The Contract Adviser

Hello Entrepreneurs! 

In a contract negotiation, there's a fine line between aggressively negotiating contract provisions that serve your interests, and stepping over legal limits.  This is especially true when negotiating certain types of provisions that courts have historically very closely scrutinized - for example, contract provisions dealing with non-competition, choice of law and exclusivity.

One way contract parties have tried to work around this issue is to include a severability provision (sometimes called a seperability provision) in their business contracts, which allows a court to "sever" offending (that is, unenforcable) provisions in order to salvage the rest of the contract.  Depending on the jurisdiction and the situation, not to mention the kind of severability provision in the contract, a court may employ several approaches to "right" the situation.  Some courts sever (that is, drop) the entire offending provision and enforce the rest of the contract.  Some courts try to salvage the provision by removing/replacing the offending words or phrases without changing the provision's sentence structure (blue pencil approach).   Other courts save the provision by making relatively extensive changes to right the offending provision (rule of reasonableness approach).

In the next few columns, we’ll dig a little deeper into how severability provisions work.

For more information about me, or to contact me directly, please leave a post or visit ContractAdviser.com

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Hello Entrepreneurs! 

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Hello Entrepreneurs! 

Yesterday, we asked what might happen if the parties to a contract agree to a liquidated damages provision.  The label doesn't matter.  It could be a termination fee, a deal kill fee, a commitment fee, a fee to be charged for each day of performance delay or default, basically any pre-agreed monetary amount to be paid that gives a contract party the right to walk away or "breach" the contract without further liability.  In this case, let's keep it simple and say that the liquidated damages provision calls for a flat fee to be paid by Party A to Party B each time Party A breaches a particular provision.

In this hypothetical, the parties are working off a contract form from another transaction, and they neglect to carefully review the boilerplate section, which contains various and sundry "miscellaneous" provisions, including the following cumulative remedies provision.

 “All rights and remedies provided in this Agreement are cumulative and not exclusive of any other rights or remedies that may be available to the parties, whether provided by law, equity, statute, in any other agreement between the parties or otherwise.”
 

Somewhere down the line, Party A breaches the contract and forks over the liquidated damages fee to Party B.  Party A returns to business as usual, thinking that this episode is done.  One week later, it receives a letter from Party B demanding additional monetary damages, plus lost profits caused by Party A's breach.  Perplexed and angry, Party A calls Party B to find out why it sent the letter when the parties clearly agreed to the "exclusive remedy" of liquidated damages.  And what's the deal with the lost profits?  Party B responds that it's entitled to the additional damages because of the cumulative remedies provision.  As far as the lost profits, explains Party B, these are consequential damages, which the parties did not specifically exclude in the contract.  The parties proceed to litigation.  No lawyer can predict with certainty how a court would rule in a case like this.  That depends on the detailed facts of the case, plus the governing law of the contract, plus where the litigation takes place, etc.

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The remedies provisions are often glossed over during business contract negotiations.  But these are the first places a court will look to for guidance in a contract dispute, so it can better understand the intent of the parties.  Therefore, it's important to carefully review your contract's remedies provisions, and seek professional help to help you negotiate them.
 
Most courts today recognize that remedies are cumulative (in the absence of contrary contract language).  “Cumulative” means that the non-breaching party is permitted to initially simultaneously pursue all available remedies (contract remedies, monetary damages, equitable relief, you name it) against the breaching party, even if the alternative theories of recovery are inconsistent.  This is the legal equivalent of throwing everything against the wall and seeing what sticks.  No worries though, in contract litigation, the court generally isn’t going to allow the non-breaching party to be made “more than whole”, so sometime during the proceedings it will pick or require the claimant to pick its remedy.
 
Despite widespread court recognition of the cumulative remedies concept, many business contracts take a belt and suspenders approach to remedies and include a cumulative remedies provision for good measure.  Here is an example…
 
“All rights and remedies provided in this Agreement are cumulative and not exclusive of any other rights or remedies that may be available to the parties, whether provided by law, equity, statute, in any other agreement between the parties or otherwise.”
 
