The views expressed in this post, as in all of my posts, are mine alone and should not be taken to represent the views of Fasken Martineau DuMoulin LLP.
“That’s off market.”
As a deal lawyer, I’ve heard that phrase more times than I care to remember. It’s supposed to be a knock-down argument. We’re supposed to pack up our bags and go home, cease and desist from any further discussion of a deal term once our counterparty claims that it differs from what other contracting parties have customarily agreed upon.
Occasionally there’s even an element of rebuke in the claim that a term is “off market”. The unspoken accusation is that, like neglectful schoolchildren, we simply haven’t done our homework (Tsk. Tsk.). Basketball fans old enough to remember NBA hall-of-fame centre Dikembe Mutombo may recall the finger wag with which he habitually celebrated blocking a shot.[i] “That’s off market” is a bit like one of Mutombo’s finger-wagging blocks: not only is the proposed deal term emphatically rejected; we’re encouraged to draw the conclusion that the proposal should never have been attempted. (Get that weak $#!+ outta here.)
I find this confounding.[ii] Settling a dispute between contracting parties simply by reference to what other contracting parties have agreed upon in the past seems, on its face, a suspect approach to getting the right result. We’re talking about a trend, right? A market trend.[iii] We’re supposed to follow the trend, without question? I’m tempted to call that approach to contract negotiation “lemming-like”, except I’m afraid that doing so would be unfair to lemmings.[iv]
Of course, those who negotiate contracts by reference to market custom are unlikely to view the practice as mindless crowd-following with potentially undesirable consequences. On the contrary, the intended significance of market custom is that it serves as a proxy of sorts for reasonableness. The reasonableness of including or excluding a certain provision (or a certain form of provision) in a contract is supposed to be established by the fact that a whole bunch of other contracting parties in a broad range of circumstances have entered into contracts that include or exclude that provision (or form of provision). By establishing reasonableness in this manner, market custom arguments tacitly appeal to our intuition that there is strength in numbers. Surely all of those people could not have gotten things all wrong? If a majority (in some cases, a substantial majority) of other contracting parties have determined that this or that term should be included in a certain type of agreement, that’s probably sufficient evidence that it’s a reasonable result, no?
It all sounds rather plausible at first blush. A substantial difficulty arises, however, because in attempting to establish reasonableness on the strength of brute numbers, market custom arguments become disconnected from an essential constituent element of reasonableness: namely, reason itself. To say that X is ‘reasonable’ is to say, as the term itself suggests, that X is able to be justified by reason. But, perversely, arguments based upon market custom increasingly surrender any supposed claim to reasonableness the more we focus on reasons and how they might influence the inclusion or exclusion of this or that term in a contract.
To see why this is so, it is helpful to remind ourselves that reasonableness depends largely on context. Taking a crude but ready example, it is generally not reasonable to strike another person, though most would agree that it may be reasonable to do so in self-defence. Similarly, depending upon context — in other words, depending upon the set of background facts and circumstances against which contractual negotiations take place — what might be considered reasonable in a contract negotiation will change.
Perhaps in the specific negotiation of concern to us, the Buyer (say, of a privately-owned operating gold mine) under an Asset Purchase Agreement is paying a bargain basement purchase price, representing a significant discount to what a DCF analysis would suggest is the fair price. It would not be unreasonable in those circumstances for the Seller to expect the Buyer — indeed, the Buyer will be economically motivated (given the value it is getting and the reasonable expectation that there would be other interested purchasers at the discounted price) — to content itself with a less comprehensive set of contractual protections than might be customary. Far from unreasonable, in fact, this makes perfect sense since the risk of value diminution in the asset, which the Buyer might otherwise feel compelled to minimize by contract, has already been minimized by the discounted price being paid (it may even have been accounted for in arriving at the discounted price).
Or maybe price paid is not the salient feature of our fact scenario, but rather the jurisdiction in which the operating mine is located. Let’s say it’s located in an especially high-risk political environment, perhaps a country whose government has a history of expropriating assets or enforcing an investor-hostile foreign exchange regime with significant penalties for non-compliance. In that case, barring a scenario like the one we just considered in which the risk has already been factored into a discounted purchase price (and in many cases the risk, albeit material, may be not be readily quantifiable such that this is not practicable), it would be entirely reasonable for the Buyer to expect, and for the Seller to expect to have to provide, additional contractual protections, over and above those customarily seen in asset purchase transactions, to reflect the amount of political risk the Buyer is prepared to take on, both during the period between signing and closing[v] and during the post-closing period[vi].
