Technology Transactions, Software and Internet Law

Consider one of the most difficult issues you’ll ever encounter when negotiating a contract: one party must make a large, long-term investment for the deal to work, but won’t sign the contract unless its investment (and its return on the investment, or ROI) is adequately protected.

Introduction

This article discusses several practical ways to protect that investment and get your deal done.  I focus on long-term investments made as part of an agreement concerning a company’s operations, such as an independent contractor agreement, technology development agreement, distribution agreement, or purchase and sale of products or services.

Operational agreements are different from investment contracts, such as stock purchase agreements or loans to a corporation, partnership (limited partnership or general partnership) or limited liability company (LLC).   Investment contracts raise additional questions under corporate/partnership, tax and securities laws.  For example, long-term cash investments can be protected using preferred stock in a corporation or special provisions for capital accounts in partnerships and LLC’s.  Loans may be protected by taking an interest in collateral, such as real estate (e.g., a mortgage on a commercial building).  By contrast, this article focuses on provisions of non-financial contracts used in operations.

By considering the 3 approaches that I describe, you’ll be far ahead of many other deal makers.

You can make a long-term investment in a couple of ways:

• Investment in the Other Party. You could pay the other party to enable it to perform a project for you.  For example, you could pay an advance to a contractor so that it will undertake a long-term software development project for you.  Similarly, book publishers often pay an “advance against royalties” to an author to enable the author to write a book.   Because funds are advanced, these are similar to loans, but the main goal is not to lend money and make a financial return.  The main goal is to get software developed or a book written.

• Investment in Your Own Company to Support a Relationship. You could invest in your own infrastructure to support a deal with someone else.  For example, if you are a service provider, you might make extensive — and expensive — one-off, custom changes to your platform and business processes in order to provide service to a large customer.

In either case, you expect a return on your investment.  You rely on your contract to make sure you receive that return.

3 Key Approaches

You can better protect your investment in operational agreements by applying these 3 key approaches:

1. Match the Contract Duration to the Investment Horizon, or Lay Out an Early Exit Path that Works
2. Focus the Relationship
3. Leverage Other Relationships Between the Parties

Let’s go through these in turn.

Approach #1: Match the Contract Duration to the Investment Horizon, or Lay Out an Early Exit Path that Works

Match the Overall Term. You generally should match the contract duration (known as the “term”) to your expected investment horizon.  If you put $5 million into a deal, and expect to receive back your $5 million plus your expected ROI in five years, you’re asking for trouble if your contract lasts only one year!  This is the kind of simple mistake that can easily happen when the business people are focused on major terms in a term sheet.  Keep your eye on this ball, especially as your deal changes.

Match the Payment Timing. Where possible, payment timing also should match up to the timeline for your desired ROI.  For example:

• Consider replacing a fixed monthly fee with a fee based on the number of customers acquired, which might could front-load or back-load the payments, depending on the timetable of marketing and promotion.

• Step up or step down payments over the duration of the contract to match anticipated sales or revenue trends, instead of fixed identical payments throughout the contract term.

Talk with an accountant before becoming too adventurous with these alternatives. Some alternatives might seem too artificial, and might not square up with accounting requirements for revenue recognition.

Early termination of the contract, in other words, an early exit path from a business relationship, creates more difficult questions.

Termination for Convenience and Kill Fee Workaround. Termination for convenience means termination by a party “for any reason, or no reason at all.”  You’ll often see it written this way in a contract.  In some contracts, the clause is written so that either party can terminate for convenience.  In others, only one party can terminate for convenience.  (If only one party can terminate for convenience, then that party essentially holds an option for the entire deal.)

Here’s how it can harm you.  Suppose you make an investment as part of a five-year operational contract, and you expect to receive a return on your investment over the five-year term.  However, both parties can terminate for convenience on 30 days notice.  Watch out!  The other party can pull the plug, terminate for convenience at any time, and your “five-year” deal is gone.  You won’t be happy if it happens to you.

If the parties absolutely need the ability to terminate the deal for convenience, here is a workaround that’s often useful.  It comes from the world of magazine publishing.  A magazine may commission an article from a writer.  However, the magazine’s needs for specific articles can change, such as last-minute advertising insertions or cancellations that affect the number of pages available for articles. The magazine needs the flexibility to “kill” (not run) the article, and so it pays a “kill fee” to the writer if the article does not run.  So it goes with other contracts.  If you make a large investment in a deal, and the other party needs the ability to exit the deal early at its whim, then it can pay for the privilege.  If it kills the deal early, it pays you a pre-set kill fee to compensate you for all or part of your investment, or even your lost revenue expected over the life of the deal.

Termination for Change of Control. What happens to your investment in the deal if the other party is bought by another company?  In our interconnected global economy, this happens all the time.  Virtually any company, public or private, can be acquired in a merger & acquisition (M&A) transaction, often on very short notice.

Even companies that are closely held within a tight-knit family are subject to a change of control, when the controlling shareholders die or become disabled, and the shares pass to another family member.  If this happens, your wonderful long-term contract may no longer be held and managed by the friendly people whom you’ve known for 20 years, but by a faceless bureaucracy known for dropping long-time partners to save a few pennies on the dollar.  Or, worst of all, your cooperative partner of 20 years may transfer your wonderful long-term contract to… your closest competitor.

That is why many contracts, especially long-term contracts, contain the ability for a party to terminate upon the change of control of the other party.  Sometimes the change of control provision is triggered only on a change of control to a competitor, either defined generically or as specified on a list.

Including a provision to terminate for change of control may enable you to exit the deal, but possibly not recoup your long-term investment, unless you include a kill fee.  Compared to kill fees for termination for convenience, I see kill fees less often for a change of control.  Instead, the parties may work out a way for the contract to continue in some isolated fashion.  Or, the parties just look for a replacement deal with someone else.

