Have any of you actually watched the video of the University of Florida student, Andrew Meyer, who was tasered (shocked with a stun gun that emits a “debilitating electrical charge“) by UF Police at a discussion with Senator John Kerry?  The student was asking a series of questions of Senator Kerry, and apparently the student did not want to give up his line of questioning and sit down when his time was up.  The student appears to be loud and obnoxious, but I cannot hear him saying or doing anything dangerous or threatening.

The UF police drag the student away from the microphone, to the back of the auditorium, and they take the student down to the ground.  It appears from the video that multiple UF police officers are on top of him.  The student is on the ground, begging the police not to taser him, … but they do.  His screaming as he is being tasered and after being tasered is astounding.

The link to the video is half-way down the linked page.Â

Watch the video.  Pay attention to the part at the bitter end, where the student is on the ground, with multiple police officers on top of him.  He is screaming, “don’t taser me,” and it sounds like he is saying “I’ll leave” (as in, “I’ll leave the conference – I’ll leave the room”).  And then the police taser him.

I am without words.

Steven Davidoff responded to my blog here last week regarding Merrill Lynch & Co., Inc. v. Allegheny Energy, Inc. and made the excellent point that just how bad for Merrill the representation I quoted really was depends in part on the limitations on indemnification that were included in the purchase agreement. For example, if the representations survived for only a short period and were subject to a large deductible and low cap, Merrill’s liability under the representation would be sharply limited. Unfortunately, the second circuit opinion says nothing about the indemnification provisions, and so I don’t know how much Merrill’s lawyers were able to take back with the left hand what they had given away with the right.

Steven also mentioned a representation that as counsel on the buy-side he generally tried to get and that is in some ways similar to the one I so criticized Merrill’s lawyers for giving on the sell-side. The representation Steven mentioned provides as follows:Â

There does not now exist any event, condition, or other matter, or any series of events, conditions, or other matters, individually or in the aggregate, adversely affecting Seller’s assets, business, prospects, financial condition, or results of its operations, that has not been specifically disclosed to Buyer in writing by Seller on or prior to the date of this Agreement.Â

As seller’s counsel, I would be willing to give this representation only if a few key changes were made. First and most important, it would have to be qualified by some materiality threshold. Every day any number of things “adversely affect” the company—far too many to be listed on a disclosure schedule—and so this representation would be false when made unless qualified as to materiality. In my view, the correct qualification here would be qualification to a “MAC”—a “material adverse change” on the company (defined with all the usual carve-outs, etc.). If the buyer’s counsel argued for a lower level of materiality—say anything “materially adversely affecting” the company—I would push back very hard. I think the seller ought not be in the position of having to determine for the buyer what is “material” to the value of the business from the buyer’s point of view.

This brings me to the second change I would think necessary: the MAC in the qualification should be a MAC on the company as a whole (including its “business” and “financial condition”), not on the company’s “assets” and certainly not on its “prospects.” “Assets” is wrong because something can adversely affect the company’s assets and not make the company itself worse off (e.g., a fully-insured asset is destroyed in an act of God). “Prospects” is wrong because no rational seller guarantees the future results of the business.Â

Third, the representation should be qualified as to time, meaning that it should pertain only to the period beginning on the date of the most recent audited financial statements of the company. Anything prior to the date should be covered in those financial statements.

With these three changes, the representation would sayÂ

Since the date of the Seller Financial Statements, there has not occurred any Material Adverse Effect on the Seller, its business or financial condition, except as has been specifically disclosed to Buyer in writing.Â

Thus modified, the representation is, I believe, customary. A representation substantially identical to it appears, for example, in the KKR-First Data merger agreement (the merger proxy for the deal, with the agreement appended, is available here):Â

Section 4.7 Absence of Material Adverse Change. Since December 31, 2006, … there has not been any Material Adverse Change or any Effect that would, individually or in the aggregate, reasonably be expected to have a Material Adverse Effect on the Company.

