Indemnity Escrows and Other Payment Guarantees

Type of indemnity or payment guarantees

Indemnification is a contractual remedy and risk allocation mechanism typically used in M&A transactions to compensate a party for damages^[2] suffered as a result of misrepresentations and breaches of warranties and covenants that become known or materialise after closing with respect to pre-closing facts, events and circumstances.^[3] Indemnification provisions are usually heavily negotiated by the parties, on the one hand, allocating the risk related to the transaction and providing certainty as to which party will be liable for such post-closing issues and, on the other hand, setting forth the terms, conditions and procedures under which the parties may seek such indemnification under the applicable transaction agreement.

In a traditional M&A transaction, the buyer as the likely indemnified party will negotiate for broad indemnification rights, while the seller as the likely indemnifying party will seek to limit the scope, term and amount of its indemnification obligations and may also try to limit the circumstances in which the indemnitee may bring a claim.^[4] It is important to note that market conditions in certain countries may force some sellers towards a more buyer-friendly approach when negotiating indemnification provisions, aimed to getting deals done in a buyer’s market, including in connection with distressed M&A transactions and unpredictable economic, political and business environments.^[5]

A core aspect of indemnification provisions that requires significant negotiation from the parties is how the indemnity will be funded and payment thereof will be guaranteed. In practice, the mechanisms typically used for funding and securing an indemnity are the execution of an escrow agreement, set-offs against future payments, particularly earn-out payments, and a partial holdback of the purchase price.

Notwithstanding the foregoing, all personal and in rem guarantees legally available may be used as indemnification or payment guarantees in M&A transactions. The choice on the payment guarantees will often depend on various factors, including the specific characteristics of the transaction, the governing law, the purchase price of the transaction relative to the contingencies identified during due diligence, the ongoing and future relationship between seller and purchaser, etc. The agreed-upon indemnification provisions and the choice of the indemnity payment guarantees come down to the creditworthiness, credibility and payment capacity of the indemnifying parties factoring in the prospects of the indemnitor after closing.

In the following pages, we will focus on describing the indemnification or payment guarantees more often used and available in M&A practice.

Escrow and hold-back

In M&A transactions, the indemnified party, typically the buyer, will often seek to secure payment of indemnification obligations of the indemnifying party, typically the seller, by setting aside or holding back an amount of cash (typically calculated as a percentage of the purchase price) until the expiration of the survival term of the indemnification obligations, thereby securing liquidity for any payment due. In cases where there are multiple sellers that are jointly and severally liable to buyer for indemnity and other post-closing obligations, the sellers may also prefer to set aside necessary funds in escrow, to reduce the risk of being held accountable for the inability of another seller to fulfil its obligations.

The main difference between an escrow and a holdback is that, in an escrow, the portion of the purchase price set aside is held by a third party (typically an escrow agent but it can also be a trustee or a financial depositary), while in a holdback the buyer or indemnified party directly retains or holds that portion of the purchase price. Naturally, the buyer or indemnified party will prefer a true holdback of the purchase price as it allows it to retain control of the funds, while the seller or indemnifying party will usually prefer the retained amount to be held by a third party, as this mechanism reduces the amount of control the indemnified party has over the funds and increases the likelihood that any funds remaining after payment of indemnification claims and expiration of the relevant term will be promptly released to the indemnifying party.

When agreeing on an escrow or holdback, parties should consider that the indemnifying party will often seek for such mechanism to be the only post-closing remedy for any indemnification claims and will try to limit the liability to the amount of the holdback or escrow amount, subject to customary exceptions, such as indemnity with respect to breach of fundamental representations or non-waivable rights in the case of fraud. In M&A practice, holdbacks are used far less often than escrows.

Furthermore, depending on the characteristics of the transaction, the parties may explore the possibility of maintaining a single holdback or escrow or separate holdbacks or escrows to secure payment of their indemnification obligations.

