Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

Before you let your team of due diligence advisers loose in the data room, it’s crucial to reach an agreement about each adviser’s role and responsibilities. Accountants, banks, and other M&A advisers recognize their success depends on their ability to deliver reliable, incisive analysis of a target’s business operations and future prospects. On the other hand, advisers also have an interest in limiting their liability for the advice they give to their clients. When negotiating engagement letters for M&A due diligence services, private equity firms and other buyers should pay careful attention to provisions that restrict their right to seek compensation for losses brought on by bad advice. In today’s post, we review several customary ways in which advisers try to decrease their risk exposure in engagements for M&A due diligence.       

Scope of the Engagement

An M&A adviser will often try to limit its liability by narrowly defining its area of expertise. To some extent this makes sense. Understandably, accountants don’t want to be held liable for having given legal advice, even if their financial review may have legal consequences, such as a modification to the deal’s structure. But private equity firms should ensure that the scope of the adviser’s engagement is not so narrowly construed that it effectively eliminates the firm’s recourse against the adviser. In M&A transactions, this issue is usually resolved by limiting the scope of the adviser’s liability to the contents of a final due diligence report. Anchoring the adviser’s liability to a specific, written deliverable eliminates ambiguity about which statements the private equity firm may rely upon. 

In practice, an adviser issues preliminary drafts of its reports to the firm and other advisers at periodic intervals throughout the due diligence process. The private equity firm, after all, wants to know immediately about any previously unknown risks or “deal killers.” An effective due diligence program helps the firm understand a potential target’s strengths and weaknesses and identify issues that need to be addressed in negotiations with the seller. Periodic due diligence updates enable private equity firms to keep abreast of what its advisers have learned about the target in real time. Without receiving some comfort in the engagement letter that they will only be liable for their final deliverables, M&A advisers may not be as willing to provide potential buyers with provisional reports.

Limitations on Liability

Engagement letters contain a number of provisions that specify the circumstances under which advisers may be taken to court and restrict the amount for which they may be sued. In New York, a court will not infer that an adviser’s liability has been limited unless clearly and unambiguously expressed in the engagement letter. Except for certain exclusions held to be against public policy, however, New York courts will uphold liability limitations in contracts between sophisticated commercial parties.       

There are several mechanisms an M&A adviser may use to limit its liability:

Causation Requirement. Advisers often seek to restrict their liability to losses that are “finally judicially determined to have resulted primarily from” a misstatement or omission. The purpose of this clause is to fix the adviser’s liability to losses directly attributable to errors in its final report. Unfortunately, the phrase “resulted primarily” has no settled sense and raises the specter of Jarndyce and Jarndyce in future litigation. A better drafting choice for a potential buyer is to make the adviser liable for all losses “directly arising from or related to” the firm’s reliance on the adviser’s final due diligence report.  

Restriction on Damages. Engagement letters generally exclude liability for any “indirect or consequential damages.” Consequential damages are losses that do not arise directly or immediately from a contractual breach, but indirectly result from the breach. They can include such claims as loss of revenue and may be recovered if a court concludes that the indirect losses were foreseeable. This provision is often heavily negotiated. Private equity firms argue it’s foreseeable that they may suffer indirect damages as a result of misstatements or omissions in an adviser’s report. Advisers in turn contend that the ultimate investment decision lies with the firm and their risk in the engagement should be commensurate with their fees. In the end, these discussions become relatively less important compared with negotiations over the adviser’s liability cap.   

Cap on Liability. One of the most important provisions in an engagement letter deals with the amount for which an adviser may be held liable. Advisers will typically seek to put a ceiling on their exposure by capping their liability at a fixed amount, at the amount of fees they receive under the engagement, or at some multiple of their fees. The amount of an adviser’s liability cap ultimately turns on a number of deal-specific factors, including the deal’s size and complexity, the importance of an adviser’s findings in the negotiation of essential deal terms, such as price, and the adviser’s transaction fee.        

Definition of Misconduct. The adviser will generally include a provision stating that it will only be liable for losses resulting from its “gross negligence or willful misconduct.” In New York, courts have described gross negligence as acts or omissions that exhibit a reckless indifference to the rights of others or “smack of intentional wrongdoing.” Though not precisely defined by the courts, gross negligence can be thought of as unintentional acts so careless that they ignore the rights of others or appear as though they were intentionally designed to do so. Willful misconduct occurs when a person commits an intentional act with knowledge that the act is likely to result in injury or damage or otherwise exhibits a reckless disregard for its consequences. Advisers’ acceptance of liability for gross negligence and willful misconduct comports with New York common law. New York courts have refused to enforce contractual provisions precluding liability for willful misconduct or grossly negligent acts, finding them to be against public policy.   

Related Posts:   Reviewing a Confidentiality Agreement: What a Potential Buyer Wants

                          Growing the Company through Strategic Acquisitions

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Yet another draft confidentiality agreement sitting in your Inbox? Private equity firms, investors, and businesses looking for growth opportunities always seem to be signing a new non-disclosure agreement with another potential business seller. Many times, a seller’s first draft of the agreement will be aggressively one-sided. What sorts of issues does a potential buyer care about in a confidentiality agreement? In today’s post, we’ll highlight some of the terms buyers typically negotiate when marking up a confidentiality agreement received from a potential seller. While some of the discussion focuses on the special situation of private equity firms, much of it applies to any confidentiality agreement related to the purchase or sale of a company. (If you’d prefer to follow the discussion below with a first draft of a non-disclosure agreement in front of you, click here.)

Definition of “Confidential Information.”  The definition of “confidential information” generally comprises all oral and written information furnished to the buyer as well as any derivative products, such as the buyer’s analyses of the seller’s underlying financial statements.   There are, however, several customary exceptions to the definition of confidential information that may be absent from a seller’s first draft. A buyer will generally seek to have the following types of information deemed non-confidential: information that (1) comes into the public domain (other than due to a breach by the buyer), (2) the buyer can demonstrate was already in its possession prior to the seller’s disclosure, (3) is given to the buyer by a third-party that is not itself bound by a duty to keep the seller’s information secret, or (4) is developed by the buyer independently, without any use of the information supplied by the seller.      

