Tag: contracts

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Corporate

Learning to draft a termination clause? Start with the events of termination.

Drafting_for_Business_Deepa_Mookerjee.jpgAfter our discussions on condition precedent clauses, restrictions placed on transfer of shares, and the meaning of ‘call’ and ‘put’ options, let us now turn our attention to the termination clause, one of the last clauses we usually see in a shareholders agreement but no less significant. It is in fact a vital clause that contains the mechanism by which an agreement can be terminated and the shareholders can exit the company.

A termination clause typically contains two main elements: (1) the events of termination; and (2) the consequences of such an event occurring. In this post, let us look closely at some common events of termination:

– Material default by one party: Take the case of A Limited and K Limited, two parties to a shareholder agreement. K Limited commits a material default and is unable to cure that default within a specified period of time. A Limited should then have the right to terminate the agreement.

While drafting this clause, clearly define the term ‘material default’. This ensures that the agreement cannot be terminated for minor ingressions and that only serious defaults will trigger the clause. Also, it reduces the scope for parties to dispute whether a ‘material default’ has in fact occurred.

Next, the defaulting party should always be provided a specified time period (known as the ‘cure period’) to rectify the situation, and only the non-defaulting party should be given the right to terminate the agreement. Specify that to invoke this clause, the non-defaulting party must always send a written notice to the defaulting party.

– Deadlock: A deadlock typically occurs when parties are unable to agree on a vital issue necessary for running the business of the company. While drafting, always define a ‘deadlock situation’. An example could be a company’s inability to hold a board meeting on three consecutive times for want of quorum.

For example, if K Limited would like the company to take a loan and A Limited disagrees and whenever K Limited tries to organise a board meeting to discuss this issue, the directors representing A Limited do not show up and so since no proper quorum is constituted for a board meeting, it can be considered a ‘deadlock situation’.

Often, the occurrence of a deadlock situation can act as a termination event. Parties may feel that it is impossible to run the business in such a situation and they would rather terminate the agreement. Discuss with your clients whether they would like a deadlock to be a termination event or whether they would prefer to resolve the situation through other means (such as arbitration).

Further, if a deadlock situation is considered an event of termination, always specify a mechanism by which one party can send a written notice to the other party specifying that this is a deadlock and it would like to terminate the agreement.

– Insolvency of the company – A Limited and K Limited are shareholders in One Limited, a corporation that is bankrupt and going through insolvency proceedings. Obviously the shareholders will then wish to terminate the agreement since it is not possible to continue running the business. While drafting this clause, it is best to specify that the agreement will terminate automatically on the occurrence of this event. This will eliminate procedural steps such as a notice being sent by one party to another.

– Cancellation of the license required to carry on business: The shareholders agreement concerns a banking company. A bank requires a license from the Reserve Bank of India to carry on business. If this license is cancelled, the bank ceases to function. Therefore, cancellation of the license (in a regulated entity) should be drafted as an automatic termination event.

– Change in law (resulting in the business of the company becoming illegal): Currently, the law permits private entities to operate airlines (subject to the necessary approvals). Assume that over a period of time, the government changes the law and nationalises all airlines. This means that private entities can no longer operate airlines. Consequently, any shareholders agreement to operate a particular airline must automatically terminate.

There is one important distinction among termination events that comes to mind when we study these clauses – some do not result in automatic termination and require parties to send written notices to each other (for instance, in case of material default or deadlock situations) and in other cases, there is an automatic termination (in case of a change in law, insolvency, or cancellation of a license). Always keep this distinction in mind while drafting. Ask your clients whether they are comfortable with certain events leading to automatic termination. After all, the thumb rule while drafting is always to reflect the interests of your client.

Finally, remember that a termination clause usually comes into play when the parties are disputing or have an issue they cannot resolve. In such a scenario, it is necessary that the termination clause is clearly drafted and sets out in a very precise manner, the events of termination and their consequences. If the clause is open-ended or vague, it is unlikely the parties will be able to follow the clause since they will end up arguing over the very intent of the clause itself. As a lawyer, your role is to try to amicably resolve the dispute or at the very least provide the most efficient way to exit from a situation that cannot be resolved!

With this, we come to the end of this post. In my next post I will write about the consequences of termination.

Deepa Mookerjee is part of the faculty on myLaw.net.

