreement. It is a special civil law contract with its own peculiarities. We suppose that the escrow agreement is a new stage for the national law, particularly contract law regulating merger and acquisition transactions.
Second, the cornerstone topic is who can act as escrow agents. As mentioned earlier, in Western countries, banks or individuals (including law firms) play the role of escrow agents. In the Russian Federation, only banks act as escrow agents. This aspect is more practical than legal, and it can be summarized by describing the extent to which the realities of Kazakhstan business will allow individuals to act as escrow agents. With regard to the attraction of those, the parties must also take into account the matters of the mechanisms and control of their activities in the escrow agreement itself. In the case of attracting banks to act as escrow agents, there are no issues concerning the disposal of the funds in opened escrow accounts. However, can the same be said about controlling the disposal of the funds by an individual? Some states of the USA, for example, employ the licensing of individual escrow agents and the government services are liable for control over observance of regulations7. For instance, in California, the Business Control Department acts as a regulatory authority and a licensor in one8. For violation of the established rules, private escrow agents bear civil, administrative and criminal liability.
Third, it is necessary to take into account the matter of the termination of an escrow agreement. We believe that the right of the escrow agent to unilaterally terminate the agreement would be contrary to the legal nature and essence of the escrow agreement. However, in our opinion, this may result in assignment of escrow agent's obligations in case of the termination of its activities.
The escrow agreement has an advantage over security measures available under the Kazakhstan laws. The realities of the present day dictate the necessity of introducing this mechanism as a separate type of contract in the law. As mentioned above, the escrow agreement may be referred to as a specific subtype of an agency agreement. It is no coincidence that, in the Concept of Legal Policy of the Republic of Kazakhstan9 it was noted that, for the purposes of stimulating business activities, it was necessary to consider the practicability of introducing agents as a subject of civil law and the legal regulation of matters concerning the agency agreement for a wider use as a legitimate contractual arrangement in Kazakhstan.
1 А.N. Dontsov. Special course lecture notes on merger and acquisition transactions in the practice of international companies. М.: Clifford Chance CIS Ltd. C.7.
2 Ibrahim F.I. Shihata "The World Bank Legal Papers", 2000, p. 334.
3 US Code of Federal Regulations, § 53715 – Escrow Fund.
4 For example, section 17000 of California Financial Code; Chapter 9 of Idaho Code.
5 J.P. Morgan 2011 M&A Holdback Escrow Report.
6 Article 860.7 of the Civil Code of the Russian Federation.
7 Chapter 645A "Escrow Agencies and Agents" of Nevada Code.
9 The Legal Concept Policy, No. 858, for the period from 2010 to 2020, approved by the Order of the President of the Republic of Kazakhstan and dated August 24, 2009,
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.