Letters of Intent and Due Diligence

Hypothetical:

Easy Rider Hogs, LLC (“E.R. Hogs” or “Seller”), a private company that has dedicated millions of dollars to develop and commercialize a driverless motorcycle, is in need of additional cash infusions to achieve its business goals and become profitable. Under pressure from its largest shareholder, Dennis Hogster, who refuses to invest any further capital, E.R. Hogs engages an investment banker to find a buyer to acquire the company.

Shortly thereafter, Googol, Inc. expresses an interest in acquiring E.R. Hogs. In an effort to retain control, however, E.R. Hogs’ management suggests that E.R. Hogs and Googol instead enter into a license agreement pursuant to which E.R. Hogs will license certain of its IP to Googol in exchange for an upfront fee and ongoing royalty payments. Googol insists on proceeding with an asset purchase but offers to negotiate a license agreement based on certain agreed upon terms if the parties can’t agree on the terms of the purchase agreement.

Shortly thereafter, Googol and E.R. Hogs enter into a letter of intent (“LOI”) for the sale of all of E.R. Hogs’ assets. The LOI contains the fundamental deal points typically found in an LOI (e.g., purchase price, structure, post-closing price adjustments, etc.). On its face, the LOI states it is not binding, except for the confidentiality and exclusivity provisions. Further, the LOI states that if the parties cannot agree to the terms of the definitive APA, they will “in good faith negotiate the terms of a license agreement with the intention of executing a definitive license agreement in accordance with the terms set forth in the term sheet attached as Exhibit A to the LOI.” Exhibit A is not signed by the parties and contains a footer that states “Non Binding Terms.”

Description of License: The license will provide Googol with a worldwide exclusive license to and under the Patents, Know-How and Materials to use, develop, make, have made, sell, export and import driverless motorcycles.

Summary of Economic Terms:

● License Fee - $6,000,000, with $2,000,000 paid up front and balance paid over 12 months as certain milestones are achieved.

● Annual Royalty Payments:○ 8% on yearly net sales of Patented Products less than $250,000,000;○ 10% on sales greater than $250,000,000; and ○ 12% on sales greater than $1 billion.

● Seller will be entitled to 50% of any amounts by which net margin exceeds 20% on sales.

After signing the LOI, Googol sends a detailed due diligence request list to E.R. Hogs and E.R. Hogs and its bankers create and populate a data room with significant information in response thereto.

Exhibit A – Basic Terms of License Agreement

Googol and its counsel carefully review the documents in the data room while they negotiate a formal asset purchase agreement with E.R. Hogs and its advisors. However, from the outset, Googol is somewhat slow to turn drafts and seems a bit reticent to engage in meetings to negotiate significant deal points, as they first want to verify the viability of E.R. Hogs’ IP. Googol requests numerous additional documents and disclosures as a result of questions arising from its due diligence. E.R. Hogs responds to some requests but lags on others, namely certain highly proprietary IP information.

Meanwhile, E.R. Hogs, increasingly desperate for a cash infusion, continues to demand that Googol engage fully in the negotiation process.

And this is how things proceed through the summer, with E.R. Hogs demanding the parties reach a final APA and dragging its feet on providing certain diligence items and Googol demanding more information about the concerns it has over the IP, until . . . the leverage shifts.

A couple of weeks prior to the expiration of the LOI’s exclusivity provisions, E.R. Hogs is contacted by a third party, Yamahog, Inc., who expresses a strong indication of interest regarding entering into a license agreement with E.R. Hogs, on very favorable terms to E.R. Hogs. As required by the LOI, E.R. Hogs gleefully informs Google of this development.

Sensing the shifting sands, Googol acquiesces to E.R. Hogs’ prior demands and works furiously to meet newly established deadlines. A couple of furious weeks later, everyone believes that the documents are close to final, with only a few important business points at issue, including indemnity obligations with regard to Googol’s IP concerns.

Meanwhile, Googol pushes hard to get E.R. Hogs to provide draft disclosure schedules, which it has not yet provided (in large part because all along it had hoped the parties would abandon the asset sale deal and revert to the license arrangement, which would not require such disclosures). Only a week prior to the expiration of the exclusivity period, E.R. Hogs finally produces draft disclosure schedules (about 100 pages of information). An initial review by the senior associate on Googol’s side shows that it resembles much of the information already reviewed from the data room.