Termination for Breach. Most contracts, except the very simplest and smallest, will specify how to terminate if the other party breaches.  (A few will rely on the underlying law instead of a specific contract provision.)  If the other party wrongly backs out of your long-term deal, it probably will renege on any remedies and any other protective mechanisms you have in place, but the mechanisms are useful if you must go to court.

Sometimes, a party will propose a “liquidated damages” clause.  This type of clause attempts to make one party pay a pre-set amount to the other party for breach of the contract, in order to avoid the expense, difficulty and delay of proving damages.  (Liquidated damages are different from kill fees above, because kill fees are not triggered by a contract breach.)  Liquidated damages should never be characterized as “penalties,” which are not legally enforceable.  Instead, they are intended to estimate the amount of damages that might occur.   Just try estimating them, though.  Oftentimes, this is an attempt to place a dollar figure on an event that is unlikely and has no clear value.  Business people quickly lose patience when asked to put a price tag on such a hypothetical event.

Liquidated damages can be useful where the parties have a general sense of the magnitude of possible harm, and want to pin a number to it.  They also can be useful as a way to measure and add up many small breaches.  However, I have seen situations where liquidated damages led to a business mindset of “keeping score” over trivia, a distraction from the more important goals of the relationship.

Make Termination More Difficult. Another workaround is simply to make the process of termination more difficult.  That gives the parties the incentive and chance to talk … and talk … and finally to resolve the issues without going to court.

• Mediation.  You can agree to mediation before going to court.  For mediation, a third party mediator is brought in (for a fee), hears both sides of the issue, and tries to get the parties to agree to a solution.  Sometimes mediators are accused of just splitting the solution down the middle.  This is fine in many situations, but won’t necessarily work if one party is clearly and deeply in the wrong.  However, it does encourage the parties to talk and resolve.

• Management Escalation Process.  You can agree to a management escalation process before going to court.  This can work well when dealing with large companies.  Many times, lower level managers who don’t (or can’t) see the big picture in a contract relationship will take overly aggressive actions, and threaten breach and litigation, and so forth.  An escalation process enables more senior personnel to discuss and resolve.  Just don’t let your escalation process become an escalator to nowhere, with no timeline or end point.

If all else fails, the parties can at least provide for an orderly transition after termination.  The party who made the long-term investment may be able to reuse its investment to some extent, particularly with the cooperation of the other party.  The parties can agree to reasonably cooperate over a period of six months, one year, or longer as needed.  Both parties should keep in mind that their customers don’t necessarily know — or care — about the relationship and its problems, but they will care deeply — and complain vocally — if their experience is negatively affected.

Working out the duration and timing is relatively simple and straightforward.  Once you have worked them out, you should then consider how focused the relationship can be.  Negotiating an appropriate focus can be much more difficult.

Approach #2: Focus the Relationship

You can protect your long-term investment in an operational contract by having the parties focus particularly on each other, to make sure that relationship achieves their business and financial goals.  There are at least five ways to do this: Exclusivity, Semi-Exclusivity, Most Favored Nation (MFN), Required Minimum Purchase, and Recoupment.

Exclusivity. One of the best ways to protect one party’s long-term investment is to receive exclusive rights from the other party.  For example, you agree to make a significant investment in customizing and marketing the other party’s software.  In return, the other party agrees not to grant rights in the software to anyone else.  Or, a distributor agrees to make a large marketing investment in a particular territory, and to support this investment, the manufacturer grants an exclusive distribution rights to that distributor in that territory.

Don’t grant exclusivity lightly, though.  I have seen many deals where one party granted exclusivity, but there was no investment or special effort by the other party.  The exclusivity was simply a “give” to the other side.  The party may come to regret that concession, if better opportunities come up and the party holding the exclusive rights doesn’t exercise them.  The “give” becomes a wasted opportunity.  You should always ask why exclusivity is necessary.

On the other hand, when one party makes a clearly-defined long-term investment in connection with a contract, it can be reasonable to grant an exclusive — at least until the expected ROI of the investment is obtained.

Try to match the scope of the exclusivity to the scope of the investment.  Mismatched exclusivity and investments can lead to resentment, attempts to work around the contract requirements, and even breach.  For example, if one party makes a long-term investment in one particular field of use of a patented technology, but doesn’t care about the other fields, then the other party should not grant an exclusive license to all fields of use in broad-brush fashion.  Likewise, if a party invests only in a particular territory, think long and hard before granting exclusive rights worldwide.

Sometimes business people will seek “exclusivity” by proposing a broad non-competition clause.   Non-competition clauses are not enforceable in California under California Business and Professions Code Sections 16600 to 16602.5, with limited exceptions for certain sales of businesses and dissolutions of partnerships and limited liability companies (LLC’s).  Such clauses are enforceable under the laws of many other states, however.

Semi-Exclusivity. In many cases, the investment doesn’t justify full exclusivity, or the opportunity is at such an early stage or is so vaguely defined that an exclusive could severely limit the granting party in unforeseen ways.  In those cases, the exclusivity itself can be narrowed.  The party could grant “semi-exclusive” rights, e.g., granting rights to two companies, and no more.   Or, exclusivity could be granted for certain fields of use of a technology, but not others, as mentioned above.

Most Favored Nation. If you agree with one company that you will not grant better terms to other companies in other contracts, then that company has “Most Favored Nation” (MFN) status with you.  MFN clauses are comparable to semi-exclusive rights, because the benefit can affect several parties.  MFN clauses can be somewhat weak, but at least the other party knows that it won’t be getting a worse deal than other partners.  MFN clauses are used most often for pricing, and are called Most Favored Customer clauses when used between seller and buyers.  Generally, if a buyer has Most Favored Customer status, the seller won’t sell to other buyers on better terms, including a lower price.   MFN clauses must be carefully drafted and negotiated, because they can impact other contracts and relationships with other customers.  They also can be cumbersome and time-consuming to monitor, unless they are very narrow.

