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WHEN CONTRACTS GO SOUR:Drafting and Due Diligence Lessons Learned From Litigation
Washington Metropolitan Area Corporate Counsel AssociationApril 8, 2008
Jerome L. Epstein, Partner Jenner & Block LLPTel: 202 639-6062
E-mail: [email protected]
Tobias L. Knapp, Partner Jenner & Block LLPTel: 212 891-1655
E-mail: [email protected]
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AGENDA
Drafting, Litigation, and Due Diligence Tips
Relating to Frequently Litigated Contractual Clauses• The Intersection of Fraud and Contract: Integration Clauses,
Disclaimers, and other Tools to Ward Off Fraud Claims
• Lessons from Recent Decisions Concerning Specific Performance/Material Adverse Change
• Best Efforts
• Arbitration Clauses
• Indemnification Clauses and Limitations of Liability
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Fraud Claims Arising Out of “Contractual” Disputes
• Essential Elements of a Common Law Fraud Claim Determining Justifiable Reliance
• Why do We Care if a Seeming “Breach” is Presented as an Intentional Tort?
• When a Buyer Sues in Tort – Fraudulent Inducement
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Tips for Avoiding Fraudulent Inducement Claims
• Merger/integration clauses are usually necessary but not sufficient.
• Protection from a Disclaimer? General vs. Specific
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Tips for Avoiding Fraudulent Inducement Claims Continued
• “As is” clause • Buyer’s access to information• Indemnification as buyer’s exclusive remedy • Anti-sandbagging clause• Caveats in offering memorandum or other pre-contract
formal descriptions
• Other contractual clauses that help defeat fraud claims, even if insufficient standing alone:
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Tips for Avoiding Fraudulent Inducement Claims Continued
• Due Diligence Tips Records of documents produced
Attendance at all interviews conducted by buyer
Requirement that buyer seek updated diligence
Buyers, in turn, must be careful to follow up on key items on their own diligence lists
Establish clear record that the other party was asked if it required more information
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Litigation Tips for Defending Fraud Claims Between Parties to a Contract
• Don’t rule out motion to dismiss
• Was missing information in the Seller’s “exclusive knowledge,” or should it have been discovered through reasonable due diligence?
• Was alleged misrepresentation a statement of opinion, or mere puffery?
• Reliance, reliance, reliance!
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Pre-Closing Disputes: MAC Clauses and Specific Performance
MAC Clauses
Specific Performance / Reverse Termination Fee
URI v. Cerberus: The “Forthright Negotiator”
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Material Adverse Change• Defining a MAC
Any condition, change or event that
has had or could/would/might
be reasonably expected to have
individually or collectively
a material adverse effect
on the assets, liabilities, condition, results or operations
or prospects
of target
and its subsidiaries taken as a whole
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Material Adverse Change• The Threshold Is High
October 1987 market crash found not to be a “MAC” (Bear Stearns/Jardine)° Market risk should have been understood
Single quarter decline in results not sufficient in and of itself (IBP v. Tyson)
• Overview of Current Delaware Law° Unknown° Material° Sustained – cannot be just a “blip” in the record
– Genesco: Court ruled that within the context of that merger, 3 to 4 months was durationally-significant (Tennessee law)
° Burden of proof is on the party claiming a MAC° Character of buyer (strategic v. financial)
– “[O]dd to think that a strategic buyer would view a short-term blip in earnings as material, so long as the target’s earnings generating potential is not materially affected by that blip or the blip’s cause” (IBP v. Tyson)
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Material Adverse Change
• Case Law / Recent Developments IBP v. Tyson Foods (Del. 2001 – New York law)
° Tyson had received extensive information about IBP prior to transaction
° IBP experienced financial difficulties – Tyson claimed MAC and IBP sought specific performance
° Court found no MAC – Tyson required to perform– General economic or market downturn not sufficient, the burden was on Tyson to
prove general decline “had the required materiality of effect”
– MAC interpreted in light of “negotiating realities”
– Tyson was a strategic buyer
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Material Adverse Change– Not a short-term speculator for whom “the failure of a company to meet
analysts’ projected earnings for a quarter could be highly material”
– Strategic buyer would view a downturn as material only if it was “consequential to the company’s earnings power over a commercially reasonable period, which one would think would be measured in years rather than months”
– Based on the financial information that Tyson had received, IBP’s first quarter earnings were down 64%, the company was on pace to have its worst financial performance in five years and earnings projections had gone from $2.38 to $1.44 per share
• “Even accounting for Tyson’s attempts to manipulate the analyst community’s perception of IBP, this was a sharp drop”
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Material Adverse Change
– In citing analysts’ wide range of projections for IBP, the court stated that “the analyst views support the conclusion that IBP remains what the baseline evidence suggests it was — a consistently but erratically profitable company struggling to implement a strategy that will reduce the cyclicality of its earnings. Although IBP may not be performing as well as it and Tyson had hoped, IBP’s business appears to be in sound enough shape to deliver results of operations in line with the company’s recent historical performance”
– MAC clauses read “as a backstop protecting the acquirer from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner”
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Material Adverse Change Holly v. Frontier Oil (Del. 2005)
° Holly learned of significant toxic tort suit filed against target, Frontier Oil° In light of litigation, parties amended litigation representations and
warranties in agreement° Court followed IBP: Burden on claiming party to prove requisite likelihood
that litigation would result in a MAC° While court agreed that the litigation could be “catastrophic” for Frontier,
Holly did not establish the requisite likelihood of such a result to establish that Frontier had suffered a MAC
° “The notion of [a MAC] is imprecise and varies both with the context of the transaction and its parties and with the words chosen by the parties”
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Summary of Disrupted Deals (2007-08)Parties Suit
FiledDeal Value
Dispute Remedy Sought Result
Accredited Home Lenders / Lone Star
08/2007 $400 mil. MAC Specific Performance
Parties settled; reduced purchase price to $295 million
Genesco / The Finish Line
09/2007 $1.5 bil. MAC Specific Performance
Court ordered specific performance; parties attempting to settle rather than close ($175 mil. cash ($139 mil. from UBS) and 12% of TFL’s outstanding common stock (approx. $29 mil.))
