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Making The Most Of Escrows

Black’s Law Dictionary defines an escrow as “money…delivered by the…obligor into the hands of a third person- to be held by the latter until the happening of a contingency or performance of a condition- and then by him delivered to the…obligee.”

An escrow is a vital transaction facilitator - particularly in aircraft purchases and sales because the parties- the funds and the registration documents are likely to be scattered throughout the world. Escrows in aircraft transactions provide three valuable functions: Validation- Logistics and Enforcement.

VALIDATION: THE GOOD FAITH- FULLY REFUNDABLE ESCROW
At the earliest phase of an aircraft transaction- which is when an interested buyer approaches a willing seller- a potential buyer may be asked (or may voluntarily elect) to deposit money with a recognized- third party escrow agent. In many cases- this deposit precedes the execution of any documents between the parties- and the escrow itself is not controlled by any agreement at all.

In truth- this is not even a real escrow because the release or return of funds is not subject to any restrictions- contingencies or conditions. The escrowed funds belong to the depositor and are thus subject to the depositor’s sole control.

However- this “escrow” validates the buyer as having the means and commitment to proceed to the next transactional step. This money deposit offers no protection for the seller- other than screening out illegitimate or nuisance offers. With the buyer’s qualifications and intentions established- the parties can go to contract- and the seller may feel confident enough to move the aircraft to a designated location for the buyer’s initial examination.

LOGISTICS: CLOSING WHEN THERE IS NO CLOSING TABLE
In a routine aircraft sale and purchase- you may have the following events taking place: (1) Bank A releases a mortgage on the sold aircraft; (2) Bank B places a mortgage on a purchased aircraft; (3) funds are sent from Bank B to Bank A to pay off its loan; (4) funds are sent by Bank B to the aircraft’s Seller; (5) funds are sent by the Buyer to the aircraft’s Seller; (6) the aircraft is de-registered from one national registry; (7) the aircraft is re-registered with another national registry; (8) a new mortgage is filed to secure Bank B’s loan; (9) Seller conveys legal title to the aircraft to Buyer; and (10) an existing lease and/or the lease of the aircraft from the Buyer to a third party is terminated.

There are other permutations that can double or triple the number of filings and exchanges needed to close. These actions are taken in a defined sequence because: (a) Bank A will not release its mortgage until it is certain of being paid off; (b) Bank B will not pay Bank A unless it is certain that the Buyer will have title and that Bank B is getting a first priority mortgage to secure its debt; and (c) Buyer does not want to pay Seller unless Buyer is certain that it will receive clear title. Logically- this sequence is impossible (like an M.C. Escher drawing) since two or more things seem to have to occur before themselves.

This is the classic ‘exchange of prisoners’ scenario- and an escrow solves it by introducing an impartial agent for delivery of documents and funds that can carry out these tasks in a single action- without the risk of interruption- upon the joint direction of the parties. In effect- all required actions (release and delivery of documents- and remittance of funds) are optimally under the control of a single independent agent- as the closing event includes irrevocable instructions from all parties that sets in motion a series of actions resulting in the completion of the multiple steps illustrated above.

Using escrows to bend time and space is a good system (perhaps the best)- but not perfect. For example- if the aircraft is being sold by a U.S. seller to a U.K. buyer- it will be coming off the U.S. registry and going onto the U.K. registry. You cannot take an aircraft off the U.S. registry unless all recorded liens are cleared. However- you cannot have a perfected lien on a U.K. registered aircraft unless the lien is recorded with the U.K. registry (International Registry issues being set aside for simplicity). So- there will be an inevitable time gap after the liens are cleared off the U.S. registry- and before the aircraft is re-registered in the U.K.

The buyer’s bank will need to exercise some faith and confidence in paying off the U.S. bank to compel the release of its lien- followed by a waiting period while the aircraft is registered in the U.K. and the buyer’s bank’s lien is recorded. There may only be a few hours when both U.S. and U.K registries are both open- and only during those hours can you achieve a same-day closing. If that window is missed- a U.K. bank officer will have a very nervous evening.