Return of Confidential Information.  Most sellers require a potential buyer to return all confidential information if negotiations end without a deal. Buyers in turn often ask that they at least be given the option to destroy the information and usually agree to a seller’s request that the destruction be certified in writing by the buyer. In a time when data rooms are often online and vendor due diligence reports are distributed by email, the physical return of confidential information may be impracticable. 

Permitted Disclosures. If the buyer is going to share confidential information with its financial, accounting, legal, or other advisers, the buyer will identify them in the agreement’s definition of permitted recipients. Of course, distributing confidential information to people not directly under the buyer’s control creates additional risks, but the buyer’s exposure can be diminished by taking some additional precautions.   

Limit Liability for Third-Party Breaches. If the buyer’s advisers have been included among the permitted recipients, then the buyer usually takes measures to limit its liability for any non-permissible disclosures by its advisers. For example, a buyer may insert language stating that the buyer will not be held liable for the disclosure of confidential information by any adviser that signs a non-disclosure agreement directly with the seller. The buyer may try to persuade the seller that the advisers are best positioned to police their respective employees’ use of the confidential information. Moreover, if advisers are contractually bound to the seller to keep the information private, they may have a greater incentive to abide by the agreement’s terms. Alternatively, a buyer may sign “back-to-back” confidentiality agreements with each of its advisers. These back-to-back agreements substantially reflect the terms and conditions of the buyer’s underlying confidentiality agreement with the seller. In the event that the buyer is sued by the seller because of a disclosure by one of the buyer’s advisers, the buyer will have a contractual cause of action against the breaching adviser.

Establishing Breach and Liability for Damages. A confidentiality agreement typically makes the buyer liable for any claims or losses resulting from the buyer’s disclosure of confidential information. It is therefore in the interest of the buyer to limit the types of losses for which it can be held liable. A buyer usually negotiates to eliminate all consequential damages (that is, damages suffered by the seller but only indirectly caused by the buyer’s breach), such as lost profits, from its liability. Another concern of the buyer is how the parties will determine whether a breach causing damage to the seller has occurred.   To protect its right to appeal a lower court’s ruling, a buyer may want to include a stipulation that a breach by the buyer must be “established by a final, non-appealable order issued by a court of competent jurisdiction.” This provision can save the buyer from the unlikely – but infuriating – situation in which it has already been forced to pay damages to the seller, even though an appellate court later rules in its favor.       

Sunset Clause. It may come as a surprise, but many first drafts of confidentiality agreements don’t include a sunset clause specifying when the buyer’s obligations under the agreement end. Given that if the deal doesn’t go through all written and electronic information will be destroyed, a reasonable term ranges from 1 to 3 years.

Non-Solicitation of Employees. When certain key employees are essential to a seller’s business, the confidentiality agreement may include clauses prohibiting the buyer from soliciting or employing the seller’s employees.   Buyers generally tailor their comments on this section to fit their specific needs. If the buyer is a company trying to grow its business by acquiring a competitor, for example, considerable care is taken to ensure the non-solicitation and non-employment provisions don’t unduly interfere with the buyer’s efforts to recruit top talent. If, on the other hand, the buyer is a private equity firm investigating a new business, then the firm generally seeks more limited exceptions. Customarily, the non-employment provision does not apply to any job offer that results from a general advertisement (such as in a newspaper or on the Internet) or occurs after a person has left the seller’s employ (without encouragement from the buyer) and a specified period of time has elapsed.

No Additional Obligations. In order to emphasize the limited nature of the buyer’s and seller’s respective obligations under the confidentiality agreement, a potential buyer often inserts a clause emphasizing that until the buyer and seller have executed a definitive agreement regarding the acquisition, the buyer doesn’t have any obligation to the seller regarding the transaction.

Novation to Acquisition Vehicle. When the potential buyer is a private equity fund, more often than not an advisory entity associated with the fund, rather than the fund itself, signs the confidentiality agreement with the seller. If the deal closes successfully, it’s in the interest of the advisory entity to be released from its obligations under the confidentiality agreement.   For this reason, private equity firms try to include a novation clause under which the advisory arm will be released, and the fund’s acquisition vehicle will assume, all of the buyer’s obligations under the confidentiality agreement upon the transaction’s closing.

Related Post: Negotiating Liability with Your Due Diligence Advisers: M&A Engagement Letters

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Does Merck-Schering’s reverse merger structure avoid triggering the change of control provision in Schering’s distribution agreement with Centocor? Only time will tell. But The Wall Street Journal reports that William Weldon, CEO of Centocor’s parent company Johnson & Johnson, admitted his company was “analyzing the situation” and “was not sitting back and doing nothing.” In our previous post, we summarized the Merck-Schering reverse merger deal structure. Today, we’ll review the Schering-Centocor distribution agreement’s change of control definition and inquire whether imprecise contract drafting may benefit Johnson & Johnson.

Ambiguity of “Change of Control” in the Schering-Centocor Distribution Agreement

The Schering-Centocor distribution agreement appears to offer two competing definitions of what would constitute a change of control. Section 8.2(c) of the agreement provides that either party may terminate the agreement if the other party suffers a “change of control.” The section begins by stating that if Schering or Centocor is “acquired by a third party or otherwise comes under Control of a third party,” then the “party not subject to such change of control” has the right to terminate the distribution agreement. The first two clauses of Section 8.2(c) indicate that Schering would suffer “such a change of control” if: (i) a third party were to acquire it or (ii) a third-party, directly or indirectly, were to own more than 50% of its voting rights, have the right to receive more than 50% of its profits, or otherwise control its management decisions. But at this point Section 8.2(c) continues in an unexpected way: it offers another competing definition of change of control.        

Without any reference to the first two clauses of Section 8.2(c), the remainder of the section purports to define the elements that constitute a “Change of Control.” According to this definition, a change of control under Section 8.2(c) would occur upon (i) a merger or other reorganization in which Schering was not the surviving corporation, (ii) any non-affiliate of Schering’s becoming a beneficial owner of more than 50% of Schering’s outstanding common stock or the combined voting power of Schering’s outstanding securities, (iii) certain extraordinary changes to Schering’s board of directors, or (iv) Schering’s liquidation or dissolution. What are we to make of this second definition?   

