How do your forms stack up to practice?

Recently, our contract analysis work raised an interesting question: how do commercial forms measure up to practice standards? In this circumstance, practice standard is defined as the best precedent files available from a law firm's document management or file system.

In summary, we discovered model forms contain less deal variations and fewer deal specifics. In one case—an asset purchase agreement—analysis showed that the commercial form contained about 50% of the firms standard terms and clause language.

For example, comparing the sub-clauses of the section captioned Purchase and Sale of Assets, the commercial form, as shown in the table, contains the basic deal elements, while the firm standard details included and excluded assets and liabilities, together with specific price allocations and adjustments.

Commercial Form	Firm Standard
Purchase and Sale of Assets	Transfer of Assets
Assumption of Liabilities	Excluded Assets
Purchase Price	Assumed Liabilities
	Excluded Liabilities
	Purchase Price
	Payment of Purchase Price
	Allocation of Purchase Price
	Adjustment of Purchase Price
	Prorations

The same differences can also be seen in the text of clauses. The commercial form provides minimal language for the purchase and sale of the assets.

"Purchase and Sale of Assets. On and subject to the terms and conditions of this Agreement, Buyer agrees to purchase from Target, and Target agrees to sell, transfer, convey, and deliver to Buyer, all of the Acquired Assets at the Closing for the consideration specified below in this 2."

The firm standard provides more details and specifics. For example in the case of the sale of assets of a high tech company, the clause provides great detail on all assets and provides a list of assets transferred including: (a) personal property; (b) raw materials and work in progress, (c) contractual rights, (d) claims, (e) intellectual property, (f) works, (g) designs, concepts, know-how and techniques, (h) permits and licenses, (i) books and records, (j) computer programs and associated data, and (k) goodwill.

Measuring Standards

By way of background, contract analysis software performs two principal tasks. First, it creates an aggregated outline (or checklist) from a set of documents. Second, for each outline element, it creates a clause library. As part of this process, the software identifies the best document and the standard clauses. "Best" is, of course, subjective. Contract analysis, like any other computer process defines such standard as the best objective or logical approach.

Finding the Standard Document

The most conforming document is the document that contains all standard deal elements and the least deal-specific variations. It is compares documents based on three main statistical elements, simplified here for purposes of explanation.

• First, the presence of articles, clauses and sub-sections, namely the building blocks of a deal document. For example, the analysis identifies whether each document has survival, amendment and waiver clauses, irrespective of where they may appear in a document. It also identifies and counts the number of deal-specific clauses that do not typically appear in a particular type of document. The ratio of standard to non-standard clauses gives us the clause commonality measure.
• Second, for clauses that have sub-sections, the analysis measures the commonality of such sub-clauses. For example, in a merger agreement, it finds and groups all possible representations and warranties and how frequently they occur. The ratio of common sub-clauses to non-standard clauses provides a measure of sub-clause commonality.
• Third, the analysis measures the commonality of the words in each clause. The analysis identifies the common and infrequent words. The ratio of common words to uncommon words in each matching clause gives us the measure of word commonality.

The document with the highest overall score is the most conforming or standard document. It is, in fact, the document containing all the standard deal terms.

Finding the Standard Clause

The approach to finding the standard clause is not the most common or frequently occurring clause. It is the clause example that contains all required language (determined by analyzing all matching clause examples) and the least amount of deal-specific language. In plain English, it is the clause that contains the core, non-negotiated language.

As an aside, when working inside law firms, it was frequently suggested that best practice precedent should be drawn from the first—and not the last—draft of an agreement, presumable based on the reasoning that it will be the least edited and changed from base standard. Contract analysis exposes the weakness of this approach because in many cases the so-called "first draft" is in fact brought forward from the last draft of the agreement used as a starting point for the new document. The way to find the core, non-negotiated language is to examine all clauses from all documents and identify the most conforming language.

Efficient Forms Creation and Maintenance

The result of this analysis is not theoretical. It has practical value, significantly speeding up the process of forms creation and maintenance.

First, find the most conforming document. In this document, all the clauses will be drafted to work together with a conformed set of define terms.

Second, for those clauses that may be missing or divergent from the standard (in this particular document), use the clause library to supplement of replace the clause. Where the most conforming document is 90% standard, the review process need only focus on the non-conforming 10%.

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.

Contract Building Blocks—the low hanging fruit of standardization

One of the challenges to creating contract templates as a reference standard is that a yardstick must be built for every document type; just as we need spell checkers for each language. Nevertheless, there are shared characteristics that can be exploited across all document types.

Virtually all contracts follow the same basic structure. While we may give these elements different labels, the basic organization of bi-lateral and multi-lateral contracts can be described as follows:

• Statement of agreement and identification of the parties
• Form and mechanics of the transaction
• Representations and Warranties
• Conditions Precedent
• Covenants (ongoing promises)
• Term and Termination (Events of Default)
• Limitation on Liability
• Indemnification
• General Provisions (Miscellaneous)

With the exception of the form and mechanics of the transaction, legal agreements share many of the same terms and provisions. Furthermore, we can predict the likely degree of similarity of each building block. For example, the General Provisions will likely be more consistent across a wide range of agreements compared to Termination provisions. I would predict that the next most consistent terms can be found in the Representations and Warranties.

Consistency across all documents offers an opportunity to standardize terms "horizontally" or at least across blocks of related agreements. Then applying the wisdom of the 80/20 rule, a relatively simple 3-step approach can realize significant productivity and quality gains.

First, create a list of all clauses in each common contract section (e.g. Miscellaneous, Covenants, or Representations and Warranties).

