Legal and Business Risk—an evolving understanding

Assessing legal and business risks in a transaction and handling those risks in deal documents is without doubt the one of the most challenging tasks a lawyer performs. Moreover, academic and professional writings indicate an evolving understanding of risk. For example, an IACCM newsletter in June 2007, noted "a growing body of evidence indicating that traditional legal approaches to the management of risk are too narrow. They can frequently result in unintended consequences that themselves represent risk to the business. Best practice organizations are tackling this by greater integration of the Law Department into the business and through more rigorous evaluations of probability and consequence, undertaken by people or teams with cross-functional skills and perspectives."

The IACCM initiative seeks to address "three core causes of weakness in existing procedures:

1) Predominant focus on consequence, rather then probability;

2) Narrow situational view, rather than assessment on a portfolio basis;

3) Failure to integrate legal decisions with overall business impacts."

In a similar sentiment, Jones Day partners Robert Profusek and Lyle Ganske published an article titled "It's Time To Rethink The Lawyer's Role In Dealmaking: Start By Facing Up To The New Realities." In the article they state "rather than staying mired in the world of cookbook dealmaking, we need to take a page from the private equity playbook. Our clients need to assess risk."

A Framework for Transactional Risk

In a draft paper, Management of Legal Risk by Financial Institutions, Roger McCormick defines legal risk as "the risk of loss to a company that is primarily caused by:

(1) a defective transaction;

(2) a claim (including a defense to a claim or a counterclaim) being made or some other event occurring which results in liability for the company or other loss;

(3) a failure to adequately protect assets owned by the company; or

(4) change in the law."

While lists of types of risk are helpful to understand the overall breadth of a topic, an organizing framework can further organize and categorize the principal risk elements, so that we might better understand the component elements, their scope and importance. A proposed framework divides transactional risk into legal and business risk.

Legal Risks	Business Risks
Substantive Enforceability Risk: Risk of illegality, unenforceability or increased exposure to litigation	Due Diligence Divergence Risk: Risk of failure to protect assets, rights, or interests
Procedural Compliance Risk: Risk of failure to comply with procedural or regulatory requirements	Customization Negotiation Risk: Risk of failure to secure best terms or unintentionally allocate risks.

First, substantive legal risk raises issues of enforceability. It is the risk that failure to conform to statutory or common law norms may render all or a part of an agreement illegal, unenforceable, or increase the probability of dispute or the cost of resolution. Substantive risks also include the danger that contract terms are not read as intended.

Second, procedural legal risk raises issues of process. It is the risk that failure to comply with procedural of regulatory practice may void, delay or increase the cost of a transaction.

Third, business form risk raises issues of due diligence. It is the risk that failure to conform to market practices and include all required terms may not adequately protect each party's interests. For example, a loan agreement may not adequately indentify the collateral, or a software development agreement that lacks an acceptance clause may limit the buyer's options in the event that application does not perform as expected.

Fourth, business negotiation risk raises issues of customization. Each contractual term—price, process, rights, obligations, remedies, etc.—may have neutral weighting or may favor one party or the other. Negotiation risk is the risk that a transaction fails to maximize each party's interest (relative to their negotiating position) or may unintentionally shift risk between the party's (not reflected in the price).

Initial Thoughts

A review of recent articles and posts indicates a slow shift of focus from purely legal risk to a deeper understanding of the business risks in the transactional practice. Over the next few posts, I intend to dig deeper into each risk quadrant and welcome your thoughts and feedback.

Contract Checklists-does sequence matter?

Many professionals use checklists to ensure high quality, consistent performance and to avoid errors of omission. We are all grateful, for example, pilots run through their checklists every time they take-off; even if it is their fifth departure that day.

Checklists received acclaim with Atul Gawande's book, Checklist Manifesto, which became a New York Times best seller in 2009. In his book, Gawande distinguishes between errors of ignorance (mistakes made because we did not know enough), and errors of ineptitude (mistakes made because we did not make proper use of what we know). Failure in the modern, complex world, Gawande asserts, is primarily due to the second reason.

It is not that the pilot, doctor or lawyer does not know how to perform a task. Moreover, it is unlikely that a checklist would teach them anything they did not already know. The main purpose of a checklist is to prevent trained professionals from a missing a step. Sometimes when we perform familiar tasks, we "see" what we expect: not necessarily what is, in fact, the case. We can, for example, mentally insert words that are absent from the text we are reading.