Representations like this, I think, are significantly different from the representation Merrill gave in the Allegheny deal. For one thing, the representation above does not amount to representing that all statements in the diligence materials were true. To prove a breach of the representation above, the buyer would have to show (a) there was a fact that amounts to a MAC on the company, and (b) the seller didn’t disclose that fact in diligence. It would be a question of a MAC-level omission from diligence, not a question of a false statement in the diligence materials. From a litigation point of view, the issue would probably come down to the seller combing the diligence materials and arguing that some obscure statement in the materials really did disclose the fact in question. From an economic point of view, the representation above creates an incentive for the seller to disclose more information rather than less in diligence, and that sounds efficient to me.

Although the representation in Merrill-Allegheny makes Merrill liable for omissions from diligence and so creates a similar incentive, it also creates an exactly opposite incentive as well. For, under the Merrill-Allegheny representation, the buyer can comb the diligence materials for an arguably-false statement and then argue that the falsity of the statement breaches the representation. Hence, the representation creates an incentive for the seller to disclose less information rather than more. To this extent, it’s very likely inefficient.

There’s another difference too. Nothing in the representation above requires the seller to make normative judgments about whether the information delivered is “appropriate” to value the company. The only judgment that the seller has to make is whether a fact amounts to a MAC on the company. It would seem possible that the seller could disclose all negative information about the company while still not disclosing some information needed to “appropriately” value the company. Imagine, for example, that inventory turnover rates are very important in the business being sold, and so valuation methodologies for this kind of business usually make use of such information. Under the Merrill Lynch representation, I think the seller would have to disclose inventory turnover information, even if there was nothing “bad” in the information (e.g., even if the turnover rates were average for the industry) and even if the buyer never asked for it. Under the representation above, as long as the turnover rates were not unusually bad, I don’t think the failure to disclose information about them would amount to a breach.

So although I didn’t want to harsh all over Merrill’s lawyers, I still think they gave a representation that was unreasonably unfavorable for their client. Steven and I both recall seeing counsel, even from elite firms, make serious mistakes similar to this—missing double materiality qualifications and so on. Steven suggested that the explanation may lie in the negotiation process being private (hence most mistakes don’t lead to public embarrassment), in an unthinking adherence to the firm’s form agreements (hence once a mistake is incorporated into the form, it gets repeated), or in over-reliance on network effects (other lawyers know what they are doing and so the associates will learn from them).

I’m inclined to think the problem is simply one of agency costs. Clients don’t read business combination agreements, and they certainly don’t read the representations—much less do they understand what can reasonably be given in representations and what cannot. Hence, when lawyers make a serious mistake, it’s often the lawyers themselves who are advising the client as to how serious the mistake was and how it ought be handled. The clients are ill-equipped to make an independent judgment. The lawyers can thus cover up the mistake at the client’s expense.

Unless, of course, some tiresome law professors want to blog about them.Â

Last week the Second Circuit Court of Appeals decided Merrill Lynch & Co., Inc. v. Allegheny Energy, Inc. (available here), which involved fraudulent inducement and breach of warranty claims in connection with a business combination agreement. The case is a straightforward application of familiar principles of blackletter law. I mention it because of certain highly unusual provisions in the purchase agreement between the parties.

First, some background. Back in 2000, Allegheny was considering purchasing GEM, a subsidiary of Merrill involved in trading energy commodities. In connection with Allegheny’s due diligence review, Merrill provided Allegheny with a great deal of information about GEM. The opinion doesn’t say what happened in this case, but usually such information is delivered under a confidentiality agreement that provides not only that the potential buyer will not disclose the information but also that the potential seller makes no representations or warranties as to the completeness or accuracy of the information provided. Such a disclaimer makes perfect sense. The materials being produced are the business records of the seller, and they were generated in the ordinary course of running the company, not to be relied on by third parties with interests adverse to those of the seller. The efficient error rate for business records is presumably much higher than the efficient error rate for contractual representations, breaches of which will almost inevitably subject the person making them to liability. Hence, if the seller represented that materials produced in due diligence were, say, “true and complete in all material respects,” this representation would very likely be false. The usual thing, therefore, is for the seller to make no representations or warranties on such materials.

