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Spotting sleeper clauses with material contracts

Companies are increasingly implementing comprehensive document management programs into their businesses. These include the use of contract management databases that serve as a repository for agreements that are downloaded as they are entered into.

These platforms usually include the ability to search for data points such as contracting parties, expiry and renewal dates, and assignment and change of control provisions, as well as other key clauses. They serve multiple purposes, not the least of which is they are a useful tool for locating contracts with provisions material to an eventual purchaser or investor performing due diligence in connection with a contemplated transaction.

Due diligence team members will key in on contractual provisions such as non-assignment and change-of-control provisions that may prevent or otherwise impact closing of a transaction, non-competes, and other contractual restrictions or covenants that may pose a risk to the acquirer or diminish the value of the acquired business.

There are a number of other more obscure or “sleeper” provisions often relevant to an eventual purchaser or investor. I will highlight a few below.  My recommendation to clients is these provisions be recorded in their clients’ contract management databases proactively to facilitate due diligence soon after agreements are entered into.

Service level agreements

Service level agreements require the provider to maintain a certain level of agreed-to reliability and quality of service. The purchaser relies on those commitments when entering into agreements of its own, so it faces an exposure if the service provider falters or refuses to provide the services.   If the services are not delivered as agreed, the SLA normally provides for some form of liquidated damages (e.g. a fixed fee for each hour or day of downtime). The clauses often approach punitive damages in nature. An acquirer needs to be confident it will be able to deliver on those commitments and should financially model its contingent liabilities as part of its due diligence enquiries.

Early termination clauses

Companies often enter into long-term agreements requiring they make fixed regular payments in return for products or services. The payment amounts are discounted on the basis that the provider will see a return on its investment over the life of the contract. Should the contract be terminated prematurely, however, the balance of the payments are immediately accelerated and deemed to be due and payable, even if the products or services have not, and will not be delivered. Termination clauses need to be reviewed to determine whether the transaction in question will cause such accelerated payment clauses to be triggered, in which case it would be important to highlight them to the rest of the team.

Post-termination obligations

Agreements may contain clauses providing for certain obligations in the post-termination period. The obligations may range from the innocuous to the onerous. For example, in the case of a manufacturer who is a party to a distribution agreement, there may be an obligation to repurchase a distributor’s inventory following a termination. Under a software licence agreement, a licensor may be required to provide ongoing technical support, including updates and upgrades following termination for a given period of time, or to locate and contract with a provider capable of providing them to the licensee. Pre-paid agreements may require that products and services continue to be made available following termination. Commercial real estate leases typically provide that the leased premises must be returned to their original condition at the start of the lease, or worse yet to base condition (i.e., bare walls and floors). These obligations are sometimes buried in the termination or effect of termination provisions.  

Licence agreements

Licence agreements (e.g. software licences, equipment licences) contain grants that describe the rights and restrictions enjoyed and imposed on licensees and sub-licensees. The grant wording must be carefully evaluated. There could be restrictions around the number of concurrent users, the location of servers, the number of seats available, and even provisions that address what happens in the event of the transaction in question such as a merger, sale, or reorganization of the licensee. The latter type of clause may require the payment of a transfer fee. It may also specifically address what happens if the acquirer has its own licence agreement with the provider (e.g. do the two agreements merge, does one prevail over the other, what is the impact on the number of permitted users, what happens if the licensee fees under the two agreements are different?).  

Epidemic failure

In addition to standard product warranties, which contain standard disclaimers, a return material authorization procedure, and remedies, purchase and sale agreements will sometimes contain an epidemic or catastrophic failure clause. These clauses provide that if a determined number of products fail over a given period of time from an identical root cause, the provider is on the hook not only for repair and replacement costs but often for the purchaser’s costs incurred in recalling products from the field (i.e., disassembly, transportation, and insurance), and testing products, as well as downstream liabilities claimed by the purchaser’s own customers. They are called “catastrophic” failure clauses for a good reason: They can be financially catastrophic! These clauses need to be highlighted as they can represent significant exposure for a purchaser of a business.

Government funding agreements

Government grants and contribution agreements provide public funds to assist with product feasibility studies, product development, the hiring of employees, marketing and sales, and the like once certain agreed milestones are met. The government bodies that fund the programs often take a security interest in all or some of the borrower’s collateral. The agreements will sometimes contain restrictive covenants to ensure the company’s assets remain in Canada, or, in the case of a provincial government body, within the province, or that a certain number of jobs be created. Typically, the agreements provide that where there is an event of default, the funding body may seize and enforce its rights against the collateral, or certain repayment clauses are automatically triggered. For example, some grants and contribution agreements are provided on a non-repayable, no-interest basis, except if the beneficiary defaults, in which case the beneficiary is required to repay all of the funds it received under the program.

Summary

Spotting these sleeper clauses after the fact, at the beginning of a due diligence exercise can be laborious, and runs the risk that such clauses can be overlooked. It is best to spot them soon after an agreement has been inked, while they are still fresh in your mind. If they are properly recorded in your client’s contract management database, they can be recalled at the push of a keystroke when needed.


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