Thursday, March 1, 2012

Comparative Analysis

A study of Employment, Contractor and Severance Agreements

Visual Complexity -  Protein Homology Graph

One of the main objectives of contract analysis is to identify the similarities—and differences—between different agreements, both in terms of their clause elements and clause language. This analysis is helpful not only to understanding contracts, but is also the means to significantly reduce contract drafting and contract management costs.

This approach goes against convention. Driven by many factors (such as training, tradition, and billing systems) lawyers, when approaching a drafting task, often see the differences—or as some may say, nuances—between one agreement and another.

By contrast, an analyst sees the similarities, but does not overlook the details. The analyst applies the science of complexity, as first articulated by Herbert Simon in the Architecture of Complexity. Two quotes capture Simon’s thesis:

Complex Systems are those that are made up of a large number of parts that interact in a non-simple way.
The fact…that many complex systems have a…hierarchic structure is a major facilitating factor enabling us to understand, to describe, and even to ‘see’ such systems and their parts.
Applying approach, I created a comparative framework for an employment agreement, an independent contractor agreement, and a severance agreement. (You can view the online version here).

1.       Structural Similarities

By applying the Unified Contract Structure to the three types of agreements, all the individual terms can be aligned. For the most part, the provisions line up. But, compared to convention, one major change is necessary to align the employment agreement with the others. The change is in the case of the termination benefits. Typically, severance benefits are included with the termination provisions or immediately following the termination events. However, to align the severance package with the Unified Contract Structure, these clauses are included as part of the consideration section.

2.       Similarities

The principal similarities are found in bulk of the document following the terms of the bargain, particularly in the representations, covenants and general provisions.

3.       Differences

Of course, there are major differences, principally in the terms of the bargain, namely, in the exchange and consideration provisions.

a.       Deal-Specific

There are interesting contrasts in the indemnification and insurance terms. In case of the indemnity terms, the employment agreement typically requires the employer to indemnify the employee; whereas the contractor agreement requires the contractor to indemnify the company. In case of the insurance, the employment agreement typically states that the employer provides Director and Officer Insurance in favor of the employee; whereas the contractor agreement will typically require the contractor to carry insurance in favor of the company.

b.      Convention Driven--Comparative Gaps

By comparing and contrasting one set of agreements to the others, it is also possible to see terms that are included in one set, but may be missing in another. For example, the expense provision in employment agreements typically contains two elements (what can be expensed, and how the expense must be documented). By contrast, the same term in independent contractor agreement often adds a third element, namely, when and how the expense must be paid by the employer.

This circumstance can also be seen when comparing acquisition agreements to finance agreements. In the case of finance agreements, they will almost always contain a representation detailing indebtedness, whereas a minority of acquisition agreements contains a similar provision. Do we then presume that lenders care about other lines of credit that might impair the value of their loans, but buyers of a business do not care about outstanding debt? No, of course, not.

As the analysis grows, it will interesting to determine to what extent it will be possible to develop a single master contract from which any particular agreement can be constructed: of course, acknowledging that many contracts will require deal-specific terms.

Monday, November 7, 2011

Standard English to Standard Business

For many years, the plain or standard English movement has sought to eliminate “legalese.” The term ‘”plain English” is, however, generally disfavored, because the goal is not to “dumb down” legal writing, but rather to use ordinary language in a manner that is readable to professionals. The difference between plain language and clear language is well described by Gail Dykstra of the CLIC Plain Language Centre. She writes:

"'Plain language' is language simplified to make it readily understandable by the average person. It is language stripped of unnecessary complexity, but not stripped of style. It is perhaps language at the lowest common denominator. It is reader-focused language. 'Clarified or simplified language' on the other hand is language that has been worked on to improve its understandability, but retains technical terms (terms of art), if necessary. It can rely on the assumption of commonly held knowledge of how the legal system or government operates in order to understand the language." Plain Language Association International

Applying the lessons to contract analysis, the clarification process is performed in two stages: clear language and clear purpose.