As the surrounding context changes, in other words, our reasons for insisting upon/against, or for accepting/rejecting, certain contractual provisions also change.
Arguments based on market custom, however, are typically insensitive to contextual distinctions and the variations they produce in what may be considered reasonable. They typically tell us, not what other contracting parties in circumstances substantially similar to ours have agreed upon but, what has most commonly been agreed upon by a much larger population of contracting parties, many of which were negotiating in contexts quite different from our own.
“67% of all M&A purchase and sale agreements involving privately owned targets[vii]include (or exclude) such and such a provision.” Before reacting to that sort of statement (Oh my! Sounds like a decisive majority…), don’t we first need to know that those agreements were negotiated in circumstances substantially similar to our own such that they reflect a standard of reasonableness appropriate to us? Of what relevance is it to us that most M&A purchase and sale agreements involving privately owned targets do not include specific indemnities for environmental costs, for example, if most of those agreements do not involve the sale of a mine (or another environmentally taxing asset or business)?
You may wonder at this point whether I’m merely identifying a problem with ‘market’ definition. Perhaps we can adjust for the context insensitivity of market custom arguments simply by specifying the relevant market with greater precision. Thus, instead of comparing our Asset Purchase Agreement to all M&A purchase and sale agreements involving a privately-owned target, we might further specify ‘the relevant market’ so that it includes only asset purchase agreements (adding deal structure context) for the purchase and sale of operating mines (adding industry and development stage context) located in high-risk political environments (adding geographic/political context) at a significant discount to fair value (adding pricing context). That certainly provides a fair amount of context and gives us a higher degree of confidence that the agreements from which we are proposing to take guidance were struck in a set of circumstances comparable to our own.
Unfortunately, however, the addition of context sensitivity to a market custom argument comes at the expense of its persuasiveness, attenuating its claim to reasonableness. That’s because the increased focus on context has the result of shrinking the relevant market. There are, logically, fewer asset purchase agreements than M&A purchase agreements of any form whatsoever, and fewer still that relate to the sale of mining assets, and even fewer that relate to the sale of operating mines, and so on. At some point, the addition of context circumscribes the universe of comparable agreements, or ‘the relevant market’, so tightly that a market custom argument loses much, if not all, of its strength in numbers. But, of course, such arguments rely upon strength in numbers for their claim to reasonableness and, consequently, their persuasiveness. Being told that 67% of agreements in the relevant market include (or exclude) this or that provision is far less compelling — it’s far less persuasive; it provides far less evidence of reasonableness — when ‘the relevant market’ comprises only three agreements than when it comprises 50.
This is obviously a quirky result. It demonstrates that arguments based on market custom are most persuasive, and have their strongest supposed claim to reasonableness, precisely when we ignore reason. The more we tailor a market custom argument to account for relevant considerations (i.e., reasons) by introducing context into the relevant market, the more we diminish the size of the ‘relevant market’ and hence the strength in numbers upon which a market custom argument relies for its claim to reasonableness and persuasiveness.
I want to set aside precisely how and why I think this disconnect between market custom and reason occurs since it would take us a bit further into the weeds than I suspect most people want to go. Instead, I want to discuss what I take to be a striking example of market custom becoming disconnected from reason and the harm (in the form of unnecessary legal fees) that can result.
Apparently, 62% of private target acquisition agreements in the Canadian market include “no shop/no talk” provisions.[viii] For those less familiar with M&A agreements, these are basically provisions that restrict the Seller from “shopping” the agreed deal to third parties in the hope of getting a better deal. They usually go further than simply restricting obvious solicitations of a competing deal. Typically, the Seller and its representatives are not permitted to even “talk” to third parties about, or do anything else that would encourage a third party to submit a proposal that could lead to, a competing deal.
