new regulations will shake up m&a escrow landscape · pdf filenew regulations will shake...

White Paper Series – May 2015

New Regulations Will Shake Up M&A Escrow Landscape A New Investment Strategy Solves These Challenges by Paul Koenig, Co-CEO, SRS Acquiom There has not been a lot of news or change around M&A escrows for decades. Hundreds of billions are invested annually into off-the-shelf products that generally meet the investment criteria of the merger parties. That is about to change. An industry in which established investment options were never given much thought is being shaken up in a way that many deal professionals have yet to consider, but will soon become apparent. A new product has features that solve for the shortfalls of the traditional alternatives. Escrow Shield Plus™ is the first escrow investment strategy tailored for M&A.

Overview Four objectives generally govern the investment of M&A escrows:

• principal protection; • liquidity when needed under the acquisition agreement; • low cost and burden of administration; and • the best yield available, provided the above objectives are met.

These objectives have guided most escrow dollars into money market deposit accounts and money market funds because they generally satisfy the first three objectives. Yield in money markets has been virtually nonexistent in recent history, but merger parties have accepted it given a lack of alternatives. New regulations, including Dodd-Frank and Basel III1, are designed to mitigate the systemic risks of the financial industry and will present greater challenges to the transaction parties in setting up escrows than a search for higher yield. Under these rules, M&A parties may soon find that traditional escrow options may no longer meet the parties’ investment criteria, and may, in some cases, become unavailable altogether. For example, banks are pruning the types of deposits they take, and on what terms, due to increased collateral they will need to maintain against certain types of deposits. As a bellwether of changes among large banks, J.P. Morgan Chase & Co., one of the largest M&A escrow servicers, recently made 1 Applicable laws include Basel III, the Dodd-Frank Wall Street Reform and Consumer Protection Act, and proposed or actual regulations from the SEC, European Central Bank, Federal Reserve Board, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation and Financial Stability Board.

White Paper Series – New Regulations Wil l Shake Up M&A Escrow Landscape

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headlines with the news that they will charge large institutional clients to hold the types of deposits most affected by the new rules.2 This could include escrows deposited into money market deposit accounts, currently the most common escrow vehicle. These deposits are likely to be accepted on less favorable terms going forward, if at all. Money market funds, the second-most common vehicle for M&A escrows, will be adversely affected by rules that introduce a “floating NAV” and allow the fund to return less than the principal amount when it has suffered losses or has insufficient liquidity. This means that deal parties will face a heightened risk of loss of principal in money market funds. The rules also pose restrictions on redemption that could impact liquidity, the second fundamental objective that deal parties seek. The new regulations affecting deposit accounts went into effect January 1, 2015 and phase in over the next year and a half. SEC regulations affecting money market funds become fully effective in October 2016. Thus, attention is required now because the typical M&A escrow duration is 12–24 months, with possible extensions if indemnification claims are made under the merger agreement. As regulations phase in, escrows invested today could be negatively impacted during the escrow period. Facing these impacts—risks to principal protection, liquidity constraints, increased fees, and decreasing yields—deal parties and their attorneys will need to think more carefully about the management of escrows than has been historically necessary.

New Rules The changes affecting M&A escrows are due to a web of regulations enacted in response to the 2008 financial crisis, developed by regulators attempting to ensure the stability of large banks and the overall financial system. The result is a complex matrix of new rules governing financial institutions and financial products. Understanding these laws and their implications is difficult because they are not under a single regulatory regime. Nevertheless, there is one net result: money market funds have new protections to avoid mass redemptions while banks must now consider the stability of the types of deposits they take and ensure there is sufficient liquidity against those deposits to meet the more stringent requirements.

Bank Deposits The amount of liquid assets that banks are required to carry against their deposits is governed by Liquidity Coverage Ratio (LCR) regulations. New regulations took effect January 1, 2015, with increasingly high reserve requirements being phased in throughout the upcoming year.3 To meet the LCR rules, banks are required to classify the deposits they take and, based on the characterization of such deposits, limit the types and maturities of assets in which they invest.4 These requirements could be especially stringent for deposits that represent non-operating account balances from corporations

2 Emily Glazer, J.P. Morgan to Start Charging Big Clients Fees on Some Deposits, The Wall Street Journal (February 24, 2015). Last accessed March 23, 2015. 3 The United States Office of the Comptroller of the Currency, Federal Reserve System and Federal Deposit Insurance Corporation, Liquidity Coverage Ratio: Liquidity Risk Measurement Standards. Last accessed March 23, 2015. 4 Davis Polk & Wardwell LLP, Basel III Liquidity Coverage Ratio Final Rule: Visual Memorandum (September 23, 2014). Last accessed March 23, 2015.