Required Minimum Purchase. Let’s say you are thinking about building a factory, but you need a certain number of orders for the factory to break even.  A customer would like for you to build the factory, because the factory can produce more products at a lower cost than existing methods.  To help guarantee that you make the return on your investment in the factory, the customer agrees to purchase minimum quantities from the new factory.  This is not as restrictive as an exclusive, because the customer can still buy from others, as long as it makes the minimum purchase from you.  Of course, depending on the numbers, a required purchase can result in an exclusive relationship for all practical purposes.

Recoupment. One party advances money to another person, so that that other person can develop a product.  The person advancing the money gets the first proceeds of the product sales until its advance is repaid to it in full, and then the parties share revenues (the upside) from there.  For example, a publisher advances $25,000 to an author to enable the author to write a book.  When the book is sold, the publisher receives the first profits to recoup its $25,000 investment.  Then, the publisher and the author share profits above $25,000, usually by the publisher paying the author a (small) royalty on sales of the book.

Once you have determined an appropriate focus for the contract, you can then review other contracts between the parties to see whether they support a stable long-term relationship.

Approach #3: Leverage Other Relationships between the Parties

If the parties have other contracts or relationships, they may create momentum so that the parties will not work with others, keeping both parties in all their relationships with each other, and enabling the party who made the long-term investment to recover it, regardless of kill fees, exclusivity, required purchases, and other legal terms and conditions.  In essence the other contracts raise the switching costs of working with another company, and create a practical barrier known as “lock-in.”

Depending on your perspective and needs, you may want to encourage or discourage lock-in.  A couple of contract provisions encourage lock-in:

Cross-Collateralization. This means that the payments or assets under one contract can be used to satisfy the obligations under another contract.  In other words, the payments due or assets under one contract serve almost like collateral for satisfying the obligations under another contract.  Although it is clearest if cross-collateralization rights are written into a contract, the law includes general rights of setoff that achieve much the same purpose.  See, for example, California Code of Civil Procedure Section 431.70.

Cross-Default. This means that the breach of one contract creates an automatic breach under a second contract.  This is often used in corporate finance transactions, where breach of one loan document (such as failure to maintain a specified financial condition) will result in a cross-default of another document (such as an agreement governing collateral, so that the lender can now foreclose on the collateral).  It is not limited to financing documents, however.  Many operational agreements can be written so that they cross-default one another.  This can create a powerful incentive not to breach any of the agreements.  This provision should be used with care, because it might facilitate an antitrust issue if one of the parties has significant market power in businesses covered by some of its contracts, and uses that power to leverage its market power in unrelated areas.

Conclusion

Whenever a party needs to protect its long-term investment in an operational contract, keep these three approaches in mind.  First, match the contract duration to the investment horizon.  If necessary, lay out an early exit path that works, considering termination for convenience with a kill fee, a liquidated damages clause, mediation, a management escalation process and a transition process after termination.  Second, focus the relationship by wisely choosing whether to use exclusivity, semi-exclusivity, a Most Favored Nation (MFN) clause, minimum required purchase or recoupment.  Finally, look at other contracts between the parties to see if the parties’ relationship should be strengthened by cross-collateralization or cross-default provisions.

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It’s the fifth anniversary of the Boadwee Law Office! I am truly thankful for the wonderful clients, colleagues and friends who’ve made these 5 years a success.

Please celebrate with me by getting a free electronic (ebook) copy of my book, Protect Your Business with Non-Disclosure Agreements.

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This month’s California Lawyer magazine has a simple and clear explanation of the latest strategies by and against patent trolls.

In basic terms, “patent trolls” are entities that own patents but do not use them in their businesses, and instead make money by licensing them and bringing lawsuits against companies who will not buy a license.  They also are known as “non-practicing entities” (NPE’s).  Their business has been fueled by large damage awards in patent infringement cases, which led to the rise of brokers and auction houses for a resale market in patents.

The article lays out many of the latest strategies by and against NPE’s:

Offensive Strategies by NPE’s

• Suing dozens of defendant companies to complicate defense coordination and raise defense costs.
• Picking off “the weakest in the herd,” by settling first with smaller defendants who cannot afford to litigate.
• Filing claims not only in court, but also with the U.S International Trade Commission (ITC), which can issue injunctions against importing a product.
• Filing suits in “rocket docket” jurisdictions where cases proceed faster and damage awards are higher.

Defensive Strategies against NPE’s

• Suing for a declaratory judgment in the court jurisdiction of choice, rather than waiting for the NPE to sue and choose a “rocket docket” jurisdiction.  (A lawsuit for declaratory relief asks the court to make a decision declaring the rights and obligations of the parties under a statute or contract.  For example, a company may ask for a declaration that a patent is invalid or is not infringed, in order to eliminate the risk that patent damages accrue while the company continues to sell products that might be covered by the patent.)
• Requesting reexamination of the patent at the U.S. Patent & Trademark Office (PTO).  For example, if more evidence is made available, the PTO could invalidate the patent that it had issued.
• Refusing to settle, and taking the cases all the way through litigation — even to the U.S. Supreme Court.
• Subscribing to a defensive patent aggregator (DPA) service, a somewhat new model.  DPA’s buy a defensive portfolio of patents or patent licenses, then make them available to subscriber companies for a membership fee.  One such DPA is RPX Corporation, which is funded by VC’s Kleiner Perkins, Charles River Ventures, and Index Ventures, and which has spent over $115 million amassing its IP portfolio.  (I say “somewhat” new, because companies have for many years obtained defensive positions through cross-licensing of patents directly, through multi-party alliances or “patent pools” and through development of industry standards, which often include patent licenses on non-discriminatory terms).

