How to allocate risk you find in due diligence We generally subscribe to the theory that commercial contracts are about allocation of risk in a transaction. Dealbook today writes about a clause in the Merrill Lynch / Bank of America merger agreement.

Here's the clause: "(c) No investigation by a party hereto or its representatives shall affect the representations and warranties of the other party set forth in this Agreement." It's found in Section 6.2(c) of the merger agreement.

The purpose of the clause is questioned. In our experience, buyers typically use language like that found in this specific clause to hold targets to the terms of the reps and warranties. The idea is that even though you perform due diligence on an issue, such as reviewing a stack of material contracts, your own diligence investigation does not excuse the target's failure to make adequate disclosures.

The situation could play out like this: material contracts are provided to the buyer that include the terms of a real estate lease that show that it must be cancelled six months before the expiration of the five-year lease or it will auto-renew. The six-month deadline has passed and so the lease will auto-renew. The target reps that there are no leases that are not cancelable on thirty days' notice, a deadline that has not passed. When this situation starts to resolve itself, targets often say "we gave you the documents, and you reviewed them." They may note that an item was specifically noted to be in contradiction with the rep as a reason for excusing the breach. With the quoted language in place, the due diligence investigation by the buyer is not a defense to the breach of the rep.

To outsiders, this sounds like the sort of weasel legalese that the public now expects from lawyers. A few other examples showcase the benefits: first, imagine a dispute about the legal effect of a notice (the target sent a notice that it believes is legally valid to cancel the lease, and the buyer disagrees. Under the rationale we've described, the deal can go forward and allocate the risk of the notice being ineffective to the target. Second, imagine further that there's a lawsuit pending (but not served) regarding the termination of the lease. The buyer will certainly want to know about it but may not want to underwrite the litigation. Using a "no threatened litigation" representation, the buyer can shift the risk of loss from the issue to the target.

Why should targets do this? Why would they take these risks? The proper allocation of risk is much like an insurance analysis -- the risk should generally lie with the party best able to manage and minimize the risk and control the outcome actual underlying event/issue. In almost every case, the target is far better equipped to at least know about the nature of the risk and appropriately price it rather than requiring the buyer to price the risk as part of what's included in the purchase price. Usually, a knowing omission from the disclosure schedule, which is how this shift of risk is typically accomplished, is only appropriate for material risks that are hard to manage and difficult for a buyer to investigate. For example, we have used this explicitly in a situation where the founder of a technology company was being challenged by a former employer about whether the employer's trade secrets were being used in the new company's products.

Labels: contracts, deals, due diligence, law

Sunday, September 21, 2008 :: posted by Rick Colosimo @ 2:03 PM

Freedom of Contract Cerberus Capital, a well-known private equity fund, recently won a short trial in the Delaware Chancery Court allowing it to terminate its acquisition agreement with United Rentals and pay the $100 million termination fee set forth in the contract. The WSJ article spells out the details and the background well, referencing the actual parties and the negotiations backdrop. The critical item of analysis, missing from much of the commentary we've seen [link to WSJ law blog?], is an analysis of the points on which the opinion turns. (For simplicity, we'll generally refer to all Cerberus defendants as Buyer and United Rentals as Target.)

Reviewing the actual opinion, here is the critical language relied on by Cerberus from Section 8.2(e), part of the termination provision:

In no event, whether or not this Agreement has been terminated pursuant to any provision hereof, shall [Buyer] ... be subject to any liability in excess of the Parent Termination Fee 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 [Buyer] of any representations, warranties, covenants or agreements contained in this Agreement, and in no event shall the [Target] seek equitable relief or seek to recover any money damages in excess of such amount from [Buyer] or any of their respective Representatives.

(NB: the opinion is available here: WSJ link.)

The language United Rentals suggested was controlling involved a specific performance provision (Section 9.10) of typical structure allowing for the seeking of injunctions to compel performance, but specifically exempting Section 8.2(e) from its purview (and Section 8.2(e) specifically notes that it supersedes 9.10).

The opinion first describes why the interpretations of the parties are both reasonable, eliminating the opportunity to resolve the case by summary judgment. Then, the opinion describes the extrinsic evidence about the shared intention of the parties, concluding essentially that the Buyer consistently rejected the specific performance remedy and that Target eventually acquiesced to edits that Buyer believed eliminated that remedy. The case might indeed be one that turns on procedure as much as anything else; Target had the burden of proving Buyer's intent and was unable to meet that burden; the opinion notes that the matter is an "exceedingly close question" in some respects. Also, the use of the forthright negotiator principle indicates that openness in negotiations actually can be rewarded: since Buyer's belief that the termination fee was Target's only remedy was well-communicated to Target, Target's failure to respond with its interpretation of the contract language during negotiations works against it during litigation.


The key point for business and lawyers to remember is that a party is captain of its offer; that is, the party making the offer to the other has the right to set whatever conditions it wants on the offer and acceptance (short of public policy violations). In other words, it's perfectly reasonable for Cerberus to reject any specific performance remedy in the contract and, by extension, perfectly reasonable for United Rentals to reject a deal that allows Cerberus to walk away. Moving to a deeper level of analysis, the meaning of contracts is tied inextricably to the remedies afforded in the event of breach. Both risk and reward are equally linked in this
respect.

A wise deal champion, listening to experienced counsel, will strive to create deal structures that are either self-enforcing, such as dead-hand provisions operating to implement conditions subsequent or covenants, or are clear about what the downside looks like for both parties. Discussing risk during the negotiation of a contract is not weakness; it's sophistication. Experienced deal participants know that deals break down in a variety of ways for a variety of reasons. Ignoring these possibilities to appear to be "positive" or "trusting" or "a team player" is foolish; only by harping on the negative do you eliminate those perceptions. It's often been said, and often repeated by us, that good deal structures don't require one party to trust the other; they make the deal support the development of trust between the parties by getting out of the way of that trust rather than relying on it.

In a later post, we'll discuss this concept of proper structure in light of the actual costs of small-business litigation, the sort of <$250,000 claim that can arise in any number of businesses.

Also, the discussion that the deletion of the offending specific performance provision rather than the circuitous "subject to" language would have been less ambiguous reminds us to discuss the practical effects of simply working too much. We assume that Buyer's counsel worked an incredible amount on this transaction and probably many others as well. More to follow.

Labels: contracts, deals, law

Monday, December 31, 2007 :: posted by Rick Colosimo @ 6:01 PM