Taking some comfort from this (because there are no time bombs in those disclosures), Googol now demands that the parties meet in person to negotiate the remaining open issues. E.R. Hogs agrees and the parties meet for two very tense days. On the second day, sensing they are close to resolving all the open deal points, E.R. Hogs dumps all the remaining due diligence items it had been holding back into data room (much of it related to its IP), and delivers updated disclosure schedules to Googol.

Googol is outraged by the last minute dump, but a quick review of the revised disclosure schedules by Googol’s counsel reveals no material changes from the draft schedules. However, while they have scanned the new information dumped into the data room, they have not had time to analyze the full importance of all of the new information, much of which is highly technical.

As a result, Googol demands that a “sandbagging” provision be included in the APA, which demand E.R. Hogs refuses, insisting instead that the agreement contain “anti-sandbagging” language. That is the final issue holding up the execution of the agreement.

Sandbagging is a risk allocation concept.

A seller provides due diligence information to buyer, often in the form of a digital dataroom, during the sale process. This information often is updated in response to diligence requests. Meanwhile, negotiation of definitive documentation (e.g., a merger agreement or asset purchase agreement) continues along a parallel track with such disclosure.

The purchase agreement typically includes indemnification provisions that obligate seller to indemnify the buyer for any misrepresentations contained in the purchase agreement (including the disclosure schedules attached thereto).

To shift some of this risk back to buyer, sellers typically insert a provision that holds a buyer responsible for the information buyer has reviewed as part of the diligence process. Such language typically provides that, notwithstanding any seller representation or warranty (as modified by the disclosure schedules) to the contrary, if seller disclosed a fact to buyer in the dataroom (or otherwise through diligence), buyer cannot later sue for a breach, even if seller provided a representation or warranty that conflicted with such information.

Brief Explanation of Sandbagging

Sample Anti-Sandbagging Provision

Seller shall not be liable under this Article VIII (Indemnification)with respect to any Losses arising out of matters within theknowledge of Buyer at the Closing Date.

Conversely, buyers typically want the seller to be held responsible for all of its representations and warranties, regardless of what is disclosed to buyer in the diligence process, and so demand “sandbagging” language that does not hold buyer responsible for any information other than that contained in the four corners of the contract (including disclosure schedules).

Sample Sandbagging Provision

The representations, warranties and covenants of the IndemnifyingParty, and the Indemnified Party's right to indemnification withrespect thereto, shall not be affected or deemed waived by reasonof any investigation made by or on behalf of the Indemnified Party(including by any of its Representatives) or by reason of the factthat the Indemnified Party or any of its Representatives knew orshould have known that any such representation or warranty is,was or might be inaccurate or by reason of the Indemnified Party'swaiver of any condition set forth in Section 7.02.

Management’s Quandary

It is now the morning of the last day of the exclusivity period. Deal fatigue has set in, and starting tomorrow, E.R. Hogs can enter into negotiations with Yamahog, Inc. Management for both E.R. Hogs and Googol are struggling with how to proceed and conferring with counsel as to their options.

Scenario No. 1

Fearing the asset sale may fall apart, Googol (after conferring with counsel) proposes that the parties remain silent on the issue of sandbagging (i.e., the agreement contain neither sandbagging or anti-sandbagging language). Thinking this is a win, E.R. Hogs agrees.

The deal is signed, and the parties move expeditiously toward closing, which occurs shortly thereafter.

Six months later, Googol is receives a cease and desist letter from a third party who threatens suit claiming its IP is infringed by certain of the IP now owned by Googol (previously owned by E.R. Hogs) and demanding that Googol cease from further infringement.

The alleged infringement possibility was documented in the dataroom prior to the execution of the LOI. A review of the dataroom’s access log shows that Googol and its advisors accessed the relevant documents on multiple occasions (establishing that Googol was, in fact, aware of the potential for infringement). But E.R. Hogs’ disclosure schedules are silent on this issue (i.e., they do not flag these potential liabilities as a future risk). As a result, E.R. Hogs’ representations contained in the purchase agreement (that its IP does not infringe on any third party rights) are untrue.

Soon thereafter, Googol sends E.R. Hogs a demand for indemnification, and E.R. Hogs responds with a strongly worded objection pointing to the date-stamped documents in the dataroom, Googol’s access and review of same and highlighting Googol’s early delays in negotiation solely for the purpose of reviewing all available information at that time. Googol commences litigation in Delaware, because the asset purchase agreement was governed by Delaware law. The complaint seeks many remedies, including all forms of damages.

