Leakage in Locked Box Deals: Clear Definitions and Professional Phrasing

Step 1 — Core definition and comparison (Locked Box leakage vs Completion Accounts adjustments)

What is "leakage" in a Locked Box context?

In Locked Box transactions, "leakage" is contract language that captures value transferred out of the target between the locked box date (a historical balance sheet date) and completion that is not within the ordinary course or otherwise permitted by the agreement. A compact, contract-ready definition might read: "Leakage means any payment, transfer, benefit or value extraction from the Group after the Locked Box Date which reduces the Economic Value of the Group as at the Locked Box Date, except for items expressly identified as Permitted Leakage." This wording ties two elements together: the temporal scope (after the Locked Box Date) and the economic effect (reducing value present at the Locked Box Date). The definition is purpose-built: it allows the buyer to step back to the historical balance and require remediation if value has been siphoned out between that historical date and completion.

Contrast with Completion Accounts adjustments

Completion Accounts operate differently. Under Completion Accounts, the purchase price is adjusted after completion based on actual post-closing balance sheet metrics—typically net debt and working capital as at completion. The buyer and seller negotiate mechanics to reconcile a target level (or a locked number) with the actuals, so items that affect value at completion are adjusted through the accounts process rather than through a leakage claim. In short: Locked Box fixes economic risk at a historic date and uses leakage to prevent and remedy post-date value extraction; Completion Accounts fix economic risk at or after completion and resolve differences by recalculating the price.

Who bears the risk and why clarity matters

Under Locked Box, the seller bears economic risk for any unauthorized leakage that happens after the locked box date — because the buyer effectively pays based on the economic position as of that date. This allocation creates strong incentives for sellers to avoid value extraction and for buyers to define leakage precisely. Under Completion Accounts, the buyer bears the risk of value movements that occur up to completion but will get price adjustments reflecting those movements; as a result, the parties must define which flows count in the accounts. Precise phrasing matters because ambiguous wording creates disputes over whether a specific transfer is permitted, whether it is a reduction of economic value, and whether it is double-counted against other mechanics (e.g., net debt).

Step 2 — Precision in drafting leakage and permitted leakage clauses

Tiered model language

A practical approach is to prepare three patterns of clause drafting so negotiators can choose a starting point: baseline neutral, buyer-favouring, and seller-favouring.

• Baseline neutral: Provide a clear, objective definition that lists categories of impermissible extractions and cross-references a schedule of Permitted Leakage. The clause should require sellers to warrant there has been no leakage and to indemnify the buyer for leakage identified up to the claim period.

• Buyer-favouring: Broaden the definition to include implied value transfers (e.g., non-arm’s-length payments, related-party transfers, gratuitous services) and narrow the Permitted Leakage list to only a short set of strictly necessary items. Require immediate repayment at completion with interest and put high evidentiary and timing burdens on the seller to prove permissibility.

• Seller-favouring: Tighten the leakage definition to explicit, enumerated items only (e.g., dividends declared and paid in accordance with a specific clause), expand Permitted Leakage categories (ordinary course payments, payroll, taxes), and include baskets or de minimis thresholds before leakage claims can be made.

Common drafting pitfalls and how to avoid them

• Overbroad wording: Vague terms like "any diminution of value" may capture ordinary course operations or overlap with net debt/working capital adjustments. Prefer concrete verbs and categories: "payments", "transfers", "distributions", "forgiveness of indebtedness".

• Implied permissions: Avoid language that permits actions unless expressly prohibited; instead, use the converse: actions are prohibited unless expressly listed as Permitted Leakage.

• Double-counting with working capital/net debt: Cross-reference the definitions of net debt, working capital and cash in the leakage clause. Explicitly exclude items that are captured by net debt or working capital adjustments to prevent overlap. For example, state that "amounts included in the definition of Net Debt or Working Capital shall not be treated as Leakage." That prevents duplicate claims.

• Remedies ambiguity: Set out precise remedies—repayment at completion, indemnity, set-off against purchase price, interest rates, time limits for claims. Specify whether the remedy is a contractual indemnity or a price adjustment; these choices have tax and escrow consequences.

