examining commonly used contract provisions

Snell & Wilmer

Enforceable or Unenforceable? Examining Commonly Used Contract Provisions

In today’s market of proliferating disputes and increasing litigation costs, the stakes are high when it comes to composing a well-drafted contract. Contracts are an everyday part of doing business. On June 11, we invite you to leave the negotiating table behind and join us aboard the historic Queen Mary to demonstrate your knowledge of commonly used contract provisions during an interactive CLE contest.

A panel including Snell & Wilmer attorneys Keith Gregory, Jim Scheinkman and Josh Schneiderman, and Power-One, Inc. Secretary and General Counsel Tina McKnight will lend insight and challenge your contract expertise on topics such as:

• Preparing contracts to avoid litigation• Understanding the enforceability of common provisions• Managing contracts in-house

Following the program, we invite you on deck for networking, drinks and beautiful harbor views.

Tuesday, June 11, 2013

3:30 p.m. – 4:00 p.m.Registration

4:00 p.m. – 5:30 p.m.Program

5:30 p.m. – 7:00 p.m.Reception

1.5 hours of CLE credit provided

The Queen Mary1126 Queens HighwayLong Beach, CA 90802(877) 342-0738

Keith GregorySnell & Wilmer

Jim ScheinkmanSnell & Wilmer

Josh SchneidermanSnell & Wilmer

Tina McKnightPower-One, Inc.

Keith Gregory | [email protected] Partner, Snell & Wilmer Keith Gregory practices in the areas of general business matters, corporate, franchise and partnership disputes, and intellectual property and commercial litigation. He is an experienced litigator, with

considerable background in intellectual property issues, licensing agreements, trade secret matters and Uniform Commercial Code issues, especially within the electronic components and semi-conductor industries. Keith serves on the SAE International AS6081 Committee, established to develop standards proscribing counterfeit parts avoidance requirements for independent distributors.

Tina McKnight | [email protected] Secretary & General Counsel, Power-One, Inc. Tina McKnight joined Power-One in December 2008 as Secretary and General Counsel. Before joining Power-One, Tina served as Senior Vice President and General Counsel of BCBG Max Azria

Group, an international retailer. Prior to that she served as General Counsel and Secretary to Magnetek, Inc., a global power supplies and renewable energy business. Tina has also held in-house legal positions with Natrol, Inc. and Great Western Financial Corporation and was an attorney in the Los Angeles office of Brobeck, Phleger and Harrison after graduating from law school. Tina earned her J.D. from the University of Southern California's Gould School of Law and her B.A. from the University of California, Los Angeles.

Jim Scheinkman | [email protected] Partner, Snell & Wilmer Jim Scheinkman is a practice group leader of Snell & Wilmer’s Business and Finance Group. His practice focuses on assisting mid-market companies and their owners in mergers and acquisitions,

financings, joint ventures, corporate governance and shareholder dispute resolution, securities offerings, technology development and transfers, executive compensation and other corporate and commercial matters. Jim also serves as general outside counsel for a variety of mid-market businesses.

Josh Schneiderman | [email protected] Associate, Snell & Wilmer Josh Schneiderman is a member of Snell & Wilmer’s Business & Finance group in the firm’s Los Angeles office. He advises clients on a wide range of transactional matters, including mergers and

acquisitions, joint ventures, franchising and public and private offerings of debt and equity securities. Josh also advises public and private companies on corporate governance matters, including Sarbanes-Oxley compliance.

June 11, 2013

mailto:[email protected]




http://www.swlaw.com/attorneys/jim_scheinkman

http://www.swlaw.com/attorneys/joshua_schneiderman

Tuesday, June 11, 2013

©2013 Snell & Wilmer L.L.P. 4

Application of Attorney’s Fees Clauses

Homer and Bart enter into an agreement that contains thefollowing clause:

“The prevailing party in any dispute arising out of thisAgreement shall be entitled to recover its attorneys’ fees andcosts from the other party.”

Homer sues Bart for breach of contract as well as on a torttheory. Homer prevails on his tort claim and is awarded$25,000 in damages, but the court finds in favor of Bart on thebreach of contract claim. Both parties seek attorneys’ fees.

Who is entitled to recover the attorneys’ fees?



A. Homer because he is the prevailing party since he received a net monetary recovery

B. Bart because he prevailed on the breach of contract claim, and under California law governing attorneys’ fees, the party prevailing on a contract claim recovers even if the other party prevailed on the non-contract claims

C. Neither party is awarded attorneys’ fees because the two claims cancel each other out

D. Both Homer and Bart are entitled to attorneys’ fees as to the particular claim upon which they prevailed, and the court will engage in complex mathematical calculations to determine how much each should receive

©2013 Snell & Wilmer L.L.P.


Correct Answer: AHomer because he is the prevailing party since he received a net monetary recovery

In determining which party recovers attorneys’ fees when a lawsuitinvolves not only a breach of contract claim but other types of claims, thecourt will look to the specific language of the attorneys’ fee clause.

• If the language is general, e.g., “arising out of” or “in connectionwith,” then a court will likely award attorneys’ fees to the party “with anet monetary recovery,” which in this case was Homer.

• If the language specifically states that attorneys’ fees will be awardedto the party “prevailing on the contract,” then a court will likely awardattorneys’ fees to the party that prevails on the contract claim, even ifthe other party prevails on other non-contract claims.

6


Enforceability of “AS IS” language

Ned Stark is in the market to buy a house and, after viewing aproperty owned by Tywin Lannister, decides to purchase it.Tywin knows that the house has been condemned by thegovernment but assures Ned that there are no governmentactions against the property. Ned and Tywin sign a purchaseand sale contract that contains an “as is” clause. One weekafter moving into the house, Ned discovers the condemnationnotice stuck to a fence post. Ned sues Tywin for variousclaims, including breach of contract and fraud, and Tywincites the “as is” clause as a defense.

Is the “as is” clause enforceable or unenforceable?



A. Enforceable because “as is” clauses are unequivocally legally binding

B. Enforceable because Ned had an opportunity to inspect the house beforehand and is therefore bound by the “as is” clause

C. Unenforceable because Tywin concealed from Ned the existence of the condemnation action by intentionally misrepresenting that the house had no government action against it

D. Unenforceable because “as is” clauses are prohibited under California law



Correct Answer: CUnenforceable because Tywin concealed from Ned theexistence of the condemnation action by intentionallymisrepresenting that the house had no government actionagainst it

• California courts recognize the enforceability of“As Is” clauses, but have recognized anexception to this rule where a seller, throughfraud or misrepresentation, intentionallyconceals a defect in the property.

• Lingsch v. Savage, 213 Cal. App. 2d 729, 740-742 (1963).

9


International Arbitration

Any dispute, controversy or claim arising out of or relating tothis contract, including the validity, invalidity, breach, ortermination thereof, shall be finally settled by binding arbitration[administered by the AAA or ICC or some other arbitrationcommission], and judgment upon the award rendered by thearbitrators may be entered in any court having jurisdiction. Thearbitration shall be conducted in English in [name of city, state,United States] in accordance with [the chosen arbitration rules,e.g., the United States Arbitration Act or the ICC Rules ofArbitration] and [the chosen governing law, e.g., thesubstantive law of the state of California]. There shall be [oneto three] arbitrators, named in accordance with such rules.”

This clause will be enforceable in which jurisdictions?



A. United States

B. China

C. Any country that has signed the United Nations “New York” Treaty

D. All Jurisdictions



Correct Answer: CAny country that has signed the United Nations “New York”Treaty

While both A and B are correct, because both the UnitedStates and China are signatories to the United NationsNew York Treaty approximately another 130 countriesare signatories to this treaty as well. The main reasonthat parties engaged in international transactions want toinclude this type of provision in their terms and conditionsis so that if a dispute arises and they are forced to litigatethen they will have an award that is enforceable in theother party’s jurisdiction.

