Legal Matters: Beware of residual clauses in NDAs for M&A transactions

A nondisclosure agreement (NDA) is typically the first agreement that will be entered into in connection with a potential mergers and acquisitions (M&A) transaction. The NDA is designed to protect the confidentiality of the seller’s technology and proprietary and/or confidential information that will be disclosed to the prospective buyer in connection with its due diligence process and review of the seller. Sellers often enter into NDAs without giving them much thought or having them reviewed by experienced legal counsel.  In an M&A transaction where the seller is presented with the buyer’s “standard form” NDA, an especially careful review by experienced counsel is strongly advised.

This article focuses on NDAs used in M&A transactions, is drafted from the perspective of the seller and specifically addresses the increasingly common use of so-called “residuals” clauses or “residual information” clauses in M&A NDAs.

Residuals Clauses

A residuals clause is designed to allow the prospective buyer to use and/or disclose confidential information received from the seller without violating the NDA. That is, residuals clauses address the issue of whether the recipient is able to use and/or disclose residual information that is disclosed or provided by the seller.

Residuals clauses have, in the past, occasionally been included in NDAs for M&A transactions.  However, in the last couple of years they have become increasingly more common, especially in NDAs drafted by counsel to private equity funds and other sophisticated financial investors. A crafty lawyer can draft a residuals clause so broadly that it essentially negates the protection afforded the seller by the NDA and potentially exposes all of the seller’s confidential information to use by other portfolio companies of the private equity fund and/or allows disclosure of the seller’s confidential information to competitors.

Generally, a residuals clause provides that any of the seller’s confidential information that the buyer learns or is given access to during its due diligence process and that is retained in its employee’s or agent’s “unaided memory,” may be used or disclosed, regardless of the confidentiality or nonuse restrictions set forth in the NDA.

Argument in Favor of Residuals Clauses

The most common argument advanced by buyers in favor of a residuals clause is that it’s difficult to separate information learned in connection with a particular M&A transaction from information that was previously learned or known. The argument is that people learn by doing, and they cannot and should not be forced to try to “segment their brains” when it comes to what they know and when it was learned.

Problems with Residuals Clauses

On the surface, the argument in favor of residuals clauses appears to have a certain degree of merit. Despite the seeming merit of that argument, residual clauses can be extremely problematical, particularly for a seller in an M&A transaction and especially when highly sensitive confidential information is involved.

While residuals clauses are not always ill-advised, they must be carefully reviewed and be drafted and tailored for each specific situation and the particular confidential information being disclosed. A poorly drafted residuals clause may result in the termination of trade secret protection for confidential information that the seller has historically protected as a trade secret, and, in certain instances, can be deemed to grant a royalty-free license to use the seller’s intellectual property/confidential information. Depending on how a residuals clause is drafted, a seller may not even be aware that it’s transferring valuable rights to its intellectual property/confidential information.

Recommendations

If you are the seller in an M&A transaction, and if the governing NDA requires the disclosure of particularly sensitive confidential information, which all such NDAs do, the best advice is to simply refuse to sign any NDA that contains a residuals clause. However, if that is not possible or if the M&A transaction is critically important to the seller, then you should attempt to limit the residuals clause as much as possible and carefully narrow and tailor the provision in order to protect the seller and its confidential information.

Below are a few recommended steps to reduce the risks created by residuals clauses:

• Consider the form of the NDA that is used (i.e., unilateral or “one way,” versus “bilateral or “two way”) and properly tailor it to the proposed M&A transaction and the confidential information involved.

• Carefully define confidential information and tailor the definition to the particular situation and confirm that the definition adequately covers all confidential information that will be provided/disclosed.

• Consider removing legending requirements (that is, any requirement that written materials be marked as being “confidential” or that oral statements be reduced to writing and indicated as being confidential” in order to be covered by the NDA) in order to avoid accidental failures to legend and possibly constitute an unprotected disclosure of confidential information.

• Consider having any subset of extremely sensitive confidential information carved out entirely and addressed separately under a special NDA implementing careful controls and procedures to limit the access to and use and disclosure of such confidential information to only those employees and agents of the buyer who the seller believes cannot exploit the information commercially.

• Confirm that any residuals clause includes language explicitly limiting the use of the seller’s confidential information solely in connection with the M&A transaction contemplated by the NDA and not for any other purpose.

• Ensure that any residuals clause only applies to information retained in the “unaided memory” of the buyer’s employees and agents without specific or intentional memorization or reference to any written or electronic information or documentation that would enable an individual to “remember” the seller’s confidential information.

• Remove any residuals clause that allows the buyer or any of its portfolio companies to use in any manner any confidential information retained in the memory of any of the buyer’s employees or agents that was obtained from reviewing the seller’s confidential information.

• Never include rights under any patents or copyrights in a residuals clause.

• Include language clarifying that no license is being granted to the buyer or its employees or agents or any of its portfolio companies to use the confidential information.

• Ensure that any residuals clause does not undermine the prohibition in the NDA on disclosure of confidential information to third parties. 

• Make sure the buyer is responsible/liable for its employees’ and agents’ improper use or disclosure of confidential information.

• If there are certain key personnel of the buyer who will be involved in evaluating the confidential information and the contemplated M&A transaction, consider including a clause prohibiting those individuals from working on any future transaction involving similar or competitive technology for a specified period of time long enough to protect the seller’s confidential information.

Thomas R. Taylor is a corporate and M&A lawyer and shareholder in the Salt Lake City office of Durham, Jones & Pinegar P.C.

This article is provided for educational and informational purposes only and is not intended to, and should not be construed as, legal advice.  Readers should consult their own lawyer regarding the applicability of the information discussed herein to their particular situation and facts.