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Imagine that you’ve bought a business that runs a web app, and a few months later you discover that a key piece of code was written not by an employee, but by an independent contractor, and that the contractor had no written agreement for that work (which under Canadian law means you don’t own the work), and wasn’t paid for it. And imagine that the contractor left after an argument with the seller, and is still so annoyed that she now wants to be paid extra for that work.
Or that you discover that the company had been withholding income tax from its employees but not remitting that money to the government. Or that it had been collecting HST on sales of products, but not remitting that. And the money is not in the bank account.
Who should bear those losses – the seller or the buyer? I think most people would agree that these (assuming they are material) are risks that should fall on the seller’s shoulders – every business has ‘warts’ and nothing in life is perfect, but the buyer will expect that certain aspects of the business are ‘in order’, and if they aren’t, will expect to pay less for the business because of it.
Representations and warranties (I’ll call them “reps” from now on) are the contractual tool that buyers and sellers use in an M&A (M&A means ‘mergers and acquisitions’) transaction to allocate the risk of these imperfections. Fred covered these in his last MBA Mondays post (I’ve titled this post playing off of his title mainly because it’s a riff off of his), so I thought I’d write a few posts explaining, from the Ontario lawyer’s perspective, some of the basics of representations and warranties in an M&A context. This is the first post – others will follow soon.
First, some terms. A representation and warranty is simply a statement of fact – for example: “we have properly collected and remitted all HST and other excise taxes required to be collected and remitted by us in the course of operating our business” or “we own or properly license all of the intellectual property that we use in our business.” It can be about the past, the present or the future. For example, “Our financial statements dated December 31, 2010 fairly present the financial condition of the Company at that time” or “We have 25 employees and their names and job titles are on Schedule A” or “The use of the Intellectual Property in the Business after the Closing Date in the manner in which it was used in the Business before the Closing Date will not infringe the rights of any third parties.” Fred’s post mentions a difference between a representation and a warranty, but in Ontario, purchase and sale agreements no longer distinguish between them – the difference is a historical footnote. The critical point is that a rep is a statement of fact which, if false, entitles the buyer to a remedy.
An “indemnity” is that remedy – it’s a promise to pay someone an amount if an event occurs. In this context it’s a promise by the seller to the buyer to pay for any loss the buyer suffers if any rep is false. Taken together, reps and indemnities allocate risk between seller and buyer. The issue is not so much whether a rep is true as it is which party bears the risk of the rep being false.
The M&A process involves (typically) the buyer preparing a draft agreement that includes a wide variety of reps (pages and pages of them – there are some very simple US examples starting on page 5 here in this example of the ABA’s Model Asset Purchase Agreement). The agreement will generally have one or several schedules in which exceptions to the reps are listed. So, if a rep is not true, the details will be disclosed by the seller to the buyer and noted on the schedule. The parties also haggle over the wording of the reps – the seller trying to make them narrower (with narrower disclosure more risk gets pushed to the buyer), the buyer trying to require full disclosure. This process of negotiation and disclosure is one of the main ways the buyer learns about the business and whether it corresponds to its expectations.
The buyer will also be doing due diligence to verify the truth of the reps and warranties. Why do the due diligence? Well, it’s one thing to have a right to sue someone if a rep is false, but wouldn’t you rather know *before* you pay whether a rep is false? That way, instead of paying and then suing for money back, you can reduce the price. So, due diligence is a critical supplement to the reps, but many things about a business cannot be meaningfully investigated, so the reps need to stand on their own as ‘insurance’ for the buyer. Due diligence is partly a legal exercise, and partly a business exercise. Lawyers will review contracts and minute books and so on, business people will review contracts, financial records, code, and so on.
Another way of looking at this is to think of the phrase “as is” – when you buy something “as is”, the buyer is at full risk of the thing not corresponding to the buyer’s expectations – there is no remedy against the seller for any variance (except perhaps for cases of fraud or other deception). When you’re buying a business from a receiver or a trustee in bankruptcy, with few exceptions that is generally the scope of the reps and indemnities you will get from the seller – very, very narrow. But when you’re paying full price, you expect to be made whole if the business is not what you reasonably expected it to be. That’s where reps and indemnities come in. This perspective also illustrates the link between the price the buyer pays and the scope of the reps and indemnity. A fully-priced deal will come with lots of protection for the buyer, while a bargain basement price (for example, from a receiver or trustee in bankruptcy) – not so much.
More on negotiating reps, and on indemnities, soon.
I’ve been enjoying Kingsley Martin’s blog for quite a while, but his latest post really resonated with me. Broadly, the point that attracted me is the often-suspected but little understood (by clients – business lawyers understand this very well) notion that many of the words that some lawyers try to sell them in their forms of contracts are essentially useless – overpriced insurance for perils of almost inconceivably improbable likelihood, if you will. Kingsley quotes a paper by two Jones Day lawyers that makes a few points in this regard:
“Many lawyers no longer add real value to dealmaking. That’s perhaps a startling and somewhat harsh allegation – especially from a couple of M&A lawyers – but we’re afraid it’s true. Let us explain.
Although the investment banks, private equity players, and M&A boutiques have kept pace with the fundamental technological and corporate governance changes in dealmaking, most deal lawyers have played the game in form but not in substance. Most of us are doing things much the same way we did back in the days when M&A was a decidedly more genteel affair.
Look at all the representations, closing certificates, and due diligence documents prepared for the banks that wrote more than $6 billion in checks to get out of the Enron securities class actions – and don’t forget all that carefully worded “we-never-depart-from-it” indemnity boilerplate.