Because the stakes are so high — millions of dollars and the fate of nascent and hugely profitable technologies — this battle of strategies will only continue.

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In the previous issue of this newsletter, I discussed how to use contracts to protect against “known unknowns,” those events and circumstances for which you know the general category of uncertainty, but not the outcome.

This article covers “unknown unknowns,” those events and circumstances that you cannot foresee.

Here are several approaches to deal with unknown unknowns in a contract relationship:

1.    Representations, warranties and indemnification approach. The previous issue of this newsletter defined and discussed how representations, warranties and indemnities can be used in a contract to protect you against known unknowns.  By drafting representations, warranties and indemnification broadly, you often can cover many unknown unknowns as well.

For example, indemnification could cover very broadly “any act or omission of the other party in connection with the relationship or the contract.”  That of course does not cover events or circumstances beyond the other party’s acts or omissions (such as a change in government regulations).  It also does not cover all threats to the existence of a party (such as bankruptcy of a company or death of an individual), which may be covered by bankruptcy, trusts & estates and family law, as I discussed before.

2.    Procedural approach. Some unknown unknowns can be dealt with by adding procedural provisions to your contracts: escalation, mediation or arbitration.  (These provisions work for known unknowns too.  I see them often in deals with high complexity or high uncertainty.)

In essence, the parties control their own mechanisms for resolving disputes, to avoid going to court over unexpected circumstances.

Escalation mechanisms provide a means for the parties to raise (or “escalate”) issues from the working group level to the senior executive level, with the assumption that senior business people can defuse potential lawsuits.

Mediation uses a third party to help the parties understand their differences and negotiate a resolution.

Arbitration uses a privately hired third party (often a retired judge) to resolve disputes outside of the public court system.  Often, to provide greater certainty, the arbitration clause can limit the arbitrator’s power and authority, such as limiting the scope of document discovery or ability to impose non-monetary penalties (injunctions).

3.    Substitution of parties approach. You can seek to substitute someone else in the relationship in place of the original (non-performing) party.  For example, permitting a contract to be sold and assigned to someone else enables a third party to assume the performance obligations and step into the shoes of the non-performer.

A third party guarantee has a similar effect, but it generally covers only the payment of money – the third party’s money (the guarantor’s) effectively replaces the money of the non-per-former.  Insurance can also serve this purpose to a limited extent.  See my article, “Contract Provisions for Troubled Times: Part 3 – How Third Parties Can Assure Performance” (Technology Law Letter #3).  This can be a good strategy, unless the guarantor cannot fulfill its commitments or ceases to exist.

4.    Hedging approach. You may choose to deal with more than one party.

In the field of procurement, this means finding a second source. If one of the parties ceases to exist, you have limited your downside and can obtain performance from others.

Of course, the 2008 economic meltdown demonstrates that there can be nowhere to hide if all the players in the industry sink at the same time.

A similar approach is to have a contract with a major vendor, but separately make a small investment in a new, unproven technology provider.  Although the main contract should fully cover the parties’ relationship, the relationship with the small newcomer provides a hedge against unknown shifts in technology or unexpected problems with the major supplier.  It also might deter the major supplier from demanding unreasonable prices.

5.    Robust “we’ll-deal-with-it” approach. Instead of trying to predict future outcomes, focus on becoming a robust, resilient player.  Examples of good defenses against the unexpected include:

• Developing contingency plans to address categories of risks.
• Creating a culture of resilience and resourcefulness that recognizes that tech-nology, the business and the market are constantly changing, and that any obstacle will be worked around and overcome.
• Emphasizing flexibility and speed of execution.
• Developing strategic relationships with industry organizations and market leaders.

For more examples of unknown unknowns, see the book The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb.

It’s impossible to foresee every event that can affect a contract.  The five approaches above will help you overcome circumstances that you cannot foresee.

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Issue #8 of Harry Boadwee’s Technology Law Letter is available.  This month’s lead article is: Using Contracts to Deal with Unknowns: Part 1 –“Known Unknowns.”  Next month, Part 2 will cover “Unknown Unknowns.”

For a free subscription, please visit www.BoadweeLaw.com/subscribe.

I welcome your comments and suggestions!

Update: Issue #8 appears below:

In this Newsletter

• Using Contracts to Deal with Unknowns: Part 1 – “Known Unknowns”
• From My Blog
• Ask Harry Boadwee

Using Contracts to Deal with Unknowns: Part 1 –“Known Unknowns”

Business people deal with unknown facts and circumstances in contracts all the time. Contracts allocate the responsibility for unknowns to one party or the other.  Most often, this means cash out of pocket for a costly unforeseen event.

In this article, you’ll learn common ways to deal with two types of unknowns in a contract: the “known unknowns” and the “unknown unknowns.”  Most people focus on the usual known unknowns, even though the unknown unknowns can have huge consequences.  We’ll look at both.

For “known unknowns,” you can identify the general category of uncertainty, but not the outcome.   You may know the probability of an outcome, or rely on experience or “gut instinct.”  For example, if people are visiting a factory, the risky outcome is that “someone could get hurt.”  Or, if you are buying some property, “the seller may not have all the necessary rights.”

In a contract, known unknowns can be addressed through representations, warranties, and indemnities crafted to cover the categories of risk you can identify.

A representation is a statement of fact from one party to the other party in a contract that the facts are true at a certain point in time.  For example, you could make a representation to the other party that you own all rights to a piece of property on the date the contract is signed.

