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Application of Escrow

Escrow is a common law term used in civil and commercial practices. Because it enhances trust among trade dealers and secures the performance of contracts, the term is not only widely used, but has been greatly developed as a complete legal system. Its core contents are: Party A deposits documents, deeds, currency, securities or other assets to an independent third party (generally known as "Escrow Agent") who, upon satisfaction of stipulated or mandatory legal conditions, hands the said assets over to Party B. It means that the transfer cannot occur until stipulated conditions are satisfied (documents signed or payment cleared or cargo delivered, etc.), or certain legal conditions are met (e.g. a certain person died or lost legal status for liability), or the assets shall be returned to Party A. For instance, a real estate developer requires a contracted construction company to pay a quality deposit fee. The construction company then requests that a bank manages the deposit fee so that the developer can use the fee only after it has paid the construction commission to the construction company. In this case, the condition for the bank (Escrow Agent) to deliver the deposit fee to the developer is that the developer will begin to pay construction commissions to the construction company.

Below are several Escrow applications that are used most often in international commerce and which have begun to be introduced to China in recent years:

1. Escrow Account

An escrow account is the most used application of escrow in business transactions. It refers to the bank account established by Party A, for example, or the Escrow Agent. Savings on the account can be delivered to Party B when conditions are satisfied, or returned to Party A. One of our clients, the developer of a large real estate project, for instance, applied for a syndicated loan from foreign banks. The lenders required that the borrower establish an escrow account at an accredited bank (in Hong Kong, usually the account of the law firm appointed by the lender). The borrower shall deposit all benefits from related contracts under the programme into the account, and shall not withdraw any money without the lender's written consent except when payment (loan, interest, fees, etc) is complete or when the total amount of the account exceeds the borrower's prospective payment for the next term.

2. Escrow Letter of Credit

An Escrow Letter of Credit (L/C) is a new form of L/C applied in international trade since World War II. It was designed by some countries to improve their international balance sheet. In China, it is translated as "conditional payment L/C," which means pursuant to the Escrow L/C clause stipulated by the importer's bank as L/C issuer, the exporter signs a draft which shall only be negotiated or paid at the importer's bank. Then the foreign currency shall not go to the account of the exporter in his home country, but to a Private Import Escrow Account at the importer's bank. Settlement transaction is allowed only when the exporter imports goods from the importer's country and needs to pay, with small room for adjustment.

3. Escrow contract

The Escrow contract here refers to a common storage contract for computer software's original code. Because the original code is the basis of software programming, if clients control the owner's original code, copying, rewriting and updating is very easy. That's why owners are reluctant to provide the code during software permit negotiations. However, the code is necessary for the client in daily technical support. To solve the dilemma, an Escrow contract is used: The software owner deposits the original code to an Escrow Agent (usually a professional agent) who keeps the code a secret. Only when the owner fails to or becomes unable to provide the service listed in the contract does the Escrow Agent inform the client of the code.

In recent years, Chinese legal scholars have accepted the term of Escrow and applied it into related legislation. A typical case of Escrow can be seen in Clause 3, Article 49 of China's Guarantee Law: "Proceeds from the transfer of the collateral during the period of guarantee shall first be used for early repayment of the secured credit or be deposited to a third party agreed by both the guarantor and the guaranteed."

Because the guarantee automatically ceases when the collateral is transferred, it is justifiable that the creditor requires early repayment of all the secured credit. But early repayment is obviously against the interest of the guarantor, especially when the guarantor is one other than the debtor and reluctant to make the early repayment for the debtor. In this regard, the law permits the guarantor to deposit proceeds from the transfer of the collateral to a third party, instead of making an early repayment, to settle the credit. Only when the credit period expires and the debtor fails to liquidate the debt shall the third party hand over the proceeds to the creditor to settle the debt.

Local lawyers engaged in new practice areas like capital reshuffle and share transfer use Escrow more frequently than before in China. Here is an example. Company A was having difficulty transferring its shares in company C, a project company established by company A and another company. Pursuant to China's real estate law, the shares were not transferable because company C had completed less than 25 per cent of its total amount of investment. To facilitate the transfer, we proposed a plan based on Escrow: Company A and Company B should enter into a share transfer contract concerning Company A's shares in company C. Since the shares were not transferable, both parties should agree to deposit the land licence owned by Company A and the payment to be made by Company B to Company A to the law firm (the Escrow Agent) who acts as a stakeholder. After the signing of the contract, Company B should take over Company A's power in Company C's operation. When transfer conditions are met, the law firm (Escrow Agent) and Company B should co-operate to go through required proceedings to complete the stock transfer. Since this plan protects the interests of both Company A and Company B, and prevents the project from being delayed, it was immediately agreed to and accepted by both parties.

Law firms are playing a more and more active role as Escrow Agents in sales contracts. When the buyer deposits goods payment to a special account (Escrow Account) established by the law firm, the law firm issues a lawyer's letter to the seller, notifying the arrival of the payment. The seller then begins to deliver goods and claim payment from the law firm with valid documents. This new practice is worth recommending, especially in today's business environment that is lacking of credit in performing contracts.

Through the discussion above, we are now clear that the mechanism of Escrow is "deposit" and "(conditional) delivery." In practice, we can design various plans for our clients in light of such a mechanism. Although there are no statutory restraints at present, it shall be noted that related parties shall make it clear in the contract responsibilities of the Escrow Agent, so as to minimize the risks invoked by negligence of the Escrow Agent. This is one of the reasons that some overseas clients request government departments to be the Escrow Agent.


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