Merrill and Allegheny eventually entered into a definitive purchase agreement for the sale of GEM, and this agreement, like virtually all business combination agreements, included elaborate representations and warranties by the seller about the condition of the business. This too makes sense. Limiting representations to ones expressly made in the agreement reduces uncertainty and forces the parties to bargain over exactly which representations will be made.

After the deal closed, Allegheny discovered that some of the key financial information Merrill provided in due diligence was false. The facts get very complicated at this point, in part because the Merrill employee running the GEM business prior to the transaction had embezzled millions of dollars from Merrill (he’s now in jail) and in part because of disputes about accounting methodologies used in preparing the information. The parties disagree about exactly which statements in the information Merrill produced in due diligence were false, why they were false, and what various of Merrill employees knew or should have known about their falsity at the time the agreement was signed.

A disappointed buyer like Allegheny can make either or both of two claims. It can argue fraudulent inducement, and so have to prove that the seller knowingly (or recklessly) included false information in the due diligence materials and that the buyer justifiably relied on such information to its detriment. Or, the buyer can argue breach of warranty, and so have to prove that the seller made a false statement in the representations in the agreement and the buyer was harmed thereby. In the first case, the universe of relevant statements is much wider, but the buyer has to prove not only that one such statement was false but also that the seller made the false statement knowing it was false (or in reckless disregard of its truth). In the second, the universe of relevant statements is confined to those made in the agreement, but all the buyer has to prove is that one such statement was false; the seller’s knowledge of its falsity is irrelevant.

The agreement between Merrill and Allegheny, however, contained some highly unusual provisions. In particular, Merrill warranted that the information provided to Allegheny “in the aggregate, in [Merrill’s] reasonable judgment exercised in good faith, is appropriate for [Allegheny] to evaluate [GEM’s] trading positions and trading operations.” This should take the breadth away from any practicing M&A lawyer. In effect, Merrill is representing not only that it believed the information provided in due diligence was true but also that it reasonably believed such information was true. Hence, any false statement in the diligence materials becomes potentially actionable: the seller will argue that Merrill should reasonably have known such statement was false.

Even worse, Merrill is representing that the information it provided was “appropriate” for Allegheny’s evaluating the business. At the very least, this means that Merrill is warranting that it reasonably believed that it delivered all the information that Allegheny needed to value the business. Hence, omissions from due diligence will become actionable. If Merrill had any information it did not produce to Allegheny in due diligence, Allegheny will now argue that such information was reasonably necessary for it to value the business and so its non-delivery to Allegheny was a breach.

Moreover, representing about whether the materials produced were “appropriate” for valuing the business also requires Merrill to make judgments about what information a buyer reasonably needs in a valuation study and so involve making judgments about what were appropriate valuation methodologies for the business in question. That, quite simply, is not the seller’s job. How the buyer values the business is something only the buyer can really know. After deciding how to value the business, the buyer should ask for what information it needs, and, even better, bargain for representations in the agreement concerning that information.

Not surprisingly, the Second Circuit reversed the district court’s summary judgment in favor of Merrill and remanded for further proceedings. The lesson here—besides the obvious one that Merrill cut a very bad deal and should hire better lawyers—is that representations should be about matters of fact the seller can be fairly certain it knows to be true, not normative judgments about what’s “appropriate,” especially from the point of view of an adverse party. Voluntary exchanges are efficient because each of the parties prefers the result of the exchange to the status quo ante. A representation by one party that the other party has evaluated the change correctly—i.e., “really” prefers it—is beyond what that party could know. Giving such a representation almost amounts to insuring the transaction for the other party. Merrill, I suspect, did not realize that it was doing that, but the result follows from the contract language, and the Second Circuit quite properly is holding Merrill to the bargain it struck.