A court would most likely determine that the meaning of a “change of control” under the distribution agreement is ambiguous because the two definitions offered are susceptible to different reasonable interpretations and may have two separate meanings.  Unless a court determined that both the first definition and the second definition were coextensive, it would likely rule that the two change of control definitions are irreconcilable. In that case, the court may have to resort to extrinsic evidence of the parties’ intent at the time of contract to resolve the ambiguity. 

Effect of Contractual Ambiguity on Reverse Merger Structure

Given the distribution agreement’s ambiguity, what effect does this have on the ostensible protections afforded by the Merck-Schering deal structure?

First, as Robert Willens at CFO.com points out, although legally Schering will become the parent corporation of Merck, from a financial accounting perspective Schering will be the acquired entity. Generally, in a business combination involving the exchange of equity interests, the acquiring company is usually the one that issues the securities. But the Financial Accounting Standard Board’s SFAS No. 141, which provides accounting guidance for business combinations, notes that in reverse acquisitions, the company issuing equity securities is often the target. SFAS No. 141 states that the acquiring company in a merger will usually be:

• the merging entity whose owners as a group receive the largest portion of the voting rights of the combined entity,
• the merging entity whose owners have the ability to elect, appoint, or remove a majority of the members of the combined entity’s board of directors,
• the company whose former managers dominate management of the combined entity, and
• the entity that pays a premium over the pre-merger fair value of the equity interests of the combined entity. 

Merck, as Willens points out, seems to fit these criteria perfectly. If the dispute over which definition controls comes down to the intent of Schering and Centocor at the time they entered into the agreement, then Johnson & Johnson could argue that the broad “acquired by” language in the first definition was meant to cover transactions like the Merck-Schering merger. Although Merck will be a wholly owned subsidiary of Schering after the merger, Merck will have effectively acquired control over Schering’s operations. 

Second, as we discussed in our previous post, before Merck merges with Schering’s subsidiary, Schering must cause its board of directors to resign and appoint Merck’s directors to Schering’s board. Interestingly, the second change of control definition in the distribution agreement precludes certain extraordinary changes in Schering’s board of directors. While the definition allows changes in Schering’s board of directors that occur as a result of ordinary course shareholder and board actions, such as the periodic nomination and election of directors, it explicitly excludes directors whose initial assumption of office results from (i) an election contest or (ii) “other actual or threatened solicitation proxies or consents by or on behalf of a person other than the [board of directors]” (emphasis added). 

The drafters of this clause probably intended it to prohibit extraordinary changes to Schering’s board of directors resulting from tender offers or other hostile takeover techniques. Nevertheless, we do not know the content of pre-merger negotiations between Merck and Schering. It’s possible that the record would show that Merck’s conduct towards Schering arguably violated this provision by seeking to place its directors on Schering’s board. Remember, Schering has agreed to put Merck’s board of directors in control of the surviving Schering corporation before Merck becomes Schering’s subsidiary in the second and final step of the merger. 

The inevitable negotiations between Schering’s and Johnson & Johnson’s lawyers about the distribution agreement will depend on which side thinks the contract’s ambiguity gives it an upper hand.

Related Posts: Merck-Schering's Reverse Merger: Change of Control Provisions in Material Contracts

           A Duty to be Forthright: Negotiators Beware!

           Pharma Contractual Dispute: Biogen and Elan to See Each Other in Court

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The recent decision of the Delaware Court of Chancery in the case brought by United Rental against the acquisition vehicles formed by Cerberus Capital imposes an affirmative duty to be forthright, or not devious, in the process of contract negotiations. The ruling seems to undo decades, if not centuries, of negotiating wisdom and practice. 

The United Rental court was unable to dispose of the case on summary judgment, as the contract interpretations offered by both sides were plausible. Because no decision as a matter of law could be reached, the court had to delve into the real intention of the parties on the issue whether they intended to provide a specific performance remedy.

To do this, the court heard testimony from 7 witnesses over a 2 day period. United Rental had the burden of proof to show that the parties intended to allow the remedy of specific performance, rather than the $100 million termination payment offered by Cerberus.

After all this testimony, the court remained unable to determine the shared objective intent of the parties. It therefore proceeded to adopt the breathtaking “forthright negotiator” principle:

“in cases where an examination of the extrinsic evidence does not lead to an obvious, objectively reasonable conclusion, the Court may apply the forthright negotiator principle.  Under this principle, the Court considers the evidence of what one party subjectively “believed the obligation to be, coupled with evidence that the other party knew or should have known of such belief.” In other words, the forthright negotiator principle provides that, in cases where the extrinsic evidence does not lead to a single, commonly held understanding of a contract’s meaning, a court may consider the subjective understanding of one party that has been objectively manifested and is known or should be known by the other party.”

Calling the negotiations “deeply flawed”, because both sides “failed to clearly and consistently communicate their client’s positions”, the Court found that United Rental’s attorney “categorically failed to communicate that United Rental believed it preserved a right to specific performance”. The Cerberus attorney, on the other hand, did clearly communicate his understanding that the agreement precluded specific performance. Because the United Rental lawyer did not continue to repeat his view that the agreement provide for specific performance, and relied instead on the fact that the agreement contained inconsistent provisions, he failed to satisfy the “forthright negotiator” principle.

It may come as a shock to corporate attorneys that deviousness has been barred from contract negotiations. Yet that is law of Delaware:  “United Rental knew or should have known what Cerberus’s understanding of the Merger Agreement was, and if it disagreed with that understanding, it had an affirmative duty to clarify its position in the face of an ambiguous contract with glaringly conflicting provisions."

A duty indeed!

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As this website predicted on November 24th, the Delaware Court of Chancery on December 21, 2007 found that the sole and exclusive remedy of United Rental was the $100 million break up fee specifically provided for in the Merger Agreement with entities controlled by Cerberus Capital.

The exchange of drafts and the meetings between the parties indicated that the breakup fee was intended to preclude any other remedies, including specific performance..  United Rental’s case was based on the fact that the contract continued to have language providing for equitable remedies like specific performance, even though other sections said that this remedy was superseded by the breakup fee. In deposition, the Cerberus attorney conceded that it would have been “clearer” to delete the specific performance section altogether.

