Escrow Based Funding: A Defense Mechanism for Business Ecosystem

To mitigate risks of business transactions, escrow accounts are gaining a lot of popularity. KPMG-based Chartered Accountant Pusha Merchant discusses what they are and how they work.

Any business transaction is exposed to varied degree of risk. Parties associated with a transaction often struggle to transact in a safe, secure and seamless manner. Escrow bridges this gap and fulfills the purpose of parking funds upon the trust of parties, till the satisfaction level of parties are met upon successful completion of the transaction.

The concept of Escrow is quite old and has had its mention since the erstwhile Companies Act, 1956 (now The Companies Act, 2013). Dividend declared by a company, which remains undistributed (for any reasons) in the hands of company shall lie in an Escrow account of the bank for a period of 7 years. The claimant of dividend, at any point of time, can exercise his or her right to claim dividend during this period of 7 years. The said provision continues to exist in The Companies Act, 2013 as well.

Thereby, money of the shareholder lies safe with the bank to claim their earnings; and at the same time, that portion of undistributed dividend needs to be deposited in Escrow account by the company and should not be used for any other purpose. This keeps the money safe to be utilized for the specific purpose only.

Conventionally, transactions involving huge amounts such as a single deal of merger and acquisition, cross-border deals use Escrow accounts for completing them. 

Now, the concept and mechanism is gaining importance and is widely used in transactions of the real estate sector, EPC turnkey projects, auctions, cryptocurrency trading, software developments and so on. So let’s look at escrow account rules in India.

Escrow Accounts & Their Operation

What is escrow account?

Escrow is a legal concept describing a financial instrument, whereby an asset, funds or securities is held by a third party on behalf of two other parties that are in process of completing a transaction. Escrow is a temporary pass-through account held by a third party.

In this mode of transaction, an account namely “Escrow account” is opened with the bank, wherein the monies/assets of the payer and payee are held by a mutually appointed escrow agent until the happening of an event or execution of transaction or performance of the contract. The banks usually act as an Escrow agent. Bank is not a party to any contracted transaction, and therefore is not responsible for the fulfillment of any contractual obligations. The role of Escrow Agent is limited to act as a custodian of funds routed through the escrow account.

An escrow account can hold money, securities, and other assets such as documents of the property entrusted, code of software being developed, etc. As per RBI guidelines, escrow accounts in India are non-interest bearing.

Can you withdraw money from escrow account? Here are the guidelines:

Permissible Credits in Escrow Account (Receipts)

1. Payment from various customers towards purchase of goods/ services.
2. Pre-funding by merchants/ payment aggregators.
3. Transfer representing refunds for failed/ disputed/ returned/ cancelled transactions.
4. Payment received for onward transfer to merchants under promotional activities, incentives, cashbacks, etc.

Permissible Debits to Escrow Account (Payments)

1. Payment to various merchants/ service providers.
2. Payment to any other account on specific directions from the merchant.
3. Transfer representing refunds for failed/ disputed transactions.
4. Payment of commission to the intermediaries. This amount should be at pre-determined rates and/or frequency.
5. Payment of amount received under promotional activities, incentives, cashbacks, etc.

The above is an inclusive list which may further allow/restrict the credits and debits based on agreement entered between parties. Further, escrow terms and conditions may also define the manner and sequence of payments to be made from funds available in escrow account.  

Waterfall Mechanism: Designing Payments

The waterfall mechanism is the crux of any escrow operation. It is a unique concept adopted from The Companies Act, 2013, which sets a differential treatment and preference for disbursement of funds based on type of liability, creditors and dues outstanding in a project or a contract.

Just like water fills the first bucket first and second bucket will get filled only after first is full, water fall payment mechanism also allows to pay off debts and dues one at a time or all in a systematic fashion such that the high tiered creditors are paid first than the low tiered creditors and then other dues. Typically, bucket size (size of debt) decreases as the water descends. Large debts involving risks are settled first, generally as under:  

1. Secured creditors
2. Statutory payments
3. Workmen’s dues
4. Unsecured creditors/debts
5. Shareholders

The escrow agreement may set out a clause providing sequence of distribution of funds from escrow account in addition to permissible debits allowed from the account. This, nonetheless, not only ensures transparency but also ensures fair distribution of funds.