Clarity of language: Clear language is, of course, a worthy goal for its own sake. It also serves to reduce ambiguity, and the potential for dispute. However, it is not easy. It is often faster and easier to draft a stream of consciousness than to clearly and succinctly craft a contract term. Indeed, this was one of the principal motivations for programming a contract analysis application. Software can review a large sample set of clauses and identify the core, standard language (or pre-negotiated language): and distinguish deal-specific terms. In addition, the analysis also finds the frequently used term modifiers. For example, the core language of the authority representation states that “the party has power to enter into and execute the agreement.” The core language often includes modifying terms, such as: “complete power,” “full power,” “requisite power” or “necessary power,” or multiple combinations of such modifiers. In many cases, the modifiers can be removed without altering the meaning.

Clarity of purpose or intent: As we strip legal agreements of their nineteenth century affections, not only does clear modern English emerge, the meaning, or business terms, also becomes evident. For example, we recently worked on an asset purchase agreement. As is frequently the case, the business mechanics transaction appeared to be very complex. From a large set of sample documents, few people could read the agreements and clearly articulate the mechanics of the transaction. By performing the two-stage analysis—which doesn't take long—the business terms pop out from the page.

·          What assets are sold and purchased?
·          Will payment be made in the form of cash, stock or debt?
·          Will full consideration be paid at closing, or will some portion be held back in escrow?
·          Will the price be adjusted to account for any difference in the value of the assets between the time of agreement and the close of the transaction?

Each of these elements has sub-elements, which gives me an idea how to further automate contract analysis. And, this will be the subject of the next post, namely, how to design modular, contract building blocks, based on techniques of object orientated programming.

Monday, October 10, 2011

Identifying Core Language—and simplifying contracts

One of the most important tasks in precedent management is developing model forms containing standard, or core language, offering alternative terms and optional language to cover deal-specific variations.

The key question is how do you identify the core, pre-negotiated language?

In the past we attempted to do this by building precedent collections based on the first draft of agreements. But, since we typically re-purpose documents, this approach is unlikely to succeed because the language of a first draft is very likely to be the terms from the last draft of the re-purposed document.

The better way to identify the core language is programmatically. Software can find and classify each clause type in a set of agreements. Then, by analyzing all the clause examples, we can find common terms, and thereby distinguish deal-specific and divergent terms. In the following example taken from the Oracle-Sun merger agreement, standard terms are shown in green highlight, less frequently occurring terms are shown in yellow highlight, and the deal-specific or divergent terms are shown in red text. In addition, this approach shows that the first clause—Corporate Existence and Power—states that Sun has made available its charter documents to Oracle: terms that would typically be included in a separate clause.

Example Representations from the Oracle-Sun merger agreement
Section 4.01. Corporate Existence and Power. The Company is a corporation duly incorporated, validly existing and in good standing under the laws of the State of Delaware and has all corporate powers required to carry on its business as now conducted. The Company is duly qualified to do business as a foreign corporation and is in good standing in each jurisdiction where such qualification is necessary, except for those jurisdictions where failure to be so qualified would not reasonably be expected to have, individually or in the aggregate, a Company Material Adverse Effect. The Company has heretofore made available to Parent complete and correct copies of the certificate of incorporation and bylaws of the Company as currently in effect.
Section 4.02. Corporate Authorization
(a) The Company has all requisite corporate power and authority to enter into this Agreement and, subject to the Stockholder Approval, to consummate the Merger and the other transactions contemplated hereby. The execution, delivery and performance by the Company of this Agreement and the consummation by the Company of the Merger and the other transactions contemplated hereby, except for obtaining the Stockholder Approval, have been duly authorized by all necessary corporate action on the part of the Company. The affirmative vote of the holders of a majority of the outstanding shares of Company Common Stock voting to approve and adopt this Agreement and the Merger (the “Stockholder Approval”) is the only vote of the holders of any of the Company’s capital stock necessary in connection with the consummation of the Merger and the other transactions contemplated by this Agreement. This Agreement constitutes a valid and binding agreement of the Company enforceable against the Company in accordance with its terms, except as such enforceability may be limited by bankruptcy, insolvency, moratorium and other similar Applicable Law affecting creditors’ rights generally and by general principles of equity.
(b) At a meeting duly called and held, prior to the execution of this Agreement, at which all but one directors of the Company were present and with all directors present voting unanimously in favor, the Company Board duly adopted resolutions (i) declaring that this Agreement, the Merger and the other transactions contemplated hereby are advisable and in the best interests of the Company’s stockholders, (ii) approving this Agreement, the Merger and the other transactions contemplated hereby, (iii) taking all actions necessary so that the restrictions on business combinations and stockholder vote requirements contained in Section 203 of the Delaware Law will not apply with respect to or as a result of the Merger, this Agreement, the Voting Agreements and the transactions contemplated hereby and thereby, (iv) directing that the adoption of this Agreement, the Merger and the other transactions contemplated hereby be submitted to a vote of the stockholders of the Company at the Stockholder Meeting, and (v) making the Board Recommendation.