Given the relatively clear cap on exposure in the Merger Agreement, one would expect that the opinion of the Delaware court would stick closely to the express contract language and the law of summary judgment. In fact, most of the opinion does that. But the court ultimately relied on an interesting though obscure principle of contract interpretation called the “forthright negotiator principle.”

According to the court, under the forthright negotiator principle, “the subjective understanding of one party to a contract may bind the other party when the other party knows or has reason to know of that understanding. Because the evidence in this case shows that defendants [Cerberus] understood this Agreement to preclude the remedy of specific performance and that plaintiff [United Rental] knew or should have known of this understanding, I conclude that plaintiff has failed to meet its burden and find in favor of defendants.”

“The forthright negotiator principle provides that, in cases where the extrinsic evidence does not lead to a single, commonly held understanding of a contract’s meaning, a court may consider the subjective understanding of one party that has been objectively manifested and is known or should be known by the other party.”

The only support for this principle cited by the court was a section of the Restatement of Contracts. 

The very interesting history of these contract negotiations indicates that the parties never explicitly resolved the issue of whether the $100 million breakup fee was the sole and exclusive remedy. The court found that because the parties never clearly drafted any agreement on the termination fee, it would award judgment to the side that most clearly and consistently articulated its subjective understanding of the agreement to the other side. In this, the court found that the Cerberus attorney was more consistent in his statements that the termination fee was intended to preclude specific performance. The attorney for United Rental, the court found, implicitly agreed with the Cerberus position during oral contract negotiations.

The case came down to this fact: “Though URI, through [its lead attorney], had many opportunities throughout the negotiation process to clearly vocalize its understanding of its rights for specific performance under the Merger Agreement, URI consistently failed to communicate this to Cerberus representatives.”

The very interesting implications of this decision for the manner in which merger negotiations are conducted will be the subject of future postings here.

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Does Cerberus have the unilateral right to walk away from its deal with United Rental and limit its exposure to a break up fee of $100 million?  Or does United Rentals have the right to specifically enforce the merger agreement?  That's the issue at the heart of lawsuits currently pending in Delaware and New York arising out of this failed acquisition. 

Cerberus had this to say about United Rental's Delaware action for specific performance in a press release issued November 19th:

"We believe that United Rentals has been less than forthright in its legal filings and its communications concerning those filings.  The fact is that RAM negotiated for and obtained the right to withdraw from the Merger Agreement of July 22, 2007 and instead make a one-time payment in the aggregate amount of US $100 million.  This ability to walk away from the transaction with this limited exposure was specifically bargained for, is clearly and unambiguously stated in the Merger Agreement and related documentation, and is not in any way conditional on the occurrence of a material adverse change, the termination of the Merger Agreement by United Rentals or any other event."

Also, according to Bloomberg, Cerberus started its own lawsuit in New York Supreme Court seeking a declaration that its maximum exposure to United Rentals is $100 million. In the suit, Cerberus says United Rentals has no remedy other than the right to pursue the $100 million brake up fee, which serves as a cap for any or all losses or damages relating to or arising out of the merger agreement.

Let's see where that clear and unambiguous statement appears in the merger agreement.  Section 8.2(c) of the agreement says:

"In the event that this Agreement is terminated by [United Rentals] pursuant to Section 8.1(d)(i) or Section 8.1(d)(ii), then [Cerberus] shall pay $100,000,000 to [United Rentals] as promptly as reasonably practicable (and, in any event, within two business days following such termination), payable by wire transfer of same day funds."

OK then.  Section 8.1(d)(i) says that United Rental can terminate the agreement upon certain breaches by Cerberus of the merger agreement, and Section 8.1(d)(ii) says that United Rental can terminate the agreement if the merger isn't completed by a certain date.  Neither of these things has happened, and United Rentals isn't seeking the fee. 

Later on, in Section 8.2(e), there is a clause limiting liability for termination events to $100 million.  It says that United Rental's right to terminate the merger agreement under Sections 8.1(d)(i) or (ii) and receive the $100 million fee under Section 8.2(c) is the "sole and exclusive remedy" of United Rentals against Cerberus for "any and all loss or damage suffered as a result thereof" and Cerberus shall not have "any further liability or obligation of any kind or nature relating to or arising out of this Agreement or the transactions contemplated by this Agreement as a result of such termination."  This fee is "the sole and exclusive remedy for recovery" in the event of "the termination of this Agreement by [United Rentals] in compliance with the provisions of Section 8.1(d)(i) or (ii)."  

So far, it looks as though United Rentals has the winning position, as this language pretty clearly says that the $100 million payment is the sole remedy only in the situation where United Rentals has terminated the merger agreement due to a misrepresentation or failed deadline.  Up until now, there isn't any absolute cap on liability if Cerberus breaches the agreement and walks away.

But keep reading.  At the very end of Section 8.2(e), comes the provision that finally supports Cerberus:

"In no event, whether or not this Agreement has been terminated pursuant to any provision hereof, shall [Cerberus], either individually or in the aggregate, be subject to any liability in excess of [$100 million] for any or all losses or damages relating to or arising out of this Agreement or the transactions contemplated by this Agreement, including breaches by [Cerberus] of any representations, warranties, covenants or agreements contained in this Agreement, and in no event shall [United Rentals] seek equitable relief or seek to recover any money damages in excess of such amount from [Cerberus].

That's pretty clear.  Although there is plenty of language in the agreement that appears to support United Rentals' position, this one sentence appearing at the end of Section 8.2(e) seems to cap Cerberus' exposure at $100 million.   The stock market seems to agree as well.

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Knowing how to get out of a deal is often as important as knowing how to get in.  When a company blows up, it's easy to find a representation that went awry.  But when things turn sour because of legislation or macro economic issues, you've got to look at the MAC clause.

The MAC, or material adverse change, clause sets the conditions under which a deal may be terminated without penalty. MAC exceptions, which are often appended to such clauses, outline specific circumstances under which the MAC doesn't apply, meaning the deal must proceed even if there is a material change.

During the deal frenzy of the past several years, sellers have had the upper hand in negotiating deal terms, a trend that has extended to the MAC clause. To win deals, buyers have agreed to loose MAC clauses with lots of exceptions, or in some cases have foregone MACs altogether.