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Best efforts clauses: Reluctance of US courts to define a “best effort” shows it is important to define it in the contract

SamarJha“Best efforts” clauses are among the most contentious and heavily negotiated clauses in asset purchase and share purchase agreements. They require one (or both) of the parties to use their highest efforts to perform some obligation. While the clause may (or may not) require a party to achieve a specific goal, the use of the term “best efforts” creates a strict standard of compliance. Effort clauses therefore require a party to commit to a particular standard of effort to comply with the provisions of the contract. For instance, in the clause, “Supplier agrees to use commercially reasonable best efforts to satisfy the requirements of…”, the best efforts clause is qualified with the term “commercially reasonable”. Common variations of “best efforts” include “reasonable efforts” and “commercially reasonable efforts”.

These clauses are generally used in situations where a party cannot guarantee a particular outcome that has to be performed under a contract, where a situation is beyond a party’s control, where there is unpredictability about the promising party’s ability to achieve an objective, or where a promising party refuses to agree on a covenant. For example, a clause may specifically state, “The Purchaser shall make any necessary filings with respect to, and use its [best efforts/reasonable best efforts/commercially reasonable efforts] promptly to obtain, all authorizations, consents, orders and approvals of all Governmental Authorities and officials that may be or become necessary for its execution and delivery of, and the performance of its obligations pursuant to, this Agreement and will cooperate fully with the other parties in promptly seeking to obtain all such authorizations, consents, orders and approvals.”

According to § 2-306 (2) of the Uniform Commercial Code (“UCC”), a lawful agreement by either the seller or the buyer for exclusive dealing in the kind of goods concerned imposes, unless otherwise agreed, an obligation on the seller to use “best efforts” to supply the goods, and on the buyer to use “best efforts” to promote their sale.

The UCC standards are unclear because Official Comment 5 does not distinguish between “best” and “reasonable” standards of effort. It explains that the obligation on the parties is to use “reasonable diligence as well as good faith”. On the face of it, it looks as if the standard is not that strict.

Your reasonable efforts are your best efforts, say US courts

BestEffort

 

Interpreting such terms according to the facts and circumstances of the case, courts have interpreted “best efforts” as “reasonable efforts” and in decisions such as Soroof Trading Development Company LTD. v. GE Fuel Cell Systems LLC, 842 F. Supp. 2d 502 (S.D.N.Y., 2012) by the Southern District of New York, these terms have even been used interchangeably. In Bloor v. Falstaff [601 F.2d 609 (2d Cir. 1979)], the court stated that while performing its obligations using best efforts does not necessarily “prevent the party from giving reasonable consideration to its own interest”, such action or inaction has to be in “good faith and to the extent of its own total capabilities” and like an “average prudent” performer. In US Airways Group, Inc. v. British Airways PLC [989 F. Supp. 482 (S.D.N.Y. 1997)], British Airways delayed investments totaling USD 750 million into the US Airways Group by not obtaining the necessary approvals without telling the latter about their intentions to not continue with the deal. The duty of good faith and fair dealing, the court said, is implied in every contract and the actions of British Airways were construed as not being their “reasonable best efforts” and a transaction done in ba

In Hexion Speciality Chem. Inc. v. Huntsman Corp. [965 A.2d 715 (Del. Ch. 2008)], the court held that the buyer breached its covenant to use “reasonable best efforts” to close the merger (Huntsman was the target, and Hexion the buyer) when Hexion took steps to subvert the financing it was seeking to acquire Huntsman. Hexion filed a suit seeking to terminate the merger without paying the contractually mandated reverse break-up fee. It argued that the surviving entity after the merger would be insolvent and Huntsman’s poor financial results triggered the material adverse effect clause in the agreement. It was held however, that one poor financial result does not trigger it and that ultimately, since Hexion did not perform the obligation in good faith, its actions constituted a willful and intentional breach.

Recently, in Apollo Tires v. Cooper Tires, Civil Action No. 8980-VCG, the moot point was whether Apollo Tires (the buyer) had failed to use “reasonable best efforts” to reach the negotiated agreement with the United Steelworkers Union (“USW”) as required by the merger agreement. The court said that a provision that specifically mandated an obligation to obtain antitrust and other regulatory approvals couldn’t be interpreted to include within it, an obligation to obtain third-party contractual consents. The language of the efforts clause asked for obtaining antitrust and other regulatory approvals and did not talk about third-party consents. In the end, Cooper Tires could not prove that Apollo Tires did not use “reasonable best efforts” to obtain the consent from USW.

Courts clearly are reluctant to provide a definition for “best efforts”. They rightly treat this issue according to the specific facts and circumstances of the case and do not have a particular definition for the term. It is not a “hell or high water” clause as it is sometimes called because, as we have seen, the promising party does not always have to do everything in its power to conclude the obligation. The courts make sure that the promising party does not ignore their own interest, incur losses just to perform the obligation, or ignore its fiduciary duties. It is important however, that the promising party’s obligation is performed in good faith and there is no willful breach of the obligation.