Escrow

In essence, an escrow is a segregated account that the parties to an M&A transaction often use for securing payment of their indemnification obligations, where the funds deposited in the account are held by a third party, whether an escrow agent, a trustee or a depositary. An indemnification escrow is typically funded by setting aside and depositing a portion of the cash payable as purchase price with a third party (whether into an escrow account, a trust or a security deposit).

Escrows are usually set forth as a contractual remedy in the main transaction agreements, securing payment of the parties’ indemnification obligations, but also must be documented and effected in a separate agreement (ancillary to the acquisition agreement), such as an escrow agreement, a trust agreement or a security deposit agreement, as agreed upon by the parties, which will include the third party’s rights and obligations in connection with its role of custodian of the funds. The choice of mechanism through which an escrow will be implemented in a given M&A transaction depends on several factors, such as the governing law, the domestic or cross-border nature of the transaction and the parties, and the leverage one of the parties may have over the other.

While escrow agreements are not prohibited by Mexican law, as is the case in most Latin American jurisdictions, they are not regulated and thus, when the transaction is subject to Mexican law, the escrow is usually implemented through the execution of a trust agreement or a security deposit.

Escrow agreement

An escrow agreement is the typical form of implementing an escrow in M&A transactions. While the escrow as such is not regulated under Mexican law and other jurisdictions in Latin America, there are other mechanisms with substantially similar effects, as we will further describe.

The parties to an M&A transaction may agree on the execution of an escrow agreement governed by US law and subject to a forum in the United States, when either the transaction documents are governed by US law and subject to a forum in the United States or one of the parties has enough leverage to insist on US law and forum for the escrow agreement. In this regard, it is very likely that the escrow agent will require that the governing law and forum of the escrow agreement be that of the jurisdiction in which the escrow agent is located, even if that governing law is different from the other transaction documents.

The escrow agreement with the escrow agent sets out the terms and conditions under which the escrow agent will hold and release the escrowed funds, in exchange for a fee. Escrow agents are usually banks or other financial institutions that often have their own standard forms of escrow agreements under which they provide their services and that set forth standard terms and conditions for these types of transactions. Although escrow agents are often open to negotiating the terms of their forms to accommodate some of the terms and conditions agreed by the parties, it is advisable to involve the escrow agent early on in the process to make sure that the terms negotiated by the parties are agreeable to the escrow agent.

Among the main terms and conditions of the escrow agreement often negotiated with the escrow agent are those regarding the distribution of funds or payments arising from indemnification claims and the rules applicable to the investment of escrowed funds. The parties will want to ensure that the escrow agent has a clear set of rules for the distribution of funds and the escrow agent will want to be released from any liability that may arise therefrom, for which the escrow agent will generally require either a joint written instruction by the parties, or a final decision of a court, arbitral panel, or other third party with authority over the underlying issue, prior to releasing any funds in the escrow. For such purposes, the parties must agree on the applicable instructions, notices and other procedural rules for the release of funds, including upon expiration of the escrow period.

Additionally, the parties often have to consider if there will be a single or separate escrow accounts covering different risks. The latter may be used when there are various specified material, guaranteed obligations or when the escrow will also cover post-closing adjustments agreed under the transaction agreement. The indemnified party will often prefer one account to have more funds available to collect the applicable claims against the indemnifying party, regardless of the underlying indemnification event, while the indemnifying party will usually prefer separate escrow accounts to isolate exposure of the amount in escrow and provide for separate escrow release dates. These considerations by the parties may also arise depending on the agreement of different release dates of the applicable indemnification obligations or other obligations guaranteed by the escrowed funds.

In transactions where the purchase price is represented by stock or a note, it is not uncommon for the parties to place such stock or notes in escrow to guarantee their indemnification obligations. In these cases, aside from the fact that the parties should pay particular attention to the applicable securities and tax provisions, they should also agree to and set forth the terms and conditions applicable for the valuation and transfer of such stock held in escrow upon an indemnity claim.