The litigation currently pending in Delaware between SLM (Sallie Mae) and J.C. Flowers & Co. will, if it goes that far, shape the understanding of MAC clauses for the next few years.  J.C. Flowers and its partners have sought to walk away from the deal, in part on the basis that new Federal legislation will decrease the earning of the company.  SLM has of course insisted that the deal must go through, and issued a press release saying that "core earnings" at the company will be negatively impacted by only 1.8 to 2.1 percent annually over the next 5 years.  The issue is whether the MAC clause is triggered by the adverse impact of the new Federal legislation.  The clause reads as follows:

"Material Adverse Effect" means a material adverse effect on the financial condition, business, or results of operations of the Company and its Subsidiaries, taken as a whole, except to the extent any such effect results from: ... (b) changes in Applicable Law provided that, for purposes of this definition, "changes in Applicable Law" shall not include any changes in Applicable Law relating specifically to the education finance industry that are in the aggregate more adverse to the Company and its Subsidiaries, taken as a whole, than the legislative and budget proposals described under the heading "Recent Developments" in the Company 10-K, in each case in the form proposed publicly as of the date of the Company 10-K) or interpretations thereof by any Governmental Authority..."

As the highlighted language shows, SLM and JC Flowers were acutely aware of the potential impact of the new Federal legislation on the earnings of Sallie Mae.  This was not a thunderbolt from out of the blue.

SLM's position is that the "core earnings" of the company will only be reduced by 1.8 to 2.1 percent  MORE than what was already presented in the 10-K.  This sets the bar well under the 10% figure which most lawyers and judges would agree is "material".  As the M&A Law Prof Blog points out, the Delaware courts set a high bar for proving a MAC.  Under these cases the party asserting a MAC has the burden of proving that the adverse change will have long-term effects and must be materially significant.

Of course the issue may be settled before any trial.  Justine Strine has been pressing the sides to settle.  A renegotiated price is the likely outcome, as SLM will not likely want to remain in the public eye after this battle.

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What do you call a guy who gives you a non-binding letter of intent to buy your company for $15.5 million, waits a few months before giving you another non-binding letter, and then sues you when you sign a binding contract to sell your company for $30.5 million?  In Nebraska, he’s called Kelly Conolly.

Conolly worked as a terminal manager for Clark Brothers Transfer, a trucking company based in Nebraska.  James Clark was the company's president and majority shareholder.  In early 2003, Conolly began talking with Clark about buying the company.  After months of negotiating, they executed a confidentiality agreement on October 17, 2003, which gave Conolly financial information about the company.  Clark asked Conolly to give him a written purchase offer in 2 weeks.  Conolly sent another non-binding letter of intent without a purchase offer.  The letter also left the purchase price open.

Clark and Conolly met the next day, orally agreed on a purchase price of $15.5 million, shook hands and left all the other terms open. Clark asked for a firm purchase offer within two weeks.  Six weeks later, Conolly's attorney sent a letter saying Conolly was interested in purchasing the company "pursuant to the terms contained in this non-binding letter of intent."  The letter named a price but reiterated that it was not a binding commitment by either party.  Conolly sent Clark an email stating, "of course this is just preliminary and a formal proposal will be forthcoming once we reach an agreement."  Six weeks later, Clark sold the company to another buyer for $30.5 million.

Conolly argued that the parties had a contract when they agreed on the price and shook hands.  The United States Court of Appeals for the Eighth Circuit held that that the terms of the oral agreement were not “sufficiently definite to demonstrate an objective intent to be bound” at the time the parties shook hands.  The parties were still negotiating many basic terms. 

Wikipedia says that chutzpa is the quality of audacity, for good or for bad.  That may be the right word.

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Contract parties very often want to pre-select the court in which any lawsuit arising under the contract must be brought. Issues of convenience and perceived fairness typically underlie the desire for these clauses. To be enforceable, forum selection clauses must be clear and unambiguous. 

A recent case from the Delaware Court of Chancery illustrates what happens when a forum selection clause is badly drafted. 

A manufacturer of microbial degradation and mold control products sued the investment banker it hired to assist with acquisitions. The manufacturer believed that the investment banker misused confidential information in the course of their relationship. The engagement letter tried to select the Southern District of New York as the sole forum in which litigation could be brought. The manufacturer sued in Delaware and the investment banker moved to dismiss the action.

Here is the defective forum selection clause:

“Any lawsuits with respect to, in connection with or arising out of this agreement shall be brought in a court for the Southern District of New York and the parties hereto consent to the jurisdiction and venue of such court for the Southern District as the sole and exclusive forum, unless such court is unavailable, for the resolution of claims by the parties arising under or relating to this agreement.” (emphasis added).

Because both the manufacturer and the investment banker were Delaware corporations, and no federal question existed, there was no basis for subject matter jurisdiction in the Southern District. That court was “unavailable”.

The investment banker argued that the parties “intended” to select any court located within the territory of the Southern District, not just the federal court called the Southern District of New York. But that’s not what the contract provision actually said, so the Delaware Court of Chancery ruled against the banker. For a forum selection clause to work, the parties must use “express language clearly indicating that the forum selection clause excludes all other courts before which those parties could otherwise properly bring an action.”  If the contractual language is not crystal clear, “a court will not interpret a forum selection clause to indicate the parties intended to make jurisdiction exclusive.”

The lesson? Use a proper forum selection clause, like this one:

Each party agrees to personal jurisdiction in any action brought in any court, Federal or State, within the County of New York, State of New York having subject matter jurisdiction over the matters arising under this Agreement. Any suit, action or proceeding arising out of or relating to this Agreement shall only be instituted in the County of New York, State of New York. Each party waives any objection which it may have now or hereafter to the laying of the venue of such action or proceeding and irrevocably submits to the jurisdiction of any such court in any such suit, action or proceeding.

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All companies look to forge strong relationships with their distributors. These affiliations are particularly important in industries where distributors add value through education, showrooms, installation or other service elements.

The first question in any distributor affiliation is how much control the supplier should exercise over the relationship. This question often turns on whether the manufacturer produces a commodity product or a proprietary one and the relative size of the parties. Distributors usually will not accept efforts to control the distribution of a product that can be obtained from a number of sources. However, a manufacturer that produces a proprietary product that is in demand has the ability, if it wishes, to exercise important controls over its distribution network.