12


Waiver of Jury Trials

California Dreaming, Inc., a CA corporation, andILUVNY, Inc., a NY corporation, enter into a mergeragreement and agree to a neutral governing law ofDelaware even though neither company doesbusiness in Delaware. The Agreement contains aclause waiving the right to a trial by jury. CaliforniaDreaming files suit against ILUVNY in CA state courtalleging breach of rep.

Is the waiver of jury trial enforceable?



A. Enforceable because DE law re waiver of jury trial will apply

B. Enforceable because CA law re waiver of jury trial will apply

C. Unenforceable because DE law re waiver of jury trial will apply

D. Unenforceable because CA law re waiver of jury trial will apply



Correct Answer: DUnenforceable because CA law re waiver of jury trial will apply

• Article I, Section 16 of the California Constitution: “Trial by juryis an inviolate right and shall be secured to all … In a civil casea jury may be waived by the consent of the parties expressedas prescribed by statute.”

• Grafton Partners v. Superior Court: CA Supreme Court strictlyinterpreted Article I, Section 16 and held that jury trial waiversare only permissible when they are “prescribed by statute.”

• Only statute that expressly permits waivers is Section 631(f) ofthe Code of Civil Procedure, which notably does not authorizewaivers before parties have submitted a claim to court.

15


Best Efforts vs. Reasonable Efforts

Montague, Inc. and Capulet, Co. arenegotiating a contract whereby Capulet willprovide services to Montague. Montagueproposes contract language that states thatCapulet will use its “best efforts,” but Capuletcrosses out “best efforts” and replaces it with“reasonable efforts.”

Which is better for Montague, “best efforts” or “reasonable efforts?”



A. “Best efforts” because it is a more stringent requirement than reasonable efforts

B. “Reasonable efforts” because a “best efforts” clause is not enforceable in California

C. It doesn’t matter because California courts have not differentiated between the two terms

D. It doesn’t matter because Montague, Inc. and Capulet, Co. will end up feuding in court anyway



Correct Answer: CIt doesn’t matter because California courts have not differentiatedbetween the two terms

• Currently, there is no case law in California specifically addressingthis issue of whether there is a distinction between “best efforts” and“reasonable efforts.”

• However, existing California case law suggests that “best efforts” and“reasonable efforts” are essentially interchangeable. AlthoughCalifornia has declined to provide a clear definition of “best efforts,”the courts have ruled that “best efforts” means that “the promisor mustuse the diligence of a reasonable person under comparablecircumstances.”

• California Pines Prop. Owners Assn. v. Pedotti, 206 Cal. App. 4th384, 387, 795 (2012).

18


Venue Selection

An agreement between Penguins, Inc. and Kings, Co. containsthe following clause:

“This Agreement shall be governed by and construed inaccordance with the laws of the State of California, and theparties hereto agree to submit to personal jurisdiction by andvenue in the State of California, County of Alpine.”

After a dispute arises, Penguins, Inc. objects to the venueselection clause, stating that it violates the California statuteregarding venue selection.

Is the venue selection clause enforceable or unenforceable?


Venue Selection

A. Enforceable, regardless of whether the choice of venue complies with the statutory venue provisions.

B. Enforceable, only if Alpine County is a statutorily permissible county.

C. Unenforceable, regardless of whether the choice of law venue complies with the statutory venue provisions.

D. Unenforceable because no one even lives in Alpine County.


Venue Selection

Correct Answer: BEnforceable, only if Alpine County is a statutorily permissible county.

• A venue selection clause is void only insofar as it disrupts statutoryvenue provisions. Agreements fixing venue in some location otherthan that allowed by statute are a violation of that policy. However,if the venue selected is permitted by statute, then the court willenforce such a provision. See Battaglia Enterprises, Inc. v.Superior Court of San Diego County, 215 Cal. App. 4th 309.

• A consent to personal jurisdiction is enforceable if freely negotiatedand not unreasonable and unjust. See Burger King Corp. v.Rudzewicz, 471 U.S. 462 (1985)

• Code of Civil Procedure Section 395 generally governs venue.

21


Mandatory Mediation

Before any legal action is filed between the parties,except for an ex parte application that seeks eitherinjunctive relief or a pre-judgment remedy such as atemporary protective order, the parties agree toparticipate in a mediation before a neutral mediatorthat will last a minimum of four hours unless thematter is resolved in less than that amount of time.The parties further agree to equally share in all ofthe costs associated with the mediation.

How will the parties benefit from this type of contractual clause?


Mandatory Mediation

A. Limit their attorneys fees

B. Keep the lines of communication open with the other contracting party

C. Allows the parties to think out of the box in reaching a solution to their problem

D. All of the above


Mandatory Mediation

Correct Answer: DAll of the above

Once litigation is filed, most parties to a contract stoptalking with each other and leave most of theircommunications to their lawyers. A mediation before thelitigation will bring the parties together and give them anopportunity to try to figure out if they have any ability tocompromise so as to allow their business relationship tocontinue. Also, if the parties choose a creative mediatorthat mediator might be able to develop ideas that theparties have not considered before the mediation.

24


Liquidated Damages

Money Bags Bank, Co. (MBB) sued Give Me Cash, Co.(GMC) for breach of contract. MBB alleged GMC failed topay $100K under a contract for financial advisoryservices. GMC disputed the claim, countering that MBBhad breached the contract. The parties entered into aSettlement Agreement calling for GMC to make threepayments of $20K each. If GMC missed a payment, MBBwould immediately be entitled to $100K plus interest andattorneys fees.

Is this provision enforceable or unenforceable in CA?


Liquidated Damages

A. Enforceable, because liquidated damages clauses are enforceable in CA

B. Enforceable, because the damages are reasonable and proportional to MBB’s damages

C. Unenforceable, because liquidated damages clauses are not enforceable in CA

D. Unenforceable, because the damages are not reasonable and proportional to MBB’s damages


Liquidated Damages

Correct Answer: DUnenforceable, because the damages are not reasonable andproportional to MBB’s damages

• While liquidated damages clauses are enforceable in California,the amount of liquidated damages has to be reasonable andproportional relative to the amount of the actual damages.

• Here, GMC disputed the underlying claim and whether or not itowed the $100K. As a result, the parties entered into asettlement agreement calling for the payment of an aggregate of$60K.The liquidated damages provision applied to a breach ofthe settlement agreement, not the financial services agreement.$100K of liquidated damages is not proportional to the actualdamages suffered here, which is loss of the $60K payment underthe settlement agreement.

27


Fundamental Policy Exceptions to Choice of Law Provisions

In California, a choice of law provisionwill not be enforced if the chosenstate’s law to be applied is contrary to afundamental policy of California.

Which of the following may qualify as a “fundamental” California policy?



A. Protection of the right of employees to not have any part of their wages taken back by their employer.

B. Protection of the right of citizens to pursue any lawful employment (policy against covenants not to compete).

C. Protection of California’s statute of limitations.

D. Protection of every citizen’s right to “Hang Loose”

E. A and B

F. B and C



Correct Answer: EProtection of the right of employees to not have any part of their wagestaken back by their employer AND Protection of the right of citizens topursue any lawful employment (policy against covenants not tocompete).

• In determining the enforceability of a choice of lawprovision, the court must determine whether (1) thechosen state has a substantial relationship to the partiesor the transaction, or (2) whether there is any otherreasonable basis for the choice of law.

• If either test is met, the court must determine whetherthe chosen state’s law is contrary to a fundamentalpolicy of California.

30


Contractual Limitations onBringing Claims

An agreement between Draper Partners, Inc. and OlsonCompany states that the representations and warrantiescontained in the agreement “survive the Closing for aperiod of one year.”

Olson Company discovers a that breach of therepresentations and warranties by Draper Partners, Inc.was made within the first year after the Closing, but doesnot bring a claim for the breach until after the expirationof the one year period.

Will the court allow Olson Company’s claim?


Contractual Limitations onBringing Claims

A. The claim is allowed because California courts are fundamentally opposed to any contractual limitation on the bringing of claims.

B. The claim is barred because it was not brought within the one year period.

C. The claim would be barred if the agreement also stated that “no claim for indemnification may be made more than one year after Closing.”