Moreover, in transactions where the parties choose to place assets other than money (such as real estate) in escrow to secure the payment of indemnity obligations, it is convenient to include provisions in the transaction documents, to determine the manner in which the relevant escrowed assets will be valuated should an indemnification event occur, and the applicable process in which such assets will be sold if necessary. Consequently, the parties must take into consideration all the legal formalities required to transfer the escrowed assets to the escrow agent under the applicable law.

Selecting the escrow agent

When choosing the escrow agent or a trustee or depositary, the parties might consider whether any of them has an existing or strong relationship with such agent to address potential conflicts of interest but also so that they are in a position to negotiate better fees and terms under the escrow agreement (or the applicable guarantee trust or security deposit agreements). Both parties look for a reliable independent party so that it will not be prejudiced towards or against any of them in following the agreed upon rules and procedures, especially regarding release of funds to any of them.

The parties should identify who the escrow agent will be as soon as possible, to be able to negotiate the escrow agreement in good time, as well as to agree on the way the agent’s fees will be paid between the parties. Although the parties may negotiate the payment of the escrow agent’s fees, it is very common for the escrow agent’s fees to be split between the indemnifying party or seller and the indemnified party or buyer. Furthermore, it will give the parties time to determine the rules applicable to the investment of the funds in escrow (or guarantee trust or security deposit).

Escrow amount and term

In M&A transactions, when determining the amount of the escrow (or amount transferred into a guarantee trust or security deposit), the indemnified party will usually try to ensure that the amount is high enough to cover all possible indemnity claims and that the term is equal to the survival period for non-fundamental representations and warranties agreed upon in the transaction agreement, which typically may range from six months to as long as three years (most commonly between 12 and 18 months).

The indemnified party may also take into consideration the effort that may be required to bring an indemnity claim and collect payment thereof, as well as the creditworthiness of the indemnifying party. On the other hand, the indemnifying parties will try to keep the escrow amount and period as small and short as possible.

In M&A transactions, it is common practice for the escrow amount to be agreed upon as a percentage of the transaction value or purchase price; however, this percentage may significantly vary between transactions, typically around 7 to 20 per cent depending on the nature and size of the deal, and the depth and results of due diligence. Escrow amounts lower than 10 per cent of the purchase price are typically limited to larger deals or in cases where the escrow is not the exclusive remedy available to the indemnified party or buyer, as other guarantees or insurance may be in place to guarantee payment of indemnity claims or other obligations of the parties under the transaction agreement.

Parties to M&A transactions often agree to post-closing price adjustment provisions, typically for differences in working capital or net debt from enterprise value determination at closing, but also to accommodate certain factors that can only be determined post-closing (e.g., inventories, number of subscribers or antitrust mandated divestitures), as a result of which the purchaser may be entitled to a post-closing reimbursement of a portion of the purchase price paid at closing or be required to make an additional payment. In these cases, it is convenient for the parties to determine whether the escrow or other security or guarantee arrangement will also secure the seller's reimbursement obligation resulting from the price adjustment and, if applicable, the procedure to be followed to apply the funds held in escrow to the payment of the reimbursement. As a general rule, however, a purchaser will be advised to ensure that the escrow or other security established to secure the eventual payment of indemnification obligations is not applied to the seller's reimbursement obligation arising from post-closing price adjustments, to prevent its indemnification guarantee from being eroded.

It is also common practice to structure the escrow in tranches that guarantee specific indemnification obligations for contingencies identified during due diligence (for instance, tax claims or pending litigation), with their own set of terms and conditions, and release dates.

Interest accrual beneficiary

In M&A transactions, the determination of which party, whether the indemnified or the indemnifying party, is entitled to receive any accrued interest generated by an indemnity guaranteed amount, if any, is especially important in guarantees in which the guaranteed amount is transferred to another entity and administrated so that it generates interest, as is the case of an escrow, a guarantee trust or a security deposit.

In a holdback whereby the buyer or indemnified party retains a portion of the purchase price, although it may be negotiated otherwise, typically the buyer is required to hold the funds in a separate account and any accrued interest will be for the benefit of the indemnifying party.

