Typically, one of the first steps in negotiating any transaction is the entry into a confidentiality agreement between the potential buyer and the seller. Because the parties are often eager to move forward with the negotiation process, the importance of this step can sometimes be overlooked. Two recent Delaware cases serve as good reminders that the terms of confidentiality agreements matter and can have real-life consequences that are worth considering before parties sign one.
Reminder #1: Make Sure Confidential Information Is Used Only for the “Purpose”
Most confidentiality agreements contain a “use restriction,” which is a provision that limits the potential buyer’s ability to use the confidential information disclosed to it by the seller. Typically buyers are permitted to use the confidential information of the seller solely for the purpose of “evaluating a transaction between the parties.”
A similar provision was at issue in a recent high-profile case in Delaware. For almost a decade, Martin Marietta Materials, Inc. (Martin) and Vulcan Materials Co. (Vulcan), strategic competitors in the construction aggregates industry, had been considering the idea of combining. In May 2010, the parties became more serious about pursuing a transaction and entered into a confidentiality agreement. The confidentiality agreement did not include a “standstill provision” (a provision that explicitly precludes the buyer from engaging in a takeover bid for a certain period of time), but did contain a use restriction similar to the one described above.
In late 2011, although Martin became very enthusiastic about acquiring Vulcan, Vulcan was not in favor of the acquisition and negotiations stalled. Instead of walking away, in December 2011, Martin made an unsolicited exchange offer and began a proxy contest to replace four of Vulcan’s directors at the next annual meeting. Martin relied in part on the confidential information disclosed by Vulcan in formulating its bid.
Vulcan sued to enjoin Martin’s takeover effort. Vulcan argued in part that the use restriction did not permit Marin to use the confidential information for a hostile takeover bid; rather, it argued that the permitted use of the information was limited to negotiating a friendly business combination. The Delaware Court of Chancery agreed with Vulcan on this point and cited a Canadian case, Certcom Corp. v. Research in Motion Ltd., (2009) 94 O.R. 3d 511 (Can. Ont. Sup. Ct. J.), for the premise that a transaction “between the parties” does not include a hostile takeover bid. Consequently, the Court enjoined Martin’s efforts to acquire Vulcan for a period of time.
This case reminds us that if a company enters into a confidentiality agreement in the course of evaluating a potential transaction, its employees and representatives should take care not to use the confidential information disclosed during the course of due diligence for any purpose other than evaluating a friendly transaction with the other party. In addition, decision-makers should be aware and take into account that once a confidentiality agreement is entered into with the potential target, the company’s flexibility to engage in a hostile takeover bid of the target at a later time may be greatly diminished.
Reminder #2: A Seller Might Lie During Due Diligence and the Buyer Probably Can’t Do Much About It
Another common provision in confidentiality agreements is a non-reliance clause. This type of clause typically states that a buyer may not rely on the completeness or accuracy of any information provided by the seller during due diligence, and that no sale contract exists between the buyer and the seller unless and until the parties enter into a definitive agreement. What happens when a seller is not completely forthcoming with a buyer during due diligence? Does the buyer have any recourse?
The Delaware courts recently addressed these questions. In the case RAA Management LLC v. Savage Sports Holdings, Inc., Del., No. 577, 2011 (decided May 18, 2012), Savage approached RAA to discuss a possible merger and the parties entered into a confidentiality agreement. The agreement stated that Savage made no representations about the accuracy or completeness of any information it provided to RAA, and that Savage would not be liable to RAA based on RAA’s reliance on such information, unless Savage breached any representations or warranties made in a later sale agreement. Additionally, RAA waived any claims against Savage relating to the potential transaction unless and until the parties entered into a sale agreement.
At the beginning of the discussions between Savage and RAA, Savage stated that there were “no significant unrecorded liabilities or claims against Savage.” However, during RAA’s due diligence process, Savage disclosed three major liabilities, which ultimately caused RAA to abandon the transaction. RAA sued, alleging that, had it known of those liabilities at the outset, it never would have pursued the negotiations and that because Savage had knowingly covered up the liabilities earlier in the process, Savage should be liable for the $1.2 million in costs that RAA incurred in performing its due diligence.
The Delaware court dismissed the complaint based on the non-reliance and waiver clauses. On appeal, RAA argued that the non-reliance clause barred claims based on negligence or mistake, but should not be extended to cover fraudulent or intentional misrepresentations. Additionally, RAA argued that the Court should not enforce the non-reliance clause on policy grounds because such a rule would give sellers an incentive to lie during the initial stages of a transaction.
The Delaware Supreme Court rejected RAA’s arguments, finding that the language of the agreement made no distinction between negligence and fraud, and that Delaware’s public policy favors enforcing written non-reliance clauses. The Court noted that, at the time of the agreement, both parties knew how non-reliance clauses had been interpreted by Delaware courts and that RAA could not escape the terms it agreed to in its written agreement.
The RAA case serves to remind us that, while due diligence is a tool designed to help buyers evaluate a possible transaction, buyers should not rely on statements or materials provided by a seller during due diligence. Many confidentiality agreements preserve the seller’s ability to limit its liability with respect to the quantity, quality, and timing of disclosures made during the due diligence process, perhaps even in the case where the seller makes fraudulent or misleading statements.
If a buyer uncovers unknown liabilities during due diligence, it will probably not be able to recover the expenses it incurred in order to make that discovery. However, the buyer may be able to limit its exposure to those liabilities by adequately allocating risk in the definitive agreement, which will be binding upon the seller. If a buyer finds that the seller’s actions or omissions are particularly egregious during due diligence, its ultimate remedy may be to walk away from the deal. Although this may seem like a disappointing result at the time, in the end, it means that the due diligence process worked.
Timothy Billion was a 2012 Summer Associate.