Socrates has been credited with the observation that “the beginning of wisdom is the definition of terms.” Whether Socrates ever actually said that, and no matter what varied philosophical meanings one can derive from this observation regardless of its author, there should be fairly wide agreement among deal makers that it is indeed wise to clearly define terms that otherwise may be susceptible to varied meanings in your deal documentation. But sometimes, even the terms used in the definition of a specific term themselves need careful definition. And a recent New York case illustrates the potential issues that can arise from one’s failure to do so.

Special Situations Fund III QP, L.P. v Overland Storage, Inc., 2017 NY Slip Op 32125(U), 2017 WL 4517773 (N.Y. Sup. Ct. Oct. 10, 2017), involved a claim by certain private equity funds (the “Funds”) that the Funds were entitled to the payment of $6 million by Overland Storage, Inc. (“Overland”) as the result of a transaction that was alleged to have triggered a change of control of Overland pursuant to a specific provision in a purchase agreement. Pursuant to that purchase agreement the Funds had paid $3 million to Overland for a 20% stake in the proceeds of a pending patent infringement claim Overland had made against a German company. But the purchase agreement also provided that if a “Specified Transaction” occurred before the litigation was resolved, the Funds would be entitled to an immediate lump sum payment of $6 million from Overland regardless of the ultimate outcome of the patent litigation and in lieu of sharing in the proceeds from that litigation. The Funds claimed that, as the result of a business combination between Overland and Tandberg Data Holdings (“Tandberg”), whereby Tandberg’s sole shareholder (“FBC”) received 54% of Overland’s common stock in exchange for 100% of its shares of Tandberg, a “Specified Transaction” had in fact occurred (indeed, FBC’s parent was also a current owner of shares in Overland, bringing the total shares owned by FBC and its affiliate, following the business combination with Tandberg, to around 63%). While the Overland common stock acquired by FBC in the Tandberg business combination was all voting stock, FBC entered into a voting agreement whereby, for a specified time, it could only nominate two members of the seven person board of Overland and was required to vote “for the remaining five positions ‘in the same proportion’ that other Unaffiliated Shareholders of Overland (i.e., holders of shares other than FBC) voted.”

“Specified Transaction” was defined as any of four different events, but the relevant event for the Tandberg transaction was the following: “an acquisition by any Person and its Affiliates of more than 50% of the then outstanding voting power of Seller [Overland].” But note that, in defining “Specified Transaction” by reference to the acquisition of more than 50% of Overland’s “voting power,” the drafters of the purchase agreement failed to define “voting power.” So, did “voting power” mean the holder of the stock’s right to vote on all matters required to be voted upon by shareholders, or just the right to vote for the election of directors? And, did “voting power” refer to the underlying nature of the stock that was acquired (i.e., whether it was designated voting or nonvoting stock), or did it refer to the actual ability to exercise that vote such that the existence of the voting agreement was relevant?

Although the court was sitting in New York, the purchase agreement was governed by California law, which sets a very low bar for the admissibility of extrinsic evidence in the interpretation of contracts. Relying on that extrinsic evidence, the court determined that the purpose of the “Specified Transaction” trigger for an early payment was the Funds’ desire to prevent any acquisition of control of Overland by a third party that would negatively influence the prosecution of the patent litigation. Because the board of directors ultimately manages the affairs of a corporation, it was the board that would ultimately decide whether to continue prosecuting or settle the patent litigation. So based on the purpose of the provision and an examination of various corporate statutes defining “voting power,” the court concluded that, in this context, the term “voting power” referred to the “ability to elect directors;” and that it was largely irrelevant what other voting rights the holders of shares had if they didn’t have the ability to elect more than 50% of the directors. But as a cautionary tale about defining terms clearly, the court expended substantial ink and took the reader on an arduous journey to reach this conclusion.

Having established that the term “voting power” applied to the power to elect directors, the court then moved on to determining how the voting agreement affected that power. The answer, according to the court, turned on whether “voting power” is manifest in the shares themselves, or in the holder of those shares. If voting power is an attribute of voting shares, then it potentially follows that a transfer of shares is a transfer of that power, regardless of any voting agreement. If voting power lies only in the holder of the shares, then it stands to reason that a voting agreement that restricted voting could nullify any transfer of such power. The court found that authorities offered support for both interpretations. But ultimately, because decisions about the prosecution of the patent litigation could only be made by the board of directors, and the voting agreement restrained FBC’s power to elect directors for a specified period, the risk of a third party controlling the decisions regarding that litigation had not been realized at the time the Tandberg transaction closed. Thus, in this context, according to the court, “‘voting power’ must be read to refer to a shareholder’s actual power and discretion to control the election of directors.” The transfer of shares to FBC, subject to the voting agreement was, therefore, not a transfer of more than 50% of the voting power of Overland.

The court points out the obvious when it says that the Funds are a “sophisticated party” and could have drafted the change of control trigger in such a way as to include the Tandberg transaction. Indeed, extrinsic evidence showed that the original language in the definition of “Specified Transaction” had used the term “voting securities,” not “voting power.” It turned out that the Funds had changed the language from “voting securities” (which probably would have picked up the Tandberg transaction) to “voting power” because they were worried about Overland issuing high vote shares to a third party that would represent a small percentage of the total outstanding shares. But by choosing to make that change to cover one scenario, they failed to cover the situation in which a large percentage of Overland shares had actually been transferred to a third party, but the ability of that large holder to elect directors had been limited for a defined period.

As Vice Chancellor Slights declared in a recent unrelated Delaware Court of Chancery decision, “[t]he words parties use to bind themselves together in a contractual relationship matter.”1 This seems particularly so with respect to the words used to define a critical term in a written agreement intended to evidence that contractual relationship. So perhaps, in drafting change of control clauses using the term “voting power,” clearly defining that term truly is “the beginning of wisdom.”