Illustrating an Escrow Account through Example

Here’s a simple example:

A Public Sector Undertaking (Customer) enters into a contract with a private organization (Contractor) for construction and execution of a large-scale turnkey project. The construction of said turnkey project takes not less than 3 years to complete. Capital and funds are invested by the Customer and Contractor gets paid as the work progresses, or as and when milestones are achieved (commonly known as milestone/progress payments including advance).  

Risks Involved in a Transaction

Naturally there is a transaction risk involved. However more from the point of view of customer considering the value of project and investment involved, since it’s gestation till trial run of the project.  

Following are the possible risks involved:

• The customer pays advance amount before the project has even started construction.
• There is a risk of scams.
• Monies may be redirected in other avenues (legal or illegal) which the customer may be unaware of.
• Customer may be concerned whether pre-determined conditions of the contract are fulfilled.
• Opportunity cost of losing interest/ return on amount blocked or paid in advance.

Escrow Account: The Process

Therefore, to safeguard the interest of both the parties, customer and contractor enters into an agreement to open an escrow account with bank. It is agreed between the parties that all receipts and payments relating to project shall be made into/from the escrow account only. The money held in escrow account shall not be owned up by the contractor until the fulfillment of terms of contract and customer cannot withdraw the money once paid for the project progress. The bank is supposed to act as an Escrow Agent keeping watch on the funds.

• Here, the escrow agreement binds customer and contractor to act in the capacity and terms and conditions of the agreement. Public sector undertaking and a private company shall be first and second party to the contract respectively. Escrow bank shall be the third party.  
• The escrow agreement shall clearly define manner of operation of the escrow account.
• Payment which can be released/ utilized by the contractor from the account i.e. debits shall be exclusively for the purpose of project only. It can also set out the order of payment such as payment to suppliers for goods and services, statutory authorities, establishment expenses, etc.
• Obligations and rights of both the parties. This may involve demanding monthly statements by the customer to validate if the funds are being utilized for the project only.
• Duties and liabilities of escrow bank. Usually, escrow bank shall act in neutral capacity.
• Service charges of escrow bank, if any.
• Closure of the account shall take place on completion of facilities and on achievement of purpose after obtaining due consent from both parties.

Advantages of an Escrow Account

This is a quite win- win situation for both parties, because:

• The customer can assure the contractor that necessary funds are invested in the project. 
• The contractor can assure the customer that funds are utilized for desired purpose only.
• A lot of trust factor is involved and ensures both parties hold their part of the deals.
• Protection and security of funds as they are held neutral with third party agent.  
• Confidentiality is maintained about the contract.  
• The working capital of the project increases as the time period of conversion of stock into cash is reduced.

This way, escrow account shall safeguard the money of the customer. At the same time, contractor shall not be able to exercise full control over the monies deposited until the purpose is achieved, thus mitigating the risk associated with the transaction.

Conclusion

An escrow bank account is all about efficient risk management, simplification of complex transactions and facilitating custody of cash, securities, and other collaterals as per the transaction type entered into. It is a very useful means to move through a transaction between two or more parties without worrying about the possible risk attached to the transaction. It is very much considered an important means in today’s scenario, wherein a lot of uncertainties are involved.

Pusha Merchant

Pusha is a Chartered Accountant by qualification, having 7 years of professional experience. She is currently working with KPMG India. Direct Taxation, Corporate Law, Contract Management are the topics that interest her.

Pusha is also a yoga enthusiast and writer by accident. She loves reading auto biographies and memoirs. She serves for the place we all belong to, under the aegis of The Art of Living foundation. On weekends, you will find her zipping in her car to exotic destinations.