Introduction & "Preliminary" Contracting-Module 1 of 6
Module I. Introduction & “Preliminary” Contracting
As a person who appreciates context, allow me to tell you a bit about my legal career before we delve too deeply into the ideas of contract negotiating and drafting. I have been a lawyer for 41 years, the vast majority of that time spent as a transactional lawyer and law professor at a major law school (teaching such as contract drafting and negotiating and running a transactional law clinic). I have a graduate law degree in intellectual property. I spent many years as general counsel/chief legal officer at a number of corporations in the realms of entertainment, advertising, franchising, oil & gas, and high tech. I also have represented innumerable individuals over the years in the context of transactions. I have negotiated and drafted at least a thousand contracts and on very broad subject matter.
Behind all bargained-for contracts is… the bargain. But the term “bargained for” suggests that not all contracts are formed through actual bargaining. In fact, the vast majority of contracts entered into in America every day are not bargained for at all; the price is set by the potential seller, and the potential buyer either buys the product (or service) or not; e.g., the price of breakfast on the menu at a restaurant. In the case of breakfast, the contract is partially written (the menu offer) and partially oral (the acceptance of the menu offer by placement of the order). The other major category of non-bargained-for contracts is what is called “adhesion” contracts. They are “adhesive” because they are written forms not open to negotiation; e.g., the contract you sign when you ship a package by overnight delivery service. Imagine walking into such an office, handing the customer-service person your package to be shipped and then indicating you wish to negotiate the terms and conditions by which the delivery will occur. The customer-service person would just look at you funny. You either “adhere” to the contract terms and conditions as stated on the form agreement or the overnight delivery service will not accept the package for delivery. It’s that simple.
On the other hand, for the significant minority of contracts that are bargained for, the bargaining is a highly complex undertaking. And while business persons are not required to engage attorneys in the negotiation and drafting processes, clearly it is wise to do so, especially as the value of the contract rises. As with breakfast at a restaurant, a bargained-for contract can be oral (or partially oral) in nature, and while there are bargained-for oral agreements of a very significant nature (both in terms of the value of the deal and the complex nature of the deal), the great majority of valuable and complex bargained-for agreements are written. There are far too many variations of written, bargained-for agreements to even try to list or detail or discuss them all here, but most of them have common negotiation and drafting components, and it is these components that will be discussed here.
2. Principle of Freedom of Contract
First, a word about the subject matter of contracts and the freedom to contract. Contract subject matter is as varied as is imaginable. As long as the subject matter does not involve criminality or other unlawful activity, pretty much anything can be the subject of a contract. Contracts can be about sales or employment or settlements or anything in between. As long as there is an offer by one party to the other, an acceptance of that offer by the other party, and some form of value passing from each side to the other, the most basic requisites of contracting have been met. There can be two parties to a contract or many parties to a contract. The parties to contracts can be individuals, companies and other types of organizations, government entities, and all variations of the above. Generally, the parties to a contract know what the subject matter is when the negotiation process begins, but subject matter can be added or subtracted during the negotiation process. While there is the general freedom to contract, there are some limitations placed on contracting — both procedurally and by way of subject matter — by various governmental entities. For example, collective bargaining on the part of management and labor unions can be subject to certain governmentally-imposed procedural (or bargaining) rules, and there are many statutes and court decisions at both the state and federal levels that speak to subject matter, such as those prohibiting the importation of embargoed goods. But, generally, the freedom to contract in America is very high.
There are as many ways to negotiate and draft agreements as there are types of agreements. For purposes of this writing, the most basic and common negotiation points and strategies will be listed and explored along with basic drafting techniques and strategies. The sample project that follows is between two parties (as opposed to multiple parties) with each party being represented by an attorney (in this case, each party’s in-house counsel). In negotiations of this type, it is impossible to separate negotiation and drafting into entirely separate components because they more or less occur at the same time; i.e., much of the negotiation occurs after the presentation of the first draft of the principal agreement by the initially drafting party to the initially non-drafting party. Until the drafting process is 100% complete — meaning that both sides have accepted the final deal — negotiating continues; every bit of the drafting process is necessarily a part of the negotiation process.
Before we enter this realm, it would be well to briefly explore another very common form of contracting, sometimes referred to as the “battle of the forms.” Companies that sell goods and services to other companies (as opposed to the business-to-consumer adhesion contract mentioned above) very commonly have form contracts that they use in making deals with buyers of such goods and services. But such contracts mostly are not “adhesive” in the sense that some bargaining away from the express language of the form commonly occurs. Sometimes, the buying entity (especially if it is quite large) will have a form contract that it uses for purchasing goods and services. When each side has a form agreement, the trick is to, first, agree as to which one will be used, and, second, to successfully negotiate the form contract chosen to be used as the starting point.
