November 13, 2018

Residual Clauses in an NDA for M&A Transactions

7 min

Residual clauses in the context of a non-disclosure agreement (NDA) for an M&A transaction are increasingly common and raise important issues for sellers in particular. A typical residual clause insulates a party receiving confidential information from being liable if it uses information retained in the unaided memory of an employee or other representative of the receiving party. Thus, a residual clause is an exception to the basic thrust of the NDA that the receiving party cannot, subject to certain fairly standard exceptions, use any information disclosed by the disclosing party.

Often in a transactional context, enormous pressure will exist to accommodate a potential purchaser's entry into the sale process. Sellers should be extremely cautious – especially with a strategic purchaser – that they do not agree to a residual clause and then disclose sensitive information to the potential purchaser if any of such information could be memorized and used under the terms of the residual clause. Such a result could undermine the value of the disclosing party in the eyes of other potential bidders, who would eventually have access through the due diligence process to the NDA containing the problematic residual clause.

From a seller's perspective, the best approach is to fight against the inclusion of any type of residual clause in a NDA. Nonetheless, this may not be possible in all contexts, and practical considerations often require compromise. This article analyzes two model clauses and attempts to highlight issues that sellers should attempt to address in a residual clause. Two standard residual clauses are set forth below.

Example 1
The Company acknowledges that the Recipient's review of the Evaluation Material will inevitably enhance Recipient's knowledge and understanding of the Company's industries in a way that cannot be separated from Recipient's other knowledge and the Company agrees that, without limiting Recipient's obligations under this agreement, including the obligations of confidentiality and non-use, this agreement shall not restrict Recipient's use of solely such overall knowledge and understanding of such industries for internal purposes, including the purchase, sale, consideration of and decisions related to other investments, so long as such knowledge and understanding was not the result of intentionally memorizing the Evaluation Material and can be recalled without having to refer back to the Evaluation Material.

This first clause is relatively narrowly drafted by allowing the recipient to use the "overall knowledge and understanding of such industries for internal purposes," provided such "knowledge and understanding was not the result of intentionally memorizing." Additional language may be added, making it clear that in no event shall such a clause be viewed as granting a license under any of the disclosing party's patents or other intellectual property, regardless of whether the receiving party engaged in intentional memorization. Another approach is to prohibit the receiving party from using the residual information to develop a competing technology.

These are fairly standard limitations but still pose risks to the disclosing party. The concept of "overall knowledge and understanding" is neither made clear by most NDAs nor well established by case law, and therefore invites disagreement between the disclosing and receiving parties as to its meaning. Additionally, the mere existence of a residual clause muddies the proof issues in any suit arising from an alleged breach of the NDA. In order to succeed on a claim for a violative use by the receiving party, seller must not only prove the use of confidential information, but must also take the next step and prove that such use does not fall within the conduct permitted by the residual clause.1

Furthermore, depending on the sensitivity of the technology and how easily fundamental aspects of it might be memorized, the Example 1 clause might be construed by a court to permit the receiving party to use that confidential information to transform its business or, in the case of a private equity purchaser, the business of a portfolio company into an entity that competes with the disclosing party. As a general matter, any residual clause included in an NDA should dovetail with the provision, required by most private equity purchasers, acknowledging the investment activities of the private equity firm (including in entities that may be competitive with seller) and the exclusion of the private equity firm's portfolio companies from coverage by the NDA. Specifically, the NDA should clarify that anyone at the private equity firm that may end up with residual information should not be a person who is involved in the day-to-day operations of any portfolio company that is not bound by the NDA. Any private equity representative receiving confidential information from a seller should have no greater involvement in the excluded portfolio company than a director seat. This limitation restricts the ability of the receiving party to deploy the information being disclosed – and potentially retained as residual information – for competitive uses.

Example 2
The terms of confidentiality under this Agreement shall not be construed to limit the receiving Party's right to independently develop or acquire competing technologies or products without use of the disclosing Party's Confidential Information. Further, the receiving Party shall be free to use for any purpose the residuals resulting from access to or work with the disclosing Party's Confidential Information, provided that the receiving Party shall not disclose the Confidential Information of the disclosing Party except as expressly permitted pursuant to the terms of this Agreement. The term "residuals" means information which is retained in memory by persons who have had access to Confidential Information, including ideas, concepts, know-how or techniques contained there (if any). The receiving Party shall not have any obligation to limit or restrict the assignment of such persons or to pay royalties for any work resulting from the use of residuals.

This second clause is much more permissive, as it is not limited to overall knowledge and understanding or to internal use, nor does the clause prohibit intentional memorization (and, similar to the Example 1 clause, it lacks language clarifying that the residual information cannot be construed to grant a license in the disclosing party's intellectual property and prohibiting the development of a competing product). It would be difficult to advise a seller to agree to an NDA with such an expansive clause.

In some cases the cost of enticing a prospective purchaser to enter a sales process may be to agree to a residual clause. If so, caution should be exercised, as these clauses can serve as a Trojan horse into an entity's highly sensitive and confidential information and, ultimately, the use of that sensitive information by a third party. One solution may be to make disclosures in tranches, with expansive residual clauses applicable to information that is not sensitive and with no residual clauses applied to more sensitive information. However, creating a tiered disclosure process complicates the overall sales process and may not be worth the additional hassles. Another solution may be to carve out specific categories of information from the residual clause. For example, the NDA may specify that the term "residuals" shall not include any information relating to a particular product, business line, or customer.

In the negotiation of the residual clause, sellers should bear in mind that misappropriation by memory is – and has been for a long time – an actionable offense under the law. Potential purchasers will often posture that a residual clause is indisputably necessary and reasonable, because their agents cannot possibly be expected not to have a memory. However, remembered information can be either appropriately avoided or inappropriately deployed, and both the receiving party and the disclosing party will need to cooperate to ensure reasonable behavior.

[1] The Google-Space Data decision out of the Northern District of California in summer of 2017 highlighted the increased burden of proof resulting from an NDA's residual clause. The court determined that Space Data's second amended complaint did "not sufficiently plead how Google's alleged conduct was not covered by [the residual] provision, or how it went beyond the scope of the NDA." [See Space Data Corp. v. X, et al., [____] Dist. Court, ND California 2017.]