D. The claim is allowed because the court would not read the boilerplate language anyway.


Contractual Limitations on Bringing Claims Correct Answer: CThe claim would be barred if the agreement also stated that “no claim forindemnification may be made more than one year after Closing.”

• Courts generally enforce a parties’ agreement to shorten a limitation period thanotherwise provided by statute, provided it is reasonable, and such agreements donot violate public policy. See Zalkind v. Ceradyne, Inc., 194 Cal. App. 4th 1010(2011).

• The Ninth Circuit has held that, because California law does not favor contractualstipulations to limit a statute of limitation, that such stipulation must be clear andexplicit. It held that a clause similar to the one in the example was ambiguous andserved only to specify when a breach of the representations and warranties mayoccur, not when an action must be filed. Western Filter Corp. v. Argan, Inc., 540F.3d 947 (2008).

• Thus, if parties wish to limit the period of time within which legal action must becommened, they should use specific language, such as that used in Answer C.

33


Joint Drafting

The agreement has been prepared and negotiations inconnection therewith have been carried on by the jointefforts of the respective parties. This Agreement is not tobe construed strictly for or against any of the partiessince both parties have jointly drafted it.An ambiguity exists in a contract entered into betweenABC Corp and XYZ LLC regarding when certain goodsare supposed to be delivered. XYZ claims that theambiguity should be construed against ABC, becauseABC prepared the contract and all XYZ did was sign it.

Will the ambiguity be construed against ABC?


Joint Drafting

A. No, because the parties agreed in the contract that it was jointly drafted

B. No, because the court determined that no ambiguity existed

C. Yes, because XYZ did not participate in any negotiations

D. Yes, because Civil Code Section 1654 controls


Joint Drafting

Correct Answer: ANo, because the parties agreed in the contract that itwas jointly drafted

While Civil Code Section 1654 typically governswhen an ambiguity exists in a contract, thatambiguity will not be construed against the draftingparty if the parties have agreed that the contract wasjointly drafted by them.

36


Time of the Essence

Florist Co. hires Grow Co. to deliver 1,000 roses to FloristCo. by July 10. The contract contains a time is of theessence clause. The agreement also provides that in theevent of a breach, the breaching party shall have 10 days tocure following notice of the breach. In reliance on the July10 delivery date, Florist Co. agrees to provide 1,000centerpieces for Happy Couple’s wedding. On July 11,Florist Co. notifies Grow Co. it has failed to deliver andneeds the roses delivered immediately for the wedding.Grow Co. delivers the roses on July 14. Florist Co. suesGrow Co. in CA for its costs to buy roses at retail for HappyCouple’s wedding.

Who wins?


Time of the Essence

A. Grow Co. wins because time is of the essence clauses are not enforceable in CA

B. Grow Co. wins because an express cure period trumps a time is of the essence clause

C. Florist Co. wins due to reliance only

D. Florist Co. wins due to reliance combined with time is of the essence clause


Time of the Essence

Correct Answer: BGrow Co. wins because an express cure periodtrumps a time is of the essence clause

• Time is of the essence clauses are generallyenforceable under CA law unless they act asa forfeiture

• However, courts will not interpret a time of theessence clause as limiting or depriving a partyof the benefit of any cure period specified inthe agreement.

39

Contract ManagementDiscussion

Tina McKnightSecretary & General Counsel

Power-One, Inc.


Typical In-House Contract Management Scenario

• Widely varying contract function among businesses

• Contract management, to the extent it exists, is disjointed

• Reasons


Role of the General Counsel’s Office

• Educate on the purpose of legal involvement

• Guide enterprise-wide contract management processes that balance risk and profit

• Create efficiencies


Successfully Engaging the Legal Department

• Understand the business • Be part of the team• Manage risk – don’t try to eliminate it • Engage executive management and

identify the “10 Commandments” for your company and TRAIN

• Understand who the decision maker is• Be efficient• Show the benefit of engaging legal

counsel early in the process


Best Practices for In-House Management of Contracts

• Have an enterprise wide contract management system

• Centralize the repository• Simplify the delegation of authority and

TRAIN• Clarify responsibilities and TRAIN• Have a process for contract submission• Focus the right Resource on Contracts

by Type44


Best Practices for In-House Management of Contracts

• Use simplified forms and templates where appropriate◦ Plain English◦ Alternative choices◦ Update

- analyze frequently renegotiated clauses and revise to reflect consistent outcomes

◦ Make forms and templates available◦ TRAIN

• Build financial review into the process before or concurrent with legal review

• Evaluate legacy contracts45

Reprinted with the permission of the Orange County Business Journal

ORANGECOUNTYBUSINESS JOURNALPage 1$1.50 VOL. 36 NO. 13 www.ocbj.com APRIL 1-7, 2013

SECURITIES Advertising Supplement APRIL 1, 2013

About Snell & Wilmer

Snell & Wilmer is a full-service business law firm with more than 400attorneys practicing in nine locations throughout the western United States andin Mexico, including Orange County and Los Angeles, California; Phoenix andTucson, Arizona; Denver, Colorado; Las Vegas and Reno, Nevada; Salt Lake

ompanies and their executives who utilize “Rule 10b5-1 Plans” toreduce the risks from insider trading claims when trading incompany securities should evaluate plan use given recentincreased scrutiny by the media and securities regulators. Since theadoption by the Securities and Exchange Commission (SEC) ofRule 10b5-1 (the Rule) in 2000, executives and directors at publiccompanies have widely used plans to take advantage of theaffirmative defense to insider trading suits created by the Rule.

Plans can be particularly helpful as class action securities plaintiffs suingcompanies and insiders, in order to establish a key element of their case, oftenpoint to executive trading occurring in close proximity with the timing ofcompany disclosures at issue in the case.

The Wall Street Journal recently conducted an investigation examining suchplans and published a series of articles within the past several months callinginto question certain plan practices by some participants. The investigationfound that of roughly 20,000 executives or trades sampled, around 1,500 ofthem recorded gains (or avoided losses) of 10 percent in the week following thetrade, compared to only 800 who posted a loss of 10 percent. Executives whotraded irregularly recorded average gains (or avoided losses) of over 20 percentin the week following their trade, a result that executives who traded on a moreregular pattern were much less likely to achieve.

The FBI and SEC in turn opened investigations concerning seven executiveswhose trades the Wall Street Journal highlighted as suspicious, while the U.S.District Attorneyʼs office for the Southern District of New York subpoenaed five ofthose seven executives. The Wall Street Journal also reported that the SEC willbe conducting broad computerized surveys akin to the Journalʼs investigation.The Council of Institutional Investors has publicly requested new Ruleguidelines or revisions for 10b5-1 Plans, while various shareholders haveproposed to companies the adoption of what they consider to be best practicesconcerning plan use.

Under the current Rule, plans must be in writing and specify, or set forth aformula for determining, the number of securities to be traded, the trade priceand the trade date. Typically, this is implemented as a contract with a securitiesbroker. Alternatively, the plan can grant a broker sole discretion over how, when,and whether to trade, but this is used less frequently. The plan can only beadopted when the executive is not aware of material nonpublic information, andthe executive is acting in good faith and not as part of a plan or scheme toevade the prohibitions of the Rule. The executive cannot deviate from the planand cannot engage in offsetting hedging transactions in connection with sales orpurchases made under the plan.

In general, plans work well for executives who have a long-term stockstrategy, such as diversification, or for planning for a known event, such ascollege funding. They are not suitable for every executive, particularly those whoprefer to have flexibility and control over their trading or who want to make aone-time trade.

Some of the current issues being discussed regarding plans, either as Rulechanges or as “best practices” implementation, include:

� Establishing a sufficient waiting period prior to trading under aplan. The Rule does not currently mandate a waiting period between planadoption and implementing trades. A sufficient waiting period is important to

““PPllaann BB”” ffoorr RRuullee 1100bb55--11 PPllaannss??by James J. Scheinkman and Lulu Chiu, Snell & Wilmer LLP

establish good faith.� Further limiting the executiveʼs ability to make amendments to or

cancel a plan. Although the current Rule bars an executive from amending aplan while possessing material nonpublic information, the Rule does notexpressly prohibit the executive from cancelling a plan at any time, includingwhile he or she possesses material nonpublic information. Frequentamendments or cancellations, however, place doubt on whether an executiveimplemented a plan in good faith.