A warranty is an ongoing promise in a contract that stated facts will remain true in the future.  For example, you could give a warranty that you will continue to own all rights to the property while the contract remains in force.   In other words, you won’t sell the property during the contract term.

If a representation or warranty turns out not to be true, the party receiving it generally can terminate the contract, sue for damages or seek other remedies.

An indemnity is “a contract by which one engages to save another from a legal consequence of the conduct of one of the parties…. ” in the words of California Civil Code Section 2772.  “To save another from a legal consequence” most often means that one party must defend a lawsuit (and pay attorney’s fees and damages awarded) if a third party sues the other party to the contract.  For example, if you have a contract with another company and your employees visit the other company’s factory, then the other company could indemnify you against personal injury lawsuits by your employees if your employees are injured during the factory visit.  For more, see the definition of “indemnity” at http://boadweelaw.com/glossary/i.html.

The continued existence of both parties is a known unknown. Business people often neglect these “existential” risks, especially in smaller contracts, but they can affect almost every deal.  Some of these risks can be dealt with under contract law, and others cannot.  Other law, such as bankruptcy, trusts & estates or even family law, may apply.  A party may be sold to another company (change of control) , or may go bankrupt and out of business.  Contract provisions can deal with the change of control (e.g., terminating the contract upon a change of control).   Because bankruptcy law can override almost any contract, that law must be considered if a party may go out of business.  If the other party is an individual person, you should consider the possible impact of personal bankruptcy, or severe disability or death (where trusts & estates or family law may come in).  For example, personal risks are important in shareholder or partnership agreements.  Other existential risks, such as seizure by a foreign government or significant new regulations, are more rare.

In the next issue, I’ll discuss how to deal with “unknown unknowns” in a contract.

From My Blog

• Enter the Hyperwrap Agreement: Turning the Page in Online Contracts.  This posting discusses a new type of online contract recently recognized by the courts, which may be useful where a “clickwrap” agreement is not practical.
  (http://tinyurl.com/hyperwrap)

• Short Introduction to Several California Laws that Affect Out-of-State and Foreign Businesses
  (http://tinyurl.com/introcalifornia)

• Business Tips for Providers of User Generated Content
  (http://tinyurl.com/ugctips)

• Data Scraping from Web Services
  (http://tinyurl.com/datascraping)

Ask Harry Boadwee

I invite your questions, comments and suggestions for this newsletter!

If you have a general question about technology transactions, contracts, negotiations, or software or internet law, [contact me].

I’ll try to answer as many questions as I can, in particular, short questions that may interest many readers of this newsletter.

All the best,

-  Harry

Please visit my newsletter archives at www.BoadweeLaw.com/newsletter.html

Harry Boadwee’s Technology Law Letter is published by the Boadwee Law Office, legal advisers to innovative companies in the fields of technology transactions, software and internet law.

I appreciate your referrals.  Please pass along or forward this newsletter (without modification).  For other uses, contact me.

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This Newsletter is for general information purposes only, and is not provided in connection with rendering of legal or other professional advice.  It is subject to the Terms of Use of the Boadwee Law Office (www.BoadweeLaw.com/terms.html) and may be Attorney Advertising in some jurisdictions.

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Software and internet contracts for years have been created by means of “shrinkwrap,” “clickwrap” and even “browsewrap” agreements (although the enforceability of “browsewrap” agreements is somewhat doubtful).

Two recent cases from Illinois courts now recognize a type of contract called a “hyperwrap” agreement.  For the business implications, you can scroll to the bottom of this posting.

As everyone knows, contracts for software and web sites can be very long, with pages and pages of text.  These contracts are often displayed where space is at a premium - e.g., on order forms or web site registration pages.  In the past, many of these pages used a “scroll box” which displays the text of the  contract in a separate window with a scroll bar. The user had to move the scroll bar up and down to see the entire text of the contract.  Scroll boxes require programming to develop and maintain.  By contrast, it is much simpler to use a hyperlink to a second web page with the contract terms.

The issue facing the courts in these cases was whether displaying a hyperlink to the terms on another page was conspicuous enough.  In other words, were the contract terms hidden from the user (similar to terms hidden in extremely small “mouse” type), or were they visible enough that the party should have seen and read them?   The courts held that the terms were visible enough because a hyperlink is like turning the page of a paper contract.

In both cases, although the hyperlink was repeated several times to the customer before acceptance, this was not the deciding factor.

Instead, both courts focused on the fact that the blue hyperlink could be easily distinguished from the background text.

In the leading case, Hubbert v. Dell Corp., 359 Ill. App. 3d 976 (5th Dist. 2005), the court stated that “[t]he blue hyperlinks … should be treated the same as a multipage written paper contract. The blue hyperlink simply takes a person to another page of the contract, similar to turning the page of a written paper contract. … [T]he hyperlink’s contrasting blue type makes it conspicuous. Common sense dictates that because the plaintiffs were purchasing computers online, they were not novices when using computers. A person using a computer quickly learns that more information is available by clicking on a blue hyperlink.”

The recent case, PDC Laboratories Inc. v. Hach Co., No. 09-1110 (C.D. Ill., Aug. 25, 2009) hailed Hubbert as “the leading authority in ‘hyperwrap’ cases.” It went on to state: “this contrasting text is sufficient to be considered conspicuous … because it is not the repetition of the display of a term that is determinative but the contrast of a term.”

The courts explicitly recognized the metaphor that clicking on a hyperlink is like turning a page. Thomas O’Toole, in the Ecommerce and Tech Law Blog observed that “if you embrace the metaphor that hyperlinks are the customary way of ‘turning a page’ online, then it doesn’t seem unfair at all to expect parties to ‘turn’ each ‘page’ of their online contracts.”

In other words, good user interface design actually aligns with the right legal result.