Most of the time, the two sides truly want to do business with one another, so the negotiation is not terribly difficult. However, when one side believes it occupies a far better bargaining position than the other side, it may choose to exercise that power and make the negotiation difficult if not impossible. Sometimes, one side will have an unrealistic view of its bargaining position. For example, let’s say a company sells computer-network security services to various brick-and-mortar merchants nationwide in the context of payment cards. And let’s say a regional grocery-store chain wishes to buy these services from this company. But when the attorney for the network-security company presents its form agreement to the attorney for the grocery-store company (fully willing to negotiate the form agreement’s terms to some extent or the other), the grocery-store chain attorney says, no, the form contract that must be used is the contract the grocery-store chain uses to buy produce from wholesalers. Excuse me? What? Lettuce? Avocados?
When the grocery-store chain attorney refuses to back off what the grocery-store chain completely unrealistically believes is a superior bargaining position in favor of negotiating the service provider’s form agreement, the potential transaction quickly becomes a non-starter. It is well to remember that in contract negotiating, it can be true that not contracting at all is sometimes the best negotiated outcome for one of the parties. The concept of bargaining position or bargaining strength, discussed later in greater detail, is commonly the very most important idea in the negotiation/drafting process and is the one idea that should be assessed as comprehensively as possible by each side before the real negotiating ever begins. It may not be possible to deduce exactly what the other side’s bargaining position is simply because all such information is not available to be learned, but some bargaining-strength information always is available, and one should try as diligently as is reasonably possible to discern the other side’s bargaining strength (while they may be slightly different, the terms “bargaining position” and “bargaining strength” are used interchangeably here).
3. The Basics of a Potential Deal
a. The Parties. In this sample negotiation, the parties are two businesses. We’ll call them ABC Network Security Company, LLC (“Seller”), and XYZ Payment Card Guaranty Company, LLC (“Buyer”). The negotiators are the chief executive officers and chief legal officers of each company.
b. Industry. Payment-card computer-network security for retail businesses.
c. Preliminary Agreements. Nondisclosure and due diligence.
d. Principal Agreement. Corporate buy-sell.
These are two companies that are in the same business; they are direct competitors. Seller heard through the industry grapevine that Buyer was interested in buying up some of the competition. That was interesting to Seller because Seller’s principal owners recently had become interested in selling so they could extract their investment and profit in order to place these funds in another industry with, in their view, more immediate and greater potential. So Seller’s CEO picked up the phone and called Buyer’s CEO (whom she knew casually from industry trade shows). Buyer’s CEO immediately expressed interest — leading to two preliminary agreements, nondisclosure and due diligence.
Because it would be Seller divulging proprietary confidential information to Buyer in the negotiation process, Seller’s CLO drafts a fairly standard nondisclosure agreement and presents it to Buyer’s CLO. After a bit of consultation with the CEOs and negotiation concerning how the return of confidential information would be handled should the sale not be consummated, the nondisclosure agreement is executed by the CEOs. Next is the due diligence agreement. Most of the time, there is no separate due diligence agreement because its terms can be effectively handled in the nondisclosure agreement or are never reduced to a writing at all (though an oral agreement may have been struck). But where, for instance, the potential buyer is requiring that the potential seller pay for certain of the potential buyer’s due diligence expenses, a separate agreement may be required. In this example, Buyer’s CLO drafts the due diligence agreement. After some minor wrangling over expense ceilings, the agreement is executed by the CEOs, and Seller begins the execution of the due diligence process. As a negotiation point, when the potential seller agrees to pay the potential buyer’s due diligence expenses (to some maximum figure), it should be clear to both parties (though it likely will not be spoken between them) that the potential seller may have a greater interest in selling than the potential buyer has in buying.
4. Due Diligence
Due diligence can be extremely important to buyers; it can mean the difference in making an excellent purchase or in making a horrible mistake. The due diligence process can be quite short or mind-numbingly complex. By way of example, a mid-range due diligence list follows.
A. Organization. √ All documents relating to the company’s organization and standing and identities.
B. Financial and Credit Information. √ All documents relating to all aspects of the company’s financial and credit situation [for some period of years].
C. Physical Assets. √ A schedule of fixed assets, including leases, and the locations thereof.
D. Real Estate. √ All documents relating to real estate.
E. Intellectual Property. √ All documents relating to patents, trademarks, trade names, copyrights, and technical know-how, and any claims or threatened claims by or against the company regarding intellectual property.
F. Employees and Employee Benefits. √ A list of employees and titles, including all financial information relating to each employee, résumés of key employees, the Company’s personnel handbook and a schedule of all employee benefits and holiday, vacation, and sick leave policies, summary-plan descriptions of qualified and non-qualified retirement plans, copies of any collective bargaining agreements, a description of all employee problems [for some period of years], including alleged wrongful termination, harassment, and discrimination, a description of any labor disputes, requests for arbitration, or grievance procedures currently pending or settled [for some period of years], and a description of worker’s compensation claims history [for some period of years].
G. Licenses, Permits, and Regulatory Agency Involvement. √ Copies of any governmental licenses, permits or consents and any correspondence or documents relating to any proceedings of any regulatory agency.