This works as long as the parties actually intend for the remedies to be cumulative, which usually isn't the case if the parties include an exclusive remedy provision somewhere else in the contract.  An exclusive remedy is intended by the parties to be the only remedy to compensate an aggrieved party for a particular type of breach.  Liquidated damages are an example of an exclusive remedy - something to the effect of "if you breach this provision, pay me X dollars, and we'll call it even."  It's common sense that somebody who agrees to sumbit to pay liquidated damages doesn't want to find out later that it's also liable for other types of damages or relief.  But this is exactly what may happen if you spend a lot of time negotiating an exclusive remedy, but then neglect the cumulative remedies provision still hanging around in the boilerplate section of the hand-me-down form contract you're using.  In the next few columns, I’ll discuss the consequences of doing so, and some possible work-arounds.  

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In my previous column, I gave the hypothetical of a seller who refuses to give a flat or unqualified representation in an asset purchase agreement because he is afraid to make a representation that may turn out to be untrue.  He's afraid of the stigma of being sued for misrepresentation (and the impact that might have on his various business ventures), but seems to understand how you (as the buyer) would want to allocate the risk of an envirornmental problem to the seller.

A possible work-around in this situation is to:

• Negotiate a qualified representation you can both live with (see my columns on flat versus qualified representations, and the materiality qualifier); AND
• Negotiate a bulletproof indemnity where the seller promises to indemnify you for any damages suffered by you (the buyer) arising from or relating to any environmental law violation, clean up, etc.  In other words, the indemnity is triggered by any environmental problem, not just the seller's breach of its now qualified (i.e., diluted) representation.

This way, the seller won't risk making a misrepresentation, but nevertheless agrees to bear the risk of environmental problems by agreeing to indemnify you for environmental law violations, clean-ups, etc. as though it was making a flat or unqualified representation.

This is just a hypothetical fact situation, and the work-around can be applied to other representations as well.  In other words, I'm certainly not advocating using a work-around to handle something as potentially devasting as an environmental problem.  In real life, it's up to you and your advisors to determine the pros and cons of doing a work-around, versus sticking to your guns (and walking away from the transaction in case you don't get your way).  Hey, maybe the risk of a potential misrepresentation lawsuit is just the kick in the pants the seller needs to go the extra mile to do a really good investigation and preemptive clean-up so that he delivers you a clean piece of property.

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Let's say you're negotiating an asset purchase agreement (APA) for your purchase of a retail car repair business.  One of the most important sections in the agreement is the representations section.  Representations are statements of fact made by one contract party to induce the other party to enter into the transaction.  In this case, the seller will be making a litany of representations to induce you to purchase the business.

In this example, let's say that because the seller hasn't owned the business for very long (having acquired it only a few years ago) he's reluctant to make unqualified or "flat" representations about the business.  So he negotiates aggressively to add a knowledge qualifier or a materiality qualifier to most of the representations.  You review his draft of APA, looking at all the qualifiers he's added, trying to figure out which ones you can live with and which ones you have to have "flat".  In particular, you're flabbergasted that he inserted a knowledge qualifier to the representation that there are no environmental law violations with respect to the property.  (You're not surprised either, given the potential devastating financial impact of an environmental law violation.)

During the ensuing negotiations, he explains that as much as he'd like to, he can't take the chance of making the environmental rep flat.  He says that as a short-term owner, he's just not confident that there aren't any problems, and as a matter of principle, he can't make a flat representation that may very well turn out to be untrue.

You explain that you empathize with his situation and appreciate his honesty, but can't accept the knowledge qualifier because he'd be off the hook as long as he didn't know, and you'd be left holding the bag.  You're not real thrilled with the materiality qualifier either because you want him (as the seller) to bear the entire risk of environmental problems.  This risk shift or risk allocation is a central tenet of contract representations.

Sellers won't necessarily shoot down the risk allocation argument.  You may find that the main reason for his refusal to make an unqualified representation is that he doesn't want to be liable for misrepresentation, including the stigma associated with a misrepresentation lawsuit.  If that's the case, maybe there's another way to tackle this issue.  More on that in my next column.  

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In my previous column, I discussed the impact of revising the following contract clause with a “good faith efforts” qualifier.

“The Manufacturer shall deliver to the Company the Prototype no later than June 30, 2009.”   

Once again, as revised…

“The Manufacturer shall use good faith efforts to deliver to the Company the Prototype no later than June 30, 2009.” 