When the payment guarantee is being held in escrow, the indemnifying party is typically the one entitled to receive the accrued interest generated by the guaranteed amount. However, the parties often negotiate whether accrued interest should be distributed to the indemnifying party or should be part of the escrowed funds that may be used to secure the covered obligations. The parties may also agree for the escrow agent to make investments under a specific set of rules. Although there is no rule of thumb, the indemnified party is usually more concerned than the indemnifying party with maintaining very conservative investment guidelines, providing for liquid investments that make it easy for the escrowed funds to be available as needed.

Release notices and conditions

In M&A transactions, release of the indemnification payment guarantees are typically subject or linked to the survival term of the indemnification obligations. The general rule is that both the payment guarantees and the indemnification obligations of the parties are released and expire, respectively, by the sole passage of time. However, the escrow terms and conditions typically provide for the extension of the release term if an indemnification claim is filed before the expiration of the release term, for the indemnified party to bring its claim to court or arbitration and, once started, until the dispute is settled.

In any case, it is advisable for the parties to an M&A transaction to agree on clear release mechanisms of the escrowed funds. These mechanisms include setting forth the procedure applicable to indemnity claims, including notices from the indemnified party to the indemnifying party upon the occurrence of any misrepresentation or breach of warranty or covenant from the indemnifying party, periods for the indemnifying party to cure any misrepresentation or breach of warranty or covenant, as well as the resolution mechanism applicable in the event of controversy on an indemnity claim (arbitration is typically used in M&A deals in Latin America).

Also, it is key to agree on clear and unequivocal release conditions or triggers. These may consist of notices to the applicable agent, which may be agreed to be given jointly by the parties upon settlement of an indemnification claim, or even from a third party such as third-party law firm confirming that the applicable conditions for releasing the funds have been met, or if a party provides a final and non-appealable judgment by competent court or tribunal requiring payment of the relevant sum to the indemnified party. Escrow agents typically prefer joint written instructions by the parties, as they do not want to be caught up in disputes among the parties (e.g., in connection with the calculation of interest payable in accordance with a court order).

In addition to the agreed release conditions, the parties may consider different or staggered release dates of the escrowed funds, which are typically preferred and negotiated by the indemnifying party or seller, while the indemnified party or buyer will prefer to maintain the escrowed funds for the longest possible period of time. This is more often agreed when the agreed upon escrow term or amount is high compared to market standards, when other obligations or adjustments are covered by the escrowed funds or when the indemnification obligations have different survival terms, in which case a portion of the escrowed amount may be released following the applicable adjustments or calculations, and the remaining amount may be released after the expiration of the applicable indemnification term.

Guarantee trust

When the parties to an M&A transaction agree on securing their indemnification obligations under Mexican law, an often used vehicle is a guarantee trust. Under a guarantee trust agreement, the indemnifying party transfers an amount of money (typically a portion of the purchase price) to a trustee, which maintains legal title to such funds and provides its services in exchange for certain fees, until the expiration of the survival term of the relevant party’s indemnification obligations under the transaction agreements.

Under Mexican law, only financial institutions such as banks and other authorised legal entities such as SOFOMs (multiple-purpose financial companies) are authorised to act as trustees in guarantee trusts. There are specific rules applicable to this form of trust and trustees typically have their own standard forms of guarantee trust agreements under which they provide their services and which set forth standard terms and conditions for these types of transactions.

Similar to provisions available under escrow agreements, under a guarantee trust, the parties may agree on specific rules for distribution of funds or payments arising from indemnification claims, the establishment of the amount of the guarantee trust and the authorised investments of the transferred funds.

Security deposit

Another legally available mechanism commonly used in Mexico to secure payment of indemnification obligations in M&A transactions is a security deposit. A security deposit is an agreement under which the indemnifying party transfers possession of funds (again, typically a portion of the purchase price) to a third-party depositary. The depositary acts solely as such (unlike the trustee to which legal title over the funds is transferred) and has the obligation to maintain such funds and any proceeds or interest accrued therefrom.

