by contributor Glenn Nieves, Clark & Trevithick | Published January 3, 2012 at 2:00 PM
As mergers and acquisitions activity sees an uptick and the prevalence of strategic buyers increases, both buyers and sellers are well advised to not only be aware of the associated risks in disclosing highly sensitive information (for example, pricing information, patent information, source code, information technology, technical specifications and customer lists) during the due diligence process, but to use a finely tailored nondisclosure agreement, or NDA, that addresses the pitfalls described in this article.
In the current economic climate, a strategic buyer, more often than not, is the preferred suitor for a potential seller due to a host of factors, including the fact that a strategic buyer is likely to pay a better multiple compared to a financial buyer. Additionally, there are a large number of strategic buyers that have been aggressive with cost-cutting measures the past couple of years and have exceeded earnings estimates. As a result they have cash that they are ready and eager to deploy in an attempt to pick up market share or enter into a new complementary business line and leverage a seller's operations and infrastructure. This ease of funding, coupled with the fact that financial buyers still face credit market difficulties, has increased the likelihood that a potential buyer is likely to be either a direct competitor or a strategic buyer. This article addresses the importance of confidentiality in the mergers and acquisitions due diligence process where the parties are direct competitors or the acquiring party is a strategic buyer.
A nondisclosure agreement, often referred to as a confidentiality agreement, is usually the first agreement in the acquisition process signed by both the seller and the buyer. Ideally, a NDA should be signed by the parties before the sharing of any confidential information. A NDA is designed to protect the confidentiality of information exchanged in connection with the consideration and negotiation of the contemplated transaction. Because of the uniqueness of a mergers and acquisitions transaction, a seller would be ill-advised to use a standard NDA that it uses with its vendors or employees or to use a short-form NDA that does not adequately address the potential pitfalls involved with disclosing confidential information. While typically a seller has more to lose when confidential information is exchanged between a seller and a buyer, in certain situations, such as where a buyer is issuing equity to a seller as part of the transaction consideration, the buyer may also be providing substantial amounts of confidential information to the seller for the seller's due diligence on the buyer. Such a situation is an example of when a well-crafted and thought-out NDA would be mutually beneficial.
One of the keys in negotiating an effective NDA is limiting the number of individuals that have access to the disclosure of confidential information. There exists an unsubstantiated myth that a recipient should seek to secure the "largest" recipient group possible. To the contrary, it is in a buyer's interest to limit who has knowledge and/or access to the confidential information of the seller that is being shared, particularly if the buyer is a strategic buyer.
It should be to no one's surprise that as the global economy continues its never-ending roller coaster ride, even deals that make sense do not get done right away or at all. A strategic buyer who fails to erect walls within its organization to limit access to a seller's confidential information to a defined small group of indispensable individuals runs the risk of facing a lawsuit if the deal does not go through and the strategic buyer "exploits" the confidential information. A buyer should create "information walls" to segregate its reviewing team from anyone who might later be involved in fields competitive with a seller.
The failure to erect a wall could lead to a strategic buyer being prohibited from entering into a market that it has been eyeing or directly competing against the seller. For example, imagine a seller who is developing new products and a buyer who walks away from a deal but, six months later, rolls out a new line of products that is substantially similar to the seller's products that are in development. No one would be surprised if the seller immediately filed for injunctive relief after discovering the buyer's new product line. In such an instance, the existence and strict adherence to an information wall would likely be perceived favorably by a judge or a jury.
The parties may want to entertain the notion that highly sensitive information should be subjected to careful controls and procedures limiting the distribution and accessibility to highly sensitive information. Such special controls and procedures may include implementing a two-tier disclosure whereby highly sensitive information is disclosed only after the execution of a letter of intent or at a later time when the parties agree that a deal is more likely than not to occur. For example, the current mode of operation for aerospace and defense industry deals, as well as the technology industry, is to disclose purchase orders, customer lists and long-term agreements in the later waves of due diligence once a deal is more likely to happen. These industries are filled with intellectual property and trade secrets, where confidentiality is integral to the success of a business and premature disclosure would have the potential to do more harm than good.