Some manufacturers build a distribution control system into their marketing plan by setting up franchise systems or exclusive distributorships from the start. Whatever the name, these systems share a common goal from the point of view of the manufacturer: to shape the way its products are distributed in the marketplace.

The past 20 years have seen a marked increase in the control exercised by manufacturers over their products. Antitrust law and policy have adopted the view that consumers benefit when a manufacturer exercises control over its network of distributors in certain ways. Of course, it remains illegal to control pricing policies. That said, there are a wide variety of measures that manufacturers can adopt to shape the way their products get to market.

Perhaps the simplest measure is to grant a customer the exclusive right to sell products in a territory. This is often necessary to entice a well-capitalized distributor to take on a new product line. Other permitted controls include customer restrictions, advertising and trademark policies, stocking requirements for inventory or samples, and full line or exclusive requirements.

Distribution Agreements

Distribution agreements are a popular way to cement the relationship between a manufacturer and its distributors. Contracts are often drafted by the manufacturer and presented to the distributor as a finished deal. However, it is generally possible to negotiate these agreements, especially where the manufacturer is launching a new product or is trying to capture a new market.

Checklist of Material Terms in Distribution Agreements

The following is a checklist of the material items that should be addressed in a distribution agreement:

• What trademarks or trade names may the products be sold under? May the distributor use the trademark as part of its business name? What sort of approvals must be obtained in connection with the use of the trademark?

• Territory: exclusive, a designated primary area of responsibility or wide open? What happens if sales are made outside the prescribed territory? 

• May the manufacturer make direct sales in the territory?

• Are any accounts reserved to the manufacturer, such as national accounts?

• Must the business be conducted from a specific location? Can new locations be added in the future?

• What happens if other distributors sell within the protected territory?

• Can the distributor handle the products of competitors?

• Is the distributor required to carry the full line of products?

• What is the term of the agreement? How is the term renewed?

• Are there minimum purchase requirements?

• Must the distributor maintain a minimum quantity of inventory?

• May the distributor sell to other distributors or only to end-users?

• How are prices determined?

• What protections, if any, are there for price increases?

• Is the distributor required to participate in promotional allowances or other rebate programs instituted by the manufacturer?

• Must the distributor disclose its financial information to the manufacturer? Are there any minimum financial criteria to maintain the distribution?

• Under what circumstances may the distributor be terminated? May either party terminate the agreement without cause? What happens to unsold inventory following termination?

• What training or ongoing technical support is the manufacturer required to provide?

• Is the distributor authorized or required to provide warranty service? What parts will be stocked? How is payment for warranty service to be structured?

• Under what circumstances can the distributor return merchandise to the manufacturer?

• What are the terms of delivery? What are the distributor’s rights to inspect and test?

• Does the manufacturer promise continuous availability of products, spare parts and/or service?

• Will the manufacturer hold the distributor harmless from and actions for patent, trademark or copyright infringement?

• What insurance are the parties required to maintain?

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The indemnification provisions of a purchase agreement function like an insurance policy. Each party (buyer and seller) stands behind its warranties and agrees to make the other party whole if there is a loss that is attributable to or covered by the misstatement or broken promise. 

In some cases, the indemnification may take the form of protection against the claim of a third party. For example, if the seller warrants that the business may be conducted without infringing the intellectual property of any third party, and that proves not to be true, then the seller must hold the buyer harmless against the claim made by the third party. In other cases, the indemnified matter may be a direct loss suffered because the quality of the assets transferred is not as represented. For example, if the seller’s receivables are warranted to be collectible in full, and there is a shortfall in collection, the buyer can recover the shortfall from the seller.

Like an insurance policy, the first question is how long the coverage lasts. The indemnification sections will say how long the representations and promises will remain in effect. This is generally a year or two after the closing, although certain representations, such as those covering taxes, employee benefits and environmental laws, will last longer as the laws they cover carry exposures that may last many years.

Next, like an insurance policy, the indemnification clause will usually have a threshold or deductible for making any claims at all, on the theory that small or minor claims do not warrant invoking the indemnification process. The size of the deductible will generally vary according to what is considered material in the transaction. A small deal may have a deductible of $10,000 while large deals can have deductibles of $100,000 and more. This issue is usually negotiated in the term sheet. Finally, an indemnification clause may have a cap on the total value of claims that can be made for indemnification, usually expressed as a percentage of the purchase price.

In an asset purchase transaction, the indemnification protection that a buyer gets will cover three events: a misrepresentation or breach of a warranty made by seller; a breach of any covenant or agreement made by the seller; and any liability that seller agreed to retain. For the seller, the indemnification covers the first two items and any liability that buyer agreed to assume but was nonetheless imposed on seller. Indemnification extends to any costs or expenses (including reasonable attorneys fees) that the protected party incurs as a result of the claim or loss, such as the costs of defending against a third party claim and the cost of asserting a claim against the other party to the deal. In fact, the only legal liability added by the indemnification clause is this obligation to pick up costs and expenses, since in the absence of the clause, the aggrieved party would still have a claim for breach of contract in case the other party breaches a warranty or covenant.

The procedures for exercising indemnification claims involve giving the other party notice of the claim and the opportunity to take over the defense of the claim, in the case of a third party liability. The party providing the indemnification generally has the right to settle the matter and both parties must assist in the defense of third party claims.

Related Posts:  What is Indemnification? Part 1 and Part 2

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The buyer of a company will often make specific promises regarding hiring and retaining employees of the business. If so, the purchase agreement will identify the buyer’s obligations in this regard and identify the benefit plans, severance obligations, and accrued bonus and vacation rights of the transferred employees. For example, the buyer may agree to grant service credit to employees for purposes of vesting in benefits, even though these credits may not be required by law.

The purchase agreement will specify the circumstances under which the agreement can be terminated.  Both parties will be able to terminate if the other party breaches the agreement and fails to cure the breach after being given the opportunity to do so. Also, the contract can be terminated if the closing does not occur by a defined date. This may occur, for example, if a third party or governmental approval is needed but can’t be obtained, or if financing can’t be obtained within a defined time period. This outside termination date is usually negotiated in the term sheet.