Similarly- even with all-U.S. parties- the actual closing depends on the actions of the FAA Civil Aircraft Registry in Oklahoma City- Oklahoma. If the parties all release documents and funds at 15:28 Oklahoma City time- and the escrow agent begins the filings with the U.S. Registry- there is no assurance that the filings will occur by closing time at the U.S. Registry.

ENFORCEMENT
Contrary to popular belief- the use of an escrow is not a failsafe way to secure an aggrieved party’s remedies in the event of the other party’s non-performance. It is- however- a great motivator - and often simplifies the resolution of a transaction that does not close. But for an escrow to serve any function- it must be governed by a clear agreement.

Escrow funds are generally defined as “hard” or “soft.” A soft escrow is largely or entirely refundable to the depositor (buyer) upon the buyer’s demand. It may be used to establish legitimacy and to justify the seller taking the aircraft off the market. Very early on in the transaction- the wise seller will ask that a portion of the escrow “go hard” - meaning become forfeitable to the seller- initially to cover the seller’s costs associated with operating the aircraft in furtherance of the sale.

If the sale does not complete- the “hard” part of the escrow is released to make the seller whole. At some point- when the buyer is irrevocably committed- the escrow “goes hard” and is forfeitable if the buyer fails to proceed to closing. Technically- there should always be a “soft” element – the escrow is refunded to the buyer if the seller is unable to deliver the aircraft as agreed. Avoid using the term “good faith escrow” to describe a refundable escrow.

That may be a common use of the term- but it is by no means universal and it could create an obvious problem. Often the aircraft purchase agreement will specify that the seller’s sole remedy for buyer’s breach or failure to close will be the release of the escrow (or a portion of it) to the seller. This is a useful way to both incentivize the buyer to buy- or to allow an amicable parting of ways. However- it is not conventional to have the release of the buyer’s escrow act as the sole remedy for both parties.

Obviously- the release of the buyer’s escrow back to the buyer may not make the buyer whole. A buyer may have inspection costs- and even contractual rights to separate damages (in addition to rights to reject the aircraft) for seller’s breach. If the buyer’s only remedy is to receive back its deposit- then the entire purchase transaction is reduced to an option that the seller can choose to exercise or not- with no adverse consequences.

The agreement governing an escrow should be reflected in each document in effect between the parties from the moment that funds are placed in escrow- including the letter of intent- and subsequently the definitive purchase agreement. Some of the best escrow agents do not offer their own escrow agreements (perhaps tiring of negotiating them with both sides)- but that does not mean that you should not have one.

When drafting escrow terms- consider all eventualities- and specify the intended outcome: What if the buyer finds a better aircraft during the inspection period? What if the seller declines to repair a discrepancy? What if there is a disagreement as to whether the aircraft meets delivery conditions? What if the aircraft is damaged before closing?

Alas- escrows are just contracts- and therefore not bulletproof. If the seller and the buyer differ on whether there has been an event requiring release of the escrow- or they differ as to the amount to be released from escrow- they will each make their respective and conflicting demands on the escrow agent (or one will make demand and the other contradict it). It is a rare case where the escrow agent picks one side in a contested escrow and releases funds- because the nominal escrow fees are not sufficient to support an litigation budget.

Assume that in the event of conflicting instructions- the escrow agent will freeze- and hope that the parties work things out. If the impasse continues- the escrow agent is likely to deposit the funds with a court and invite the parties to present their arguments to a judge. Think twice before causing an escrow agent to freeze a large deposit over a small financial disagreement. This will turn a small financial disagreement into a much larger one- making reasonable compromise more difficult. You do not want to risk inciting the buyer’s fury by withholding a large escrow over a small dispute- since this will lead to litigation where only the lawyers get rich.

To make the most of escrows: (1) reflect the escrow terms in the transaction documents (as a stand-alone or as part of the purchase agreement) and include the escrow agent’s signature; (2) consider all possible scenarios and make certain that the escrow provisions cover each scenario properly; and (3) build in clauses that minimize the risk of a frozen escrow.

Greg Cirillo is a partner with the Washington- D.C. law firm Wiley Rein LLP- representing private and commercial operators- owners- lessors and financiers in structuring the sale- acquisition- ownership and operation of aircraft. Greg can be reached at Tel: +1 703-905-2808- Email gcirillo@wileyrein.com


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