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A Litigator’s Perspective on Drafting Operational Documents

A Litigator’s Perspective on Drafting Operational Documents by David Fryman, for Contract NerdsDrafting the operational documents may not seem like the most exciting part of complex commercial transactions, but as a litigator, I’m here to tell you that business disputes are often won or lost in the fine print of your operating, partnership, or shareholder agreement.

Whether it’s a business sale, merger, or venture capital raise, major transactions often involve creating or reorganizing new entities and with that, drafting new operational documents.

The problem is that operational documents are usually drafted from boilerplate forms at the end of the deal, after the lawyers have used most of their available brainpower to properly structure the transaction, spell out the payment terms, research potential tax issues, and ensure compliance with any regulatory requirements, all while dancing around difficult personalities and delicately managing client expectations.

But while the key business terms may be addressed in the main transactional documents, the operational documents typically govern the parties’ conduct during the life of the transaction. And that means, when a dispute arises, the devil is often in the operational documents’ details.

In this article, we’ll discuss some important factors to consider when drafting them for your next deal.

Avoid 50/50 Management Wherever Possible

When there are two parties with about equal contributions to a venture, it’s tempting to give them both equal say in management decisions. What happens when there’s deadlock? You might be thinking both parties would be motivated to negotiate a reasonable solution because the business wouldn’t be able to function otherwise.

But in many cases, the parties aren’t evenly matched. What often happens is one party can afford to hold out for longer and uses that leverage to force the other party to bend to its will. Since most states have some version of the broad business judgment rule, as long as the powerful party has some pretext to rely on, the other party may be left without a remedy.

One solution is to give each of the parties control over different decisions, depending on their relative expertise and their contributions to the venture. Another is to have the parties elect an odd-numbered board of managers at the outset, when everyone is on the same page and still playing together nicely.

Make sure you negotiate management terms in light of your client’s specific needs and circumstances. Talk to your client about how they envision their participation in the venture and try to anticipate how specific management language could help them.

An “Important Decisions” clause may require unanimous or supermajority consent for certain decisions. When drafting these provisions, try to avoid having the Important Decisions include things that the venture would need in the ordinary course of business. That could exacerbate the problem you’re trying to solve by allowing one party to use it as extortion.

Divorce is Part of the Life of a Business

Ask yourself how many marriages you know ended in divorce. And marriages are at least intended to last forever. A business marriage, on the other hand, should be designed to last for exactly as long as it’s in both parties’ best interest, and not a day longer.

Because when a particular business relationship stops being in a party’s best interest, it will start looking for a way out. And if there isn’t a clean, straightforward path to divorce in the operational document, that way out will turn into a dispute.

One solution is to include a buy-sell clause in the operational document that’s customized for the venture’s nuances and unique concerns.

When thinking about business divorce, consider how restrictive covenants can hinder parties’ ability to leave the venture. Various restrictive covenants are essential to protect a venture, especially if it involves valuable intellectual property or an innovative business model.

But there’s a balance. The harder you make it for a party to leave, even when the business is no longer in its best interest, the more likely that party will find a pretext for litigation.

Mandatory Mediation is Surprisingly Helpful

I know many lawyers are skeptical of mandatory mediation. How well can it work if the parties aren’t otherwise inclined to mediate in good faith? And if they are, why require it?

First, the parties may be willing to mediate but won’t admit it because it’s a sign of weakness. But if the operational document requires it, then the mere act of requesting mediation becomes a formality between two feuding parties that doesn’t say anything about their respective positions.

Second, mediation creates an obstacle to litigation. It’s a cardinal rule of human behavior: The harder something is, the fewer people will do it. It’s the reason business owners find bureaucratic red tape so frustrating and why disproportional tax increases drive companies to different jurisdictions. And it’s true of litigation as well. Put another hurdle in front of litigation and the parties will work harder to avoid it.

Customize Your Arbitration Clause

Arbitration isn’t appropriate for every operational document, but it can provide a streamlined dispute resolution process. Although the parties have to pay more upfront for arbitration, it’s cheaper in the end. It’s significantly faster which limits the amount of damage that an ongoing dispute can do to a business. Unlike in litigation, where the parties are entitled to extensive discovery by law, an arbitrator can curtail unnecessary discovery, thereby reducing legal fees.

Since arbitration is a creature of contract, the entire process is customizable. So rather than cut-and-pasting the boilerplate arbitration clause for your next deal, think about ways to mitigate the expense and inefficiency of a potential dispute down the line.

One option is requiring the arbitrator to have specific experience or expertise. When litigating niche-industry contracts, you spend time and resources framing specialized information for a judge with little to no experience with the subject matter. Judges have a limited amount of time and attention to devote to your pleadings and briefs, which means the pages you spend on background are pages not spent on legal analysis and argument. Having a subject-matter expert hear your client’s dispute means you can get straight to the point. You can require, for example, that the arbitrator be a lawyer with at least 10 years of active experience in a specified practice area, such as information technology or commercial construction. When going this route, remember to define your criteria carefully. All this efficiency isn’t worth it if you end up with a dispute over arbitrator eligibility.

You can also include specific expediting procedures. The clause can provide, for instance, that the hearing take place within 90 days of filing and an award rendered within 120 days. This might make sense where the anticipated kinds of disputes are over small dollar amounts. It could also prevent one party from using the threat of a long, drawn-out litigation to strongarm the other side. Be careful here as well. Your client may find itself with a valid claim but one that requires extensive discovery or time to subpoena witnesses.

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When handling your next big deal, remember to save some brainpower for the operational documents. You’ll save your clients from litigation and give them a leg up when you can’t.

David Fryman is a New York-based litigator and founder of Fryman PC, a litigation boutique devoted to representing clients in commercial disputes involving contracts, business dissolution, and intellectual property infringement.

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