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(typically accounts other than those supporting payroll and accounts receivable/payable activities) and deposits from alternative investment companies, such as private equity and hedge funds.5 The largest banks—those defined as Systemically Important Financial Institutions are subject to more stringent rules due to the greater threat a failure of such a bank would present to the overall banking system and economy. These are sometimes referred to as the “too big to fail” institutions and are among the largest servicers of M&A escrows. Banks are therefore narrowing the deposits they will take and/or will offer less attractive terms.6 Other large banks are expected to follow J.P. Morgan’s lead on deterring certain types of deposits. Because M&A escrows require immediate liquidity for reasons set forth in the acquisition agreement and can be moved at any time, banks or their regulators may determine the duration of such deposits to be uncertain. They are likely to become more expensive and less desirable for the banks in light of the new LCR rules, and the economic terms on deposits offered to deal parties could be substantially worse due to a combination of reduced yields and higher fees. To address this, many escrow banks likely will encourage customers to start moving escrow deposits to off-balance-sheet products. Money market funds historically have been the most common off-balance-sheet alternative to money market deposit accounts, but they too are now saddled with new rules that will likely make them an unsuitable investment option for many transactions.

Money Market Funds On July 23, 2014 the SEC adopted a new set of rules governing the structure and operation of money market funds.7 New regulations are phasing in now, with the most significant changes occurring on October 14, 2016. The new rules could subject escrows invested in these products to the possibility of principal loss and liquidity limits. Institutional money market funds will be forced to change how they report asset values and the manner in which corporate investors record them. These changes apply only to institutional money market funds, and not to retail funds (those limited to natural persons and therefore not applicable to most M&A escrows) or to governmental funds (those investing at least 99.5% in cash and government securities, which are addressed in the next section below). With respect to principal protection, these regulations present two issues. First, institutional funds will be required to change the investment and redemption price from a fixed rate to prices based on the daily net asset value (NAV) of the fund’s portfolio, known as a “floating NAV.” Historically, money market funds were allowed to price purchases and redemptions at a stable value, typically $1.00 per unit. When investors sold or redeemed their interest in the fund, they generally received a return of their investment plus accrued interest, even though the NAV of the underlying portfolio changed on a daily basis. The risk in the difference between the NAV and the fixed $1.00 price was assumed to be minimal given the short-term and relatively safe nature of the underlying assets in the fund. In 2008,

5 Victoria McGrane & James Sterngold, Fed Sets Tough New Capital Rule for Big Banks, The Wall Street Journal (December 9, 2014). Last accessed March 23, 2015. 6 Kirsten Grind, James Sterngold & Juliet Chung, Banks Urge Clients to Take Cash Elsewhere, The Wall Street Journal (December 7, 2014). Last accessed March 23, 2015. 7 The United States Securities and Exchange Commission, SEC Adopts Money Market Fund Reform Rules (Washington, DC: 2014); see also Michael S. Caccese, Claire E. Pagnano, Rita Rubin & George P. Attisano, Summary of New Market Fund Rules Adopted by the SEC, K&L GATES (August 5, 2014). Last accessed March 23, 2015.