“No shop/no talk” provisions are standard in public target acquisition agreements. And they make a lot of sense in that context. In a public acquisition transaction, the sale is negotiated on behalf of the target company by the target’s board of directors (or a committee thereof). It is generally understood that the fiduciary duty of corporate directors to act in the best interests of the corporation requires that the target have a “fiduciary out” — the right to terminate the acquisition agreement, if necessary, in order to consummate a competing transaction that the directors have determined is superior to the agreed transaction (and therefore in the best interests of the corporation). “No shop/no talk” provisions are the quid pro quo for the acquiror’s agreement to provide the target with a “fiduciary out”, which would otherwise introduce substantial uncertainty to completion of the agreed deal. In essence, the uncertainty is managed by restricting representatives of the target from engaging in discussions with third parties about, or otherwise soliciting, encouraging or knowingly facilitating, any proposal that could reasonably be expected to result in a competing transaction (i.e., a potential superior proposal). Thus, target directors remain free to consider and respond to a superior proposal, including if necessary by causing the target to terminate the agreed deal in order to enter into an agreement to complete the superior proposal, but only if, among other things, the superior proposal is initiated by a third party without being solicited, encouraged or facilitated by representatives of the target.
This need to strike a compromise, between providing the target with a “fiduciary out” in order to ensure that its directors are able to discharge their fiduciary duties by having the freedom to respond to a superior proposal that may be in the best interests of the corporation, while minimizing the completion risk thereby created through the use of “no shop/no talk” provisions, typically does not exist in a private target transaction. That’s because there typically is no “fiduciary out” in a private target acquisition agreement.[ix] In fact, there’s typically no need for one.
This is just a function of the fact that the target is, in fact, private: in other words, either it is a corporation, shares of which are not publicly held, or it is an asset owned by such a corporation. In the case of a share purchase transaction (i.e. where the target is a privately-held company), this usually means the sale is negotiated and entered into directly by the shareholders of the target company — often it’s a single corporate shareholder but multiple selling shareholders are not uncommon. Shareholders, however, owe no fiduciary duty to the corporation, whether generally or specifically in the context of disposing of their shares. Accordingly, they no more require a “fiduciary out” in binding themselves to the sale of their target shares than I require one in binding myself to the sale of my used bike.
Private asset purchase transactions may appear different in this regard, but they’re not really different in substance. It’s true that the sale of an asset by a private company may be negotiated on behalf of the company by its board of directors (i.e. since the asset belongs to the company and not to its shareholder(s)), but there is typically no real risk that the directors will face a claim of fiduciary breach in negotiating or permitting the company to complete the sale, since the deal is typically negotiated with the full knowledge, and in many cases requires the cooperation/approval, of the shareholder(s). Hence, again, no real need for a “fiduciary out”.
So why do 62% of private target acquisition agreements in the Canadian market include “no shop/no talk” provisions? If the Seller does not have (because it typically does not need) a “fiduciary out”, why should the Buyer care if the Seller’s representatives are out shopping the deal? Let the Seller go out and solicit a vastly superior proposal, let it talk some third party into the deal of the century, if it can manage that; without a “fiduciary out” it won’t in any way impact the Seller’s obligation to complete the agreed upon transaction.
In a small percentage of cases — I’d say, aggressively, 10% of private acquisition deals, at most[x] — the target has dozens, or even hundreds, of shareholders (typically, employees or former employees), almost all of which have no role in the negotiations. In those cases, it is reasonable to suppose that the acquisition agreement would include some sort of “fiduciary out” (i.e. since those deals mimic the conditions of a public acquisition transaction, even though the target is not technically a public target), such that it would make good sense to include “no shop/no talk” provisions. But what of the remaining 52% (at least) of private target acquisition agreements in the Canadian market that include “no shop/no talk” provisions? What’s going on in those cases?
There may be any number of possible explanations, but I think the most plausible is that a whole bunch of contracting parties were too busy worrying about what other contracting parties had agreed upon in the past to consider whether it made sense — whether there was good reason — to include “no shop/no talk” provisions in their own circumstances. Regardless of whether I’m right about this, one thing seems certain: market custom in this case sanctions a practice that appears incapable of being justified by reason.