Discussion Regarding Scenario No. 1

Sandbagging v. Non-Sandbagging Provisions – both arguments have merit.

● Buyers object to anti-sandbagging language because it shifts the issue awayfrom the veracity of seller’s reps to buyer’s pre-closing knowledge of theliability. Establishing knowledge is dependent on various facts and\circumstances and susceptible to subjective determinations. There is also theissue of who has the burden of proving buyer’s knowledge.

● Seller will argue that they should not be obligated to indemnify a buyer whowas fully aware of a liability prior to closing, regardless of what is in thedisclosure schedules. It is simply unfair and essentially results in buyerobtaining an un-negotiated reduction to the purchase price.

Who prevails on the language to be included in the purchase agreement typically depends on who has the most leverage in the deal. In the hypothetical, the parties chose to remain silent on the issue, a solution that probably happens more often than not without the parties fully understanding the consequences of doing so. Before you agree to this, you should be aware of the impact of the decision.

If the M&A agreement is silent on the issue, a buyer’s ability to make post-closing indemnification claims for a misrepresentation of which it has pre-closing knowledge depends on governing law. Unfortunately, various states have differing interpretations.

Generally, courts interpreting NY law have found that a buyer who has actual knowledge of a misrepresentation prior to closing waives its rights to indemnification. In Galli v. Metz, 973 F.2d 145, 151 (2d Cir. 1992), the court held:

[where] a buyer closes on a contract in the full knowledge and acceptance of facts disclosed by the seller which would constitute a breach of warranty under the terms of the contract, the buyer should be foreclosed from later asserting breach. In that situation, unless the buyer expressly preserves his rights under the warranties, . . . we think the buyer has waived the breach.”

○ Note, however, the Galli case and other NY cases have suggested that if the seller is not the cause of buyer’s knowledge (i.e., if a third party informed buyer of the breach), buyer may yet prevail in its claim for indemnification (i.e., no waiver).

In other jurisdictions, a buyer’s entitlement to indemnification for a misrepresentation that was known to buyer prior to closing depends on the buyer’s reliance on the misrepresentation. This used to be the case in Delaware (and remains the case in other jurisdictions). For example, the court in Kelly v. McKesson HBOC, Inc., CIV.A. 99C-09-265WCC, 2002 WL 88939 (Del. Super. Jan. 17, 2002), interpreting Delaware law, suggested that a buyer must show reliance on a breached representation to assert a valid claim against seller. If a buyer knew or should have known that a seller representation was untrue at the time the relevant agreement was executed, the buyer could not have reasonably relied on such representation. Thus, buyer's claim against seller fails.

However, more recent Delaware opinions indicate that a claim of breach of representations and warranties does not require reliance by the buyer. In Interim Healthcare, Inc. v. Spherion Corp., 884 A.2d 513,518 (Del. Super. Ct. 2005), the court stated:

The extent or quality of [buyer’s] due diligence is not relevant to the determination of whether [seller] breached its representations and warranties in the [a]greement. To the extent [seller] warranted a fact or circumstance to be true in the [a]greement, [buyer is] entitled to rely upon the accuracy of the representation regardless of what [its] due diligence may have or should have revealed.

Bottom line: this is less than settled law and varies between jurisdictions, with outcomes dependent on facts and circumstances. In our hypothetical, E.R. Hogs, which closed on the deal believing that silence on the issue of sandbagging was in its favor, is about to discover that, since Delaware law applies, Googol likely is going to be entitled to indemnification since the alleged potential infringement was not disclosed in E.R. Hog’s disclosure schedules.

Practice Tips:

1. Buyer and seller should be aware of the sandbagging issues throughout the negotiations and due diligence process. Given uncertainty in the courts, counsel for both parties should endeavor to draft the document to reflect the parties’ intent and agreement on this issue. These provisions are generally upheld in almost every jurisdiction. Some potential negotiation nuances include:

● Provide that buyer must have actual knowledge of seller’s misrepresentations in its reps and warranties prior to closing;

● Specify the individual representatives of buyer whose knowledge counts;

● Negotiate who has the burden of proof regarding buyer’s knowledge; and

● Limit any anti-sandbagging language to information received before some date certain (i.e., to a time where buyer had comfort with disclosures so as to protect against last minute data dumping).