� Limiting the adoption of multiple or overlapping plans. Although anexecutiveʼs use of multiple plans may be justified under certain circumstances,having more than one plan may raise questions as to motivation.

� Company involvement and tracking of plans. The Rule does not requireexecutives to provide the plan to the company. However, having the plansfurnished to the company can further demonstrate good faith, and thecompanyʼs ready access to the plans is very useful when in the midst ofaddressing the securities law implications of a significant company developmentor crisis.

� Public Disclosure of Plans. Company disclosure of plans in a Form 8-K orother filings also may be helpful to support a good faith determination. It alsomay be beneficial from an investor relations standpoint to avoid stock analystand investor alarm over insider sales when the inevitable subsequent Form 4filings occur.

While identification and evaluation of “best practices” is very appropriate,companies should be wary of “one size fits all” approaches. Rule 10b5-1 Plansshould be viewed in the context of, and as a part of, a companyʼs overall insidertrading policies. Moreover, companies should keep in mind that executives maybe reticent to use plans if the requirements imposed for use are overlyburdensome and restrictive. Careful thought should be given to establish thosepolicies which best advance for a particular company and its executives thegoals and purposes of having these plans.

C

Jim Scheinkman

Jim Scheinkman is a partner in the Orange Countyoffice of Snell & Wilmer and is a practice group leaderof the firmʼs Business & Finance Group. Contact Jimat [email protected] or 714.427.7037.

Lulu Chiu

Lulu Chiu is an associate in the firmʼs Los Angelesoffice whose broad transactional practiceencompasses real estate and business finance andsecurities law. Reach Lulu at [email protected] or213.929.2548.

City, Utah; and Los Cabos, Mexico. Representing corporations, smallbusinesses and individuals, Snell & Wilmerʼs mission is to take a genuineinterest in our clients, understand their objectives and meet or exceed theirexpectations. Visit www.swlaw.com for more information.

Editor

Jeff Beck

602.382.6316

[email protected]

Authors

Marshall Horowitz

213.929.2519

[email protected]

Joshua Schneiderman

213.929.2545

[email protected]

Angela Perez

602.382.6354

[email protected]

C O R P O R A T E C O M M U N I C A T O R

Negotiating Investment Banking M&A Engagement Letters: Keeping the Investment Bank Incentivized While Protecting Your InterestsBy Marshall Horowitz and Joshua Schneiderman

Congratulations … we hope. Your company has battled through the past several years of troubled economic times and has come out on the other side stronger for it. Cautious investors who have been hoarding their cash are slowly testing the investment waters, and a flurry of investment bankers are rummaging through the remnants looking for the diamond in the rough that entices some of this sidelined money back into the markets. One of the wiser investment bankers now remembered a distant meeting with you and has realized, rightfully so, that your company’s recent EBITDA growth and margin expansion make you a very appealing candidate to a potential buyer. The investment banker has approached your company, laid out a compelling

SPRING 2012

Jeff Beck’s Quarterly Tidbit of Interest:

The Bureau of National Affairs reported that a Manhattan Institute Center for Legal Policy study showed that just 2 percent of shareholder proposals offered for votes at annual meetings of the largest 150 U.S. public companies were from institutions without a social, religious or labor affiliation and about two-thirds of all shareholder proposals filed at those meetings were filed by one of four individuals (or their family members or foundations).

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case for why a sale at this time might make sense for your company, and has convinced you to plant a “for sale” sign in your corporate offices and test the market. The investment banker has served up his firm’s “standard engagement letter,” and asked that you sign it so you can partner up and kick off the process.

At this point you are conflicted — you know this investment banker is supposed to be “on your side” and “working for you” and you certainly do not want to start the relationship on the wrong foot. At the same time, there are a number of provisions in the engagement letter that make you uneasy, and you wonder whether they are customary or if there is room for negotiation. Beyond some of the obvious negotiable points (such as the amount of the success fee), we highlight below several aspects of the engagement letter that should be evaluated with care and that have room for negotiation.

Fees

Without going into all the issues related to the investment banker’s fee, there are a few points that come up frequently in discussions with investment bankers, such as the possibility of a progressive fee structure and the timing of payments to the investment banker, which are worth addressing here. The fee payable to the investment banker in an engagement letter is most likely calculated as a percentage of the price for which the company is sold.

While an investment banker should always be working to get the company the greatest value in the sale, it is not uncommon to tweak the fee structure to give the bank some extra encouragement. One way to accomplish this is through a progressive fee schedule (sometimes referred to as a “Reverse Lehman” formula), where the success fee percentage increases as the sale price crosses certain thresholds. Under certain circumstances, minimum and/or maximum fees might be appropriate. While some banks will insist on a minimum fee, it is nevertheless important to negotiate the amount of the minimum fee to ensure that the bank remains properly incentivized to get its client the best deal.

Also worth considering are provisions in the engagement letter that relate to the timing and manner of payment of the investment banker’s fees. It is possible that a potential buyer makes an offer for a company that its owners think is too low, and they counter with a higher price. For example, the buyer may have expressed some concern about whether the company’s projected future revenue levels are realistic, but has indicated a willingness to pay an additional amount for the company following the sale if the projections pan out — commonly referred to as an earnout. In this situation, the company probably would not want its investment banker to collect a fee at the time of closing on the earnout component — it is reasonable that the banker should only get paid if the company/owners get paid.

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To account for this, the engagement letter should specify that the investment banker does not get paid its fee on the earnout unless and until the earnout component of the purchase price is actually earned and paid. If the investment banker balks at this position, as a compromise, the parties might agree that the banker will receive its fee at the closing of the transaction based on a transaction value that factors in receipt of only a portion of the earnout amount. In addition, if the investment banker is amenable to the idea, it may be prudent to specify that the banker gets paid in the same form of consideration as the company/owners get paid, so that, for instance, if the company/owners receive equity in the buyer as consideration, the company/owners do not have to come up with cash to pay the banker.

In addition, while it is common for an investment banker to receive an upfront retainer and a success fee upon consummation of a transaction, occasionally an engagement letter will call for milestone payments at other points in time. For instance, the investment banker may have included a provision in the engagement letter that calls for payment of a portion of its fee upon the signing of a definitive transaction document, and the balance of its fee upon consummation of the transaction. If the banker has proposed a structure that incorporates milestone payments, and that is something a company is willing to consider, it is best

to ensure that the milestone payments are only earned upon the achievement of legally meaningful and objective events. For instance, if the banker has asked for a milestone payment upon the signing of a letter of intent or term sheet, a company will likely want to resist this point, as letters of intent and term sheets are often nonbinding. While a letter of intent may be meaningful from a moral perspective, it typically only requires the parties to continue to negotiate in good faith, which would leave the company paying an investment banker fee with no assurance that it actually has a binding transaction. Most investment bankers will agree to offset any amounts owed for a success fee against the company’s retainer. Finally, the banker may propose that its fee be calculated off a base that includes “value” over and above the cash purchase price, such as lease payments (if there is an affiliated landlord) or the value of compensation under employment agreements entered into in connection with closing. These types of items should be viewed with skepticism and negotiated with great care.

Carveouts from the Definition of “Transactions”

The engagement letter will typically provide that the investment banker will be entitled to its fee upon consummation of a “transaction.” In a sale context, the term “transaction” will usually be defined to cover the sale of all or part of the capital

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stock of a company, the merger of a company with an acquirer, or a purchaser’s acquisition of all or substantially all of a company’s assets. It is also not uncommon for the term “transaction” to be defined even broader, and to pick up capital raising transactions such as issuances of debt and equity securities. Depending on a company’s circumstances, however, there may be a number of transactions that it will want carved out from the definition of “transactions.”

