Legal: The benefits of escrow

“Cash flow is the lifeblood of the construction industry.” So said Lord Denning in 1971, and the demise of Carillion provides a harsh reminder of this universal truth. Much of the recent public focus has been on the supply chain, with outrage over retentions abuse and the promotion of the Aldous bill attracting much air time and space in this and other media outlets.

But main contractors also need to be paid. It is cash from the employer that “oils the wheels” and, in an increasingly risk-averse climate, contractors are looking to protect themselves against the risk of non-payment by their client. This is especially true where the employer is a special purpose vehicle (SPV), an overseas entity or is otherwise unable to demonstrate its creditworthiness. 

Of course, contractors already have a number of statutory and other rights if they are not paid on time. For example, they may suspend work, claim interest, commence adjudication and ultimately terminate the contract. However, these are all “after the event” remedies and none guarantees payment if, for example, the employer becomes insolvent. 

The sum [in escrow] will typically equate to the maximum predicted spend in any two-month period

Escrow

On larger projects, a common solution to this problem is to use an escrow arrangement. Under an escrow, the employer sets aside a sum of money in a ring-fenced account, managed by an escrow agent. The sum will typically equate to the maximum predicted spend in any two-month period during the works, to cover both certified monies and work in progress. If the employer fails to pay an amount due, the contractor – having given advance notice of his intention to do so – may draw on the escrow fund to make up the shortfall. The escrow agent may be a bank or a firm of solicitors, although many law firms are now reluctant to offer this service because of onerous anti-money laundering requirements. 

Devil in the detail 

So far, so good. But if the escrow is to work as intended, it needs to be properly documented, so that all those involved are protected. In summary, the escrow creates two separate (but interlinked) relationships; one between the contracting parties, and one between the parties and the escrow agent.

As between the parties, it needs to cover matters such as the appointment and replacement of the agent; opening, topping up and closing the escrow account; the trust status of the fund (to protect it in an insolvency situation); the procedure for withdrawing monies from the account; and miscellaneous matters such as interest and dispute resolution. 

The agent in turn needs to know what to do if it receives a demand; it will wish to be reimbursed for its administrative costs, plus fees and taxes; and it will expect an indemnity against losses arising from the performance of its duties, unless caused by its own fraud or wilful default. 

The CLLS form

Capturing all these requirements in legal words is complex and can lead to prolonged negotiations. The problem has been made worse by the absence of a standard form to use as a basis.

Now the construction law committee of the City of London Law Society (CLLS) has stepped in to fill this gap, with the publication of a model form of escrow agreement and accompanying guidance notes (downloadable from the website at www.citysolicitors.org.uk). 

The model form draws on the variety of examples in use, seeking to consolidate them into a single, balanced document. It covers all the points above and includes a range of options, allowing the parties to tailor it to reflect their specific needs. It assumes that the underlying contract is JCT 2016 Design & Build, but can easily be adapted for use with other standard or bespoke forms. 

The CLLS hopes that its model will be widely accepted by the industry, as have its previously published templates (the novation agreement and letter of intent).

Conclusion

An escrow arrangement will not be suitable in every case. The administrative burden will be hard to justify for projects below a certain scale; many employers are financially strong enough that an escrow is not needed; and not all employers have immediate access to the funds required to set up an escrow account.

Where an escrow cannot be provided, the parties will need to consider alternative forms of security, such as a letter of credit, payment guarantee or letter of comfort from the employer’s bank. However, in appropriate cases, the CLLS model should provide a helpful tool for the parties to document their escrow arrangement efficiently and keep the wheels turning.