We discovered how "good faith efforts" only requries the obligor to make an honest effort to meet its obligation.  There is no requirement to even put in a "reasonable effort" to meet the deadline - click here to see my column on "reasonable effort" . 

Today, let’s take a look at what happens if the Company successfully negotiates to insert a “best efforts” qualifier instead.  (Note how unlike in the other columns, I say if the "Company" successfully negotiates, instead of the if the "Manufacturer" successfully negotiates... read on to see why...)

“The Manufacturer shall use best efforts to deliver to the Company the Prototype no later than June 30, 2009.”

To the layperson, "best efforts" sounds alot like the "good faith efforts" advice a coach would give to a young ballplayer - "Just do your best."   But "best efforts" and "good faith efforts" are not the same.  In fact, many lawyers would place them at opposite ends of the spectrum.

Of the three qualifiers discussed (i.e., good faith efforts, reasonable efforts, and best efforts), best efforts is the strictest.  It requries the obligor (in this example, the Manufacturer) to meet its obligation even if it has to pay more to do so.  Let's say that because of internal delays, the Manufacturer can't ship the Prototype until the day before the deadline.  Many lawyers would argue that "best efforts" would require the Manufacturer to ship the Prototype using overnight delivery service, even if the cost of doing so would wipe out the planned profit margin for the transaction.

To summarize,

Unqualified - “The Manufacturer shall deliver to the Company the Prototype no later than June 30, 2009.” - There is an absolute obligation to deliver by the deadline.

Qualified language - 

Best efforts qualified language - “The Manufacturer shall use best efforts to deliver to the Company the Prototype no later than June 30, 2009.”  This is the strictest of the qualified choices.

Reasonable efforts qualified language - “The Manufacturer shall use reasonable efforts to deliver to the Company the Prototype no later than June 30, 2009.”  This the next on the spectrum.

Good faith efforts qualified language - “The Manufacturer shall use good faith efforts to deliver to the Company the Prototype no later than June 30, 2009.”  This is the most lenient standard.

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In yesterday’s column, I discussed the impact of revising the following contract clause with a “reasonable efforts” qualifier.

“The Manufacturer shall deliver to the Company the Prototype no later than June 30, 2009.”   

Once again, as revised…

“The Manufacturer shall use reasonable efforts to deliver to the Company the Prototype no later than June 30, 2009.” 

Today, let’s take a look at what happens if the Manufacturer successfully negotiates to insert a “good faith efforts” qualifier instead.

“The Manufacturer shall use good faith efforts to deliver to the Company the Prototype no later than June 30, 2009.”

It’s a good idea for a contract obligee* to reject any attempt by the contract obligor* to weaken the obligor’s obligations with a good faith efforts qualifier, especially if the obligation is important or key to the transaction.  This is common sense.  An obvious example… a manufacturer shouldn’t grant exclusive distribution rights to a distributor who won’t agree to exercise anything more than good faith efforts to meet minimum purchase targets.

* In contract parlance, the obligor is the party with the duty to perform.  The obligee is the party with the right to receive performance.

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“[Party A] shall deliver to [Party B] the _________ no later than [date].”

This is a simplified version of a provision in a business contract that requires Party A to deliver something [you fill in the blank] to Party B by a certain deadline.  If you are Party A, how much wiggle room will you have in terms of meeting the deadline?

To help analyze this question, let’s put some real contract parties in there, and fill in the blanks.

“The Manufacturer shall deliver to the Company the Prototype no later than June 30, 2009.”

As drafted, there is no wiggle room; the Manufacturer will be in default if it doesn’t deliver the Prototype by June 30^th.

Here are some ways to build some wiggle room into the contract… 

Reasonable efforts 

“The Manufacturer shall use reasonable efforts to deliver to the Company the Prototype no later than June 30, 2009.”

By inserting the underlined language, the Manufacturer will have the obligation only to use reasonable efforts to deliver the Prototype by the deadline.  There is no requirement that the Manufacturer break the bank or go beyond the call to meet the deadline.  While this buys some wiggle room for the Manufacturer, contract qualifiers such as “reasonableness” introduce uncertainty into the contract's interpretation.  The threshold for “reasonableness” and whether the Manufacturer has done enough to reach that threshold are typical fodder for litigation.