Suppose a company has been in very preliminary talks for several months with one of its suppliers about the possibility of combining the two companies to take advantage of synergies. If, after the investment banker has been engaged, these talks become more serious and a decision is made to pursue a combination with the supplier, arguably the investment banker should not be entitled to a fee. After all, this was a potential transaction the company identified and nurtured on its own prior to discussions with the investment banker. It is not uncommon, therefore, to list on a schedule to the engagement letter a number of parties with whom the company has already had discussions about a sale transaction and to specify that a sale to, or combination with, any of those listed entities will not be considered a “transaction” for which the investment banker will be entitled to a fee. Remembering of course that the goal is to keep the investment banker working hard

on the company’s behalf, the company might instead provide for a reduced fee to the banker in connection with a sale to a party listed on the schedule.

Alternatively, imagine a situation where several years ago, as part of a capital infusion from a minority investor, a company granted that minority investor an option to purchase a 51 percent stake in the company at a set price in the future. The company will likely want its engagement letter to make clear that if the minority investor exercises its option during the term of the engagement with the investment banker (or during the tail period, discussed below), then the banker will not be entitled to collect a fee for that transaction.

Services

One important component in an engagement letter is a description of the services that the investment banker will provide in connection with the engagement. This list of services may include reviewing a company’s financials and comparing them to industry data, identifying and approaching potential purchasers, coordinating potential buyers’ due diligence efforts and assisting in negotiations. If the investment banker has not already offered to do so, and it is not addressed in the engagement letter, it is important to reach an agreement at this stage on who will be responsible for drafting the disclosure document that will be used

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to market the company. If the engagement letter is not clear as to who will bear responsibility for preparation of marketing materials, the investment banker might request an additional fee if the company enlists its assistance with such tasks down the road. The services provision of the engagement letter should also make clear that the company has the final decision on all important transaction matters, such as final approval of marketing materials, who the bank shops the company to, whether to engage a bidder in further negotiations and, most importantly, whether to accept or reject a purchase offer.

The Banker’s Expenses

The engagement letter likely calls for the client to reimburse the investment bank for all expenses it incurs in furtherance of the engagement. While a company will not have much luck asking the investment bank to cover its own expenses, there is often room to establish a cap on out-of-pocket expenses that the investment banker will not exceed without first obtaining the client’s consent. This cap can be a monthly cap or an aggregate cap. Alternatively, the parties might agree that the investment banker will not incur any individual out-of-pocket expenses in excess of a certain amount without first obtaining the company’s consent, though before agreeing to a provision such as this, it is important to note that it affords the investment banker some wiggle room to divide what may seem like one expense

that crosses the agreed-upon threshold into multiple separate expenses none of which reach the threshold.

Term, Termination and Tail

Most investment banks structure the term of the engagement in such a way that it will perpetually renew absent some affirmative action by the company to terminate the engagement. For instance, the engagement letter might provide that the engagement lasts for six months, but that it automatically renews for additional successive one-month periods if neither party provides written notice of its intent to terminate the engagement. Provisions such as this are notorious for catching up with unwitting companies who forget to notify their investment banker of their intent to terminate the engagement and wind up on the hook for a hefty commission when they enter into an unrelated transaction some years down the road. Further, as discussed in detail below regarding “tail periods,” sending the termination notice one month in advance of signing up for the new transaction is unlikely sufficient to steer clear of paying the investment banker its windfall. Rather than agree to the investment bank’s standard formulation of the termination clause, it may be preferable to propose that the engagement automatically terminates after a set number of months unless the parties mutually agree in writing to extend the term of the engagement.

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In addition, and almost without fail, an investment banker will insist that the engagement letter include a “tail period.” The tail period is a period of time after the termination of the engagement during which, upon the completion of a transaction, the investment banker would still be entitled to its fee. While it is fairly common to negotiate the duration of the tail period, there are other features of the tail that can often be revised to a company’s benefit. Frequently, the investment banker will propose that the phrase “transaction” means the same thing for purposes of the scope of its own engagement as well as the tail period. Depending on the amount of leverage a company has with its investment banker, the company may have luck narrowing the scope of the types of “transactions” that would be covered by the tail. For instance, the investment banker might agree that it will only receive a payment for consummation of a transaction in the tail period if that transaction is with a third party who was solicited by the investment banker during its engagement and received a copy of the company’s disclosure document. Depending on the circumstances, it might even be appropriate to limit the investment banker’s fee in the tail period to cover transactions with parties who were brought to the company’s attention by the investment banker and with whom the company engaged in “active and substantive negotiations” (which is a phrase that should be defined in the engagement

letter). To limit the potential for disputes down the road, it is also not uncommon for the engagement letter to provide that upon termination, the investment banker must provide the company with a list of those parties who fit within the “active and substantive negotiations” standard.

Indemnification

Probably the most confusing part of any engagement letter for a company is the indemnification provision, which is notorious for being filled with run-on sentences that can extend for up to half a page. If the indemnification provision is not contained in the body of the engagement letter, it will be attached as an annex or exhibit to the main letter. In general, there is relatively little room for negotiation of the indemnification provision. The investment banker will generally insist on being indemnified for any liability it incurs in connection with or as a result of the engagement other than any liability resulting from its own willful misconduct or gross negligence. This standard is common across banks, and it would be highly unusual for a bank to agree to accept liability for any conduct on its part that does not rise to this level. Investment banks are of the view that it is someone else’s company they are marketing, and therefore the company needs to be responsible for what is said. While a company may have some success tinkering with the terms of the indemnification provision on the margins,

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banks are typically very reluctant to deviate from their standard language.

Conclusion

While it is no doubt important for a company to maintain a positive and collaborative relationship with its investment banker, that does not mean the company should simply accept the initial draft of the engagement letter that its investment banker serves up without negotiating certain fundamental points. In fact, discussing the points set forth above prior to signing of the engagement letter will help the parties avoid disputes during the course of the engagement, which should help foster a productive working relationship. An investment banker can add tremendous value to a sale process by helping to demonstrate a company’s value, identifying and engaging potential buyers and assisting with negotiations; however, before engaging an investment banker, it is important that a company do so on reasonable terms that strike an appropriate balance between incentivizing the banker and protecting certain of the company’s legitimate interests. A reputable banker will understand and appreciate the company’s needs for many of the protections discussed in this article, and will probably even respect the company more as a client if the company recognizes and can articulate its need for these protections.

Social Media Practices and Policies for the Pharmaceutical IndustryBy Angela Perez and Brandon Batt (formerly an

associate with Snell & Wilmer)

The Food and Drug Administration’s much anticipated draft guidance related to the use of social media by pharmaceutical companies fell far short of what the industry expected. More than two years after the FDA held initial hearings on the topic, it quietly released social-media guidelines that addressed only one particular issue: communications relative to off-label uses of their products. But, there is more guidance to come. The FDA indicated upon release of this limited guidance that it expects to release multiple draft guidances relative to social media and other issues, including fulfilling regulatory requirements when there are space limitations (i.e., the 140-character limit of Twitter) and correcting misinformation.

While the guidance itself is important and marks the first time that social media channels such as Twitter and YouTube have been mentioned by name in FDA guidance, its narrow focus provides little in the way of direction to an industry yearning for clarity relative to online marketing issues generally. Despite its narrow focus, there is a silver lining. The pharmaceutical industry can take comfort in the fact that the guidance does not appear to suggest

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that the industry stop using social media for marketing purposes.

The pharmaceutical industry has been understandably disappointed by the pace of progress relative to guidance on the use of social media. Big Pharma spent $1 billion in online promotions last year and is expected to reach $1.5 billion in spending by 2014; however, we believe this represents a fraction of the spending that might be expected if clearer guidelines were established. Rather than wait for definitive guidance from the FDA that many predict will never come,[1] a host of industry players are making attempts at developing consensus on a way forward. In February 2012, the Digital Health Coalition introduced its Social Media Guiding Principles and Best Practices for Companies and Users, which represents a consensus of the industry’s top digital marketers on issues relating to social media and online communications. Though the document was conceived as an exercise in industry self regulation, the group hopes it will inform FDA thinking on the topic.