Depositaries are usually financial institutions authorised as such under Mexican laws and regulations that provide their services in exchange for a fee. As in the escrow and guarantee trust agreements, the depositaries often have standard security deposit agreements for those types of transactions. However, the parties may negotiate certain terms and conditions to abide by the provisions of the transaction agreements.

Bankruptcy remoteness

Which of the previously mentioned mechanisms is chosen depends on the nature of a particular transaction. The parties have to consider several factors, such as the applicable fees for each mechanism (guarantee trust or security deposit) and even the particular regulation that would apply in the absence of a specific agreement on a particular subject. In particular, counsel to the party in which favour the security is established must carefully analyse how the bankruptcy or insolvency laws apply to the selected mechanism to ensure that the security arrangement is effectively bankruptcy remote. As a general rule, security arrangements where the collateral remains in the possession of the potential indemnitor are less bankruptcy remote because even if the applicable insolvency laws recognise the preferred status and ranking of secured creditors, separating the collateral from the bankruptcy proceeding may be time-consuming and costly, in some cases to the extent that it significantly diminishes the value of the collateral. Security arrangements where the collateral is in possession of the creditor (e.g., pledge) provide better protection to the secured indemnitee. Ultimately, security arrangements where not only possession but also title is transferred to the potential indemnitee or a third party are most effectively bankruptcy remote, as is the case for trust agreements, where title, and not only possession, of the collateral is transferred to the trustee and the trustee can retain possession and proceed to the sale of the collateral and use of the proceeds to pay the indemnitee, irrespective of the bankruptcy proceeding.

Holdback and set-off rights

Parties to M&A transactions, and specifically the buyer, may seek to secure payment of their counterparty’s indemnification obligations by holding back a portion of the purchase price until the expiration of the survival term of the indemnifying party’s indemnification obligations.

On the other hand, when an M&A transaction provides for one or more post-closing payments that are contingent on the satisfaction of certain milestones related to future performance, the indemnified party may seek to secure payment of the indemnifying party’s indemnification obligations by including a set-off covenant in the applicable transaction agreement.

Holdback of the price by the purchasing party

If a holdback of a portion of the purchase price by the purchasing party is agreed as guarantee of the indemnifying party’s indemnification obligations, the indemnified party will directly hold or retain that amount until the expiration of the survival term of the indemnification obligations or shorter period agreed upon. If, upon expiration of the applicable term, no indemnity claim and payments are due or pending, the indemnified party is required to deliver the holdback amount to the seller or target.

Holdbacks are not commonly used as guarantee payments as they give full control of the holdback amount to the indemnified party. Thus, holdbacks are agreed upon when the buyer or indemnified party has substantial leverage over the seller or indemnifying party or when there is a broader long-term business relationship between the parties to the transaction. Usually the seller or indemnifying party will prefer that the funds are held by an independent third party.

The parties may also agree that a holdback covers both working capital adjustments or other price adjustments and indemnification claims. Under this scenario, it is common to agree to the release of a portion of the holdback amount following the final working capital calculation or price adjustments, and the remaining holdback amount to be released after the expiration of the indemnification survival term.

Set-off right against earn-out and other future payments

The parties to an M&A transaction may agree on one or more payments to be made by the purchaser to the seller or indemnifying party after closing, should the target company achieve certain previously defined financial goals or milestones. Such payments are known as earn-out payments and are usually stated as a percentage of gross sales or earnings or other financial metric. The main purpose of an earnout is to allocate the future risks and rewards of a target company, whereby the parties share both the success and the risk of the outcome of the target company during the earn-out period.

Therefore, if the purchase price of an M&A transaction includes certain future or milestone payments or earn-out payments, usually to be paid to the selling or indemnifying party, the parties to such transaction may consider using a set-off mechanism for securing and funding indemnification obligations. Under this mechanism, the parties may agree on certain provisions in the transaction agreement for the purchasing party to withhold the pending milestones or earn-out payments to which the seller or indemnifying party is entitled as guarantee payment of its indemnification obligations if indemnity claims and payments derived therefrom arise and are due to the indemnified party after the closing of the transaction.