Define “best efforts” to reduce uncertainty

To avoid uncertainty in terms of performing obligations and enforcement, firstly, it is important for the parties understand their rights and obligations under the “best efforts” provisions. Parties can also define the terms in the contract. As we have seen, courts have provided a subjective interpretation only when the agreement did not provide a definition for “best efforts”. The definition should clearly define the promisor’s capability, reasonable business practice, and the industry standard in relation to the obligation. Providing objective criteria would implore the courts to stick to the contractual language.

Samar Jha recently received an LLM from the University of Pennsylvania Law School.

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Corporate

Learn to draft a loan agreement like a pro

DeekshaSinghLoan agreements, like most commercial agreements, have a standard structure that must be moulded and adapted to suit specific transactions. In corporate lending, that is, where a bank is lending to a company, the amounts involved tend to be substantial and both the bank and the borrower will typically have legal representation. The bank’s lawyers usually draft the first version of the loan documents and the borrower’s lawyers review and negotiate the terms of the agreement on behalf of the borrower.

Remember, a loan agreement goes through many rounds of discussions and negotiation. A drafting lawyer must be prepared to rework the draft several times.

Term sheet

Before the lawyers begin drafting, the bank and the borrower enter into a term sheet that lays down the key commercial points that they have agreed upon in relation to the loan. Referred to as a financing term sheet, it is the basis for the legally binding documents that the lawyers have to draft. Generally, it covers only the more important aspects of a deal, without going into every detail covered in a binding contract. Typically, the authority or committee within a bank that reviews and approves loan proposals also considers financing term sheets.

Facility agreement

Often, a corporate loan is also called a ‘facility’ provided by the bank to the borrowing company and so, a corporate loan agreement is also known as a facility agreement.

A facility agreement between the bank and the borrower sets out the terms laid out in the term sheet in the form of a binding legal agreement. It contains the details of the loan, the manner in which the loan will operate, and the terms and conditions that have to be fulfilled by the parties to the agreement.

Each facility agreement is different and is drafted bearing in mind the nature of the facility. While there are several ways of drafting facility agreements, all of them can be divided into the following key sections—introductory, interpretation, operational, terms and conditions, and boilerplate clauses.

The introductory section

APCCLP_CompanyLaw-BannerAt the beginning of a facility agreement, the introductory section contains all the vital information that sets up the contract. This is typically the part where the drafter tells the reader what is being communicated, and what will be contained within the body of the contract.

The title, the exordium, the recitals, and the table of contents, which are items that are found at the beginning of most commercial agreements, are placed at the beginning of a facility agreement also.

The interpretation section

Every facility agreement also needs a separate section defining the special terms used in the agreement, or terms that are used in a particular way in the agreement. Typically, in facility agreements in India, definitions are provided at the beginning.

This section should be accurately drafted as it will significantly impact the way in which key clauses in the agreement operate. Many definitions are common to all facility agreements, but they can have minor variations depending on the specific transaction. It is, therefore, important for the drafter to tailor the definitions to suit the term sheet.

Most facility agreements will define terms like “Borrower”, “Obligor”, “Material Adverse Effect”, and “Event of Default”. A drafter must examine the terms of the particular loan transaction and determine how they should be defined.

In addition to a definitions section, a facility agreement can also contain a section that sets out specific rules for interpreting the agreement. These rules apply through the document.

The operational section

DraftingCreditFacilityAgreementsThis is the section of the facility agreement that deals with the operational details of the loan, that is, the amount of the loan, the term and purpose of the loan, how the loan will be drawn by the borrower, the repayment schedule, the details of payment of interest, conditions relating to prepayment of the loan, and so on. Obviously, these details are transaction-specific and the drafter will need to rely on the commercial understanding contained in the term sheet to draft the clauses in this section.

Terms and conditions

The terms and conditions section of a facility agreement is transaction-specific and contains the terms and conditions based on which the lender agrees to give a loan to the borrower. These terms and conditions differ among agreements and include both generic conditions that any lender would ask of a borrower—such as the borrower’s capacity to take the loan—as well as conditions that specifically relate to the facts and circumstances of that particular facility. An example of a specific condition is one where the borrower has to obtain the necessary environmental approvals, if the loan is for setting up a power plant.

Broadly, the provisions in this section can be categorised as representations and warranties, undertakings, events of default, and consequences of events of default. This section also includes provisions protecting the bank from changes in circumstances that could affect the loan.