This isn’t a purely academic concern: there are real costs being incurred by clients. My experience in public deals is that “no shop/no talk” provisions (along with other deal protection and “fiduciary out” provisions) are among the most heavily negotiated. How much time, how much in legal fees, do you suppose was spent negotiating these provisions in the context of private transactions for which they were never really required?
Somehow a finger wag seems appropriate here. Better still, perhaps a head shake.
[i] My far younger and hipper colleague, Andrea Kruyne, was kind enough to advise that my example is dated and that Bismack Biyombo resurrected the finger wag during the Toronto Raptors’ deep run in the playoffs this year. She also tells me a whole generation of readers may associate the finger wag with a particularly memorable scene in the movie Jurassic Park (I must confess that I don’t recall the scene). I wonder if my failure to reference these more current examples leaves me open to criticism that my real issue with following market trends is that I’m not very good at keeping up with the times.
[ii] Not so much in the case of standard form contracts. I don’t negotiate many of those. (Does anyone on Bay Street? At our rates?) Nor do I have an issue with resorting to market practice or any other expedient that serves to minimize the time and costs associated with settling agreements that are really intended to settle themselves. The comments that follow in the text are intended to apply primarily to the implementing documentation for significant corporate transactions. I speak mostly of M&A purchase and sale transactions because they are most familiar to me, but many of my comments are generalizable to other significant corporate transactions for which standard form documentation is not available.
[iii] My partner Jessica Catton Rinaldi helpfully points out that this way of conceptualizing ‘market custom’ — namely, as nothing other than a trend — brings to the surface part of the incoherence in slavishly following market custom. Like all trends, market practice changes over time. Among other things, improvements in practice may develop, which are introduced to the market through proposed deal terms that are, of necessity, initially off market. But whether or not shifts in market practice represent improvements, the very fact that they occur argues against the notion that prevailing practice is a fixed reference point from which we must not stray.
[iv] The widespread belief, popularized by modern culture, that lemmings periodically commit mass suicide by running head-first off cliffs, thoughtlessly following the behaviour of the group, is of course now understood to be a misconception. So much the better for lemmings, I suppose, but I fear the English language will suffer for it. It seems we need a new short-hand to identify a person who follows a large group or community on an unthinking course towards preventable harm. “Market follower”, though perhaps apposite (as the text will demonstrate), seems less catchy and is certainly less evocative of powerful imagery than “lemming.”
[v] The Asset Purchase Agreement might include, for example, unusual “material adverse change” provisions relating to political risks that materialize prior to closing.
[vi] The Asset Purchase Agreement might also include “off market” specific indemnities relating to expropriation of assets (on the basis of facts or circumstances that existed prior to closing) or the costs associated with any future penalties imposed for non-compliance with the foreign exchange regime during the period prior to closing.
[vii] See the 2014 Canadian Private Target Mergers & Acquisitions Deal Points Study (For Transactions Signed in 2012 and 2013): A project of the Market Trends Subcommittee of the Mergers and Acquisitions Committee of the American Bar Association (the “ABA Private Deal Points Study”), a commonly relied upon market trend analysis used in negotiating private transactions.
[viii] ABA Private Deal Points Study, slide 61. Granted, the data is somewhat stale, being based upon a sample of 60 acquisition agreements signed in 2012 and 2013. Maybe the trend in more recent vintage private target acquisition agreements is to no longer include “no shop/no talk” covenants. Regardless, I’m puzzled that they could ever have been a ‘market custom’ feature of private target acquisition agreements, for reasons explained in the text.
[ix] I base this assertion on personal experience and on discussions with a number of my partners who also have substantial experience in negotiating private M&A transactions. I assume our experience does not differ drastically from that of others. In fact, I’d be shocked to hear that it does. In this regard, I note that the ABA Private Deal Points Study includes no disclosure of the percentage of private target acquisition agreements that include a “fiduciary out”. I take this to be indirect corroboration of my experience and that of my partners since, if a significant percentage of private target acquisition agreements did in fact include a “fiduciary out”, that would certainly be a remarkable fact worthy of disclosure, in light of the logic that follows in the text.
[x] Again, I base this assertion on personal experience and on discussions with a number of my partners. I’d certainly be interested to hear from anyone who claims to have a different experience.