Hubbert and PDC leave open a question concerning contract acceptance.  Under these cases, hyperwrap agreements lie on a spectrum between browsewrap agreements (which have no separate acceptance mechanism), and clickwrap agreements (which have a separate and explicit mechanism for acceptance, such as checking a box or pressing an “I Accept” button).   The PDC court expressly distinguished the clickwrap cases.  However, in both Hubbert and PDC there was a mechanism to highlight to the customer that the terms would be binding.  In Hubbert, most of the order forms in dispute had a separate notice that said “All sales are subject to Dell’s Term[s] and Conditions of Sale.”  In PDC, the terms were specifically referenced in the final step of the order process which said, “STEP 4 of 4:  Review terms, add any comments, and submit order.”

What these cases mean for business people:

• It is acceptable to place contract terms on a separate page if they can be easily found via a hyperlink.

• The hyperlink needs to be obvious in a customary way, like a paper page-turn.  At a minimum, a standard blue hyperlink appears to be acceptable.  However, some creative designers prefer other hyperlink designs, and those alternative designs may not be acceptable.  Better to use the standard hyperlinking display conventions where possible.  Keep this in mind also with paper documents that use hyperlinks to incorporate terms.

• For acceptance, it is best to use a “clickwrap” mechanism, such as checking a box or pressing an “I Accept” button.  However, it appears that courts are becoming receptive to other methods of bringing the terms and conditions to the attention of the other party, particularly if they are emphasized in the proper place in the contracting process.

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Issue #7 of Harry Boadwee’s Technology Law Letter is now available.

The lead article is: The Three Critical Negotiations in Any Contract.

For a free subscription, please visit www.BoadweeLaw.com/subscribe.

I welcome your comments and suggestions!

Update: Issue #7 appears below.

In this Newsletter

• The Three Critical Negotiations in Any Contract
• Postings from My Blog

The Three Critical Negotiations in Any Contract

Any contract requires not one, but three, critical negotiations.

The first is the negotiation between the two parties to the contract.  Without the “main deal,” there can be no agreement.

The second and third negotiations are the internal negotiations within each party, or between each party and others (such as vendors and subcontractors), that are needed so that each party can sign the main deal.  Ignoring them can kill your deal, even if you’ve agreed to a term sheet.

You’ll see these negotiations most clearly in deals between large companies.  Large companies often use specialists and experts, both in-house and as independent contractors, in many fields, such as human resources, finance, procurement, marketing, sales, real estate, and legal.  These persons may even be focused in narrower sub-fields.  They may work within operating business units or corporate functional units.  They may be responsible across the entire company or for narrow geographic regions.

The key is that they generally have some voice in the negotiations, even if they are not sitting at the negotiating table.  Their voice may be expressed through policies (e.g., an information security policy) or processes (e.g., a contract approval process).  These policies or processes often reflect the outcome of a difficult and drawn out give-and-take between internal groups with varying power and influence.  They may be very inflexible, yet demand complete flexibility from the other party.  For instance, a party may request the other to comply with a policy that cannot be negotiated, but can change at any time.  Even requesting a change to such a policy can trigger internal negotiations within one party that are more painstaking than the main deal.

These issues can be solved in several ways:

1.  A party designates a person or group whose job is to “knock heads together” internally, guide the internal negotiations and present the results to the other party.  This is often the role of business development, legal or even sales groups.  The party may have “escalation” processes to speed up these internal negotiations, by raising issues of competing interests to senior executives for resolution.  This approach can be efficient, but be aware that keeping the internal negotiations behind the curtain can delay a deal, and create confusion and concern in the other party due to lack of transparency.

2.  The specialists and experts of each party may engage directly with one another.  For example, one party’s “tax person” negotiates directly with the other party’s “tax person,” the HR person speaks with the HR person, and so forth.  A business development or legal group coordinates the specialist negotiations.  This approach works best when the specialists and experts have authority to make decisions and the outcomes of their negotiations don’t impact other areas.

3.  Certain policies are “locked in concrete” and never negotiated as one-offs.  The policies and processes evolve over time as various third parties object to them and workarounds are found.  The speed of this evolution depends on the market power and attractiveness of the company as a deal partner.  Sometimes the policies can be dealt with by interpretation or by agreement that certain points of the policies don’t apply to the deal at hand, or will apply only if specified conditions occur.  Or, the contract may provide a means to terminate or renegotiate if the inflexible policies become too burdensome or costly.

You can make real progress in a deal, particularly a complicated one, if you spot these issues early and resolve them via one of these approaches – especially an approach that is compatible with the parties’ corporate cultures.  It may be as simple as helping a party recognize and use resources, such as people and processes, that already exist.

The three critical negotiations also apply to negotiations between small companies or sole proprietors.   Compared to large companies, their internal decision making may be simple.  However, they are more vulnerable to third party limitations that they can’t control, such as those imposed by investors, licensors or vendors.  It’s critical to spot these limitations as early as possible.  If you catch them in the early formative stages of a deal before expectations are set, you may be able to restructure the transaction, or bring in a third party (such as an outsourcer) who can work around the limitation.  If you spot them later, your deal could be seriously delayed or lost.

In summary, the internal negotiations of each party, and the negotiations with outsiders such as investors and vendors, are as important as the negotiations between the two parties in their main deal.  Flagging and resolving these negotiations early will keep your main deal on track and help make it a success.

Postings from My Blog

Here are some postings from my blog at www.BoadweeLaw.com/blog:

•    Using an API (Application Programming Interface) versus Open Source
(http://tinyurl.com/ndgfjf)

•    Lifting the Lid on Open Source Hardware
(http://tinyurl.com/nyrmk8)

All the best,

-  Harry

Please visit my newsletter archives at www.BoadweeLaw.com/newsletter.html

Harry Boadwee’s Technology Law Letter is published by the Boadwee Law Office, legal advisers to innovative companies in the fields of technology transactions, software and internet law.

