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Drafting Nondisclosure Agreements in the M&A Context: Consider What Will Happen When the Deal Goes South

October 11, 2012 By Leave a Comment

Let’s say you’re buying a business. As a condition to receiving more information, you are required to sign a nondisclosure agreement that contains all of the usual blather. You then start to sift through the mountains of information provided (and have your accountants and lawyers do the same, at considerable expense) to decide whether the company is worth purchasing, and on what terms. You like what you see, so you negotiate a letter of intent, and continue your due diligence investigation. You spend five or six months in negotiations and due diligence to the tune of many thousands of dollars (or more).

Then, let’s say at the eleventh hour you discover something really unfavorable about the company – in fact, three such issues emerge, so significant that you would never have considered buying the company at all if you had known about them. You didn’t suspect their existence, because you had been told verbally at the beginning of the process that there were no such issues. However, once found, these issues cause you to terminate negotiations.

What about the money you spent on negotiations and due diligence? Might you be able to recover that? Does it matter whether the seller intentionally withheld information about the negative issues until the last minute or simply forgot to provide it earlier?

For possible remedies, turn to the nondisclosure agreement. Let’s suppose it contained provisions something like the ones below:

The “Non-Reliance Disclaimer” Provision

Purchaser understands and acknowledges that neither Seller nor any Seller Representative is making any representation or warranty, express or implied, as to the accuracy or completeness of the Evaluation Material or of any other information concerning Seller provided or prepared by or for Seller, and none of Seller nor the Seller Representatives will have any liability to Purchaser or any other person resulting from Purchaser’s use of the Evaluation Material or any such other information. Only those representations or warranties that are made to a purchaser in the Sale Agreement when, as, and if it is executed, and subject to such limitations and restrictions as may be specified [in] such a Sale Agreement, shall have any legal effect.

The “Waiver of Claims” Provision

Purchaser understands and agrees that no contract or agreement providing for a transaction between Purchaser and Seller shall be deemed to exist between Purchaser and Seller unless and until a definitive Sale Agreement has been executed and delivered, and Purchaser hereby waives, in advance, any claims . . . in connection with any such transaction unless and until the parties shall have entered into a definitive Sale Agreement.

A plain reading of these provisions seems to preclude you from bringing any claim based on seller’s failure to provide information prior to the execution of a definitive sale agreement. Perhaps your best argument is that the most reasonable interpretation of the first provision above is that it bars claims based on mistakes or negligence in providing accurate and complete due diligence information, but not outright fraud, or is at least ambiguous on this point. You could shore this up with the argument that a court should refuse to enforce these provisions on policy grounds — courts should not enable a party to use a contract to shield itself from liability for its own fraud.

In RAA Management, LLC v. Savage Sports Holdings, Inc. [1], the Delaware Supreme Court, applying New York law (and holding that the result would be the same under Delaware law), recently rejected these arguments by a potential buyer in a case involving facts similar to those set forth above and affirmed the Superior Court’s holding dismissing the buyer’s case.

The Superior Court held that “where a sophisticated investor like RAA Management agrees to perform due diligence with the understanding that the seller disclaims any warranty of accuracy or completeness in the information it provides to the potential buyer, the due diligence is governed by . . . a buyer beware notion, that even absolves the seller from intentional fraud” (emphasis added).

The Superior Court pointed out that the language in the first provision above does not distinguish between information that is inaccurate or incomplete because of negligence or mistake and information that is inaccurate or incomplete because of alleged fraud or because it was intended to be so; therefore, the argument that the language should be construed as providing an exception for “fraudulent” or “intentional” misrepresentations has no merit. The Superior Court also found the language unambiguous, examining prior cases construing similar provisions.

The policy argument also cut no ice with the Superior Court, which reviewed prior cases that set forth Delaware’s “public policy in favor of enforcing contractually binding, written disclaimers of reliance on representations outside of a final sale agreement.” Sophisticated parties cannot negotiate such disclaimers and then claim that they in fact did rely on such representations and are entitled to relief.

The obvious lesson of RAA Management is one for potential purchasers – if your nondisclosure agreement contains provisions similar to those above, don’t proceed in reliance on the information you receive during the due diligence process; if anything does go wrong, don’t expect to recoup any of your expenses.