Representations and warranties

The representations and warranties in a facility agreement typically focus on issues such as:

– Whether the borrower is a legally incorporated entity, carrying on business legally, and is duly authorised to take the loan and enter into the agreement;

– Whether the loan agreement and other finance documents for the transaction will be valid, admissible as evidence, duly stamped or registered, and binding on the borrower;

– Whether the borrower has committed any default in relation to the loan or has committed any default that could impact the loan;

– Whether all the information, including financial statements, that the borrower provided to the lender, are true, accurate, and in the form that the lender requires;

– Whether the rights of the lender under the loan agreement or the security documents are in any way subordinated to any other creditor of the borrower;

– Whether the borrower has any legal proceedings pending against it that could affect the borrower’s business or its ability to repay the lender; and

– Whether the assets offered to the lender as security are legally owned by the borrower, and whether they are free of any existing encumbrances.

Covenants

Covenants or undertakings are provisions in the loan agreement that relate to actions that the borrower company is required to carry out (known as affirmative covenants), or prohibited from carrying out without obtaining prior consent from the bank (known as negative covenants). These can also be financial covenants, which  set out parameters for the borrower to follow during the tenure of the loan. Typically, this section contains some specific financial definitions provided by the bank, based on which the bank intends to judge the financial performance of the borrower. The breach of these covenants can be an immediate event of default.

Events of default and consequences

InfrastructureLawThe section on events of default tends to be extensive, in order to protect the interests of the bank in the best way possible. Broadly, events of default focus on the following key points:

– Events relating to the loan agreement: Naturally, any non-payment of any amount due to the bank, any breach of, or any misrepresentation under the loan agreement will be considered an event of default by the lender. Similarly, any breach, or misrepresentation in relation to the security documents will also be included as an event of default.

– Events relating to the borrower: There will also be some other events, which affect the borrower’s ability to repay the loan that will be included as events of default. These include cross-default provisions that consider non-payment by the borrower in other loans as a default, any events in relation to the insolvency of the borrower, the cessation of business by the borrower, any illegal activity by the borrower, and so on.

Since loan agreements tend to be fairly one-sided documents, where the obligations remain primarily on the borrower, events of default are usually linked only to breaches by the borrower and not by the lender.

Deeksha Singh is part of the faculty on myLaw.net.

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Eight clauses that you will come across in business contracts

The skills required to draft and review contracts well are best acquired through practice. While many become experienced negotiators of contracts, many lawyers continue to struggle with them. To make things a little easier, here is a brief look at eight clauses that you will encounter commonly in the business world.

Parties to the contract

KareenaRaveenaEvery party to the contract is named in this clause. It is vital to the validity of the contract itself since any ambiguity in identifying the parties can render a contract null and void. If you are drafting the contract, make sure that you clearly state the names of all the parties and then, refer to them throughout the contract using the same nomenclature. Remember, consistency is key to good drafting.

Definitions

The clause containing the definitions of the important terms and concepts referred to in the contract is important because the contractual relationship will flow from the meanings of these words. Remember to be as precise as you can because it will affect the operation of the entire contractual relationship.

Confidentiality

Amitabh_KhamoshThis clause is included in contracts to maintain the confidentiality of vital information for businesses such as ‘trade secrets’ or other types of information that is explicitly marked as ‘confidential’.

Sometimes, when negotiating a contract, parties share confidential information with each other even before the contract comes into effect. To protect the interests of the parties in case the negotiations do not culminate in a contract, such a clause is often drafted as part of a stand-alone agreement called a ‘non-disclosure agreement’. It is a contract that survives even if the actual business contract does not come into effect.

Intellectual property rights

Very often, in the course of employment or business, individuals and enterprises create and use intellectual property. Intellectual property is a precious source of income and it is very important to clearly identify in a contract, its ownership, usage, and the rights of the parties in relation to the intellectual property. While the creator of some intellectual property usually has all rights in it, those rights belong to the employer or the person who has commissioned the work when it is created for an employer or if the work has been commissioned. Parties can also agree to share the ownership or profits from its exploitation.

Non-compete and non-poaching clauses

Apart from protecting trade secrets and intellectual property, businesses must also guard against the transfer of vital information to their rivals through employees who are offered greater incentives to do so. In a non-compete clause, an employee (usually) agrees to not to enter into, start, or join a profession or trade in competition with the employer. A non-poaching clause is relevant in agreements between businesses. In it, organisations mutually agree to not hire employees from each other. Both non-compete and non-poaching clauses can be limited to a certain period of time.

Indemnity, warranty, and guarantee

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Indemnification is important for protecting an organisation from errors committed by those outside it. Warranties and guarantees are important to establish a reliable framework of trust between partners in a business for the successful execution of a business contract. These clauses can often lead to separate indemnity, warranty, guarantee, and in some cases, full-fledged insurance agreements that are distinct from the original business contract.