I appreciate your referrals.  Please pass along or forward this newsletter (without modification).  For other uses, contact me.

To receive your own subscription to this newsletter, visit www.BoadweeLaw.com/subscribe or send an email to Subscribe@BoadweeLaw.com

Copyright © 2009 Boadwee Law Office.  All rights reserved.  20370 Town Center Lane, Suite 100, Cupertino, CA 95014.  Tel: (408) 253-6100.  Fax: (408) 253-6200.

This Newsletter is for general information purposes only, and is not provided in connection with rendering of legal or other professional advice.  It is subject to the Terms of Use of the Boadwee Law Office (www.BoadweeLaw.com/terms.html) and may be Attorney Advertising in some jurisdictions.

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What’s the most useful clause in a contract?

Find out my view in the latest edition of Harry Boadwee’s Technology Law Letter.  I also discuss the launch of my new online Technology Contracts Glossary.

For a free subscription, please visit www.BoadweeLaw.com/subscribe.

I welcome your comments and suggestions!

Update: Issue #6 appears below:

In this Newsletter

• The Most Useful Contract Provision?
• Launch of Technology Contracts Glossary

The Most Useful Contract Provision?

In my view, the most useful contract provision is the “term”
of the contract, in other words, the time period that the contract is
legally in force before it expires.

Why?

Because a very short-term contract (such as month-to-month) can
eliminate many issues, shorten negotiations and even reduce legal
fees.  If the parties don’t like what’s happening under the contract,
they can let it expire.

On the other hand, a lengthy contract (five years or more) can
become like a ball and chain, even if it was very reasonable when it
was signed.  This is because the world changes, and no one can predict
the future.  Given enough time and money, lawyers can negotiate every
possible contingency and edge-case you can imagine, and give you a
contract the size of the Manhattan telephone directory.  You see this
for example, in information technology outsourcing agreements, which
often last for eight years or more.

It is very easy to overlook this simple and commonplace clause.   And yet this clause can have a profound impact on your deal.

You probably could accept very onerous and heavy-handed deal
terms… if they last for only one day.  On the other hand, even the
most simple contract terms can become an unbearable burden…  if they
run for 20 years.

If you want to reduce the time and expense of negotiating your
deals, there is a simple fix.  Make your deals on a month-to-month
basis.  If either party objects to the deal in the future, they can
exit, clean and simple.

If you want a deal to look longer, for “optical” purposes only, you
can sign up to a fixed term (such as two years or five years), but
allow either party to terminate “for convenience” on 30 days notice.
Termination for convenience is often written as “termination for any
reason or no reason at all.”

It will look like a longer deal, but in effect it really is a
month-to-month deal.  Watch out, though, for contracts that give this
right only to one party, not both.  The contract would then be in
essence an option contract, which only one party could exit.

I have seen month-to-month agreements and termination for
convenience clauses eliminate many unnecessary negotiations and
roadblocks to getting a deal done.

There is less to fight over if either party can leave at will.

This strategy won’t work for every contract relationship, however. 
First, accountants may require an actual binding long term agreement
for accounting and financial purposes. Second, this strategy is less
effective when one of the parties has a large fixed investment to
protect.  Large outsourcing agreements raise this issue. The outsourcer
needs a long-term contract to recoup its investment in setting up the
systems and infrastructure to perform the services.  Similarly, lenders
and investors may require a true long-term contract to act as
collateral for a long-term loan or investment.

Can you imagine that a company would use the term of a contract as a
competitive advantage? That’s exactly the approach of America’s Best
Value Inn, a new hotel chain, according to The New York Times (http://tinyurl.com/5zgykh). 
Most hotel chains, such as Wyndham Hotels, require franchisees to sign
up to contracts of 15 to 20 years.  By contrast, America’s Best Value
offers franchise agreements that are renewable each year.  Many
franchisees like this flexibility.

A short contract term isn’t a cure-all, of course, even for hotel
franchisees.  One lawyer mentioned in the article, who represents
franchisees, says his clients prefer long-term contracts, to protect
the franchisee from losing its franchise if it doesn’t pay for
expensive upgrades to its facilities every few years.

If your contract needs to protect a large, fixed investment by you
or the other party, then a short contract term probably isn’t the
answer.  In the future, I’ll discuss how to protect yourself in that
situation.

Launch of Technology Contracts Glossary

I recently created a glossary of terms used in technology transactions.  You can read it at http://www.BoadweeLaw.com/glossary.

This is a first release, so it needs more work.  The navigation is
primitive, but you can use the search box on the web pages to look for
a particular word.

Unlike many online glossaries and dictionaries, this is not intended
to be a dry listing of words and terse, cryptic definitions.  For many
terms I try to explain why the word is used or important.  For this
reason, some definitions are not as precise as some lawyers would
prefer, but they have plenty of alternatives to find that information.

Anyway, I hope it is helpful to you.  As always, I would appreciate receiving your comments and corrections.

All the best,

-  Harry

Please visit my newsletter archives at www.BoadweeLaw.com/newsletter.html.

Harry Boadwee’s Technology Law Letter is published by the Boadwee
Law Office, legal advisers to innovative companies in the fields of
technology transactions, software and internet law.

I appreciate your referrals.  Please pass along or forward this newsletter (without modification).  For other uses, contact me.

To receive your own subscription to this newsletter, visit www.BoadweeLaw.com/subscribe or send an email to Subscribe@BoadweeLaw.com

Copyright © 2009 Boadwee Law Office.  All rights reserved.  20370
Town Center Lane, Suite 100, Cupertino, CA 95014.  Tel: (408)
253-6100.  Fax: (408) 253-6200.