The failure to manage the release of the confidential information could also result in several unfavorable consequences that might cause severe harm to the seller's business. For example, if employees learn their company is looking to sell, they may quit out of fear of the uncertainty surrounding a sale. The loss of a key employee or of employee morale would be detrimental to a business. Another unfavorable consequence may be that competitors use the information to undermine the company's standing with its customers and business partners.
Residuals clauses are contentious and highly negotiated. A residuals clause creates an exception to the prohibitions against use and disclosure of confidential information. It permits the subsequent use of "residual" information -- information that is retained by the unaided memory of employees who had access to it. The disclosing party typically resists the inclusion of such a limitation because it fears the consequences of any use or disclosure whatsoever. To alleviate the fear, a buyer may propose qualifying terms to the clause. One qualifying term may be to specify a range or field of permitted use for residual information and that any disclosure of residual confidential information will be limited to those that are inherent in the permitted use. Another qualification would be that the permission to use or disclose, as an exemption to the confidentiality obligation, is not a license to the disclosing party's intellectual property.
The disclosing party must confirm that the definition of "confidential information" covers the information and materials to be provided to the recipient including any confidential information that may have been provided prior to the signing of the NDA. Disclosing parties typically aim to obtain a broad definition that would address this concern and cover any notes, analyses, studies, etc., that are prepared by the receiving party or its representatives that reflect information they were provided by the disclosing party. The receiving party will generally limit confidential information to information that is nonpublic, confidential or proprietary in nature.
As with any defined term and exceptions to a general rule, the devil is in the details. Does public information mean "in the public domain," or is it meant to cover "publicly available information"? How is information that is already possessed by a receiving party to be dealt with? How will information disclosed by a third party who is not prohibited from disclosing by any obligation of confidentiality be treated? A well-crafted definition of "confidential information" will address these potential pitfalls and aid the parties in determining permitted use in the event the deal falls through and the parties go their separate ways.
When negotiating a NDA, the parties should be mindful that a possibility exists that the deal will fall apart and the parties will go their separate ways. By the time parties decide to call off a deal, an enormous amount of confidential information, such as trade secrets, licenses, nonpublished patent applications, customer lists and pricing lists, have been disclosed. The retrieval of such confidential information and any residual information is of paramount concern to the disclosing party as that information likely serves as the lifeline of its business. On the other hand, the receiving party will not want to turn over materials memorializing its analysis and other receiving-party prepared information.
One solution to this problem is to provide in the NDA that confidential information provided by the disclosing party will be returned to the disclosing party while the receiving party's analysis or other prepared information will be destroyed and the receiving party shall certify such destruction. From a seller's perspective, the return of such information by a strategic buyer is the preferred course of action as it provides the seller with a sense of finality in knowing that the strategic buyer does not have further access to the seller's confidential information.
If the disclosing party is a publicly traded company, there is a real concern that a proposed "friendly negotiated" acquisition will develop into a hostile takeover. Such concerns are generally addressed in a standstill agreement. That being said, depending on how the confidentiality provisions in the NDA are crafted, such provisions may have the effect of a standstill, even though there is no valid ongoing separate standstill obligation in effect at the time a hostile bid is commenced. Courts have held that a standstill obligation presumes the use of confidential information and prohibits its use usually for a short period of time; the confidentiality obligation found in a NDA, on the other hand, requires proof of the use of confidential information and prohibits its use normally for a longer period of time. Courts have also stated that there is a public policy rationale in favor of enforcing NDAs in order to foster value-maximizing transactions and to provide certainty in the M&A process.
The drafting of an effective NDA is not a simple cookie-cutter exercise. Ensuring confidentiality in the mergers and acquisitions process is key to protecting the parties' interests. Engaging a competent and experienced mergers and acquisitions legal counsel to navigate these troubled waters should be a top priority for any potential buyer or seller.