Is there any lesson for lawyers drafting nondisclosure agreements (other than to be aware of the issues so you can advise potential purchasers appropriately)? Could, or should, lawyers attempt to carve out fraud and intentional misstatements or omissions from a provision disclaiming reliance on information provided? Disclaimers and waivers such as those in the RAA Management nondisclosure agreement are customary and a seller’s attorney would likely make the usual noises about what is market and where the risks should be allocated. Sellers have little incentive, anyway, to withhold intentionally negative information until late in the process. Furthermore, intent would be difficult to prove – but a carve-out for intentional misstatements or omissions would at least enable a disappointed purchaser in RAA Management’s situation to avoid a dismissal.

Footnotes

[1] RAA Management, LLC v. Savage Sports Holdings, Inc., No. 577, 2011 (Del. May 18, 2012)

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© 2012 Jennifer Wilson — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: General Business Law Tagged With: , , , , , ,

Buying a business? Here are 6 items that should be in your letter of intent.

July 28, 2011 By 2 Comments

One of the first formal steps in the process of buying a business is drafting a letter of intent. It’s important to understand that a letter of intent is not the end of the negotiation process but merely the beginning of formalizing it. But it is a crucial step. A well-written letter of intent can reduce the potential for misunderstandings later and will get all of the parties’ assumptions and views on the critical terms of the deal on paper. A letter of intent is not, however, the actual agreement that governs the terms of the purchase, and in fact, if written properly is not an agreement at all.[1]

Here are some items that should be included in a letter of intent to purchase a business:

1. The document must be clearly identified as a letter of intent. The document should make it clear that it is not a binding contract to buy or sell the business. The parties may want to include, and some states will impose automatically, a duty to negotiate in good faith. A good faith provision can be useful, especially for the seller, to prevent one party from using the negotiation and due diligence process solely to collect information about the other party and their business.

2. The letter of intent should state from the outset whether the deal will involve the sale of stock or the sale of assets. It would be unfortunate if both sides spent significant amounts of money but one party thought from the outset that they were talking about a stock sale and the other party thought they were talking about an asset sale. If this point is not discussed from the very beginning, the deal could fall apart as the deal structure that is preferred by one party may not be feasible for the other party.

3. The letter of intent should include both a purchase price and an explanation of the assumptions that the purchase price is based upon. During the due diligence process, it may turn out that many of the early assumptions used in calculating the purchase price will turn out not to be true. If the method for calculating the purchase price is included in the letter, the parties have a road map on how the purchase price should be adjusted.

4. If the deal is a purchase of assets, the parties should allocate the purchase price to the different assets on the acquisition target’s balance sheet. This allocation can have great effect on the tax implications of the deal for the parties. Since tax considerations are often critical to whether a deal is feasible, there needs to be a common understanding of purchase price allocations at a very early stage of the deal process.

5. The method of payment should be set out. As in point 2, if one party has in mind an all cash deal, and the other party has in mind a deal where the seller will hold onto a note or some other retained interest in the acquisition target, then it is a good idea for the parties to get on the same page from the outset, before either party has spent significant amounts of time and money on the deal.

6. All other major deal points that are important to either party should be included. If either party has any other deal points that are crucial to them, they should let the other party know relatively early. Examples of these include: whether key employees must be retained for the deal to close, any expected non-compete agreements that the seller will sign, and if the buyer will be assuming any liabilities of the seller. Springing these on the other party late in the process may result in a failed deal after everybody has spent a lot of time and money.

Many times parties try to get away with vague letters of intent with the assumption that the details will be ironed out later. The problem is, the details are often what kills the deal. Parties may also assume that it is a good idea not to put too much in writing because they will be “boxed in” when negotiating the definitive purchase and sale agreement. But if a letter of intent is drafted properly, the parties will not be boxed in; rather they will have an easier time agreeing to changes in the deal as circumstances change because the assumptions they used will be included in the letter of intent. The non-binding nature of a letter of intent always gives one party the option to walk away if things turn out not to be the way they expected. The effort spent on drafting a letter of intent will be helpful later by smoothing future negotiations and by eliminating unfeasible deals from the outset.

Footnotes

[1] Letters of intent will often have certain parts which are enforceable, such as a covenant not to sue. So saying that it is not an agreement at all is somewhat misleading. Rather, the substantive terms of the acquisition are not considered to be part of any enforceable agreement.

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© 2011 — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: General Business Law Tagged With: , ,