In this context, the challenge of reviewing long, complex legal documents is especially daunting. We can proof-read what is on the page; it is much harder to proof what might be missing, potentially located in another section of the section, or duplicated elsewhere.

Unfortunately, few lawyers have ready access to formal document checklists. For some complex deals firms will prepare deal checklists to orchestrate the preparation and filing of documents and coordinate work among the lawyers involved in the transaction. But, these checklists rarely capture the detail needed to review each agreement. Lawyers must rely on a mental checklists honed over years of experience. But, in the face of unrelenting pressures to be ever more efficient—and do things faster—more opportunities for errors will undoubtedly arise.

There are, however, surrogates for formal checklists. As in many situations, knowledge management can, as pointed out by Chris Boyd of Wilson Sonsini, "capitalize on existing law firm information flows and business processes." In this case, the existing information resource is the table of contents of existing—hopefully exemplar—agreements.

Contract analysis can shed additional light on how to make best use of existing resources. It aggregates multiple documents into a single combined outline. Viewed as an outline, it is in many ways a comprehensive checklist of all deal terms. How it is organized and order presents some interesting choices. The clauses in the outline—both the top level and the sub-clauses in each section—can be ordered in:

(a) a traditional sequence
(b) an alphabetical order, or
(c) a logical and categorized sequence.

Question: what is the best approach?

Consider a simple example based on a partial list of clauses found in the Miscellaneous or General Provisions section, in which the more frequently occurring terms are highlighted in bold text.

Traditional	Alphabetical	Logical
Notices Interpretation Assignment Successors and Assigns Binding Effect (Parties in Interest) Severability Schedules and Exhibits Remedies Cumulative Specific Performance Governing Law Arbitration Headings Mutual Drafting Amendment Waiver Counterparts Entire Agreement Jurisdiction Waiver of Jury Trial Attorneys' Fees	Amendment Arbitration Assignment Attorneys' Fees Binding Effect (Parties in Interest) Counterparts Entire Agreement Governing Law Headings Interpretation Jurisdiction Mutual Drafting Notices Remedies Cumulative Schedules and Exhibits Severability Specific Performance Successors and Assigns Waiver Waiver of Jury Trial	(a) Scope of Agreement Entire Agreement Counterparts Schedules and Exhibits Amendment Waiver (b) Parties Binding Effect (Parties in Interest) Assignment Successors and Assigns Notices (c) Enforcement Arbitration Governing Law Jurisdiction Waiver of Jury Trial Attorneys' Fees (d) Interpretation Remedies Cumulative Specific Performance Severability Interpretation Headings Mutual Drafting

In choosing between the three alternatives, the programmer in me will normally select the logical alternative. However, each alternative carries advantages and disadvantages.

First, the principal advantage of the traditional sequence is familiarity. Lawyers expect to find provisions in predictable locations.

Second, the alphabetical order serves as an index of the clauses in the same manner as the lexicon at the back of reference books. It can serve as a useful tool to check for duplicate terms. For example, if you create an alphabetical list of the all the terms found in a merger agreement, you will likely find a clause typically called "Further Assurances" occurs in the Merger section, the Covenants and Additional Agreements sections, as well as the Miscellaneous section; all containing similar, but slightly divergent terms.

Third, the logical sequence serves a role similar to the outline or table of contents at the front of a reference book. It helps determine whether all the appropriate terms exist and that they are combined the appropriate sequence.

The sequence of terms, like any taxonomy, can be categorized by reference to its goals or purpose. Applying this approach, the Miscellaneous section can be organized by defining the "law of the agreement" and grouping the clauses by: (a) scope of the agreement, (b) parties, (c) enforcement, and (d) interpretation. While this may not be that significant for the humble "boiler-plate," terms, it can be extremely useful when applied to more complex sections, such as the Representations and Warranties of a merger agreement. In this case, the sequence and order can follow the due diligence process and organize the clauses in something like the following:

• Company Status
• Authority and Permissions to Conduct Business
• Financial Condition and Reports
• Assets
• Liabilities
• Contracts and Other Obligations
• Compliance with Laws and Internal Controls
• Environmental Matters
• Employee and Labor Matters
• Information Supplied and Full Disclosure
• Other Representations and Warranties

Now, it is much easier to evaluate whether something is missing or perhaps inappropriate to the context of the transaction.