The Company in this example may have legitimate business reasons for rejecting the revision.  The Company may need the Prototype by the deadline so that it can meet its own deadlines and commitments.  If the only way for the parties to move forward is to add “reasonable efforts”, then the Company will need to find other ways to add some teeth to the agreement, perhaps by backloading the milestone payments, or introducing the payment of liquidated damages (a kind of "penalty", but don't call it that in the contract because "penalties" are mostly unenforcable) for each day the delivery is delayed.  Remember, this is tricky too because any time you introduce a financial penalty into a contract, you risk that a court might interpret the penalty as the exclusive remedy, thus foreclosing other remedies that might otherwise be available.  It's also tricky because depending on how the liquidated damages language is drafted, and depending on the interplay between that clause and any limitation of liability or cumulative remedies provision, the Manufacturer might find itself liable for more than just the fixed penalties he thought he negotiated.

There are other ways to qualify this provision – “good faith efforts” and “best efforts”.  They sure sound innocuous, but have pitfalls that I’ll discuss in upcoming columns.

For more information about me, or to contact me directly, please leave a post or visit ContractAdviser.com

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Today, I’ll talk about another Materiality Qualifier, one in which the person making the representation (in this case, the seller) doesn’t have to make the disclosure unless the disclosed fact, situation or circumstance has or is expected to have a material adverse impact on the disclosing person’s business.  For an otherwise fastidious seller, this eases the paranoia it might have about the consequences of making an honest mistake in forgetting to list trivial “parking ticket” type violations.  For the reasonable purchaser, this representation should be sufficient to give it a heads up of violations that really matter so that it can walk away from the transaction or remediate and negotiate a price adjustment.    

Here is the revised representation.  The underlined language contains both a List the Exceptions qualifier and the Materiality Qualifier discussed above.

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“The obligations of the Stockholders to the Purchaser under this Agreement are joint and several.”

This is a variation of a provision sometimes found in stock purchase agreements (SPA) to apportion liability among the selling stockholders.  Each of the stockholders is an obligor with the duty to sell its shares, and make the usual laundry list of representations and perform all the covenants and indemnities set forth in the SPA.  For example, if the stockholders fail to disclose an environmental problem in the SPA (let’s assume that nobody caught the issue in due diligence either), then the purchaser (as the obligee) would have a claim against them based on the misrepresentation.  The extent to which the aggrieved purchaser/obligee can pursue any of the stockholders/obligors for this misrepresentation (or any breach of contract or to enforce any covenant or indemnity) depends on the type of apportionment clause contained in the agreement.

In most cases, the purchaser is going to want to include a provision similar to the above language to make all the stockholders jointly and severally liable for all obligations.  In case of a misrepresentation or other breach, or in case the purchaser needs to enforce any covenant or indemnity contained in the SPA, this clause will allow the purchaser to go after all the stockholders together or any one or more of the stockholders separately for any amount up to the entire aggregate amount (not just the pro rata portion) of the claim, regardless of the degree to which any of the stockholders is at fault.

Where does this leave the passive investor with a small to medium stake in the company and probably no say or even knowledge about the day-to-day activities of the company?  It seems like rough justice to allow the purchaser to pursue this investor for the entire amount of the liability.

The passive investor might try to negotiate a hard monetary cap on the amount of his liability.  He can argue that the purchaser is more than protected if the remaining stockholders agree to joint and several liability.

Contribution

In most cases, however, the purchaser won’t budge.  It will invoke the oft-repeated mantra that the purpose of the reps and warranties is to allocate risk, and the stockholders (as a group) are still in a better position, vis-à-vis the purchaser, to know about (or at least to have investigated) the potential risks of the business.  The purchaser wants the flexibility to go after the deep pockets and really doesn’t care which stockholder is to blame.  It just wants to be made whole, by anybody.  In this case, the stockholders may need to enter into a separate contribution agreement to apportion the liability among themselves in the event any of them is forced to bear a disproportionate amount of liability.  Apportionment can be based on relative fault or just on their percentage ownership of the company.