H. Environmental Issues. √ All environmental information of every kind [for some period of years].
I. Taxes. √ All tax information of every kind [for some period of years].
J. Material Contracts. √ A sample copy of all standard agreements and a schedule of all other current agreements.
K. Product or Service Lines. √ All information concerning existing products or services and products or services under development and a summary of results of all tests, evaluations, studies, surveys, and other data regarding existing products or services and products or services under development.
L. Customer Information and Marketing. √ A schedule of the company’s [some reasonable number] largest customers in terms of sales thereto and a description of sales thereto [for some period of years], a schedule of unfilled orders, a list of and explanation for any major customers lost over the last two years, the company’s current advertising programs, marketing plans and budgets, and printed marketing materials, and a description of the company’s major competitors.
M. Litigation. √ A schedule of all pending and threatened litigation, all documents relating to any injunctions, consent decrees, or settlements to which the Company is a party, and a list of all unsatisfied judgments.
N. Insurance Coverage. √ A schedule and copies of the company’s general liability, personal and real property, product liability, errors and omissions, key-man, directors and officers, worker’s compensation, and other insurance, and documentation concerning the company’s insurance claims history [for some period of years].
O. Professionals. √ A schedule of all law firms, accounting firms, consulting firms, and similar professionals engaged by the company [for some period of years].
P. Articles and Publicity. √ Copies of all articles and press releases known to the company and relating to the company [for some period of years].
5. Term Sheet and Basic Terms
While the due diligence process is ongoing, general discussions are held by the two CEOs over the following several weeks (neither side wants to be seen as being in too much of a hurry because that has the potential of significantly affecting negotiations). The result of these discussions is yet another document, though it rarely ever is a contract. It is called a “term sheet.” The term sheet is negotiated by the CEOs without legal assistance from the companies’ CLOs because term sheets (normally) do not involve matters of legality. Term sheets most ordinarily include a series of bullet points listing the most basic terms and conditions of the contemplated final agreement. It is not executed by either party since it is not meant to have legal significance or meaning (and may include a statement to that effect). During the negotiation and drafting process, one or more of the terms listed in the term sheet usually is further negotiated, sometimes hotly. Once the term sheet has been negotiated (though not necessarily finally), it is delivered to the CLOs so that the negotiating and drafting process may begin with these basic terms being at least preliminarily understood. Here are some typical term-sheet categories (and terms for this sample negotiation).
A. Purchase Price: $50,000,000.00.
B. Payment Method: Cash (wire transfer).
C. Reserve for Unknown or Unforeseen Circumstances: Ten percent for one year from date of full execution of final agreement.
D. Stock Purchase: 100%.
E. List of Major Tangible Assets by Category: Office equipment, vehicles, and firewall inventory.
F. Excluded Assets: An unrelated internet technology and 100% of the shares in the wholly-owned subsidiary that owns the technology.
G. Requirements: Due diligence completed by [date] and final agreement completed by [date].
H. Non-Binding Nature of Term Sheet: This document is unexecuted and has no legal force or effect whatsoever.
There are many things in life that are objectively determined. In a spelling test, you either spell the word correctly or incorrectly. Objectivity decides questions or issues by rules and strict procedures. But without a doubt, most things in life are determined subjectively. Subjectivity may be defined as outcome determination by thought; based on opinion. Objectivity may be defined as not being influenced by personal feelings or interpretations or prejudices; based on fact (“cat” is spelled c-a-t and not k-a-t; this is a fact, no subjectivity required). My father loved music. I love music. My view of music and his view of music overlapped somewhat but only at the edges. I remember him being aghast at hearing a semi-classical/pop favorite of his turned into rock ‘n’ roll/pop. I liked “his” version and loved “my” version. He loved “his” version and thought “my” version should be banned from the airwaves. Music — a no more subjective notion could there be. So how about negotiating contracts? Is there a set of rules and procedures used in every instance by both sides of a negotiation to reach a negotiated result; i.e., is there an objective approach? Alas, as with music, nothing could be further from the truth.
The literature of negotiating contracts is awash with systems and rules and rigid approaches. It might be nice if it worked that way, but it does not. There are dozens upon dozens of books and seminars and other materials that state flat out exactly how to negotiate. But all these “objective” methods actually in themselves are subjective because they are nothing more than the opinion — though perhaps the strongly held (and even largely successful) opinion — of the author of that particular negotiating system; they are not fact. Therefore, all a person can do when trying to decide a negotiation strategy in a particular situation is to use her best judgment as to how to proceed. One reason this is true is that every — and I mean every — negotiation is different. All this said, however, there are certain ideas that are well worth considering — at least as a starting point — as they have stood the test of time. In the outline that follows, we will use ideas of negotiating that are commonplace and common sensical. This study course is not meant to be exhaustive on the subject of negotiating; for instance, there are many negotiating systems that would seem to require the successful negotiator to have a Ph.D. in clinical psychology. While psychology commonly plays a part in negotiating, “mind games” are not the main thrust of this educational endeavor.