Termination of the contract

Every contract must indicate a manner of ending. Some contractual relationships may not specify a termination date, such as employment contracts where employment ends on superannuation. Other contracts, such as those for the performance of a service or the use of a product, must clearly specify the duration of the contract and how to terminate it so that parties can either renegotiate terms afresh or renew the contract if required.

Jurisdiction

Jurisdiction plays a crucial role in any contract. It acquires importance when the contractual relationship deteriorates and requires judicial intervention. A contract can state the law it is to be governed by, that is, the law applicable to the subject matter of the contract. It can also state which court(s) will exercise jurisdiction in case parties choose to take judicial recourse such as the courts of a particular city, or which mechanism will be used to redress disputes, such as arbitration tribunal.

(Suhasini Rao is part of the faculty on myLaw.net.)

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Drafting a Memorandum of Understanding

Drafting_for_Business_Deepa_Mookerjee.jpgLet’s say you are the CEO of ABC Limited, a multinational company. You have had oral discussions with the CEO of Apples Pte, a non-resident company that, in a highly lucrative deal, wants to invest in your company. While you do not want binding documents to be signed at this stage, you would like some kind of documentary proof that this deal is being negotiated. What would you do?

Ideally, both parties would sign a Memorandum of Understanding (“MoU”). In all commercial transactions, initial discussions between parties are usually followed by the execution of a document that lays out the preliminary intention of the parties to enter into a deal. This document is termed a MoU, a term sheet, or a letter of intent — terms are often used interchangeably in commercial transactions.

At first glance, a MoU looks like a simple document. Drafting the MoU however, is one of the most important steps in the transaction. This is because it serves as the basis for more detailed legal documents. It thus lays the groundwork for a transaction and ensures that the parties agree on all major issues, thereby reducing the possibility of a misunderstanding.

Signing_an_MoUWhile drafting a MoU, always ensure that you specify the correct name and description of the parties. If this is not done, it is a clear loophole that may allow either party to wriggle out of the deal, as the MoU does not place any obligations on them. Similarly, include a clear description of the deal. Never use vague or unclear language as it creates confusion.

Let’s understand some other key points to keep in mind while drafting a MoU.

Binding or non-binding?

A MoU can be drafted to be either legally binding on the parties to the MoU or serve as a document that is not binding and only captures the intent of the parties. A legally binding MoU is useful when parties have already agreed on major aspects of the deal and do not want this understanding to change under any circumstances. It also ensures that the parties do not back out of a deal without facing any consequences.

Assume that Apples Pte. has agreed on the amount of consideration, the nature of indemnification, and all the representations and warranties to be provided under the deal. All of these are key points that make or break a deal, and so you may want to enter into a binding MoU to ensure that Apples Pte. is tied to the deal. On the other hand, if the negotiations are still at a very preliminary stage, you could consider a non-binding MoU. It gives you the comfort of some documentary proof of the discussions, without restraining you from backing out of the deal at a later stage.

Often parties opt for a non-binding MoU as they wait to complete a due diligence exercise. This is a detailed investigation of a company and its results typically affect the terms of the deal materially. Parties therefore, do not want to enter into any binding documentation before the investigations are complete.

Exclusive or non-exclusive MoU

Non-ExclusiveMoU_MemorandumofUnderstanding.jpgA MoU can be exclusive or non-exclusive. For an exclusive MoU, parties are restrained from entering into similar MoUs with any other entity during the term of that MoU. On the other hand, the document can be drafted on a non-exclusive basis, in which case, the parties are free to enter into discussions with other entities dealing with the same subject.

If you are apprehensive that your competitors may also approach Apples Pte, start negotiations with them, and thus harm your deal, you can enter into a MoU on an exclusive basis. This would mean that during the term of the MoU, Apples Pte is barred from negotiating with any other party.

Confidentiality

During negotiations of this nature, to understand the nature of each other’s businesses and the general condition of the company, parties exchange a lot of information, much of which is proprietary in nature. Obviously, no party will invest without having complete information about the investee company. In order to ensure that this information is not leaked to your competitors or the public in general, one very important clause that must be included in every MoU is a comprehensive confidentiality clause. Always insist on a clause that states that all information exchanged between the parties is to be treated as confidential and must never be disclosed to the public.

These are just few of the important clauses that you will see in every MoU. Remember always, that there is no set format for a MoU. It could be a one-page document or it could run into several pages. Ultimately, at the end of the day, the nature, contents, and form of the MoU will depend upon the nature of the deal and what your clients want.

(Deepa Mookerjee is part of the faculty on myLaw.net.)