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Non‑disclosure agreements (“NDAs”) are routinely entered into in connection with a wide variety of business transactions, including M&A and financing transactions and certain other business and technology development relationships, as well as numerous transactions in which technology and/or proprietary and confidential information (“Confidential Information”) will be disclosed to a prospective buyer or business partner.  While volumes could be written about NDAs in general, this article focuses on NDAs used in M&A transactions (an “M&A Transaction”), is drafted from the perspective of the seller, and specifically addresses the increasingly common use of so‑called “residuals” clauses or “residual information” clauses.

An NDA is typically the first agreement that will be entered into in connection with a potential M&A Transaction.  The NDA is designed to protect the confidentiality of information exchanged in connection with the consideration and negotiation of an M&A Transaction and information exchanged in the course of the due diligence process and review of the seller.  Generally, in most M&A Transactions, the seller will be the party disclosing Confidential Information, but, in certain transactions, such as where the buyer will be issuing its equity securities as part of the transaction consideration, the buyer may also be providing Confidential Information to the seller in connection with the seller’s due diligence on the buyer.  Sellers in M&A Transactions often enter into NDAs without giving them much thought or having them reviewed by experienced legal counsel, which is always ill advised and often proves to be a mistake.  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.

Residuals clauses

A “residuals” clause or “residual information” clause in an NDA is designed to allow the receiving party (usually the buyer) to use and/or disclose Confidential Information received from the disclosing party (usually 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/disclosing party.

Residuals clauses are not a new invention, and they 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 sophisticated private equity funds and other financial investors.  With the continuing strong activity by private equity funds in M&A Transactions, sellers must pay particular attention to residuals clauses, and in certain instances, are well‑advised to simply not pursue an M&A Transaction with any prospective buyer who insists on the inclusion of a residuals clause.  A crafty lawyer can draft a residuals clause so broadly that 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 non‑use restrictions set forth in the NDA.

Below is an example of a residuals clause that was drafted by a large east coast law firm and included in an NDA one of my clients was recently asked to sign in connection with an M&A Transaction:

Notwithstanding any other provision of this [NDA], a receiving party shall be free to use the residuals resulting from access to or work with any Confidential Information provided hereunder for any purpose.  The term “residuals” means information in non‑tangible form, which may be remembered by persons with access to the Confidential Information, including ideas, concepts, know‑how or techniques contained therein, in their unaided memories (without reference to the Confidential Information).  A receiving party shall not be obligated to limit or restrict the assignment of such persons or to pay royalties for any work resulting from the use of residuals.

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.  Thus, for example, a buyer of a software company would not be able to use specific code it becomes aware of, but, for example, the methods of structuring software algorithms in general would be a “residual” that could be used by other portfolio companies or disclosed to others.  The rationale is that it would be difficult for the buyer to separate general methods of writing code that it learns from other prospective investments or portfolio companies from methods it learns from the seller in the contemplated M&A Transaction.

Problems with residual 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 disclosing party’s intellectual property/Confidential Information.

Residuals clauses are also potentially problematic because generally the parties to NDAs in M&A Transactions do not contemplate actually transferring ownership rights to any intellectual property/Confidential Information through the NDA.  Rather, most NDAs in M&A Transactions are intended to merely allow access to the seller’s Confidential Information in order to allow the buyer to evaluate the proposed M&A Transaction.  Depending on how a residuals clause is drafted, a seller may not even be aware it’s transferring valuable rights to its intellectual property/Confidential Information.

Even the most carefully drafted and tailored residuals clauses present significant risk for sellers.  For example, it’s very difficult to prove whether something was retained in someone’s “unaided memory,” and what constitutes previously known or learned information is, at best, difficult to identify and subject to dispute.

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 NDA’s 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.  However, sellers should keep in mind that business reasons may dictate the relative importance of certain of these recommendations and that lesser relevance be attributed to others.  The below list does not contain every issue a seller may need to consider and negotiate, nor is it a substitute for review by an experienced M&A lawyer.

• Consider the form of the NDA that is used (i.e., unilateral or “one way”, verses “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 (such as pricing information, contemplated expansion or new products, and customer lists) 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, especially where the buyer is a private equity fund with direct competitors in its portfolio.
• 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 (such as e‑mails and notes, or anything else 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.  It’s one thing to allow a prospective buyer to review Confidential Information in connection with its due diligence on an M&A Transaction, but it’s an entirely different matter to grant a prospective buyer a license to a patent or copyright.  Any residuals clause must explicitly exclude any rights under any patents and copyrights.
• 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.

As indicated above, this article focuses on residuals clauses in NDAs used in connection with M&A Transactions.  Care should be exercised to make certain that all of the other “standard” and customary concepts are included in the NDA, such as the buyer’s obligation to return or destroy Confidential Information if the M&A Transaction is terminated or discussions cease, the confidentiality and non‑disclosure of the existence of the NDA or the fact that negotiations are taking place, any of the terms of the contemplated M&A Transaction, the non‑solicitation of the seller’s employees and customers, and remedies, among others.

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.