STUCK IN THE MIDDLE WITH YOU: HOW NON-CIRCUMVENT AGREEMENTS FOR INDEPENDENT SPONSORS HELP THEM AVOID BECOMING JUST A MIDDLEMAN

“This case presents yet another example of the dangers of being a middleman. Once a middleman has put together two parties who do not need him to do a deal, he is vulnerable if those two parties choose to deal with each other, without paying compensation to him.” Vice Chancellor Strine in Cura Fin. Services N.V. v. Electronic Payment Exchange, Inc., 2001 WL 1334188, *1 (Del. Ch. 2001).
 
Non-circumvent agreements (“NCAs”) are essential tools for independent sponsors to safeguard their interests in complex commercial transactions. These agreements ensure that the independent sponsor maintains leverage during negotiations and is protected against being unfairly excluded from deals. Without a properly drafted NCA, equity investors may try and bypass the independent sponsor, diminishing their bargaining power or eliminating their role entirely. This article explores the critical aspects of NCAs, emphasizing their enforceability, provisions for damages, attorney fees, and the importance of venue and governing law provisions.
 
The Importance of Non-Circumvent Agreements
 
Independent sponsors play a pivotal role in identifying and structuring investment opportunities. They bridge the gap between equity investors and investment opportunities, contributing significant expertise and effort to deals. However, the absence of an enforceable NCA leaves the independent sponsor vulnerable to circumvention by equity investors who might exploit the independent sponsor’s efforts without fair compensation.
 
To that point, often the act of “circumventing” is not nefarious but more akin to a “pot/poker-bully” in a game of Texas Hold’em.[1]  The investor with a large sum of money may just negate the fact that you’ve spent hundreds of hours cultivating the target, getting it amenable to a sale, and developed a plan and strategy to actually buy, build and exit the business.  In short, you’re more than a middleman or finder but in fact a sponsor. 
 
Accordingly, a well-drafted NCA provides an independent sponsor with:
 

1. Negotiating Leverage: NCAs create a framework that discourages equity investors from bypassing the independent sponsor. With a clear agreement in place, investors are more likely to negotiate fairly, knowing that legal consequences could follow any attempt to circumvent the independent sponsor.
2. Legal Protection: In the event of a breach, an NCA provides an independent sponsor with a basis for legal recourse. Without this, the independent sponsor’s contributions might go uncompensated, leaving them with limited options to recover their share of the deal’s value.

 
Drafting Non-Circumvent Agreements Properly
 
For an NCA to be enforceable, it must be specific and well-defined. Courts often scrutinize these agreements, and poorly drafted clauses can render them unenforceable. One notable case is Glob. Energy Consultants, LLC v. Holtec Int’l, Inc., 479 F. App’x 432, 2012 WL 1528904 (3d Cir. 2012). In this case, the court refused to enforce the NCA due to a lack of definiteness in its terms.
 
To avoid similar outcomes, NCAs should:

1. Clearly Define Prohibited Activities: Specify the actions that constitute circumvention. For instance, prohibit investors from directly approaching or transacting with parties introduced by the independent sponsor without the independent sponsor’s consent.
2. Limit Scope and Duration: Overly broad agreements are more likely to be struck down. Define reasonable geographic, temporal, and activity-specific limitations to ensure enforceability.
3. Include Comprehensive Terms: Cover scenarios such as indirect circumvention, ensuring the agreement accounts for creative methods equity investors might use to bypass the independent sponsor.

The Need for a Liquidated Damages Provision
 
An effective NCA should include a liquidated damages clause to address potential breaches. Liquidated damages provide a pre-determined amount that the breaching party must pay, simplifying the process of seeking compensation. Without this provision, proving damages can be challenging, as courts may deem them speculative.
 
The case of Cura Fin. Services N.V. v. Electronic Payment Exchange, Inc., 2001 WL 1334188 (Del. Ch. 2001), highlights the risks of omitting liquidated damages provisions. In this case, the court rejected the plaintiff’s damages theory and adopted the defendants’ damages theory because of the lack of reliable information to support the plaintiff’s damages theory. By specifying liquidated damages in advance, an independent sponsor can avoid this pitfall and reduce the burden of proving harm.
 
