A confidentiality agreement, also known as a nondisclosure agreement, is typically the first legal document to be prepared, negotiated, and signed when initiating the process of selling or buying a company.
At first glance, the purpose of a confidentiality agreement appears straightforward. It aims to ensure that the information disclosed by the seller (and/or the target company) to potential buyers during a proposed transaction remains confidential and is not shared with others.
However, some prospective sellers might overlook the need to ensure that the confidentiality agreement also restricts the recipient from using the information for any purpose other than evaluating the potential transaction. Such an oversight could occasionally lead to significant issues, especially if the recipient is a competitor of the discloser.
Due to its purpose, a confidentiality agreement is almost always drafted by the seller, who often relies on it the most. However, sellers are frequently the less experienced party in a merger and acquisition (M&A) transaction.
However, sometimes a confidentiality agreement may be included as a binding component of a letter of intent or term sheet prepared by the prospective buyer.
It can take the form of a contract or a unilateral undertaking (hereinafter referred to generally as confidentiality agreements), executed before providing access to confidential information to any recipient. Although sellers or buyers often view these agreements as standardized or simple documents that just need to be signed as a formality before a prospective buyer begins their due diligence process, confidentiality agreements are actually quite complex and come with various potential pitfalls.
The main areas of focus when drafting and negotiating a confidentiality agreement typically include (this list is not exhaustive):
(a) identifying the parties involved;
(b) defining confidential information and any exceptions;
(c) outlining the nature and scope of confidentiality obligations;
(d) specifying permitted uses and disclosures of confidential information;
(e) addressing the return or destruction of confidential information;
(f) including any additional non-solicitation or standstill obligations for certain types of transactions;
(g) determining the duration of the confidentiality obligations; and
(h) establishing the remedies available to the discloser in case of a breach of confidentiality obligations.
We will discuss these key points of attention below to highlight some potential pitfalls they may conceal.
(A) Parties to a Non-disclosure Agreement
Focusing on the parties involved in a confidentiality agreement might seem odd., as the seller and buyer typically appear to be the usual participants.
However, any potential buyer should carefully consider whether the target company should be a party to the confidentiality agreement or at least be designated as a third-party beneficiary.
In an auction process sale, for instance, where multiple prospective buyers enter into confidentiality agreements, the final purchaser may need to rely on these agreements after completion to protect its new investment from disappointed competitors.
This goal could also be achieved through other legal means, such as including a provision in the confidentiality agreement that allows the final purchaser to require the discloser to enforce its confidentiality arrangements against other bidders, or through assignment provisions that transfer the discloser's rights in the confidentiality agreements to the final purchaser upon completion of the transaction.
(B) Definition of Confidential Information
It’s expected that the discloser will advocate for the broadest possible definition, potentially including the fact that the parties are considering the transaction. Meanwhile, the recipient should request standard exceptions to the definition of confidential information, such as:
(a) information that is publicly available;
(b) information that must be disclosed due to legal or regulatory requirements;
(c) information already in the recipient’s possession before disclosure;
(d) information disclosed with the discloser's prior consent; and
(e) information independently developed by the recipient.
If the definition of confidential information includes reports and analyses created by the recipient and its advisers based on the confidential information, the recipient must ensure it can comply with obligations to return or destroy such reports and analyses.
Similarly, if the confidential information encompasses the mere existence of the negotiations on the contemplated transaction, the recipient should consider whether it will be able to return or destroy any internal emails, reports, and documents that simply mention the existence of the contemplated transaction.
(C) The nature and scope of the confidentiality obligations
The scope and nature of the confidentiality obligations are also crucial points for negotiation, ideally approached with practicality by both parties.
For instance, are the obligations concerning the storage and security of the confidential information or its use post-disclosure feasible? If they apply to the recipient, are they equally practical for its authorized recipients? Will these obligations necessitate the recipient and/or its authorized recipients to implement extra storage or security measures?
(D) Permitted use and/or disclosure of confidential information
Discussion and agreement regarding disclosure to what are termed authorized recipients are also essential topics to address.
A confidentiality agreement should not hinder a recipient from reasonably utilizing the confidential information for its permitted purpose. In most transactions, this necessitates the recipient's ability to share it with specific individuals, known as authorized recipients. These may include management bodies, key officers, employees or agents, members of its investment committee (if applicable), prospective co-investors or financiers, and professional advisers.
Subsequently, once the authorized recipients are determined, the parties must also reach an agreement on how liability will be allocated in the event of a breach of confidentiality obligations by any of these authorized recipients. The discloser will advocate for the recipient to bear full liability for any breach of confidentiality obligations, typically through a porte-fort clause.
On the other hand, the recipient will advocate for each authorized recipient to establish direct contractual relationships with the discloser and be exempt from liability. However, the recipient may accept liability if one of its authorized recipients fails to sign a direct confidentiality agreement with the discloser.
Additionally, obligatory disclosure requirements to public authorities, regulators, or other entities (e.g., stock exchanges) should be adequately addressed. While the discloser may typically be unable to prevent such compulsory disclosures, it can attempt to impose reasonable constraints and other obligations (e.g., prior notification).
(E) Returning or destroying the confidential information
It's crucial to remember the obligation to return or destroy confidential information if the transaction doesn't proceed. Several issues may arise here. Initially, the recipient must ensure that it isn't compelled to return or destroy any information it's legally or regulatory required to retain.
Next, the recipient should exercise caution regarding, for instance, (a) the timing for returning and destroying the information, (b) its capability to completely eradicate electronically stored data, which could be highly intricate and expensive, and (c) the documents that the recipient or its authorized representatives may need to retain in accordance with legal requirements, regulations, and internal corporate policies.
It's essential to also remember the obligation to return or destroy confidential information if the transaction doesn't proceed. Various challenges may arise here. Initially, the recipient must verify that it won't be compelled to return or destroy any information it's legally required to retain under law or regulation.
(F) Duration of the confidentiality obligations
All parties involved in a confidentiality agreement should recognize that confidential information often loses its secrecy over time or becomes no longer commercially sensitive. Thus, entering into a confidentiality agreement for an indefinite duration should be avoided, as it could allow any party to unilaterally terminate it with reasonable notice. Furthermore, a confidentiality agreement should not continue to bind the "final purchaser" after the completion of any planned transaction involving 100% of the target company.
With a sensible approach, parties should aim to establish a specific and reasonable term consistent with market standards, which typically ranges from two to five years, taking into account variations across different industries.
(G) courses of action available for the discloser in the event of a breach of confidentiality obligations
Lastly, the parties involved in a confidentiality agreement will need to reach consensus on the penalties in case of a breach of confidentiality obligations. The discloser will typically seek to negotiate what's commonly known as an "indemnity" within the confidentiality agreement, as proving damages resulting from a breach of confidentiality can be challenging in court. The recipient, especially if it's a private equity fund, is likely to resist this request and may rely on common law principles. If an "indemnity" is to be considered, the recipient must ensure that any alleged breach or damage is recognized by a court before any payment is due, and the discloser must have a reinforced obligation to mitigate its losses.
The above points highlight the sophistication and potential pitfalls of confidentiality agreements in M&A transactions, emphasizing the need for careful drafting and negotiation to protect both parties' interests.
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