Section 4.03. Governmental Authorization. ….
Section 4.04. Non-contravention. The execution, delivery and performance by the Company of this Agreement and the consummation by the Company of the Merger and the other transactions contemplated hereby do not and will not (with or without notice or lapse of time, or both): (i) contravene, conflict with, or result in any violation or breach of any provision of the certificate of incorporation or bylaws of the Company, (ii) assuming compliance with the matters referred to in Section 4.03 and that the Stockholder Approval is obtained, contravene, conflict with or result in a violation or breach of any provision of any Applicable Law or Order, (iii) require any consent or approval under, violate, conflict with, result in any breach of or any loss of any benefit under, or constitute a change of control or default under, or result in termination or give to others any right of termination, vesting, amendment, acceleration or cancellation of any Contract to which the Company or any Subsidiary of the Company is a party, or by which they or any of their respective properties or assets may be bound or affected or any Governmental Authorization affecting, or relating in any way to, the property, assets or business of the Company or any of its Subsidiaries, or (iv) result in the creation or imposition of any Lien on any asset of the Company or any of its Subsidiaries, with such exceptions, in the case of each of clauses (ii), (iii) and (iv), as would not reasonably be expected to have, individually or in the aggregate, a Company Material Adverse Effect, provided that in determining whether a Company Material Adverse Effect would result, any adverse effect otherwise excluded by clause (A) of the definition of Company Material Adverse Effect shall be taken into account.

By examining a large data set and finding the standard language, we can quickly identify the core, pre-negotiated terms. Next, we remove duplicate and unnecessary terms, and simplify the language.

1.1. Organization [Party] is duly incorporated, validly existing and in good standing under the laws of the State of [_____].

1.2. Qualification. [Party] has organizational power and legal qualifications to own, lease and operate its properties and conduct its business

1.3. Authority
(a) [Party] [is authorized / has corporate authority] to enter into and perform its obligations under this Agreement, and
(b) the execution, delivery and performance of this Agreement [has been / will be] duly and validly authorized.

1.3. No Violation or Conflict. The execution, delivery and the performance the obligations of this Agreement will not:
(a) result in a violation of [Party]'s certificate of incorporation or bylaws,
(b) result in a violation of any law, judgment or order applicable to [Party],
(c) conflict with, result in a breach of, or constitute a default, or give rise to any right of termination, acceleration or cancellation, under any [material] contract to which [Party] is a party.

Now, isn’t that clearer? In addition, the example is styled with line breaks to improve readability and to better serve as a checklist of deal terms. Based on the standard language, agreements can be conformed to deal specifics by adding additional terms and qualifications, such as materiality or knowledge qualifiers.

Of course, you can do this manually, without the aid of technology. However, I have seen numerous instances where even after countless hours of review by highly qualified attorneys, initiatives to create model forms:

(a)    fail to identify the core language,
(b)    contain duplicate or over-lapping terms, and
(c)    contain numerous examples of deal-specific language.

As the old adage illuminates, technology guides us to “see the forest for the trees.”

Wednesday, September 7, 2011

Contract Analysis: Standard and Negotiated Terms Measured by Commonality and Consistency

The last post reviewed the top negotiated and disputed terms determined by a survey conducted by the IACCM. The survey revealed a surprising difference in viewpoint between negotiators and business managers.

The survey prompted further thought on whether statistical analysis can identify key contract clauses.

The statistical tools used in contract analysis identify the most commonly occurring clauses and the most similar clauses. Plotting these two measures in a matrix creates the quadrants shown the diagram.