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Again, here’s the “flat” unqualified representation that the purchaser would like the seller to make…

Okay, let’s examine the above qualified representation a bit more closely.  The revision may not serve the seller well because the representation seeks to capture significant violations of ANY law or regulation, even laws or regulations that are only tangentially related to the business.  Let’s say the seller is in the food business and is compliant with all laws and regulations related to the health and safety of its workers and customers (OSHA, FDA, local health laws, etc.).  Let’s say that the seller forgot to pay a citation it received for failing to shovel the sidewalk in front of its store (no slips and falls, nobody got hurt, but there it is, a $100 citation and fine, a significant violation of the sidewalk shoveling regulation).  This is a significant or “material” breach of a “small” law, and must be disclosed in this scenario.  If the seller forgets to include the citation in the exhibit, then it opens itself up to a misrepresentation claim.

On the other hand, purchasers aren’t well served by this version either.  The seller of the food business in my example can interpret this version to avoid the disclosure of minor infractions of important food safety laws.  Most purchasers of food businesses would want a heads up about even minor infractions of laws so important to the operation of the business.

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A representation is a statement of fact made by one party to induce the other party to enter into the transaction.  In a sale of business transaction (whether an asset or entity sale), the seller makes a litany of representations about the business it’s selling (and about its ability to enter into the transaction) to induce the purchaser to buy the business.

In today’s column, I’m going to focus on the “Compliance with Laws” representation that a seller of a business makes in a sale of business transaction.  The typical buyer isn’t going to want to take over (or pay full price for) a business that it thinks may be breaking the law.  The seller makes the “Compliance with Laws” representation to assure the buyer that the Company isn’t in violation of any law or regulation.

The parties typically spend quite a bit of time negotiating the wording of this representation. 

The buyer would like the seller to make the representation “flat”, that is, without qualification.

Here is a variation of a standard “flat” Compliance with Laws representation (asset purchase version).

“The Seller is not in breach or violation of any….. law, regulation or other rule of any government authority or ruling or other determination of any court or other tribunal to which the Seller, or with respect to which any of its assets or business, is subject.”

In this case, any violation of the law, no matter how trivial, would subject the seller to a possible claim by the purchaser for misrepresentation, even if the violation has no material adverse impact on the business being sold.  (For a rough analogy, imagine that you are applying for a home loan and the bank refuses to approve your application because you have an unpaid jaywalking ticket.  Assuming that the ticket is for a small amount, it has no bearing on your creditworthiness.)

Most sellers, on the other hand, want to qualify this representation with wording that minimizes this risk.

The Seller can qualify the representation several ways.

List the Exceptions –

“Except as set forth in attached Exhibit A, the Seller is not in breach or violation of any….. law, regulation or other rule of any government authority or ruling or other determination of any court or other tribunal to which the Seller, or with respect to which any of its assets or business, is subject.”

In the revised representation, the seller would list all the violations in an exhibit to be attached to the asset purchase agreement.  Note that this method is only as accurate as the memory of the seller.  If the seller forgets to list a violation, then it’s a misrepresentation.  For the seller, although better than a flat representation, it’s still not so forgiving.
 

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Here's a question I received about Confidentiality Agreements.  My answer follows below. 

Question:

I am the owner of a food manufacturing business and I am talking to a large food company that is looking to outsource the manufacture of their signature frozen entrée dish.  They don’t want any one party to have access to the entire secret recipe, so they plan to enter into subcontracts with multiple manufacturers to make the different parts of the dish.  My company will be the subcontractor to make the special sauce part of the dish for them.  They want me to sign a secrecy agreement where I promise not to disclose (forever) the secret recipe of the sauce.  Since I’ve not yet seen the recipe, I have to take their word that the recipe is truly unique and secret.

The secrecy agreement states that “Confidential Information includes any information disclosed by Disclosing Party [that’s them] to Receiving Party [that’s me], whether in written, tangible or verbal form, including, but not limited to, business, financial, sales, marketing and technical information.  An exception is made for any information that is or becomes a part of the public domain.”

Sincerely,

Amarillo, TX

___________________

Dear Bob,

I assume in this case that there will only be a one-way flow of information - the secret recipe from your counterparty to you.  In other words, I assume that you don’t have any of your own confidential information that you will be furnishing to them.  If you do, then that will change the dynamics of the negotiations because you’ll need to enter into a mutual confidentiality agreement.  In that case, what’s good for the goose becomes good for the gander because it’s hard to negotiate less stringent confidentiality obligations for yourself at the same time you try to bind your counterparty to more stringent confidentiality obligations.