As the parties generally conduct the transaction across the borders of several states, the laws of one state will be chosen to govern the contract. Also, the courts of a specified jurisdiction will be chosen to hear disputes arising under the contract. In lieu of court adjudications, the parties may elect to implement an alternative form of dispute resolution, such as mediation and arbitration.

The purchase agreement will often have a number of things attached to it, such as schedules of information, forms of notes, or equity instruments delivered as part of the purchase price and allocations of the purchase price. These items are specifically incorporated in the purchase agreement and often constitute part of the items delivered by the parties at the closing.

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Although office and manufacturing leases are generally recorded on the books as a liability, they are in fact critical business assets. Substantial investments are made in preparing an office or manufacturing center for occupancy. Also, a company generates good will associated with its location.

When leasing office or manufacturing space, an initial matter to consider is the difference between rentable and usable square footage. Prices are usually quoted on an annual square foot basis, so it is important to know whether the quote is based on actual useable space. Tenants should verify the square footage number provided by the landlord before signing the lease.

It’s also important to make sure that the uses planned for the space are permitted under the lease. The permitted uses should be broad enough to allow possible changes in the business, or to allow for a possible assignment or subletting of the space to a third party. The best use description is “any lawful use.” If the owner’s consent must be obtained to a change in use, it should be given readily unless there is a reasonable objection.

The commencement date of the lease is often different than the signing date to allow for necessary improvements in the space. What happens if the space is not ready on the commencement date? At a minimum, rent should be abated, and if the problem continues for a period of time, the lease should be cancelable at the option of the tenant. The termination date must also be spelled out clearly.

The base rent for the primary term is usually clear enough. What about escalations during the term of the lease, such as annual increases? Are there other escalations, such as cost of living increases? Leases often add a supplemental charge for the expenses of maintaining common areas, heating and air conditioning and operating costs. Care must be taken to make sure that any expenses are directly related to the occupancy of the space (excluding the owner’s overhead expenses). The owner should be required to account for the expenses and justify any requested increases. There should also be provisions for audits of expenses. It is prudent to negotiate clear provisions on any escalations or increases and even to cap any such increases.

The owner generally demands a security deposit for the lease. Sometimes a letter of credit can be substituted for a cash deposit. If cash is required, the interest should accrue to the tenant.

Tenant is generally responsible for the cost of the utilities that it uses when occupying the space. There should be separate utility meters so that the tenant doesn’t end up paying for other occupants or common area utility charges.

It is usually necessary to make certain improvements to the space before the tenant can move in. What will be the cost of these improvements and who will pay them? The owner will sometimes provide a work letter for improvements as an inducement to secure a long-term lease. If so, the owner sometimes wants to specify the company that will provide the contractor services. If that’s the case, it is important to prepare a detailed construction letter setting out all the requirements of the renovation, as with any contractor. Whoever is the contractor should be responsible for obtaining any necessary permits and approvals. At the end of the lease term, the owner will generally own the improvements, but if there are any special fixtures that the tenant wishes to take away, these should be specified in the lease.

If something goes wrong with a structural element of the space or one of the mechanical systems, whose responsibility is it to fix the problem and who pays? It is important to detail these responsibilities, and to factor them into the cost of the lease if the tenant is forced to assume responsibility for them. Leases generally contain a requirement that the space be returned at the end of the lease in the same condition as at the beginning, subject to ordinary wear and tear. Is this consistent with the use that tenant intends to make of the space? The tenant should consider the costs of returning the facility to its original condition if major modifications were made during the course of the lease.

The tenant should have the right to sublet or assign the lease, as long as the new tenant is reasonably acceptable to the owner. The lease will generally spell out the standards of what is an acceptable subtenant or assignee. The tenant should be allowed to assign to an affiliate without the consent of the owner, as long as it remains primarily liable under the lease. The assignment clause should be read carefully to determine if there is a deemed assignment in the event of a change in control of the tenant. If the assignment or sublet is at a higher rental, the owner will often try to keep all or most of the increase.

The owner should warrant certain basic conditions, such as quiet enjoyment, ownership and class of building, if appropriate. If the building is destroyed or rendered unfit for occupation, the tenant should of course have the right to cancel the lease.

Tenants should generally negotiate for options to renew the lease at the end of the basic term. The tenant may also want to secure rights of first refusal on contiguous space in case the space becomes available and the company is outgrowing its initial quarters. Attention should be paid to the rules and regulations of the building as well as things like weekend and evening access, security and exterior lighting, signage and parking spaces.

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No one cares about the law of sales and collections until something goes wrong.   When disputes arise, the parties dust off the “boilerplate” provisions printed on the back of their purchase orders and invoices. Often these provisions are in conflict with one another or do not cover the issue that actually exists. In these circumstances, where the contract involves the sale of goods, the parties must look to the provisions of the Uniform Commercial Code for answers. This Code, adopted in every State, provides a uniform body of rules for sales of goods. For sales of services, the common law of contracts applies. 

The success of the Uniform Commercial Code in regulating the sale of goods has crossed over into general contract law, and many provisions of the Code have influenced the development of general contract law.

Article 2 of the Uniform Commercial Code: Contract Terms and Conditions

Article 2 of the Uniform Commercial Code covers how and when contracts for the sale of goods are formed; warranty obligations; how contracts must be performed; what happens when a party breaches a contract; and what remedies are available when a breach occurs.

Forming Contracts

Any sale of goods for a price of $500 or more must be reflected in written form. The writing must be sufficient to indicate that a contract for sale has been made by the parties and must be signed by the party against whom enforcement is sought. However, this requirement is waived in sales between merchants if one party sends a written confirmation of the contract and the other party fails to object within 10 days of receipt.

Apart from this requirement of a “writing,” the rules of contract formation are very liberal. A contract may be made in any manner sufficient to show agreement, including conduct by both parties that recognizes the existence of such a contract.

A written offer by a merchant to buy or sell goods which gives assurance that it will be held open cannot be revoked during the time stated in the offer. If no time is stated, then the offer must remain open for a reasonable period of time, but not in excess of three months.