Strictly speaking, a set-off is the reduction of future payments in the amount owed to the indemnified party under the indemnifying party’s indemnification obligations. This mechanism may be a good incentive for the indemnifying party to perform as intended; however, the downside is precisely the fact that such future payments are often conditional or uncertain to occur. If the target company fails to meet the specified milestones within the agreed periods, the buyer will be released from paying the applicable payment or earn-out to the seller.

Under this mechanism, the buyer or indemnified party will seek to have the right to withhold and offset contingent payments that have materialised for the benefit of the seller, against amounts owed by the seller to the buyer in connection with indemnification claims. In the end, the agreed-upon provision will often depend on the leverage the indemnified party may have over the indemnifying party. Usually, the parties agree on the specific provisions applicable for exercising a withholding and offset right, such as the requirements applicable thereto, notices and dispute resolution mechanisms between the parties. When the parties do not agree on the applicable mechanisms for exercising and settling disputes on these matters, it may be more complicated in practice as they would have to raise such claims before the competent courts and payment derived therefrom may only be collected upon a final and non-appealable judgment.

Other in rem guarantees

In some cases, the parties’ indemnification obligations can be secured by assets different from cash, often related but not within the scope of the transaction. The buyer will seek that the assets used to secure such indemnity payments are of greater value (whether collectively or individually) than the estimate of the indemnification amount agreed by the parties. Assets that have an active trading market (such as equity of publicly traded companies) are also preferable. Assets that may provide immediate liquidity like real estate or privately held shares with dividend rights are also appealing. Assets used as guarantee can be owned by the indemnifying party or by a third party (usually related to the indemnifying party). However, involving a third party will necessarily increase the complexity of the negotiations and the execution.

In the event of an indemnity claim, the indemnified party would be entitled to receive payment thereof whether by acquiring title to the collateral or by the amount derived from the execution and sale of such assets, as agreed by the parties.

There are two main types of in rem guarantees, depending on whether the collateral is real estate or personal property, available to parties to an M&A transaction for securing their indemnification obligations: mortgages over real estate and pledges over stock or other personal property. These guarantees are typically required to be granted before notary public and registered before public registries to be valid and perfected, that is, enforceable on third parties.

Although these guarantees are available for parties to an M&A transaction to secure indemnification obligations, they are not commonly used in practice. For further information on these guarantees, please see this chapter in the first edition of this guide.

Personal guarantees

Parties to an M&A transaction may agree that their payment indemnification obligations are guaranteed by a third party, which may or not be related to the parties to the transaction. In these types of guarantees, the person or entity that issues the guarantee undertakes the indemnifying party’s payment obligation either directly or in case of default by the indemnifying party, and, as a result thereof, the indemnified party has a direct action against the third party granting the guarantee to collect payment derived from an indemnity claim.

Parent guarantees and other personal guarantees granted by related parties

In practice, guarantees granted by related parties to an M&A transaction are usually an alternative when the seller is a holding or special purpose vehicle or is otherwise not an operating company with sufficient creditworthiness and thus the parent company or another affiliate has to guarantee the seller’s obligations. In contrast, such guarantees are typically not required when the indemnifying parties are stand-alone companies or entities with a substantial balance sheet and operations of their own.

These payment guarantees can be (1) parent guarantees, granted by a parent or an affiliate company of the indemnifying party to secure any indemnity payment obligation of such indemnifying party and often implemented through the inclusion of a specific guarantee clause in the transaction agreement or the execution of a separate surety agreement setting forth the guaranteed obligations, customary waivers to guarantor’s legal protections, limitations of guarantor’s liability and other terms and conditions of guarantor’s obligations; and (2) joint and several liability of multiple sellers or of a parent company or other affiliate, used when there is more than one indemnifying party and all such parties guarantee all of their obligations under the transaction agreement, including their indemnification obligations, as joint and several obligors. For further information on these guarantees, please see the first edition of this guide.