Those documents really didn’t come in handy at all. Think about it – there was very little in what the deal lawyers did that ultimately protected the secondary defendants in the Enron class action cases.
Plainly, merger papers for public company deals have become the intellectual equivalents of deeds in a real estate deal. Half of the words merely repeat what has been said somewhere else. Really now, has anything bad ever happened because all the Form 5500s weren’t filed? Half of the remaining paperwork is boilerplate, leaving only a handful of provisions that are important: the money, closing, social, and fiduciary provisions.
Come To Terms With The New Realities Of Dealmaking
Our corner of the profession must come to terms with the new realities of dealmaking. We’ve got to see that the deal documents themselves are no longer the primary focus. The basic forms of merger, divestiture, and similar transaction documents haven’t changed in decades. Once the absolute domain of the big law firms, deal document creation has become a decidedly commoditized process. Deal documentation thus can be done just as easily from Nebraska as from New York. The Internet has made this so – “flattening the world,” in Tom Friedman’s words. So, while the process of documenting deals has remained unchanged, the business world these documents describe has been turned upside-down. Today, the emphasis is on risk, and the language of risk is a language in which deal lawyers must become fluent. That is where we can, and should, best add value.”
I haven’t heard this basic notion expressed so well in quite a while. And while the practical implications of this idea may vary outside of a M&A practice, which is the subject of the article, the core idea is the same across a wide variety of practices. Why does this happen? Well, the business model that has developed in law over the past few generations involves training and employing an army of highly leveraged young lawyers to do rote document assembly work at massively inflated prices. Technology is finally fighting back, though it has been slow to gain traction.
How do we handle this at Hyndman | Law? Well, first, we don’t delegate work to untrained personnel. It’s done by experienced personnel who can work efficiently. Second, we recognize that there “are just a handful of contract clauses that are critical” – our core values are simplicity and common sense. We understand where complexity makes sense, and are allergic to it everywhere else. Third, we spend time training our clients to not need our help. And we think we do that very well.
With any luck, before too long we’ll be obsolete.
Dan Michaluk has an interesting post on @Slaw_dot_ca about Anne Cavoukian saying Patriot Act privacy concerns here are overblown.
One of my favourite moments at the first mesh conference was sitting with a group of people chatting about blogging. This was 2006, so while blogging was becoming very sophisticated, much of it was still shiny and new. Jason Fried was sitting at the table, as was Paul Kedrosky and my mesh colleague Mathew Ingram. And tucked in a corner of the table, quietly working away on his laptop and hidden behind it, was Matt Mullenweg – on his way, but still just getting started, on his mission to change media.
Just as the conversation turned to WordPress, and what Matt was doing, we were joined by Elliot Noss, the CEO of the Toronto tech company, Tucows. Elliott jumped in and said he would love someday to meet the guy who started WordPress. Long pause, and then waves of laughter, as Matt emerged from behind his laptop, blinking, slightly embarrassed at the attention. Matt looked like a kid – he was a kid – but here he was changing the world, one blog at a time.
Recently, WordPress posted a Creative Commons licensed version of their WordPress.com terms. Where appropriate I’ve started recommending them to clients, with some Canadian-izing adjustments, because they’re great, and because they’re written, as far as these things go, in very easy-to-read english. Big props to Matt and team for doing this.
Along the way I thought it would be fun to post my Canadian-ized version, which I’ve set out below. If you’ve been following the blog, you’ve probably noticed that we’re releasing selected legal forms on an open basis, so working on this just seemed like a perfect fit. (More to come in the weeks ahead – stay tuned!) There aren’t many changes to the WordPress.com terms here. You can see the exact changes here (to the WordPress terms as they were today) if you’re interested.
Here’s a short description of the main changes:
2. Unless a site is really focused on adults, or there is some specific legal requirement, I don’t see much point in telling people under a certain age that they can’t use the site. Kids are going to visit what they visit. If you’re concerned about kids using your site, think about your marketing and messaging, and think especially about integrating that sensibility into your design.
3. We don’t have a DMCA in Canada, so that section is changed. The operator reviews incoming complaints, and takes the action believed appropriate at the time.
5. After a famous (for lawyers) case involving Dell a few years ago, Ontario amended its consumer protection laws and mandatory arbitration is no longer the norm in consumer contracts. Here is my friend David Canton‘s article on the Dell case.
6. A PQ language charter provision is added.
Other than some other minor revisions, that’s it.
As always, one size may not fit all. Please keep in mind that website terms are not generic – there are many variables, and every form is not right for every situation. As always, consider consulting a lawyer to talk through your needs and what is appropriate for you. This work is licensed under this Creative Commons license. Finally, this form is provided for educational purposes only. Your use of it does not create a lawyer-client relationship with us, and we assume no responsibility for any consequence of using this document.
I believe in transparency and simplicity, so I’m just delighted to be able to do this. Reasonable people can disagree on these changes, so if you have comments on them or proposed revisions to them, let me know in the comments.
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Here is a simple form of confidential information, invention assignment and non-solicitation agreement. The form of employment agreement it’s used with is here.
Please keep in mind that these types of agreements are not generic – there are many variables, and every form of agreement is not right for every situation. As always, consider consulting a lawyer to talk through your needs and what is appropriate for you.
The document is provided in Word format. Any intellectual property that Hyndman | Law has in the form is licensed on an open basis – for any use, by anyone, without attribution.
This form is provided for educational purposes only. Your use of it does not create a lawyer-client relationship with us, and we assume no responsibility for any consequence of using this document.