Step 3 — Interaction with other price mechanics and remedies

How leakage fits with net debt, working capital, and cash-free/debt-free mechanics

Leakage must be coordinated with the other price mechanics. Cash-free, debt-free mechanics typically define an economic transfer of cash and debt that will be adjusted from the base price. Leakage is separate: it addresses unauthorized value extractions between the locked box date and completion. Drafting should therefore: (i) define Net Debt and Working Capital clearly; (ii) exclude items already reflected in Net Debt or Working Capital from being Leakage; and (iii) specify whether returns of capital or debt repayment are treated as leakage, as part of Net Debt, or as permitted actions.

A common approach: define a granular set of items that constitute Net Debt (cash and equivalents, interest-bearing debt, overdrafts) and then add a clause that states that any cash movements that are captured by Net Debt are not Leakage. Conversely, if the parties wish dividend payments to be Leakage, say so expressly; otherwise, dividend payments may be captured by net debt or fall into a grey area.

Interest on leakage and negotiation language

Buyers often seek interest on leakage to compensate for time value of money and to incentivize prompt remediation. Parties can negotiate:

• Rate: fixed (e.g., 4% over base rate), statutory interest, or a market reference rate.
• Default: whether interest accrues from the moment of leakage, from completion, or from the date of demand.
• Scope: interest on the principal leakage amount only or compounded interest including legal costs.

Sample negotiation rationales: Buyers argue for immediate interest from date of leakage because the buyer was deprived of value from that date; sellers argue for interest from completion only, or for a lower rate, to limit exposure.

Baskets, caps, and timing

Baskets and caps limit small or aggregate claims and are common in seller-favouring positions. negociarors choose:

• De minimis baskets: minimum claim size below which no remediation is payable.
• Aggregate caps: total leakage claims capped at a percentage of the purchase price.
• Single-item thresholds: items below a threshold treated as immaterial.

Time limits are critical: set a clear period in which leakage claims may be brought (e.g., for a period equal to the longest warranty survival or a shorter period targeting specific leakage risks). Also specify the cut-off for interest calculation and the method of calculation.

Dispute resolution: expert determination vs arbitration

For quantification and valuation disputes, expert determination offers speed and finality for purely technical valuations (e.g., was X a leak and how much?). Arbitration is better when legal questions (contract interpretation, broader remedial claims) are at issue. Drafting should specify:

• The scope of referable issues (quantification only, or also interpretation?).
• The qualifications of the expert/arbitrator (accounting vs legal expertise).
• Time limits for referral and decision, and consequences of failure to comply.

Step 4 — Active drafting and critique practice (conceptual guidance)

Although exercises are not included here, the core drafting and critique mindset should guide learners when redlining clauses. Use the following checklists and mental models when you draft or review leakage language:

• Clarity: Is the temporal scope explicit? Are the verbs concrete (paid, transferred, forgiven)? Are cross-references to definitions (Net Debt, Working Capital) precise?

• Coverage: Have you enumerated all common forms of value extraction (dividends, distributions, related-party transfers, debt forgiveness, asset sales, pricing above market)? Does the Permitted Leakage schedule capture ordinary course items?

• Quantification: Do you define how Leakage will be measured (book value, cash value, market value)? Is there a clear remedy (repayment, indemnity, set-off)?

• Remedy and timing: Is there an obligation to repay at completion or within a specified number of days? Is interest specified and when does it run? Are legal costs covered? Is the remedy an indemnity or price adjustment?

• Enforceability: Could the clause be interpreted to allow double recovery or to preclude legitimate claims? Are dispute resolution mechanisms appropriate to the likely issues? Are baskets/caps calibrated to the deal economics?

Finally, when preparing negotiation positions, translate commercial objectives into precise drafting choices: buyers seeking protection prefer broad leakage definitions, narrow Permitted Leakage lists, immediate repayment at completion, a high interest rate, short claim periods, and low caps or no caps; sellers seeking protection prefer narrow leakage definitions, wider Permitted Leakage lists, baskets and caps, interest only from completion or a low rate, and streamlined determination mechanisms.

By internalizing these drafting priorities and using the checklists above, negotiators can produce contract-ready leakage definitions phrasing that allocates risk, minimizes ambiguity, and dovetails cleanly with net debt, working capital and cash-free/debt-free mechanics.