·         The upper-right quadrant—standard clauses—contains frequently occurring, consistent clauses. Examples of such clauses should include so-called “boilerplate” provisions.  However, as the analysis can also show, such boilerplate provisions may, in fact, exhibit wide variation in language.

·         The upper-left quadrant—negotiated clauses—contains commonly occurring, divergent clauses. These are clauses that appear in most agreements, but contain different language. Such language variation may occur due to negotiation between the parties creating different terms, or it can be attributable to different drafting customs and personal preferences.  For example, the purchase price clause in an acquisition agreement will likely exhibit wide variation across a set of documents. However, similar degrees of variation can also be found in a severability clause.

·         The lower-right quadrant—transaction-specific clauses—contains clauses that do not occur frequently, but when they are found contain consistent language. A good example of a transaction-specific clause is “The Offer” term found in a set of merger agreements. This term may appear in about 20% of the agreements—indicating that such transactions are structured as a tender offer. In these cases, the language will likely be very consistent.

·         Finally, the lower-left quadrant—deal-specific clauses—contains infrequently occurring clauses that display wide language variation. These are clauses that are custom-tailored to a particular transaction.

However, not all clauses fit neatly into this schema. Clauses that should contain consistent language are often, in practice, highly variable. In large part, this background divergence can be attributed to custom and personal drafting preferences. Indeed, this is very evident when analyzing documents from a large number of different organizations, compared to a set from a single law firm or corporate legal department. The more varied the source of the documents, the more diverse the clauses and the language. Of course, the fact that divergence increases with the diversity of the source set should not be surprising because they will contain a wider range of drafting customs and personal preferences. They key point is that as divergence increases above a certain threshold, the usefulness of the statistics is reduced.

Using a set of documents from a single law firm, the analysis can identify the top 10 most frequently occurring, divergent clauses. Once again the study reveals a number of surprises.
Top 10 Negotiated or Variable Clauses from a Set of Merger Agreements
1.         The Merger / Effects of the Merger
2.         The Merger / Directors
3.         General / Severability
4.         General / Counterparts
5.         General / Non-Survival of Representations and Warranties
6.         General / Waiver of Jury Trial
7.         Representations and Warranties of the Company / Information Supplied
8.         General Provisions / Interpretation
9.         Representations and Warranties of Parent and Sub / Information Supplied
10.       Termination / Effect of Termination

It is frequently the case that the most divergent clauses are found in the first few representations and warranties and in the general provisions. As further posts will examine, these differences are largely due to personal preferences and the use of compound and overlapping clauses (See, post Contract Readability -- Part 2 for definitions of compound and overlapping clauses).

The wide differences in language also indicates that these are the clauses where attorneys are spending significant time in contract drafting. However, few would assert that all these provisions are the most significant terms in the agreement. In fact, with rare exceptions, few of the top 10 negotiated or highly variable clauses will appear on the IACCM’s most disputed clauses list.

Tuesday, August 30, 2011

Top Negotiated and Disputed Contract Terms (IACCM Survey)

The IACCM 10th Annual Survey, 2011 Top Terms in Negotiation, contains a wealth of information about the state of contracting. It reveals a clear difference between the top negotiated terms and the top terms subject to claims and disputes.

The authors see the disparity caused by a tension between negotiators and business managers. The survey reveals that negotiators focus on disputes and the consequences of claims; while business managers seek to manage the ongoing relationship between the parties. According to the survey, negotiators focus on “asset protection and the consequences of failure.” Business managers, on the other hand, seek “clarity over scope and goals and over the on-going governance and management procedures for the relationship.”

Top 10 Negotiated Terms
Top 10 Disputed Terms
1. Limitation of Liability
1. Delivery / Acceptance
2. Indemnity
2. Price / Charge / Price Changes
3. Price / Charge / Price Changes
3. Change Management
4. Intellectual Property
4. Invoices / Late Payment
5. Payment
5. Performance / Guarantees / Undertakings
6. Liquidated Damages
6. Service Levels and Warranties
7. Performance / Guarantees / Undertakings
7. Payment
8. Delivery / Acceptance
8. Responsibilities of the Parties
9. Applicable law / Jurisdiction
9. Liquidated Damages
10. Confidential Information / Non disclosure
10. Scope and Goals

Key points in the survey:
1. Effective contract negotiation requires a clear understanding of the differences between consequences and probabilities. Too often negotiators delve into all possible risks without assessing the likelihood that such outcomes will in fact occur.