Regardless of the ambiguous state of the law, the use of social media continues to grow as a major form of communication between FDA-regulated companies and their customers. Companies must interpret the FDA’s guidance and use it as a means of understanding the FDA’s thinking on the subject of social media. Below is some information on how participants in the industry are using social media despite

the lack of guidance, followed by some suggestions for implementing an effective social media strategy at a pharmaceutical company.

Industry Practice

Big Pharma’s use of social media is expanding but companies still need to be cautious. Big Pharma currently utilizes many types of social media platforms to discuss public policy, corporate responsibility and to generally promote their brand and products to the public. For example, companies like Sanofi and Pfizer have used websites and online videos to engage in educational campaigns in connection with the need for various products. It is estimated, however, that the vast majority of companies in the pharmaceutical industry do not participate in social media. For these companies, there may be a larger burden associated with remaining compliant with applicable regulations in the fast-pace world of social media. New tools are developed on a rapid basis, which requires companies to improvise and to consistently review and/or modify their social media strategies. For example, when Facebook Inc. began allowing customers to post messages on companies’ pages, companies such as Johnson & Johnson and AstraZeneca deleted some of their pages and temporarily removed others due to the uncertainty created by the situation.

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Social Media Practices and Policies: Some Suggestions

Being part of a heavily regulated and competitive industry can result in a cultural environment that does not easily lend itself to safely making the kind of instant unfiltered communications often seen in social media channels. To combat the associated risks, companies today must work closely with both their legal and marketing teams to maintain an up-to-date social media policy and to ensure its compliance with its terms.

As FDA-regulated companies continue to expand their use of social media, the need for diligent monitoring of the company’s and employees’ communications is more important than ever. Large numbers of employees engaging the public (on their own behalf or the company’s) amplifies the potential for violating applicable laws or a company’s internal policies. It has been predicted that in 2013 and beyond, all industries are likely to encounter a new generation of privacy, employment, defamation and other legal claims arising out of these social media platforms. Proper and consistent training will allow employees to safely use social media while still growing a customer base and business.

Below are some basic tips to help a company maintain a healthy social media existence in the pharmaceutical industry.

1. Maintain a Written Social Media Policy

• Basic Terms. The purpose of the social media policy is to guide the company and employees’ use of social media. A well-drafted social media policy will discuss the basic guidelines regarding permissible and prohibited conduct, best practices and the level of privacy employees should expect when using either company or personal equipment.

• A Social Media Policy Should Establish Processes and Procedures. A social media policy should include processes and procedures to ensure that social media communications are properly vetted by the appropriate departments. Having a clear workflow will allow the company to properly create, monitor and censor communications before they are sent, including posting any disclaimers or declaring the company’s sponsorship of a website or product. This “workflow” also will help to prevent communications that are distributed through an incorrect medium. For example, while promoting a drug through a social media site, companies should ensure that promotion is restricted to the physicians who have agreed to receive promotional content and does not reach the public.

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• A Social Media Policy Should be Transparent.

• Employees. Employees should be aware that all communications on company-owned equipment can be subject to review by the company. The company’s social media policy (in conjunction with other policies) should establish realistic privacy expectations for employees, referencing the fact that each employee’s right to free speech is not unlimited, and that they are prohibited from disclosing the company’s confidential or proprietary information and they are prohibited from disclosing off-label information to the public at large. If your company monitors its websites and social media accounts (Facebook, blogs, etc.) for unapproved, harmful, deceptive or illegal comments, have disciplinary actions in place and be diligent to enforce them.

• Customers and Business Partners. Every comment or response to the company’s communications may affect its reputation or relationships with other parties, not to mention violate applicable regulations (think: doctors posting recommendations on how to use products to the public). Although the current thought is that companies are not responsible for the comments of others, this issue can be further

mitigated by making it known to the public what types of communications will not be tolerated.

• Every Employee Should Sign an Acknowledgement. Each employee should sign an acknowledgment stating he or she has read the company’s social media policy and agrees to abide by its terms and conditions.

2. Train All Employees

• Training is Crucial. Companies can substantially mitigate their exposure by training all employees about its current policies and the “dos and don’ts” related to social media. According to a recent study, almost 15 percent of employees have made a status update or tweeted about their work; 31 percent of employers surveyed reported having taken disciplinary action against employees for the information they communicated about the company.

• Employees are Responsible for Their Own Messages. Well trained employees should understand who is responsible for creating, editing and reviewing communications before they are published to one of the company’s social media accounts. Employees should be on notice that any comments related to the company or its products must be accompanied by a statement verifying they are an employee of the

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company, along with an appropriate disclaimer.[2]

3. Keep Organized

• Given the regulatory controls placed on companies in the pharmaceutical industry, the threat of an audit by the FDA or another governmental agency is real. Companies should prepare for this reality by using technology that automatically archives all communications in a way that makes them easily accessible in the event of an audit.

4. Other Important Tips

• Security measures always should be taken to protect confidential information.

• If social media communications include a disclaimer, remember that per FDA guidance, the public should be able to access all related information easily with only “one click.”

We expect the FDA to provide additional guidance in the future related to social media. In the meantime, FDA-regulated companies should be careful with their approach and apply existing laws to social media communications just as one would to other forms of media governing the industry. Above all, remember that social media can be an incredible asset

to a company’s objectives when used responsibly.

Notes:

_______________

[1] Note that while the FDA has not provided guidance related to social media, other government agencies such as the U.S. Federal Trade Commission, the National Labor Relations Board and the Securities and Exchange Commission have provided guidance that may be applicable to a company’s social media communications.

[2] For example, “the views expressed herein are mine alone and do not necessarily reflect the views of [my company].”



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©2012 All rights reserved. The purpose of this newsletter is to provide our readers with information on current topics of general interest and nothing herein shall be construed to create, offer, or memorialize the existence of an attorney-client relationship. The articles should not be considered legal advice or opinion, because their content may not apply to the specific facts of a particular matter. Please contact a Snell & Wilmer attorney with any questions. The Corporate Communicator is published as a source of information for our clients and friends. This information is general in nature and cannot be relied upon as legal advice. If you have questions regarding the issues in this newsletter, you may contact a Business & Finance professional or your regular Snell & Wilmer contact.

Denver Roger Cohen [email protected] 303.634.2120

Brian Furgason [email protected] 303.634.2096

Brian Gaffney [email protected] 303.634.2077

Kristin Sprinkle [email protected] 303.634.2112

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Las Vegas Pat Curtis [email protected] 702.784.5226

Sam McMullen [email protected] 702.784.5221

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Los Angeles Susan Grueneberg [email protected] 213.929.2543

Marshall Horowitz [email protected] 213.929.2519

Joshua Schneiderman [email protected] 213.929.2545

Gregg Sultan [email protected] 213.929.2555

Orange County Katy Annuschat [email protected] 714.427.7410

Anthony Ippolito [email protected] 714.427.7409

George Ng [email protected] 714.427.7444

William Pedranti [email protected] 714.427.7445

Jim Scheinkman [email protected] 714.427.7037

Mark Ziebell [email protected] 714.427.7402

Phoenix Jeffrey Beck [email protected] 602.382.6316

Anne Bishop [email protected] 602.382.6267

Brian Burke [email protected] 602.382.6379

Brian Burt [email protected] 602.382.6317

Jon Cohen [email protected] 602.382.6247

Franc Del Fosse [email protected] 602.382.6588

Michael Detro [email protected] 602.382.6697

Michael Donahey [email protected] 602.382.6381

Matthew Feeney [email protected] 602.382.6239

Cheryl Ikegami [email protected] 602.382.6395

Richard Katz [email protected] 602.382.6142

Eric Kintner [email protected] 602.382.6552

Daniel Mahoney [email protected] 602.382.6206

Joseph Miller [email protected] 602.382.6738

Angela Perez [email protected] 602.382.6354

Terry Roman [email protected] 602.382.6293

Melissa Sallee [email protected] 602.382.6302

Jeff Scudder [email protected] 602.382.6556

Garth Stevens [email protected] 602.382.6313

Bianca Stoll [email protected] 602.382.6236

Nicholas Varela [email protected] 602.382.6237

Salt Lake City Cortland Andrews [email protected] 801.257.1802

Ken Ashton [email protected] 801.257.1528

Chad Hoopes [email protected] 801.257.1938

Brad Merrill [email protected] 801.257.1541

John Weston [email protected] 801.257.1931

Tucson Lowell Thomas [email protected] 520.882.1221

Business & Finance Attorneys

Reprinted with the permission of the Orange County Business Journal

ORANGECOUNTYBUSINESS JOURNALPage 1$1.50 VOL. 35 NO. 39 www.ocbj.com SEPTEMBER 24-30, 2012