This Newsletter is for general information purposes only, and is not
provided in connection with rendering of legal or other professional
advice.  It is subject to the Terms of Use of the Boadwee Law Office (www.BoadweeLaw.com/terms.html) and may be Attorney Advertising in some jurisdictions.

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Issue #5 of Harry Boadwee’s Technology Law Letter is now available.

The lead article is: Should You Sign Your Term Sheets?  The Power of Commitment and Consistency.

For a free subscription, please visit www.BoadweeLaw.com/subscribe.

I welcome your comments and suggestions!

Update: Issue #5 appears below.

In this Newsletter

• Should You Sign Your Term Sheets?  The Power of Commitment and Consistency

Should You Sign Your Term Sheets?  The Power of Commitment and Consistency

I recommend using term sheets for most deals other than the simplest ones.  Clients often ask me, “Should we sign the term sheet?”

Previously, I told them it really doesn’t matter.   From a legal viewpoint, if the term sheet states that it is not a legally binding contract, then it isn’t a contract, and signatures are irrelevant.  I said, “Although it doesn’t matter legally, sign it if the parties want to show their commitment to the deal.”  I would add, “It also can be useful if the company requires internal approvals for deals.  Signing a term sheet can help you get the approvals and show that you got them.”

My recommendation today is stronger: if you want to commit the parties to a deal – even if the commitment is not legally binding – then sign the term sheet.  The reason is not legal, and not to memorialize internal approvals.

The reason is to trigger the psychological drives of commitment and consistency.

In his book, Influence: The Psychology of Persuasion, social psychologist Robert B. Cialdini explains how people can be persuaded to move to higher levels of commitment to an action or issue.  They do this out of a desire to be consistent with what they have already done.  According to Cialdini, the tactic is to start with a small request in order to gain eventual compliance with related larger requests.

One tactic is the foot-in-the-door technique.  Psychologists Jonathan Freedman and Scott Fraser tested and demonstrated its effectiveness.  A researcher went door to door making an outrageous request of homeowners to place a public service billboard on their front lawns.  “They were shown a photograph depicting an attractive house, the view of which was almost completely obscured by a very large, poorly lettered sign reading DRIVE CAREFULLY.”  Understandably, 83% refused the request for the giant sign.

However, 76% of a particular group agreed to the request.  Two weeks before, this group had first agreed to a small request: to display a three-inch-square sign reading BE A SAFE DRIVER.  Cialdini explains that they agreed to the large request to maintain consistency with their prior agreement to the small request.

For another sample group, a researcher asked homeowners merely to sign a petition for “keeping California beautiful.”  Approximately 50% of that group later agreed to display the giant DRIVE CAREFULLY sign.

Cialdini observes that “What [these] findings tell us, then, is to be very careful about agreeing to trivial requests …. I am rarely willing to sign a petition anymore, even for a position I support.” He goes on to discuss the “committing power of written statements,” such as written goals and objectives.  See the book for an explanation of why the drives for commitment and consistency may work, and descriptions of circumstances where they may be particularly strong.

By the thinking of Cialdini, and the research of Freedman, Fraser and others mentioned in the book, the term sheet can become the small commitment that grows into the larger commitment of a definitive contract.  Signing the term sheet helps trigger the drives of commitment and consistency.

That is well and good if you are the person pushing for a definitive deal on your terms.  If you aren’t, how do you defend against this strategy?

First, Cialdini recommends calling out the person who is using the strategy:  “I don’t try to deny the importance of consistency; I just point out the absurdity of foolish consistency.”  I would add that consistency itself can be molded: lawyers can “interpret” or “construe” wording in a term sheet or contract in order to pay lip service to consistency.

Second, obtain a review by persons who do not feel the tug of commitment and consistency.  In large companies, seeking approvals by persons “up the ladder” or by functional groups (such as a finance, legal or procurement department) means that persons who are not psychologically committed will review the deal.  Startups rely on their board members, investors and outside lawyers for this.  (This approach uses the forces of “authority” and “social proof” that Cialdini describes elsewhere in his book.)

Third, if the term sheet is not legally binding, remind yourself as much as needed that it is not a contract. “The deal isn’t done until both parties sign the definitive written agreement.”  This undercuts the force of the original commitment.

Finally, be wary of people – even on your own team – who mischaracterize your deal. Many will call a vague handshake a “done deal” when it has barely begun.  Others do this to ram through internal approvals.  This risks losing flexibility and necessary changes to the deal.  On the other hand, many organizations lack momentum and a drive to close transactions, and too much review can slowly kill a transaction.  Strike a balance.  Smoke out the true blocking issues, resolve them and sign the definitive agreement, or move on.

Term sheets are excellent tools to define your deals.  Keeping in mind the powerful drives for commitment and consistency, sign them with care.

All the best,

-  Harry

Please visit my newsletter archives at www.BoadweeLaw.com/newsletter.html

Harry Boadwee’s Technology Law Letter is published by the Boadwee Law Office, legal advisers to innovative companies in the fields of technology transactions, software and internet law.

I appreciate your referrals.  Please pass along or forward this newsletter (without modification).  For other uses, contact me.

To receive your own subscription to this newsletter, visit www.BoadweeLaw.com/subscribe or send an email to Subscribe@BoadweeLaw.com

Copyright © 2009 Boadwee Law Office.  All rights reserved.  20370 Town Center Lane, Suite 100, Cupertino, CA 95014.  Tel: (408) 253-6100.  Fax: (408) 253-6200.

This Newsletter is for general information purposes only, and is not provided in connection with rendering of legal or other professional advice.  It is subject to the Terms of Use of the Boadwee Law Office (www.BoadweeLaw.com/terms.html) and may be Attorney Advertising in some jurisdictions.

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