2. Effective contract negotiation should focus more on reducing the probability of failure as opposed to addressing the consequences of failure.  The authors comment on the fact that acceptance / delivery tops the list of disputed terms, saying: “It is quite an indictment of our contract management processes if the first time we do anything serious about non-conformance is when it reaches the acceptance / delivery phase.”

3. The root cause of the divergence can be attributed to key disputed terms—change management together with scope and goals—that do not appear in the top negotiated terms. The authors assert that this is evidence that “the goals of the relationship are not clearly spelt out (or that changes are not adequately thought through); that the scope is therefore frequently misaligned with the goals (or itself badly written).”

4. The study concludes by stating that in the future: “[c]ontracts will become vehicles for defining and managing relationships as well as the tool through which transactions are undertaken.”
Reflecting on the survey, the unified contract structure should be revised to capture the importance of relationship management. The majority of contracts governing an ongoing relationship handle asset protection in the covenants section and consequences of failure in the events of default or termination provisions: they rarely contain relationship management terms. Drafters interested in including such terms can refer to governance language in master services agreements.

Monday, July 18, 2011

Clause Elements

Each time I review a set of clauses for the Clause of the Day, I am stuck by their common features, even though the source material is drawn from a wide range of different agreement types, drafted by different firms, for different clients.

The clauses all share common characteristics. They frequently use the same terms of art or common phrases.

Deeper analysis shows that they are composed of common sub-elements. For example, the Non-Disclosure Obligation in confidentiality agreements contains four components: (a) confidentiality, (b) non-use; (c) non-disclosure; and (d) protection of information. The Conduct of the Business clause in acquisition agreements typically contains four elements requiring the seller to: (a) conduct business in the ordinary course consistent with past practice; (b) preserve its business organization (or assets); (c) keep its directors and employees; and (d) keep its customer and supplier relationships and preserve the goodwill of the business.

Clauses, just like the agreement as a whole, are a checklist of elements, detailing required and optional clause terms.

Of course, the existence of common features is really not surprising. The clauses are all seeking similar objectives. The language has evolved over time, much like common law, into a well used reference. But while, commonality exists, it has not been codified.

By contrast, in the field of architecture, design and build standards are codified. MasterSpec, by ARCOM, provides comprehensive documentation that “automates specification production tasks and simplifies creating custom office masters for specific regions, clients, and products.” (MasterSpec). My architecture friends tell me that standards are required because the lawyers would otherwise sue them.

Analysis of clause elements highlights the value of precedent and the related contentious issue of garbage-in; quality-out. Words are important. Precedent is important. What is included (or omitted) in the clause is just as important as how the language is expressed.

Tuesday, July 5, 2011

Organizing the Covenants Article in Legal Agreements

A covenant is an agreement to perform, or to refrain from performing, a specified action. It exercises a continuing interest over an asset, property interest, or performance obligation. For example, a covenant on real estate "running with the land" imposes restrictions upon the use of property regardless of the owner. Covenants may be applied to a property license (e.g. a software license,) or a license to use money (a loan), or a license to use real property (a lease) to limit the use of the asset. A covenant can also be applied to a performance obligation to restrict the actions of a party bound by the covenant, such as a non-compete provision.

The covenants article in legal agreements is, however, frequently unorganized. Related provisions may not be located near each other making it difficult to determine if the article contains all required clauses and does not contain duplicate or overlapping provisions.

Where a high-level organizing theme is found, it is sometimes an arbitrary classification that cannot neatly group all the terms. For example, where a pre-closing/post-closing classification is used, where should the confidentiality covenant appear? An analysis of legal agreements shows that the Covenants article is generally grouped into 5 different, high-level organizing themes:

  • Single Covenants Section
  • Covenants and Additional Agreements
  • Covenants of the Seller and the Buyer
  • Affirmative and Negative Covenants
  • Pre-Closing and Post-Closing Covenants
An alternative classification considers the purpose or goals of the covenants. While some goals may overlap and serve multiple purposes, the principal objectives are:

  • Perform actions to consummate the agreement
  • Keep the parties informed
  • Preserve and protect property
  • Comply with laws, regulations and obligations
  • Limit or control actions
Applying this scheme, ContractStandards proposes the following organizing theme that can be applied to all agreements.