MERGERS & ACQUISITIONS Advertising Supplement SEPTEMBER 24, 2012

n late August, a California appellatedecision provided a useful primeron drafting non-competitioncovenants in California merger andacquisition transactions. In FillpointLLC v. Maas, the California Court of

Appeals affirmed a judgment of theOrange County Superior Court holdingunenforceable a non-compete in anemployment agreement entered into aspart of a business sale. The decisionprovides useful guidance for buyers indrafting non-competes to properly protect the goodwill of the acquired business in amanner that will withstand court scrutiny.

Non-competes in CaliforniaCalifornia has a strong public policy protecting each personʼs right to pursue his or her

chosen lawful occupation. This public policy is codified in California Business andProfessions Code Section 16600 and provides that generally “every contract by whichanyone is restrained from engaging in a lawful profession, trade, or business of any kind isto that extent void.”

The California Legislature has provided an exception to permit non-competes enteredinto in connection with business sales. Business and Professions Code Section 16601allows that any person who sells the goodwill of a business may agree with the buyer torefrain from carrying on a similar business within a specified geographical area in which thebusiness has been carried on for so long as the buyer carries on a like business. Thisexception is available in transactions structured as a sale of substantially all of theoperating assets of a company or its division or subsidiary, or the sale by a shareholder ofhis or her stock in a company. As part of an enforceable non-compete, courts will alsoenforce non-solicitation covenants barring the seller from soliciting the sold businessʼsemployees and customers.

In allowing this exception, California has recognized the important commercial purpose inprotecting the value of an acquired business, recognizing that, when a seller is paid for thegoodwill of a business, it is unfair for the seller to engage in competition which diminishesthe value of the sold business.

However, courts have emphasized that this exception is limited and have declared that,in order to uphold a non-compete pursuant to Section 16601, the contract may notcircumvent Californiaʼs deeply rooted public policy favoring open competition and mustclearly fall within this limited exception.

The Issues Presented in FillpointIn 2005, Handleman Co. acquired Michael Maasʼs stock in Crave Entertainment Group.

In the Stock Purchase Agreement, Maas agreed not to compete with the sold business fora period of 36 months following the closing. As part of the acquisition, Maas entered into anEmployment Agreement containing a non-compete covenant for one year following thetermination of his employment with Crave. Maas resigned from Crave about three yearsafter its sale and after the expiration of the non-compete in the Stock Purchase Agreement;however, approximately six months later, he began working for a competitor of Craveduring the period that the non-compete in the Employment Agreement remained operative.Fillpoint, which had acquired Crave from Handleman, then sued Maas for breaching hisEmployment Agreement and also sued his new employer and its principal for interferencewith contract.

In its decision, the Court was willing to read the Purchase Agreement and theEmployment Agreement together as an integrated agreement as the agreements weresigned by the parties around the same time and referenced each other. This was helpful tothe buyer since a non-compete in an employment agreement, standing alone withoutintegration with a purchase agreement, would be unenforceable. This is also consistentwith other California court decisions which have generally held that the location of a non-compete in a document separate from the purchase agreement, such as an employment ornon-competition agreement, is not fatal, in and of itself, to its enforcement provided that thecovenant otherwise meets the statutory requirements.

However, the Court declared that the fact that the two Agreements should be readtogether does not mean that the non-compete in the Employment Agreement is enforceableautomatically. In striking down the non-compete in the Employment Agreement, the Courtdistinguished that covenant from the non-compete in the Purchase Agreement Maas hadcomplied with, which the Court considered appropriate to protect the goodwill of theacquired business for a specified period and to serve the purposes of the statutoryexception. The Court viewed the non-compete in the Employment Agreement differently,finding that that covenant was much broader and prevented Maas for one year afteremployment termination from making sales contacts or making actual sales to anyone whowas a Crave customer or potential customer, working for or owning any interest in abusiness which would compete with Crave, or employing or soliciting for employment anyof Craveʼs employees or consultants.

The Court concluded that the non-compete in the Employment Agreement was directedtowards affecting Maasʼ rights to be employed in the future – in this case, for a year afterthe end of the three-year non-compete period in the Purchase Agreement. In doing so, theCourt cited a “concession” in the buyerʼs appellate brief that the two covenants wereintended to deal with different damages the employee might do wearing his separate hatsof majority shareholder and key employee. Accordingly, the Court held that the PurchaseAgreement covenant was properly focused on protecting the acquired goodwill for a limitedperiod of time, but the Employment Agreementʼs covenant improperly targeted Maasʼfundamental right to pursue his profession.

In addition, the Court also found that the non-solicitation provisions were too broad. It

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noted that the provision barred solicitationof even potential customers. It also citedits prior decision in Strategix Ltd. v.Infocrossing West Inc. which considerednon-solicitation provisions prohibiting thesolicitation of all employee and customersof the buyer as being impermissiblybroader in scope than non-solicitationprovisions which barred solicitations ofcustomers and employees of the soldbusiness only.

Key Considerations for BuyersA review of this decision and other cases leads to a conclusion that had the non-

competition covenant in the purchase documentation been drafted differently, the buyermay have achieved its aims by keeping the employee from competing during the one yearafter his employment ended. For example, the Fillpoint decision distinguished an earlierdecision in Alliant Ins. Services v. Gaddy which upheld identical covenants in a purchaseagreement and an employment agreement which applied for the later of five years followingthe purchase or two years after termination of the employeeʼs employment with the newcompany.

When drafting non-competes, buyers and their counsel should consider the following:Integrate, Integrate, Integrate. It is critically important that the various transactional

documents appropriately reference each other, particularly if non-compete covenants arecontained in documents outside of the Purchase Agreement. The covenants in differentdeal documents should also be consistent with each other. One of the factors which mayhave influenced the decision in Fillpoint was the fact that Maas had already satisfied hisnon-compete in his purchase agreement. Accordingly, the buyer had to justify separate anddifferent non-compete provisions in the employment agreement. Had the provisions beenconsistent with each other, it would not have faced this battle.

Make Your Case for Enforcement in the Deal Documents. The non-competeprovisions should be drafted with an eye towards subsequent legal challenge and shouldmake the case themselves as to their absolute necessity to protect the acquired businessʼsgoodwill. This can be done through a number of means including, recitals confirming thatthe purpose of the non-compete is to protect the goodwill and the reasonableness of theprovisions in doing so, closing conditions and other provisions which make clear the buyerwould not have closed on the purchase without these essential protections, and allocatingpart of the deal consideration to goodwill.

Donʼt be Greedy. Buyers should not overreach by barring sellers from activities beyondthe scope of the statutory exception. The courts will take umbrage at covenants which notonly bar solicitation of the customers and employees of the acquired business but whichcast a broader net to all of the buyerʼs employees and customers. Practitioners sometimestake illusive comfort that courts will “blue pencil” non-competes with overbroad or omittedrestrictions and make them enforceable by providing reasonable limitations. However,California courts will not go so far as striking a new bargain for the purposes of saving anillegal contract. As stated by the Court in Strategix, “had the parties intended to reach suchlimited – and enforceable – covenants, they could have negotiated for them. We will not doso for the parties now.”