2. Negotiate and include sandbagging provisions in the LOI. The initial phase of negotiation often involves only high-level participants (e.g., c-suite executives, lead banks and lawyers, etc.), and one side may have more deal leverage than later in the process, once resources have been committed. Further, even if a client is forced to accept sandbagging provisions that run contrary to their interests, it is far simpler to plan ahead and enter the negotiation process armed with knowledge of risks and responsibilities.

3. Conduct negotiations and the deal process as if you were guaranteed to be on the losing side of a sandbagging argument.

● For sellers, disclosure schedules should be prepared early and reviewed often. Advisors can help the client create dataroom disclosure that mirror (and act as) disclosure schedules, thus making preparation of both more efficient.

● For buyers, devote appropriate resources to diligence from the outset. Increasingly, clients or their advisors will conduct cursory or high-level reviews to save on fees early in the process and assume that they can play catch up later in the process if the deal is likely to proceed to execution. Obviously, this can create significant risks on a number of levels, but important items are most often missed when people are tired and hurried.

4. Beware of other tactics designed to impute anti-sandbagging concepts without express language, for example, statements buried in disclosure schedules which incorporate the dataroom, or elements thereof, by reference.

E.R. Hogs, who has seller’s remorse in light of Yamahog, Inc.’s indication of interest, refuses to concede on the sandbagging issue and instead storms out of the meeting room and terminates discussions regarding the sale of its assets to Googol.

Immediately thereafter Googol sends a letter stating that it believes they can still overcome the obstacles preventing execution of the purchase agreement, but that in the alternative it is prepared to proceed in good faith to negotiate the license agreement contemplated by the LOI.

While simultaneously negotiating a license agreement with Yamahog, Inc., E.R. Hogs sends Googol a draft license agreement that contains terms that vary significantly from the term sheet attached to the LOI.

● The license is not “non” exclusive● License Fee has been raised to $40,000,000 (from $6MM) and is payable all up

front.● And the Annual Royalty Payments have increased:

○ From 8% to 10% on yearly net sales of Patented Products less than $250,000,000;

○ From 10% to 15% on sales greater than $250,000,000; and ○ From 12% to 20% on sales greater than $1 billion.

Scenario No. 2

When Googol balks at the revised terms, E.R. Hogs enters into the license agreement with Yamahog, Inc., at which time Googol sues E.R. Hogs, claiming that E.R. Hogs failed to negotiate its license agreement in good faith.

Discussion Regarding Scenario No. 2

Although the names and setting in the hypothetical have been altered to protect the innocent, this hypothetical is a real life example: Siga Technologies, Inc. v. Pharmathene, Inc., 67 A. 3d 330 (2013).

In, the Delaware Supreme Court approved recovery of “benefit of the bargain” damages for breach of a duty to negotiate based on an expressly non-binding LOI. SIGA owned a potentially valuable antiviral drug for the treatment of smallpox. However, SIGA no longer had the resources to develop or exploit that drug. Sensing an opportunity for a merger, PharmAthene entered into negotiations to provide financing. SIGA was not interested in a merger and offered to enter into a license in exchange for funding. The parties negotiated a non-binding License Agreement Term Sheet (“LATS”). However, rather than agree to the LATS, PharmAthene insisted that the parties explore a merger first. Therefore, the parties executed to a merger agreement which specifically provided that, if the merger did not close by the stated deadline, the parties would “negotiate in good faith with the intention of executing a definitive Licensing Agreement in accordance with the terms set forth in the LATS.”

The merger failed to close by the deadline, which was not extended by SIGA. PharmAthene had its lawyers draft a definitive licensing agreement based upon the LATS. However, by this time, SIGA’s fortunes had improved significantly. SIGA had received NIH funding, and estimated that the value of its drug was worth more than three times what it had previously estimated. PharmAthene expressed a willingness to re-negotiate some of the economic terms of the LATS but insisted that the definitive agreement adhere to the structure and general terms contained in the LATS. SIGA suggested a higher up-front payment (from $6 million to $40 million) and a 50-50 profit split, and promised to draft a formal proposal. Instead, SIGA proposed a one-sided, 102-page draft LLC agreement that completely disregarded the LATS, as well as the terms it previously said would be acceptable. PharmAthene objected that the terms were “radically different” from the LATS. SIGA issued an ultimatum that, unless PharmAthene was willing to negotiate “without preconditions” regarding the LATS’ binding nature, the parties had “nothing more to talk about.” The lawsuit ensued.

