Early in the acquisition process, the prospective buyer typically will find it necessary to obtain detailed financial and other business information about the target company in order to formulate an offer. In a friendly transaction, in particular, this need will be recognized by the target company as well. The established mechanism for allowing the prospective buyer access to the information it needs, while at the same time protecting the interests of the target company in that information, is a confidentiality agreement.
Confidentiality agreements once tended to be short, relatively simple documents that recognized a general confidentiality undertaking by the prospective buyer. In some cases, business information about the target company was provided without any confidentiality agreement in place, although a clause in the letter of intent, if one was later entered into, usually covered past as well as future disclosures.
This has changed significantly in recent years. Confidentiality agreements are now commonly entered into upfront, often contain expansive definitions of what constitutes "confidential information", and frequently include a number of other provisions that significantly affect the rights and obligations of the parties.
Scope of confidential information
In 1995, the Committee on Negotiated Acquisitions of the American Bar Association's Section of Business Law drafted and published a model confidentiality agreement (the Model Confidentiality Agreement) for use in connection with mergers and acquisitions. The Model Confidentiality Agreement, admittedly seller-oriented, illustrates the trend toward a very broad definition of what constitutes confidential information and includes for this purpose:
- all information of the target company constituting trade secrets; and
- all other information concerning the business and affairs of the target company that has been provided to the prospective buyer.
Under the Model Confidentiality Agreement, the definition of what constitutes confidential information is not narrowed by traditional exclusions such as information which becomes generally available to the public, or information made available to the prospective buyer without wrongful actions on the part of a third party providing the information. Instead, those exclusions only constitute exceptions to the limitations on use of the information by the prospective buyer. Another traditional exclusion, information developed independently by the prospective buyer itself, is omitted altogether on the theory it is too difficult to prove or disprove. The comments to the Model Confidentiality Agreement state that the purpose is to define confidential information in the broadest possible terms, and in effect to accord all disclosed information the equivalent of trade secret protection even though much or all of that information might not merit such protection under applicable law.
The prospective buyer obviously will wish to narrow the definition of confidential information as much as possible in order to minimize the risk of inadvertently violating the confidentiality agreement as well as to avoid converting to confidential status information about the target company it already may possess. Narrowing the definition reduces the prospective buyer's disclosure risk, and documenting information about the target company received independently from other sources should be helpful as well.
Restrictions on use
A confidentiality agreement typically restricts the prospective buyer from using the confidential information for purposes other than evaluating a possible acquisition of the target company and expressly limits the prospective buyer’s right to disclose the information to other persons. Confidentiality agreements also impose on the prospective buyer an obligation to police persons to whom it is permitted to disclose the information.
Sellers often attempt to include no detrimental use language in confidentiality agreements. For example, the Model Confidentiality Agreement provides that the prospective buyer "will not use any of the Confidential Information either for any reason or purpose other than to evaluate a possible acquisition transaction or in any way detrimental to the company (it being acknowledged that any use other than evaluation of and negotiating the possible acquisition transaction will be deemed detrimental)." Language such as this might, for example, preclude the prospective buyer from using the information to later make an unsolicited bid for the target company since the transaction then would not have been negotiated. It could also create various uncertainties due to the vagueness of the word detrimental.
Another key issue concerns the categories of persons to whom the confidential information may be disclosed. Lawyers, accountants and other advisors commonly are included in this group, but prospective buyers often overlook the need to include financing sources. Please note in this regard that the Model Confidentiality Agreement expressly prohibits disclosure to financing sources without the target company’s specific prior written consent.
The target company often seeks to impose on the prospective buyer an obligation to require each permitted recipient of the confidential information to sign a separate confidentiality agreement substantially in the form signed by the prospective buyer. It may, however, be impossible for the prospective buyer to persuade lenders and other third parties to do so, thus raising a compliance issue. A less stringent policing standard therefore is desirable from the prospective buyer’s standpoint, as is a stated limit on the duration of its confidentiality undertaking.
Non-disclosure of negotiations
Confidentiality agreements may include a provision prohibiting the prospective buyer from disclosing that negotiations with the target company are taking place or the possibility of a merger or acquisition involving the parties. There are several reasons for this, including the target company’s desire to avoid the disruption of its business that could result from its employees, customers and suppliers knowing that the business is for sale.
Maintaining confidentiality might also be in the prospective buyer’s interest in order to avoid signaling that the target company is "in play", which could attract other possible bidders. Consequently, it may be appropriate to negotiate a non-disclosure commitment that is mutual.