Personal guarantees granted by third parties

Exceptionally, indemnification obligations may be guaranteed by third-party financial institutions, either through a standby letter of credit or a surety bond. Although these guarantees are available for parties to an M&A transaction to secure indemnification obligations, they are not commonly used in practice. For further information on these guarantees, please see the first edition of this guide.

Standby letter of credit

A standby letter of credit is an instrument whereby a financial institution, acting upon the request and instructions of a client, irrevocably agrees to pay certain amount of money to a third party upon demand and delivery of certain documents. As the letter of credit constitutes a direct obligation of the financial institution, from the indemnified party’s perspective the credit risk is shifted from the indemnifying party to the financial institution, which is very favourable to the indemnified party, though usually expensive.

In M&A transactions, the standby letter of credit can be a mechanism for securing the parties indemnification obligations, for which the indemnifying party must obtain such standby letter of credit from a financial institution naming the indemnified party as beneficiary, and such indemnified party is entitled to obtain payment for any damages derived from an indemnification claim directly from the financial institution issuing the standby letter of credit. Standby letters of credit used in M&A transactions are commonly subject to rules issued by the International Chamber of Commerce, such as the ISP98 (International Standby Practices published in 1998) or the UCP 600 (Uniform Customs & Practice for Documentary Credits published in 2007).

This mechanism is often used in M&A transactions when the indemnifying party either (1) previously provides the applicable funds to the financial institution for the issuance of the standby letter of credit; or (2) has an existing line of credit with the financial institution and the standby letter of credit used to secure its indemnity obligations is the means to dispose of that credit. In both cases, the standby letter of credit is irrevocable.

The standby letter of credit may be convenient for the indemnified party as it is easily enforceable and the risk of insolvency of a financial institution is typically low, especially relative to the indemnifying party’s; however, the letter of credit may entail a big financial burden to the indemnifying party as it will have to obtain (or use an existing) credit facility with the financial institution and in some cases grant collateral to secure its obligations before that institution and assume restrictive covenants during the term of the credit facility.

Surety bond

Another useful indemnity guarantee granted by a third party is the surety bond. In order to guarantee an indemnity payment through a surety bond, the indemnifying party has to contract with a surety institution, which agrees to pay such party’s indemnity payment obligation in case the indemnifying party fails to do so.

The surety bond is typically implemented through the execution of a surety agreement or surety line. It is possible for the parties of a surety agreement to determine the scope of the surety bond; by default, the surety institution has order and excuse benefits in granting a surety bond. Therefore, due to the order benefit, the surety institution is liable before the indemnified party only if the indemnifying party has failed to make the respective payment. Likewise, the surety institution has the excuse benefit, through which it can appoint some or all the indemnifying party’s assets to pay for the indemnity amount if such amount is requested from the surety institution by the indemnified party. Both the order and the excuse benefits can be, and in practice are normally, waived by the surety institution, which would be more convenient to the indemnified party, since it would have higher collection possibilities against the surety institution.

The surety institution collects a fee, typically calculated as a percentage of the contingent amount, in connection with the secured amount and has recourse against the indemnifying party if the institution has to pay some or all of the indemnity claim. In practice, the surety institution usually requires the indemnifying party to prove its solvency so that the surety institution can validate its creditworthiness. The surety institution may even require the contracting party to guarantee the payment of the secured obligations by some other means (for example, a mortgage).

Promissory note

Although not very commonly used, it is also useful for the parties of a transaction to secure the payment of their indemnity obligations through the execution and delivery of one or more promissory notes. The promissory note is a negotiable instrument that constitutes an unconditional promise of payment made by the indemnifying party should that indemnifying party be bound to pay any indemnity claim to the indemnified party. Promissory notes may be convenient because of their nature as negotiable instruments, which means that, in practice, they can usually be enforced in special judicial procedures that are often faster and give greater collection rights to the indemnified party than other mechanisms, such as the possibility of embargoing assets from the indemnifying party at the beginning of the judicial proceeding. However, a promissory note does not provide security over specified assets and therefore, it does not solve for potential lack of creditworthiness and insolvency of the indemnifying party.

Notes