SLM Corp / J.C. Flowers
10/2007 $25 bil. MAC $900 mil. Termination Fee
Parties settled; refinanced $30 bil. of SLM debt
HD Supply / Carlyle Group, et al.
N/A $10.3 bil. MAC N/A Parties renegotiated; reduced purchase price
Harman / KKR N/A $8 bil. MAC N/A Parties renegotiated; KKR and Goldman purchased $400 mil. in Harman convertible debt
United Rentals / Cerberus
11/2007 $4 bil. Remedy for breach
Specific Performance
Specific performance not available; $100 mil. termination fee
3Com / Bain Capital N/A $2.2 bil. Termination Fee N/A Pending
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Material Adverse Change
• Lessons Learned – Practice Tips Despite recent activity, no major definitional changes
Materiality threshold – beware of the “Gray Zone”° Typically not quantified – “know it when you see it” is scant comfort
– Limited use of quantified metrics
– Including such metrics would remove uncertainty, but could reduce leverage to renegotiate or result in termination right
– Example: If a target growing at 30% per year for 3 years has a flat quarter, is that a MAC?
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Material Adverse Change• Rely on the MAC for the truly unknown facts, but use
specific additional conditions/requirements to address the known risks
– e.g., Consider requirement to satisfy certain hurdles/conditions– Use MAC out as a backstop rather than the primary line of defense
Facts and circumstances analysis– Interpret MAC in light of “negotiating realities”
Anticipate the introduction of extrinsic evidence to interpret an ambiguous MAC clause
– Be careful what you ask for and do not get
Additional contract provisions will also be considered– e.g., Genesco duration of cure period
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Specific Performance• Other Drafting Considerations
Reverse termination fees began as private equity buyers began to eliminate financing contingencies (which many strategic buyers don’t need)
° Reverse termination fees were payable to target/seller if deal didn’t close because financing wasn’t available
Quickly evolved into broader limitation on private equity buyers’ liability if transaction didn’t close for any reason
Exclusivity became important because private equity buyers would not put “full, faith and credit” up to support a deal unless burn was capped
Led to questions about circumstances under which a private equity buyer could walk from deal for any reason
Practices/drafting varied° Some made it clear contract was essentially an option
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Specific Performance° Others were less clear – included payment as exclusive remedy but then
also included specific performance as well – inconsistent
° Others indicated target could specifically enforce obligations to draw financing and close but that the fee capped damages of sponsor if deal didn’t otherwise close
Specific Performance° MAC Cases (IBP, Frontier Oil, Genesco, etc.)