It is common in an auction situation or where the target company is otherwise being shopped around to restrict a prospective buyer from disclosing confidential information even to other prospective buyers who have been provided the same information. The target company’s motivation in doing so usually is to prevent potential bidders from teaming up to make a joint bid or sharing information about the target company for other purposes. Obviously, the prospective buyer will wish to avoid such restrictions to the extent possible.
The prospective buyer may also wish to negotiate a most favoured buyer provision to ensure that its obligations with respect to the confidential information are no more onerous than the obligations of the most favorably treated other prospective buyer.
Transactions involving competitors
Mergers or acquisitions involving competitors, common these days, raise special problems. Government officials have on occasion (eg at the American Bar Association’s Annual Antitrust Spring Meetings) expressed concerns regarding the exchange of competitively sensitive price, cost, marketing and similar information during the due diligence phase of prospective mergers or acquisitions involving competitors. Those concerns understandably focus on prospective transactions which do not proceed. One of the concerns is that the negotiations might have been a sham to mask an anti-competitive purpose. Another concern is that even if the negotiations were not a sham, future developments such as stabilization of prices in the industry might suggest some connection back to the aborted transaction.
Prudently drafted confidentiality agreements will take these concerns into account by regulating access to certain types of information. For example, the prospective buyer’s marketing and production personnel might be screened from cost, price and similar information of the target company. These might of course be some of the very people the prospective buyer wishes to rely on to evaluate certain aspects of the target company’s business.
Once the parties have agreed on price, it might be prudent to cease further exchanges of sensitive competitive information during the pre-acquisition phase. The prospective buyer presumably should also avoid sharing its price or other data with the target company, although in a merger of equals there may be legitimate reasons to do so.
The competitor problem takes on an additional twist where the target company is being auctioned. Does specifying in the confidentiality agreements required of prospective buyers who are competitors of the target company that their access to sensitive competitive information will be limited, but not so restricting prospective buyers who are not competitors, flaw the auction process? It has been suggested that it might and the issue must be addressed by the target company and its advisors.
Proposed mergers and acquisitions involving competitors in high tech fields raise yet another issue. A prospective buyer who reviews the target company’s technology in depth as part of the due diligence process in a transaction which does not proceed risks having its independent product developments and innovations characterized as a misappropriation of the target company’s confidential information.
The prospective buyer thus must choose between full due diligence on the one hand and legal risk on the other. A similar dilemma is presented by confidentiality agreement restrictions on the hiring of the target company’s employees by the prospective buyer.
So-called standstill provisions may be included in a confidentiality agreement, or in a related agreement, if the target company is a public company. These provisions vary, but their purpose generally is to govern the extent to which the prospective buyer may acquire shares of the target company’s stock, launch a takeover bid or otherwise seek to obtain control of the target company or its board of directors (eg through a proxy contest). A standstill provision may be included in a confidentiality agreement as the price of a hostile bidder being given access to confidential information of the target company or it may be included as a precautionary measure in a negotiated transaction.
A detailed discussion of issues presented by standstill agreements is beyond the scope of this article. Counsel and their clients should be aware, however, that such issues may include questions of enforceability as well as reconciling such agreements with the duties of the target company’s board of directors.
LETTERS OF INTENT
There is an increased awareness of the issues presented by using a letter of intent, sometimes also called a memorandum of understanding, heads of agreement or by some other name (herein, letter of intent). When this type of pre-acquisition agreement is used, increasingly it is being drafted with an eye toward avoiding unintended legal consequences.
Reasons for letters of intent
Letters of intent traditionally have been used for a number of reasons, including to:
- memorialize the parties’ general understanding regarding price, structure and other key terms;
- support financing applications;
- permit early filing of a premerger notification under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the HSR Act);
- reflect the parties’ "moral commitment" to the deal; and
- tie up the target company through ‘no shop’ or similar commitments.
The prospective buyer and the target company often have different reasons for wanting a letter of intent. The prospective buyer may be most interested in securing a no shop commitment from the target company while remaining as flexible as possible in areas such a purchase price adjustments and indemnification rights until it is able to complete its due diligence investigation. On the other hand, the target company may be motivated more by having the purchase price and other key financial terms set in stone.
Legal risks of letters of intent
The risk presented by a letter of intent is that it might be found to constitute a binding agreement between the parties. This risk is often not fully appreciated when the parties commit their agreement in principle to paper, sometimes without the benefit of legal counsel.
Numerous court decisions in the US have dealt with the legal effects of letters of intent. The general principles the courts typically follow in these cases are summarized in Letters of Intent in Corporate Acquisitions prepared by the Committee on Negotiated Acquisitions of the American Bar Association’s Section of Business Law:
- If the parties intend not to be bound to each other before the execution of definitive agreement, the courts will give effect to that intent and the parties will not be bound until the agreement has been executed. This is true even if all issues in the negotiation have been resolved.