1. Perform Actions (Consents, Approvals and Filings)

1.1. Best Efforts
1.2. Cooperation
1.3. Consents and Approvals
1.4. Stockholder Meeting (Approval)
1.5. Third Party Consents
1.6. Regulatory Filings
1.7. Governmental Approval
1.8. Securities-Related
1.9. Listing Approvals
1.10. Exclusive Rights
1.11. Fees and Expenses
1.12. Assistance

2. Information and Notification

2.1. Access to Information
2.2. General Information Obligation
2.3. Financial Statements
2.4. Information Regarding Collateral
2.5. Title Information
2.6. Casualty and Condemnation
2.7. Notice of Developments
2.8. Notice of Default
2.9. Notice of Litigation
2.10. ERISA Notices
2.11. Environmental Notices
2.12. Regulatory Notices
2.13. Officer’s Certificates
2.14. Inspection

3. Business and Operations

3.1. Corporate Existence
3.2. Charter Documents; Amendment of Material Documents
3.3. Nature of the Business; Lines of Business
3.4. Conduct of the Business (Ordinary Course)
3.5. Goodwill
3.6. Company Name; Company Headquarters
3.7. Maintain Books and Records
3.8. Accounting Changes
3.9. Fiscal Year; Fiscal Quarters
3.10. Limitations on Changes; Fundamental Changes
3.11. Ownership of Subsidiaries
3.12. Transactions with Affiliates

4. Equity; Ownership Interests

4.1. Capital Structure
4.2. Transfer of Equity Interests
4.3. Dividends; Distributions
4.4. Issuance of Securities
4.5. Stock Option Plans
4.6. Capital Expenditures
4.7. Restricted Payments

5. Assets

5.1. Acquisition of Property
5.2. Disposition of Property
5.3. Limitations on Leases
5.4. Limitations on Sale Leasebacks
5.5. Maintain Properties
5.6. Maintain Insurance
5.7. Intellectual Property

6. Liabilities

6.1. Pay Obligations
(a) Payment of Taxes
(b) Payment of Debt
6.2. Limitations on Indebtedness
(a) Leverage Ratio
(b) Fixed Charge Coverage Ratio
(c) Liquidity
6.3. Subordinated Debt
6.4. Limitations on Liens
6.5. Limitations on Loans, Advances and Investments
6.6. Limitations on Guaranty Obligations
6.7. Limitations on Contingent Obligations
6.8. Limitation on Negative Pledges
6.9. Limitations on Swap Agreements / Hedging
6.10. Restrictive Agreements / Burdensome Agreements
6.11. Protection of Lender’s Priority Status
6.12. Additional Collateral
6.13. Additional Guarantors
6.14. Pledged Assets
6.15. Appraisals

7. Personnel & Employment

7.1. Compensation
7.2. Employee Benefit Plans
7.3. Directors and Officer’s Insurance
7.4. Resignation of Directors
7.5. Severance Arrangements
7.6. Employee Matters; Hiring Employees
7.7. Employee Inventions Agreements
7.8. Employee Confidentiality Agreements

8. Compliance with Laws and Obligations

8.1. Comply with Laws and Regulations
(a) Environmental Compliance
(b) Bulk Sales Law
(c) Blue Sky Laws
8.2. Comply with Agreements and Obligations
8.3. Performance of Obligations

9. Use of the Transferred or Licensed Asset

9.1. Use of Proceeds
9.2. Restrictions on Use of Licensed Property

10. Restrictive Covenants

10.1. Confidentiality
10.2. Non-Competition
10.3. Non-Solicitation of Business
10.4. Non-Solicitation of Employees
10.5. Non-Disparagement
10.6. Enforcement
10.7. Acknowledgement
10.8. Publicity and Announcements

11. Further Assurances

11.1. Further Assurances
11.2. Disclosure Supplements