° Reverse Termination Fees - United Rentals v. RAM Holdings (Del. 2007)
– RAM (Cerberus subsidiary) sought to terminate transaction and pay break-up fee
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URI v Cerberus: Forthright Negotiator
– Conflict based on provision which offered URI the “sole and exclusive remedy” of enforcing break-up fee
– Because the court held that (i) the language of the merger agreement presented a direct conflict between provisions relating to remedies and (ii) the evidence of negotiations was too muddled to clearly support URI’s interpretation of the relevant provisions, the court applied the so-called “forthright negotiator” principle to the two key provisions at issue
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URI v Cerberus: Forthright Negotiator
° Section 9.10 of the Merger Agreement supported URI’s request for specific performance: United Rentals “shall be entitled to seek an injunction or injunctions to prevent breaches of this Agreement by [RAM Holdings] or [RAM Acquisition] or to enforce specifically the terms and provisions of this Agreement and the Guarantee to prevent breaches of or enforce compliance with those covenants of [RAM Holdings] or [RAM Acquisition]”
° Section 8.2(e) supported Cerberus’ claim that specific performance was unavailable: “Notwithstanding anything to the contrary in this Agreement, including with respect to Sections 7.4 and 9.10, (i) the Company's right to terminate this Agreement in compliance with the provisions of Sections 8.1(d)(i) and (ii) and its right to receive the Parent Termination Fee pursuant to Section 8.2(c) or the guarantee thereof pursuant to the Guarantee, and (ii) [RAM Holdings]'s right to terminate this Agreement pursuant to Section 8.1(e)(i) and (ii) and its right to receive the Company Termination Fee pursuant to Section 8.2(b) shall, in each case, be the sole and exclusive remedy”
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URI v Cerberus: Forthright Negotiator
Court found these provisions to be ambiguous and “hopelessly conflicted”° There was no “single, shared understanding with respect to the availability of specific
performance”
The “forthright negotiator” principle: If a provision is ambiguous and the extrinsic evidence does not establish a meeting of the minds, the subjective understanding of one party may bind the other if the other has reason to know of that understanding and does not convey its contrary interpretation
° “Though URI … had many opportunities throughout the negotiation process to clearly vocalize its understanding of its rights for specific performance … URI consistently failed to communicate this to Cerberus representatives”
° “From the beginning of the process, Cerberus and its attorneys have aggressively negotiated this contract, and along the way they have communicated their intentions and understandings to URI”
° Specific performance was not available to URI
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Best Efforts
• Example: Party A Shall Use its “Best Efforts” to Sell the Product
• Do You Really Need This Clause? The Litigators’ Full Employment Act
• “Best Efforts” is a Notoriously Ambiguous Term That Can Lead to Protracted, Fact-Intensive, and Intrusive Discovery
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Best Efforts Continued
• Courts Have Widely Varying Interpretations
At a minimum “good faith” is required, but that is a fairly low bar.
Usually the term “reasonable” is read in, but that still leaves a wide window.
Some courts use a more objective test, such as what is “commercially reasonable.” See, e.g., Bloor, 601 F.2d at 613 n.7 (noting different formulation by New York courts – that “best efforts” requires party to perform as well as an “average prudent comparable” company in the same business).
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Best Efforts Continued
• Problems with an Open-ended “Best Efforts” Clause May be interpreted to require you to maintain quality at a level comparable to
industry participants with greater resources and options
May open up discovery as to what other companies are capable of in order to show what is “reasonable”
May open up discovery on negotiations
The business client’s nightmare: inviting discovery as to other business decisions your client has made
May be read to prevent party from pursuing opportunities with other partners (divided loyalty), even when the contract does not otherwise have an exclusivity obligation
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Best Efforts Continued
• Drafting Tips If you are the party who will be doing the heavy lifting,
try to avoid a general “best efforts” clause entirely.
If you are the beneficiary of the “best efforts,” it is a helpful standard to keep the other side’s feet to the fire – but you may still suffer from endless fact-intensive disputes.
Consider metrics or specific factors as alternative to “best efforts.”
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Best Efforts Continued
• If you must use a “best efforts” clause – Consider at a minimum specifying that “best efforts” means
“commercially reasonable”
Better still define “best efforts” to mean “commercially reasonable efforts, taking into account reasonable efforts for a business similarly situated to Y in the X industry”
Use specific examples (e.g., filing certain forms, degree of sales efforts or expenditures) as part of the definition of “best efforts.” Could be “including, but not limited to . . .” or “best efforts principally to be determined by commercially reasonable efforts in the areas of x, y, and z”
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Best Efforts Continued
Or use specific metrics as a ceiling
Use other contractual clauses to eliminate unintended breadth of “best efforts” clause
Require other side to meet “clear and convincing evidence” or other high bar in dispute resolution clause
Include an opportunity-to-cure provision as a condition to termination
During contract performance, maintain a good record that decisions were made based on “normal” exercise of business judgment in the industry
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Arbitration
• Pros and Cons of Arbitration Clauses
• Don’t Reinvent the Wheel for a Standard Clause
• Additional Drafting Details to Consider Mandatory Mediation
Mandatory Expertise/Background of Panelists
Confidentiality
Specifying Scope of Discovery
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Arbitration Continued
Time Limits/Schedule
Place of Arbitration
Allocation of Costs and Fees
Limitations on Damages
Form of Award/Decision
Limitations on Types of Claims
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Indemnification and Limitationsof Liability
• Tips from a Litigator’s Perspective
• Don’t assume you cannot get a limitation on consequentials, incidentals, etc.
• Beware of “form” contracts or lopsided negotiations with one-sided indemnification clauses. Courts can enforce agreements where you have agreed to indemnify the other side for losses, even when the other side is negligent.
• Specify who is being indemnified (e.g., in addition to contracting party, its officers, directors, employees, agents)
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Indemnification and Limitationsof Liability Continued
• Specify the conduct triggering indemnification; e.g., any act or omission arising out of seller’s performance, including its subcontractors? Only for breach of contract?
• Watch for ambiguity as to the type of indemnification or types of losses to which indemnification applies – e.g., for personal injury, property damage, attorneys’ fees and duty to defend/costs of defense, economic loss?
• Watch for damages you thought were excluded coming in through the back door – e.g., in a termination clause, or an additional form contract incorporated by reference.
• Consider caps – applying a specific cap to a set of specific indemnifiable events.