The Delaware Supreme Court upheld the trial judge’s finding that SIGA breached the duty to negotiate in good faith by proposing terms that were not “substantially similar” to the economic terms in the LATS. The Court agreed that, even though the LATS was not signed and expressly stated on each page that it was “non-binding,” the incorporation of the LATS into the merger agreement, and the language requiring negotiation of an agreement “in accordance with” the LATS nevertheless meant that the parties were obligated to negotiate toward a license agreement with economic terms substantially similar to the terms of the LATS if the merger was not consummated. The Supreme Court upheld the trial court’s finding that SIGA acted in bad faith by proposing completely new terms and effectively disregarding the LATS.

To make matters worse, the Delaware Supreme Court held that PharmAthene could recover “benefit of the bargain damages” (i.e., the value of the licensing agreement that “would have been entered into” but for the bad faith). The Court held that “[w]here the parties have a . . . preliminary agreement to negotiate in good faith and the trial judge makes a factual finding, supported by the record, that the parties would have reached an agreement but for the defendant’s bad faith negotiations, the plaintiff is entitled to recover contract expectation damages.” To be sure, the trial court’s findings were based upon the particular and somewhat unusual facts in this case. Nevertheless, the Court’s determination that SIGA could not insist on terms or conditions that did not conform to the preliminary, expressly non-binding agreement, and that benefit of the bargain damages could be recovered, appears to differ from the laws in other states.

For example, in California (see Copeland v. Baskin Robbins U.S.A., 96 Cal. App. 4th 1251 (2002)) and New York (see Goodstein Construction Corp. v. City of New York, 80 N.Y.2d 366, 590 N.Y.S.2d 425 (1992)), “benefit of the bargain” or lost profit damages generally are not recoverable because, as the Copeland court explained, “there is no way of knowing what the ultimate terms of the agreement would have been or even if there would have been an ultimate agreement.”

Practice Tips:

1. To mitigate risk of the unintended enforcement of an LOI, parties should consider including the following language in the LOI.

● The parties agree that this letter of intent does not constitute a binding commitment by either party with respect to any transaction, [with the exception of the confidentiality and exclusivity sections set forth above.]

● The non-binding provisions of this letter of intent reflect only the parties’ current understanding of the contemplated transaction, and a binding contract will not exist between the parties unless and until they sign and deliver one or more definitive agreements, which will contain material terms not set forth in this letter of intent.

● No obligations of one party to the other (including any obligation to continue negotiations) or liability of any kind shall arise from executing this letter of intent, a party’s partial performance of the terms of this letter of intent, its facilitating or conducting due diligence, its taking or refraining from taking any actions relating to the proposed transaction or any other course of conduct by the parties [other than breach of the confidentiality and exclusivity provisions set forth above].

● The parties agree that neither party shall have a duty to negotiate in good faith and that either party may discontinue negotiations at any time for any reason or no reason.

● Any letters, drafts or other communications shall have no legal effect and shall not be used as evidence of any oral or implied agreement between the parties.

2. Choice of law other than Delaware to govern the LOI (e.g., California or New York). The definitive agreement can be governed by Delaware, but the LOI should not be, given the holding in SigaTechnologies.

3. Expressly state that the LOI is non-binding (except for confidentiality or exclusivity), disclaim any to be bound by any particular term or to be required to reach any agreement. While it may not be practicable or ideal to include such a provision, practitioners may also want to consider expressly disclaiming any duty to negotiate in good faith.

4. Limit the remedies to preclude lost profits, recovery of costs for anything other than a breach of any binding terms that are specifically described.

5. Parties to a contract should not assume that an expressly non-binding agreement will be found to be unenforceable in every state. By expressly delineating what is enforceable, by limiting the remedies, and by choosing favorable law, parties can limit their exposure and avoid being surprised by an adverse court ruling.

6. Of course, language alone may not provide an effective safeguard against breach of contract lawsuits based on “non-binding” term sheets. Parties also should be cautious in their communications and actions to avoid inadvertently obligating themselves to the terms of a letter of intent or a duty to negotiate in good faith.

● For example, a party should refrain from accusing the other party of “breaching” the non-binding provisions of the letter of intent and avoidinternal or external communications to the effect that the deal is done before definitive agreements are signed.

● A party also should proceed with caution in demanding economic terms more favorable than those expressly set forth in the term sheet. Courts often cite such “re-trading” as evidence of bad faith.