- On the other hand, if the parties intend to be bound before the execution of a definitive agreement, the courts will also give effect to that intent and the parties will be bound even though they contemplate replacing their earlier understanding with a definitive agreement at a later date.
- Parties intending to be bound before the execution of a definitive agreement will be bound even if there are certain issues which have not been resolved. Depending on the nature of the open items, either the courts will supply commercially reasonable terms for those unresolved issues or the courts will impose a contractual duty on the parties to negotiate the resolution of those issues in good faith.
Things get murkier when attempting to apply these principles, however, and the cases often turn on the actual language of the letter of intent as well as on oral communications and actions of the parties. "Looks like we have a deal" and similar statements, possibly accompanied by handshakes, may indicate an intent to be bound. This is particularly true if the letter of intent contains conflicting language as to intent.
Even if a letter of intent is ultimately determined not to be a binding agreement, it nevertheless may be found to impose on the parties an obligation to bargain in good faith. While this duty may not require that the parties actually reach a definitive agreement, it does require that a party not try to kill the deal simply by refusing to negotiate, making outrageous demands or merely accepting a higher offer from another party.
Because of the legal issues presented, parties may wish to consider by-passing a letter of intent and instead focus on negotiating a definitive acquisition agreement. This approach has the advantage of ensuring that before a binding contract is concluded, all issues will have been thoroughly negotiated and the agreement of the parties carefully documented in writing. Obviously, by-passing a letter of intent has some negatives associated with it as well since, among other things, it will not provide a written basis for the prospective buyer to seek financing or for the parties to file at an early date under the HSR Act.
It also does not provide the parties with the comfort of having key terms reduced to paper. Transactions often drag on, memories can fade and new suitors may enter the picture.
Because of these considerations, an alternative approach favored by some is to use a term sheet. A term sheet is a written recitation of the key business terms of the transaction, often using bullet points, without the kind of language frequently included in letters of intent that tends to raise issues regarding whether the parties intended to be bound.
If a letter of intent is used
If the parties to a prospective transaction deem it desirable to use a letter of intent for some reason, the document should be carefully drafted, bearing in mind the potential legal ramifications as well as the business purpose it is intended to serve. Normally it is good practice to divide the letter of intent into two distinct sections – one clearly labeled ‘binding provisions’ and the other clearly labeled ‘non-binding provisions’. Binding provisions would include such matters as the prospective buyer’s right to conduct due diligence, any no shop obligations on the part of the target company, HSR Act filings and responsibility for brokers’ commissions and other expenses. The non-binding section would briefly cover key deal points such as purchase price and adjustments thereto, scope of representations and warranties, indemnification obligations and any escrow to secure those obligations. A concluding paragraph might reemphasize that except as otherwise expressly provided, the parties do not intend to create a binding agreement in any respect.
The cross-border element
The cross-border character of many of the mergers and acquisitions taking place today adds another dimension to the issues presented by pre-acquisition agreements. Just as attitudes and customs relative to due diligence investigations may vary by country, it is important to recognize that the legal effect given to certain pre-acquisition agreements may differ by jurisdiction as well. Thus, for example, inclusion of the phrase "subject to contract", which might make a letter of intent non-binding in one country, might not have the same effect under applicable US law.
These differences raise the issue of whether a prospective buyer should include choice of law and forum clauses in pre-acquisition agreements where the target is a US company. That may be an option if there is confidence that such clauses will be given effect. However, a preferable approach normally will be to structure and draft such agreements in a way that takes into account issues presented by US law.
Parties to prospective cross-border transactions also need to be mindful that factors other than private confidentiality agreements may come into play insofar as disclosure of information by the target company is concerned. For example, depending on the prospective buyer’s host country, government licensing requirements might apply in the case of disclosures of certain technical information. In addition, if the US target company is a defense contractor or subcontractor, attention must be paid to the requirements of the US Department of Defense’s National Industrial Security Program which restricts access to certain classified information possessed by that company.
Pre-acquisition agreements have evolved and taken on new importance due to the increased focus of target companies on protecting their confidential business information, the proliferation of mergers and acquisitions involving competitors, considerations presented by takeover bids and auctions and other factors. Cross-border transactions raise additional issues that must be taken into account, including differences that may exist between the legal treatment of such agreements in the prospective buyer’s host country and in the US and government restrictions on the target company’s ability to provide certain technical information pursuant to a confidentiality agreement.
Originally printed in the International Financial Law Review Special Supplement, "A Legal Guide," June 1998.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.