ConclusionThe law governing non-competes in California mergers and acquisitions serves as

another example that careful thought and analysis is requisite to accomplish the partiesʼobjectives and to implement their bargained agreements. Parties who proceed withoutunderstanding what courts will permit and who overreach do so at their peril.

Jim Scheinkman

Jim Scheinkman is a partner and practice group leader of thefirmʼs Business and Finance Group in Snell & Wilmerʼs OrangeCounty office. His practice focuses on assisting mid-marketcompanies and their owners in mergers and acquisitions,financings, joint ventures, corporate governance and shareholderdispute resolution, securities offerings, technology development andtransfers, executive compensation and other corporate andcommercial matters. Jim also serves as general outside counsel fora variety of mid-market businesses. Jim can be reached at714.427.7037 or [email protected].

Christy Joseph

Christy Joseph is a partner and practice group leader for thelabor and employment law group in Snell & Wilmer’s OrangeCounty office. Her employment-related litigation experienceincludes representation of employers in federal and superiorcourts, as well as before administrative agencies in mattersinvolving wrongful termination, discrimination claims, sexualharassment, ADA and medical condition claims, wage and hourclaims including class actions, tortious interference, unfaircompetition, breach of fiduciary duty and trade secrets. Christyʼspractice further includes counseling employers not involved inlitigation regarding contractual, statutory and legal rights, and employment obligationmatters. She can be reached at 714.427.7028 or [email protected].

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Counterfeit electronic parts flood U.S. marketBy Keith M. GregoryReprinted and/or posted with the permission of Daily Journal Corp. (2012).

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Electronic components are essential to our daily lives. They are incorporated into medical devices as well as cell phones, our automobiles and MP3 players. Also, electronic components are incorporated into sophisticated military and aerospace items. Unfortunately, the number of counterfeit electronic parts being produced and sold by unscrupulous manufacturers has exploded in the last 10 years, flooding the military, aerospace and commercial markets. This flood of counterfeit electronic parts was abrupt and unanticipated. By the time government and commercial contractors, distributors, and the federal government began to recognize the scope of the problem, millions of counterfeit parts had entered the supply chain.

In mid-2007, the U.S. Department of the Navy began to suspect that an increasing number of counterfeit electronic parts were permeating the U.S. Department of Defense supply chain, and it asked the Bureau of Industry and Security’s Office of Technology Evaluation, under the Bureau of Commerce, to conduct a base assessment of the counterfeit electronics in the supply chain. In January 2010, the Department of Commerce released its study in a report titled “Defense Industrial Base Assessment: Counterfeit Electronics.” The findings of the Department of Commerce were shocking. Between 2005 and 2008, the incidents of counterfeit electronic parts encountered by original component manufacturers more than doubled. In fact, the incidents of counterfeit electronic parts increased in every industry tracked in the study, and the Department of Defense encountered counterfeit electronic parts in “every type of discrete electronic component, microcircuit, bare circuit board, and assembled circuit board.”

The Department of Commerce found that “[t]he proliferation of counterfeit parts is not limited to occasional, isolated incidents, but is increasingly present at every level of the supply chain.” It further concluded that “[n]o type of company or organization has been untouched by counterfeit electronic parts. Even the most reliable of parts sources have discovered counterfeit parts within their inventories.”

In 2011, the Senate Armed Services Committee followed up on the Department of Commerce’s assessment of the

counterfeiting industry, initiated an investigation and held a hearing in November 2011. The SASC investigation confirmed the Department of Commerce’s findings that counterfeit electronic parts had flooded every aspect of the supply chain.

The problem of counterfeit electronic parts in the supply chain stems not from American contractors and distributors, but from the actions of the counterfeiters, many of whom are based in China. These counterfeiters take fake and used parts (obtained from electronic waste imported from the United States) and disguise them to look like genuine new parts so that they can be sold to contractors and distributors in the United States.

In ideal situations, contractors can source electronic parts directly from the original component manufacturers, thus minimizing the risk of receiving counterfeit parts. But the original manufacturers often stop producing the needed electronic parts long before the lifecycle ends for the products in which they are used. Reengineering or redesigning the electronic parts is usually prohibitively expensive, and procurement agents often find it necessary to purchase aftermarket manufactured parts to replace worn parts in the still useful products. Because sourcing these aftermarket parts from unknown sources is often the only option, there is a risk that counterfeiters will introduce counterfeit parts into the supply chain.

The federal government too has struggled to stay ahead of the flood of difficult to detect counterfeit parts. A March 2010 report by the Government Accountability Office noted that the Department of Defense was only in the “early stages of gathering information on the counterfeit parts problem” and had not adopted a uniform definition of “counterfeit parts.” And in its 2010 assessment, the Department of Commerce observed that the Department of Defense had not yet established regulations for authenticating parts or reporting incidents of counterfeiting.

Indeed, there is no Department of Defense-wide recognized definition of “counterfeit parts.” There are no regulations establishing authentication procedures. There are no reporting requirements. And the department relies on antiquated procurement and quality control practices that are not specifically designed to address counterfeit electronic parts.

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Keith M. Gregory 213.929.2547 [email protected]

Keith Gregory practices in the areas of general business matters, corporate, franchise and partnership disputes, and intellectual property and commercial litigation. He is an experienced litigator, with considerable background in intellectual property issues, licensing agreements, trade secret matters and Uniform Commercial Code issues, especially within the electronic components and semi-conductor industries. Keith was recently appointed to the SAE International AS6081 Committee, established to develop standards proscribing counterfeit parts avoidance requirements for independent distributors.

Both the Accountability Office and the Department of Commerce recognize that the government needs to act to help prevent counterfeiters from introducing counterfeit parts into the supply chain.

The recent flood of counterfeit parts being manufactured and the lack of guidelines have resulted in largely inconsistent anti-counterfeiting procedures being employed by different distributors. Even when distributors identify counterfeit electronic parts, they are uncertain as to what actions they should take or to whom to report the counterfeiting. Largely due to this confusion, as the Department of Commerce documented in 2010, only 9 percent of independent distributors reported notifying federal authorities after learning that a counterfeit part had shipped. Fortunately, some distributors have independently taken leading roles in attempting to reduce the risk of counterfeit products entering the supply chain. These distributors use sophisticated testing and inspection procedures, maintain approved supplier lists, have begun to avoid sourcing materials from identified high risk areas, quarantine suspect counterfeit parts, and work with organizations dedicated to fighting counterfeiting.

The government has recently begun to address the growing counterfeiting problem and looks to soon establish universal protocols for contractors and distributors to follow. On Nov. 29, 2011, Sen. Carl Levin introduced an amendment to the National Defense Authorization Act that begins to establish guidelines for the detection and reporting of suspect counterfeit electronic parts. The amendment passed and was signed into law by President Barack Obama on Dec. 31, 2011. It gives the Secretary of Defense six to eight months to define

“counterfeit electronic parts” and establish regulations aimed at keeping counterfeit parts out of the Department of Defense’s supply chain. These regulations will finally give contractors and distributors much needed guidance on what constitutes a counterfeit part, procedures to minimize the risk of passing counterfeit parts along in the supply chain, and what actions to take if a company believes it was sold counterfeit parts.

In addition to initiating the development of universal reporting and testing procedures, the amendment aims to target bad actors who are responsible for counterfeit parts entering the government’s supply chain. It directs the Secretary of Defense to develop remedial actions, including suspension and debarment, against suppliers who repeatedly introduce counterfeit parts into the supply chain. Levin emphasized that the amendment was aimed at those suppliers who “repeatedly fail” to avoid placing counterfeit parts into the supply chain, rather than diligent suppliers who are themselves occasional victims of counterfeiters who flood the market with their parts. In this manner, the amendment attempts to strike a balance between going after repeat offenders, who have shown a deliberate lack of diligence in attempting to keep counterfeit parts out of the supply chain, with the acknowledgment that some counterfeit parts can slip through even the most rigorous anti-counterfeiting measures.

These steps taken by federal government will have the effect of creating a more level playing field where counterfeiters will no longer be able to control the market and make it a safer place for manufacturers, distributors and consumers.


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