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however, one money market fund, the Reserve Fund, “broke the buck.” In other words, the market value of the fund’s assets dropped sufficiently below the book value of those assets that the fund could not meet the regulatory requirements to maintain the stable $1.00 price for investment and redemption purposes. Other funds also “broke the buck” but were propped up with injections of capital by their sponsors as to not impact customers. 8 With the upcoming change to a floating NAV regime, merger parties could suffer a loss of principal if the NAV on the redemption date is lower than the NAV on the date the fund was purchased. This affects decision-making today because a full return of principal can no longer be assured for any institutional money market fund investment that could have all or a portion of the deposit released after the implementation of floating NAV rules. The second, and potentially more problematic, challenge is that money market funds can impose liquidity fees of up to two percent of the amount of any redemptions beginning in October 2016 if the ratio of the fund’s weekly liquid assets (assets redeemable for cash within the week) to total assets falls below a certain level. Therefore, M&A parties could be at risk of principal loss based on the independent dynamics of the fund in which they invest—dynamics that are unrelated to the M&A transaction itself. This combination of floating NAV and liquidity fees means that investors in institutional money market funds likely will no longer be sufficiently certain of receiving a return of 100 percent of principal that is required to meet the investment parameters for most M&A escrows. Should a money market fund suffer a loss, investors are not protected against any such loss by the government or, in most cases, by a guarantee from any other organization or entity. If there is a loss on the account so that the deal parties do not receive a return of the full escrow deposit, they will have to determine who suffers that loss. Further, accounting rules will require some fund investors to account for the fluctuations in the value of escrowed funds in their internal books and records, potentially increasing the administrative burden of investing escrows in these products. In additional to risks of loss of principal, money market funds will have new restrictions on their ability to guarantee immediate liquidity when required under the acquisition agreement. Beginning in October 2016, money market funds may suspend redemptions for up to ten days if a fund’s weekly liquid assets fall below 30 percent of total assets. This means that liquidity might not be available when needed. Finally, as a result of these new regulations, available yields with money market funds are likely to be lower in the future. Fund managers will have an incentive to manage the portfolio more conservatively by maintaining higher levels of liquidity, and compliance costs are likely to increase. This combination of factors is likely to result in additional downward pressure on the already very low yields available. Escrow banks will likely charge higher escrow administration fees and limit or eliminate fee waivers since their earnings from placing escrows into money market funds will be constrained or non-existent. The result is that institutional money market funds, which in the past fit the typical investment criteria for most M&A escrows, are unlikely to satisfy the needs of many future transactions. 8 Marco Cipriani, Michael Holscher, Antoine Martin & Patrick McCabe, Twenty-Eight Money Market Funds That Could Have Broken the Buck: New Data on Losses During the 2008 Crisis, LIBERTY STREET ECONOMICS (October 9, 2013), Last accessed March 23, 2015.


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Flight to U.S. Treasury Funds? If bank deposits and money market funds no longer meet the investment criteria required for M&A escrows, parties might look to Treasury funds as an alternative. The primary issue with investing in Treasury funds is that demand may greatly exceed supply as large sums of money (not just those related to M&A escrows) are expected to move into Treasury products. Indeed, some government-backed money funds were closed to new clients during the 2008 financial crisis due to the imbalance resulting from too much demand for too few eligible investments. Gross portfolio yields (not counting fees) neared zero. Treasury funds are exempt from the floating NAV rules discussed above but are subject to the new rules regarding redemption limits and liquidity fees that the funds' boards may enforce during market duress. As a result, Treasury funds also might not be a suitable solution for many M&A escrows.

A New Solution for These Challenges In light of the regulatory changes outlined here, many of the historical alternatives for M&A escrow accounts are unlikely to remain viable on most transactions going forward. The fundamental reasons for choosing these alternatives—principal protection and liquidity when needed—can no longer be assured by all money market deposit accounts and money market funds. Attorneys and their clients should carefully consider their investment options and consider new approaches. They will need to reevaluate which options will meet their objectives over the entire escrow period rather than simply considering whether an option seems to work at the time of closing.

Two Industry Leaders Launch Escrow Shield Plus℠ Responding to the evolving marketplace, SRS Acquiom, a leader in M&A services, and AXA Equitable Life Insurance Company (AXA Equitable), one of the country’s top insurance companies, have created a new product designed specifically for M&A escrows. Based on a patented method, Escrow Shield Plus offers a collateralized principal guarantee from an highly-rated financial institution, liquidity on demand when required to pay indemnification claims or for scheduled releases, the opportunity for higher yields, no fee options on many transactions, and the ease and simplicity in account administration provided by M&A professionals. (Note: restrictions and limitations apply; see discussion and notes below) Principal Protection Funds in Escrow Shield Plus are placed in a separate account insulated from any liabilities arising out of AXA Equitable’s other lines of business and obligations. The assets in the separate account serve as collateral solely against the obligation to repay Escrow Shield Plus investments. AXA Equitable guarantees that assets in the separate account together with designated assets in AXA Equitable’s general account will meet or exceed liabilities under all Escrow Shield Plus Agreements at all times. Such funds are further protected by a guarantee against loss from AXA Equitable. This guarantee to return principal and accrued interest (whether in satisfaction of valid claims, upon the scheduled expiration of the escrow period or a combination thereof) is backed by the full balance sheet of AXA Equitable.9