The importance of including a liquidated damages provision is also illustrated by Schwartz v. Sensei, LLC, 2022 WL 576301 (S.D.N.Y. Feb. 25, 2022). In that case, the defendant breached a non-circumvent provision by failing to pay the plaintiff whose introduction resulted in a successful investment in the defendant. Fortunately for the plaintiff, the contract included a liquidated damages clause. That clause entitled the plaintiff to 15% of the total value of the transaction that breached the non-circumvent provision. The court enforced that liquidated damages provision and awarded the plaintiff money damages in that amount.
 
Key considerations for drafting liquidated damages clauses include:
 

1. Reasonableness: The amount must not be punitive but should reasonably estimate the harm caused by a breach. Notably, the court in Schwartz held that the liquidated damages provision was not plainly disproportionate even though it entitled the plaintiff to more than double the fee that the plaintiff would have received had the defendant not breached (i.e., 7% of the amount of any investment).
2. Clarity: The clause should be clear and specific to avoid disputes over interpretation.
3. Alignment with Jurisdictional Standards: Ensure compliance with the legal requirements of the chosen jurisdiction to enhance enforceability.

 
Provisions for Attorney Fees
 
Litigation can be costly, and without a provision for attorney fees, the expense of enforcing an NCA might outweigh the potential recovery. Including a clause that allows the prevailing party to recover reasonable attorney fees ensures that the independent sponsor can pursue legal action without fear of financial ruin.
 
Without such a provision, even a successful lawsuit might become a Pyrrhic victory. The independent sponsor could win the case but lose in economic terms because the attorney fees exceeded the damages award. To mitigate this risk:
 

1. Specify Fee Recovery Terms: Clearly outline the circumstances under which attorney fees are recoverable.
2. Ensure Fairness: Avoid overly one-sided provisions that might discourage a court from enforcing the clause.

 
Venue and Governing Law
 
Selecting the appropriate venue and governing law is another critical aspect of drafting NCAs. Delaware and New York are preferred jurisdictions for many commercial transactions due to their sophisticated court systems and experienced judges. Both states have well-established legal frameworks for handling complex business disputes.
 

1. Delaware: Known for its Court of Chancery, which specializes in corporate and commercial law, Delaware offers predictability and expertise in resolving disputes related to NCAs.
2. New York: As a global financial hub, New York’s Commercial Division courts are adept at addressing intricate commercial agreements. The judges in New York’s Commercial Division have extensive experience in interpreting NCAs, providing additional certainty to parties.

 
When choosing a venue and governing law, consider:
 

1. Jurisdictional Expertise: Opt for jurisdictions with a strong track record in enforcing similar agreements. For example, the court in Schwartz applied well-settled rules of New York law to enforce a liquidated damages provision against a party that breached a non-circumvent provision.
2. Convenience: Ensure the chosen venue is practical for all parties involved.
3. Enforceability: Verify that the jurisdiction’s laws support the specific provisions of the NCA.

 
Conclusion
 
Non-circumvent agreements are indispensable for independent sponsors seeking to protect their interests and contributions in commercial transactions. However, their enforceability and effectiveness hinges on careful drafting and the inclusion of critical provisions that address liquidated damages, attorney fees, venue, and governing law. By addressing these elements, an independent sponsor can create robust agreements that deter circumvention, provide legal recourse in case of breaches, and ensure fair compensation for their efforts.
 
Independent sponsors must collaborate with experienced legal counsel to draft NCAs tailored to their specific needs and circumstances. With a well-crafted agreement, they can navigate the complexities of commercial transactions with confidence, secure in the knowledge that their interests are safeguarded.
 
If you have any questions about this article, please contact Douglas R. Hirsch, co-head of Litigation at Sadis & Goldberg, at (212) 573-6670 or dhirsch@sadis.com, Jim Ancone, partner in Sadis & Goldberg’s Litigation department, at (212) 573-8149 or jancone@sadis.com, or Paul J. Marino, head of Mergers & Acquisitions at Sadis & Goldberg, at (212) 573-8158 or pmarino@sadis.com.