While the logical approach appears helpful, I am mindful of the adverse impacts of change, especially for those who expect provisions in a particular place in the document.

In general, I have concluded that when building document templates and checklists based on documents from a single firm, or perhaps those of an industry or regional group, the best approach is to follow the existing form. However, when building templates based on publicly available documents, it is frequently true that no clear sequence emerges and in this case, it seems preferable to establish a new logical sequence.

Contract Life Cycle--document assembly is just one part of the puzzle

I was an early adopter of automated drafting. Back in 1988, with an IBM 8088, 64K memory and Borland's first C compiler, I wrote basic document assembly and client management software. They were not the most user-friendly applications. They did not need to be. I was the sole user. However, the software radically changed my practice and career.

More than 20 years later, the technology of automated drafting is both powerful and easy to use. But it has yet to be broadly adopted as I naively anticipated those many years ago.

I now realize that unless the entire contract life cycle is automated—not just the drafting bit—then automated drafting can be expensive, limited in utility and potentially unsustainable.

The complete life cycle has four main elements, which when systematized, creates a virtuous feedback loop.

1. Production

The first element in the life cycle is a means to efficiently produce documents. Over the years, drafting has changed little. We can start with a blank page (very inefficient and very rare), a document assembly system (very efficient, but rare), a model form (efficient, but infrequent), or the last closest document (inefficient and very common). Why is repurposing the last draft inefficient? Unless, you are drafting a particular type of document daily, you have to read through all its terms and adapt them to current needs. Moreover, any drafting improvements are captured in a particular document, which may or may not form the basis of the next draft project.

2. Automation

The precursor to efficient drafting is some means to organize the material. Typically, this consists of a checklist (or outline) and a clause library. The first time I tackled a large scale automation project, I did it manually. I asked the lawyers in an estate planning group to give me copies of their forms and exemplar documents. When printed out, the stack of documents was about 2 feet high. I might have used less, but that would have risked missing important variations.

My approach was to find the fattest document (on the grounds that it likely contained the most number of clauses) and then list each of its clauses in a database. I then went serially through the pile and for each document added clauses to the database that I had not seen before. By the end of the process, I had a list of 250 unique clauses for Testamentary Wills and 350 unique clauses for Trusts. With this clause library, the system could construct any Will or Trust. The next step was to find the range of language for each clause. As you can imagine, the approach—while thorough—was very time consuming, taking about 3 months for each document type.

3, of course, months is far too much time. A set of 20 documents would take 5 years to automate. It is therefore not surprising that such efforts have been limited to those practice areas that frequently use a small number of documents, or have need for less complex forms. In order to reduce the time, and costs, there are two approaches: (a) reduce the number of input documents, or (b) automate the process of creating the document outlines and clause libraries. I have taken the later approach. (See, Empirical Analysis: What's Market?)

3. Review

The third element of the contract life cycle is document review. This process is typically more formalized in corporate legal departments compared to law firms. Frequently legal departments will have different levels of review depending on the nature of the transaction and its contract value.

This element of the contract life cycle is, however, absent from document assembly systems, significantly limiting their utility. Indeed, for all the money spent on developing document automation systems, they only assist the lawyer when she or he is tasked with creating a first draft. They cannot help with the more common task of reviewing a document.

While other professions, notably airline pilots and physicians, have widely adopted the use of checklists, lawyers rely on their experience, skill and recall to ensure that transactional documents capture the business needs of the deal. As with other elements of the life cycle, absent of some form of automation, the cost of creating and maintaining deal checklist is likely cost prohibitive.

4. Audit

The final stage of the life cycle addresses to need to monitor usage of the precedent systems. Again, audit systems are typically lacking in most document assembly solutions. As a result, they lack a means to efficiently maintain their collections. The challenge has always been that the templates are constructed in the assembly system, but edited in a Word processor, where such changes cannot be easily or automatically picked up by the assembly software. Over time, the edited documents get "out-of-sync" with the assembly systems and at some point the drafting templates have to be re-created. Again, lacking an automated system, such maintenance can be just as expensive as the initial cost of creating the assembly system.

5. Conclusion

If we do consider the entire life cycle: (a) setup costs can be reduced by automating template creation, (b) utility can be added by providing a means to review contracts, and (c) the system can be maintained through a process of continuous improvement by feeding new documents back into the system.