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Liquidity On Demand Escrow Shield Plus releases escrowed amounts as and when needed according to the terms of the M&A agreement. This includes any payments upon the scheduled expiration of the escrow period or in satisfaction of indemnification claims. If any assets are sold at a loss to meet such obligations, then AXA Equitable—not the M&A parties —bears the risk of such loss. Limitations apply if early termination is requested.10 Fees and Yield Escrow investments in Escrow Shield Plus earn crediting rates set by AXA Equitable that have the potential for yields that exceed traditional investment products, particularly in light of the regulatory changes addressed in this paper. The assets in the separate account are managed within the liquidity parameters—average maturity and redemption characteristics—of the underlying escrows. The approach is based on a patented method utilizing SRS Acquiom’s extensive M&A escrow experience. In addition, there are no fee options on many transactions. Crediting rates may be subject to change.11 Ease and Simplicity The M&A professionals at SRS Acquiom work to streamline account administration to make the process easy and simple, especially when combined with payments administration services. The online platform of Acquiom Clearinghouse™ eliminates tedious paperwork; shareholders can confirm holdings and submit instructions in minutes. Acquiom can administer all payments types, including those treated as compensation. As the regulatory landscape changes, deal parties may need to look beyond historical options for M&A escrow deposits. As they assess which investment options best meet their escrow needs they may want to consider Escrow Shield Plus, the first product designed to solve for emerging issues and provide benefits beyond traditional escrow alternatives.

About SRS Acquiom SRS Acquiom is the global leader in providing M&A post-closing services that deliver better economics with unprecedented ease and efficiency for buyers and sellers. The company represents more than 80,000 shareholders in 95 countries and has been engaged on 800 transactions, valued at $130 billion. Visit srsacquiom.com

About the Author

Paul Koenig Co-CEO SRS|Acquiom +1 303.957.2850 [email protected] www.srsacquiom.com

Securities offered through Acquiom Financial LLC, member FINRA/SIPC and an affiliate broker-dealer of SRS Acquiom LLC. Escrow Shield Plus is not available in all states. Acquiom Financial LLC does not make recommendations, provide investment advice, or determine the suitability of any security for any particular person or entity. Acquiom®, SRS®, and Acquiom Clearinghouse™ are registered trademarks or trademarks of SRS Acquiom LLC or its affiliates. All other logos, company names or product names are trademarks or registered trademarks of their respective owners. Escrow Shield Plus is issued by AXA Equitable Life Insurance Company (NY, NY).


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Addit ional Footnotes

9. Principal Protection

The return of the principal amount (net of any valid claims) and any accrued interest is guaranteed by AXA Equitable. This guarantee is secured by the assets in the separate account and backed by AXA Equitable’s general account. Guarantees are based on the claims-paying ability of AXA Equitable.

Invested assets are held in a separate account segregated from AXA Equitable’s other assets. Should there be any loss on the assets of the separate account, AXA Equitable is obligated to make the investors whole on invested capital and any accrued interest. The separate account is insulated from any claims that other creditors and policyholders might have against AXA Equitable’s general account. In contrast, in bank deposits the depositor is an unsecured creditor of the bank, subject to the limited protection of FDIC insurance.

There is no risk of floating Net Asset Value (NAV) reducing the size of principal. New rules take effect October 2016 that could require that institutional prime money market funds will no longer be carried at a stable net asset value and therefore could have a risk of loss of principal.

10. Liquidity

The Buyer and Seller may voluntarily request to terminate the Escrow Shield Plus agreement early. If AXA Equitable grants a request to terminate early, the remaining account balance may be reduced due to a negative market value adjustment. If the Escrow Shield Plus contract is terminated early due to a claim reducing the balance amount to zero, there is no penalty, and the full amount of the account, including accrued interest, is released in full.

11. Crediting Rate

The crediting rate is the earnings rate paid for investments in Escrow Shield Plus and is set by AXA Equitable for new contracts on a weekly basis. Crediting rates may change in only limited, defined circumstances:

Claims Rate Adjustment. Aggregate claims disbursements, greater than a percentage specified in the prospectus, of total purchase payments may reduce the crediting rate.

Subsequent Deposits into the Separate Account. The crediting rate may be adjusted downward upon the receipt of subsequent funds because crediting rates for new contracts are set on a weekly basis.

Pooled Rate Adjustment. AXA Equitable may declare a Pooled Rate Adjustment to counteract a loss in the market value of an asset held in the separate account that is due to the issuer of the asset either defaulting on its obligations or experiencing a downgrade. AXA Equitable may also declare a Pooled Rate Adjustment if it anticipates that an issuer will default on its obligations due to creditworthiness and AXA Equitable sells the asset of the issuer to avoid further losses. AXA Equitable will not declare a Pooled Rate Adjustment due to a change in market value of a separate account asset that is solely the result of a change in market conditions, such as a spike in interest rates.

It is possible that a change in the crediting rate under these defined circumstances could result in a crediting rate of 0.00%, resulting in no interest being earned.

new regulations will shake up m&a escrow landscape · pdf filenew regulations will shake...

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