Second, mark each clause as either standard or deal-specific.

Third, build a library containing the standard and alternative language for each clause.

Simple. However, I should disclose that I've received significant push-back on standard document building blocks. In one case, I was told that is would be impossible to create a standard Miscellaneous section of boiler-plate terms because, for example, the assignment clause requires customization to each deal. Of course, terms must be tailored to the transaction. However, the variations are predictable and can be supplied. Others have warned that clauses are dependent on the terms of other provisions and therefore cannot be read in isolation. It is true that some deal terms are conditional on other provisions, but again such conditionality can be predicted and, where it exists, it should be clearly identified to prevent mistakes in the use of precedent.

As an example, we can apply the approach to the Miscellaneous section of the set of 106 intellectual property security agreements analyzed in a prior post. The complete list contains 32 clauses shown in the chart below where the blue bar shows the commonality (frequency) of each clause and the yellow bar display the language consistency (variance), based on calculation of standard deviation.

If we focus on the 8 most common clauses appearing in at least 1/3 or more the documents, we can see that the language is universally more consistent. For the less common clauses there appears to be more divergence: some highly consistent; others very inconsistent.

In non-mathematical terms, the analysis provides additional support for the 80/20 rule, namely: in the case of frequently appearing clauses there is already broad consensus on the standard language. And, such consensus can hopefully reduce some of the political hurdles associated with contract standardization.

Latent Legal Market Revisited—A Rare Win-Win

Law firms want high value "bet-the-business" work, where no effort is spared and legal fees are not questioned. As many commentators have pointed out this market is shrinking and the number of law firm specializing in this type of work is dwindling.

Ever since I picked up a computer and started programming, I've thought about the other end of the market: the low margin business. I've pitched the concept to many firms with very limited success. And, described in terms of "let's go after low value business" lack of interest is hardly surprising.

From the Law Firm's Perspective

First, the desired high margin business is also very low volume. The seemingly less desirable low margin business is high volume. I suspect the total value of low margin business is at least as large as high margin work.

Second, another rationale for avoiding routinized work is that it may be perceived as less intellectually challenging. However, I would point out that what a simple individual representation may lack in challenge is more than supplemented when the goal is to meet the needs of all present and future clients in a systematized and packaged legal service.

Third, standardizing lower value work (NDAs, employment agreements, sales agreements, etc) is an excellent training vehicle for associates, employing underutilized lawyers.

From the Client's Perspective

General Counsel is challenged not only to reduce their outside legal fees—more likely than not comprising the non-standard, high value work—but also their internal costs. And, for every merger agreement executed by a business, they are likely hundreds of employment agreements. In order to reduce costs and increase quality, many, in-house departments, for example Cisco, have invested in standardization projects. But, such efforts still represent a small fraction of the overall volume of work.

Combining Interests

Rather than describe the opportunity as "low value" business, there are better marketing approaches. Employ law firm associates to build standard forms and document assembly systems for their clients, using the expertise of the firm's senior attorneys to ensure adherence to best practices. The law firm bills for its legal services, the client benefits from reduced cost. Moreover, if law firms fail to assist business reduce their day-to-day costs, will in-house lawyers invest in document standardization forever cutting outside counsel out from this line of work?

How large is the low-margin, high volume market? In order to estimate the cost-benefits of document standardization, I've built an ROI calculator to weigh the cost of building standard templates compared to time required to draft documents using the "last draft" method. Here's a link to the calculator. If I'm right then the cost savings to businesses are very significant and scaled up to the entire market, it's a huge opportunity for law firms.

Measuring Commonality and Consistency—Do the Numbers Tell a Story?

Those who have read a few posts in the blog know that much of my research is based on pure statistics. And, of course, we know the adage: "lies, damn lies, and statistics." But, can they tell a story? Can they offer some insight into how lawyers use precedent and how precedent evolves over time?

Where clauses are repurposed from an earlier precedent, they remain very consistent. Is that because they are copied but not substantially changed, or is it because the language of a particular contractual provision can only be defined in a relatively limited number of ways?

Early research confirmed that the consistency of legal document can be measured. The results of the analysis uncovered an unexpected conclusion: the more sophisticated the underlying transaction, the more likely the document will be consistent. A merger agreement, for example, is more likely to be consistent than an employment agreement.

In order to further test these propositions, we must distinguish between: (a) the elements of a contract and (b) how each of those elements is defined. Mathematically we can measure these values by commonality and consistency. Commonality is calculated by the frequency of a particular clause. For example, we may find a governing law clause in 90% of the sample agreements, while a severability clause may appear in 50% of the documents. Consistency is calculated by the standard deviation of a factor itself calculated primarily by the commonality of the words in the clause.

I recently ran these statistical measures of commonality and consistency for merger agreements and intellectual property security agreements. The charts display the outline organization of the agreement and for each caption, the bar chart shows the commonality of the clause in the blue bar and its language consistency in the yellow bar. You can click on the images above or the links in this paragraph to see a larger (readable?) image.

In the case of the merger agreement, we see high commonality of clauses and high consistency of language. Indeed, the presence of these two factors indicates a market standard. However, in the case of the intellectual property security agreement we see only two common clauses: grant of security interest and rights and remedies. However, all clauses (whether common or uncommon) display a high degree of language consistency.

What observations can be draw? First, there is great opportunity to standardize (and enjoy the efficiencies thereof) in the reps, covenants and miscellaneous sections. It is truly remarkable the variation in the clause selected. Second, the greatest opportunities for standardization will likely come from building deal checklists, not just clause libraries. It appears that we generally agree as to the language of a given clause, but there is less agreement on what clauses should be included.