Here is some general information that may help you.  Remember that this is not legal advice, and I’ve made no attempt to look at your entire contract or gather any additional information about your specific situation.  Consider hiring an experienced attorney in your state to help you to formulate a plan of action tailored to your specific situation.

Definition of Confidential Information

The quoted language appears to state the definition of Confidential Information, along with one exception.  The first question you want to ask yourself is how much and what kind of information will be disclosed to you.  Is it just the secret recipe or is it a bunch of other information?  Right now, the draft’s definition of Confidential Information is very, very broad, and designed to encompass a wide range of information.  The draft also makes no attempt to distinguish between information disclosed in written or tangible form (such as on disk or via samples) on the one hand, and information that is verbally disclosed on the other hand.  This means that even information that is mentioned in passing conversations becomes subject to the agreement (which may be what your counterparty intended, as onerous a burden that might be for you).

From your perspective, it’s best to tighten up the definition to limit “Confidential Information” to information disclosed only in written or tangible form and clearly marked or stamped as “confidential”.   If they insist that verbal information also be protected, then try to negotiate language that limits the protection to only verbal information that they clearly indicate is “confidential” at the time of verbal disclosure, and that they reduce to written form or summary written form within a very short time period after the verbal disclosure.  Have them stamp these written documents as “confidential” as well.  This will help you to keep track of what’s confidential, and what’s not.  Basically, you want to shift to your counterparty the burden of proving that they disclosed something to you – if it’s not stamped, then it’s not confidential.  As currently drafted, you have the burden to prove that they didn’t disclose something to you.  Another way to try to limit your liability is to eliminate categories of information you don’t want or need to see.  For example, if all you need is the secret recipe, then try to negotiate to eliminate the financial information and other categories listed in the definition.

Public Domain Exception

You mention that your secrecy agreement requires you to keep the Confidential Information secret “forever”.  This is a logical and reasonable requirement from a “secret recipe” owner’s perspective (think cola or franchise fried chicken).  If you want to work with them, you may have no choice but to agree to keep the recipe confidential indefinitely.  But it’s also logical and reasonable for you to question why you have to continue to keep something confidential that may already or may in the future become widely known.  You alluded to this possibility when you mentioned that you have no idea if the recipe is unique.  If, for example, it turns out that the recipe can also be found in dozens of cookbooks, then the recipe isn’t a secret.  Fortunately, their draft already contemplates this situation by containing an exception to the definition of Confidential Information – roughly translated, the exception states that if the information, in this case the secret recipe, becomes generally known to the public (part of the public domain), then the recipe is no longer deemed “Confidential Information”.  If the recipe is no longer deemed “Confidential Information”, then it follows that it is no longer protected.  Interestingly, your counterparty failed to qualify the words “An exception will be made for any information that is or becomes a part of the public domain” with the words “through no fault of the Receiving Party” or “other than as a result of a violation of this Agreement by the Receiving Party”.  It’s not likely, however, that a court would let you get away with purposely revealing the secret recipe, and then claiming that the recipe legally has become part of the public domain. 

Many confidentiality agreements also contain the following additional exceptions to the definition of Confidential Information:

• An exception for any information that is already known to the Receiving Party prior to disclosure, as shown by written records of the Receiving Party.  This means that the information is not deemed Confidential Information if the Receiving Party can prove that it already knows it.

• An exception for any information that becomes known to the Receiving Party via disclosure from a third party, provided that the third party has the lawful right to make such disclosure.  This means that the information is not deemed Confidential Information if the Receiving Party receives the information from somebody else, as long as that party didn’t obtain or disclose the information illegally (for example, industrial espionage) or contrary to a confidentiality agreement it is a party to.

• An exception for any information that is independently developed by the Receiving Party, as shown by written records of the Receiving Party.   This means that the information is not deemed Confidential Information if the Receiving Party independently develops the secret recipe.  Most secret holders are going to be reluctant to grant this exception because they don’t want to give the impression that they are encouraging this type of activity.  On the other hand, if you turn the tables and reverse roles, most large companies that are the Receiving Party in confidentiality agreements will probably want to have this exception.  They’ll claim to have well-established “Chinese walls” to keep your secrets from reaching other employees (in other divisions, etc.) that may be working on similar projects.

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