If the customer’s purchase order contains one set of terms and conditions, and the acceptance or invoice contains another set, the additional terms of the invoice become part of the contract unless the offer limits acceptance to the terms of the offer or they materially alter it. In addition, conduct by the parties that recognizes the existence of a contract will be sufficient to establish a contract, even though the writings do not establish one. Accordingly, written exchanges and conduct must be tightly controlled to avoid inadvertent contracts.

A party may delegate performance of a contract to someone else, unless the other party has a substantial interest in having the original party perform the contract. Either party may assign its rights under a contract except where the assignment would materially impact the other party’s duties, burdens or risks.

Warranties

Unless the parties otherwise provide, the following warranties are assumed to be made by the seller as to the goods:

1. Seller has title to the goods and the right to transfer them.

2. The goods are delivered free from any security interest or other lien (other than those the buyer actually knows of).

3. The goods are “merchantable” (generally, the goods are fit for the ordinary purposes for which they are used).

4. When seller has reason to know any particular purpose for which goods are required and buyer is relying on seller’s skill or judgment to select goods, there is an implied warranty that the goods are fit for such purpose.

5. A statement of fact relating to goods creates an express warranty that the goods conform to the statement.

6. A description of the goods creates an express warranty that the goods conform to the description.

7. A sample creates an express warranty that the whole of the goods conform to the sample.

Special care must be taken to exclude or modify these warranties if they cannot be supported. Generally, the contract should contain express language that excludes warranties, or states that goods are sold “as is” or “with all faults.”         

Performance

The UCC spells out how contracts are to be performed in cases where the parties have omitted the details. For example, if a buyer has paid all or part of the price of goods and the seller becomes insolvent, the buyer may recover the goods from the seller if the seller’s insolvency occurred within 10 days after receipt of the first installment of the price. Also, the buyer has the right to inspect goods at a reasonable place and time and in any reasonable manner before payment is due.

Breach of Contract

When there are defects in the goods, or a defect in their method of delivery, the buyer has the option to reject or accept all the goods or accept any portion that is acceptable and reject the rest. A notice of rejection must be delivered “seasonably,” the buyer cannot delay unreasonably.   In addition, if the buyer rejects the goods while they are in his possession, he must follow the reasonable instructions of the seller with respect to the rejected goods. If no instructions are received, the buyer may store the goods for seller’s account, reship to seller or resell for seller’s account.

On the other hand, once the buyer has accepted the goods, he must pay at the contract price for any goods accepted. Acceptance occurs when the buyer after a reasonable opportunity to inspect the goods signifies to the seller that the goods are conforming, or fails or make an effective rejection (after having an opportunity to inspect). Although accepted goods may not be reshipped to the seller, buyer retains any claim based on non-conformity of the goods to warranties.

When reasonable grounds exist that make one party feel that performance by the other may be impaired, that party may demand assurances of due performance from the other party. Until he receives such assurances, he may suspend his performance. If the cost of performing the contract suddenly increases dramatically due to an event that undermines a basic assumption of the contract, the seller may delay its delivery or even fail to deliver the goods.

Remedies

When a seller discovers that buyer is insolvent, he may refuse to deliver goods except for cash, including payment for all goods previously delivered. When a buyer receives goods on credit while insolvent, the seller may reclaim the goods on demand made within ten days after the receipt.

When a buyer breaches the contract, typically by not accepting goods or failing to pay for goods already received, the seller may recover damages for non-acceptance or cancel. Damages in the case of non-acceptance of goods is the difference between the market price at the time and place of delivery and the unpaid contract price, less expenses saved as a consequence of buyer’s breach. However, if this measure of damages is inadequate to put seller in as good a position as performance would have done, then the measure of damages is the profit (including reasonable overhead) which seller would have made from full performance. Damages, in the case of non-payment, are the price of goods accepted, plus incidental damages. Alternately, when the buyer has failed to accept goods seller may resell the goods in a commercially reasonable manner and recover the difference between the resale price and the contract price, plus incidental damages. The seller does not have to account to buyer for any profit made on the resale.

When a seller breaches the contract by failing to make delivery or when the buyer rightfully rejects goods, then buyer may cancel and recover so much of the price as has been paid. In addition, the buyer may purchase goods in substitution of those due from seller and recover from seller the difference between the cost of the substituted goods and the contract price, together with incidental and consequential damages, but less expenses saved. Alternately, the buyer may recover damages for non-delivery equal to the difference between the market price at the time the buyer learned of the breach and the contract price, less expenses saved.

The measure of damages for breach of warranty is the difference between the value of the goods accepted and the value they would have had if they had been as warranted. The parties may specify liquidated damages in the agreement, but the measure must be reasonable in light of the harm caused by the breach. Unreasonably large liquidated damages are void as a penalty. Any action for breach of any contract for sale of goods must be commenced within four years after the breach occurs. The parties may shorten the period to one year (but not less).

Article 9 of the Uniform Commercial Code: Security Devices

Article 9 of the Uniform Commercial Code contains a powerful tool to aid in the collection of accounts, although many companies do not take advantage of it. It gives sellers of goods the right to retain a security interest in the goods (or other assets of the buyer) until payment. Without a security interest, the seller must take a back seat to creditors (typically banks) that do take advantage of this law.

Security Interests

A seller of goods can retain a security interest in the goods if the following procedures are adopted:

1. The buyer signs an agreement granting a security interest in the goods.

2. A financing statement is filed in the office of the Secretary of State of the state in which the buyer is located or incorporated.

The advantage of a security interest is that the secured party has a priority to the goods in the event the buyer becomes insolvent. Proceeds from any sale of the secured goods must be paid first to the seller in satisfaction of its account. A security interest in goods disappears once the goods are resold to another buyer in the ordinary course of business.

If buyer defaults in payment, a seller with a security interest in goods may take possession of the goods either by judicial process or without judicial process if it proceeds without breach of the peace. A secured party may also require the debtor to assemble the collateral and make it available to the secured party. The secured party may dispose of the collateral by public or private sale in a commercially reasonable manner. Any proceeds of such a sale must be applied first to the expenses of sale and then to the satisfaction of the debtor’s obligations. The secured party may also accept the collateral in full or partial satisfaction of the obligation under certain circumstances.

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