Cutting “BIG BOYS” Down to Size The controversial document that can let a seller avoid post-deal litigation for holding back information should be handled only with utmost care.

“Big boy” letters and “big boy” provisions of agreements have come into increasing use in transactions involving sales of publicly traded securities, including mergers, acquisitions, and divestitures. The trend should serve as a warning to all parties in these transactions: Use such letters and provisions with care. In its simplest form, a big boy letter is a document in which one party – for example, the buyer in an m&a deal – agrees not to sue an insider because of information that was not disclosed by the insider – in our example, the seller. Caution is urged not only because the enforceability of these letters and provisions are considered to fall into the gray area of the law, but because a recent decision by the Third Circuit Court of Appeals addressing “big boy” provisions of an acquisition agreement raised questions regarding enforceability provisions by departing from prior judicial rulings. This article reviews the current state of the law with respect to the enforceability of big boy provisions, suggests language to include in big boy letters, and recommends steps companies should consider taking when drafting these documents. What – or Who – is a “Big Boy”? Big boy letters typically are used when one party, such as a seller, has material non-public information that it does not want to disclose and yet wants to preclude any future claims based on the non-disclosure. Presumably, the buyer would agree to waive future claims if it wants to speed up a complex transaction or forgo the time and expense of additional due diligence. Big boy letters of late have been used extensively in sales of distressed debt securities by owners who have accumulated non-public information by serving on creditors committees, and in sales of portfolio companies by private equity firms. Although the exact content of big boy letters varies, most include some or all of the following representations by a buyer that it is: * Financially sophisticated, i.e., it is a “big boy.” * Aware that the insider may have access to material non-public information. * Not relying on any representations not expressly set forth in the big boy letter. * Waiving all claims against the insider arising out of the purchase or sale of the securities. Historically, courts and the SEC have not reached a clear-cut determination as to whether big boy letters are enforceable – in other words, whether the seller can rely on them completely in a transaction and be absolved of future liability on that deal. Certainly, there have been a number of opinions in related areas which, when coupled with inclusion of certain key provisions in a big boy letter, seem to indicate that they can mitigate, although not entirely eliminate, the risk of liability under federal securities laws. However, a decision by the Third Circuit Court of Appeals earlier this year in connection with the acquisition of a utility property by AES Corp. indicated that there might be circumstances in which the insider or seller cannot escape future liability for non-disclosure of material information. Enforceability of Big Boy Letters There are two basic theories supporting the enforceability of big boy letters: * By signing a big boy letter, the non-insider has explicitly waived the right to all claims arising out of the trade. * Even if this waiver is found to be unenforceable, the non-reliance provision makes it impossible for the non-insider to prove that it reasonably relied on the alleged non-disclosure. There is no direct precedent on the enforceability of big boy letters – in particular, the “claim waiver” and non-reliance provisions. However, the Securities Exchange Act of 1934 and related case law provide some guidance as to how a court might rule. Section 29(a) of the Securities Exchange Act Section 29(a) of the Securities Exchange Act provides that “[a]ny condition, stipulation or provision binding any person to waive compliance with any provision of [the Exchange Act] or of any rule or regulation thereunder shall be void.” Accordingly, the plain language of Section 29(a) would appear to invalidate the “claim waiver” provision of a big boy letter. However, waivers and releases of federal securities laws claims have been enforced in a number of cases. Moreover, these cases indicate that even if the “claim waiver” provision of a big boy letter is invalidated, the non-reliance provision can serve as a “backstop” defense to a claim under the SEC’s Rule 10b-5 dealing with fraudulent actions, since a plaintiff must, in most circumstances, prove “reasonable reliance” to prevail. Case Law A number of court decisions suggest that while it is unlikely that an absolute waiver of securities fraud claims will be enforced, big boy provisions can, at a minimum, mitigate the risk of liability for federal securities fraud, depending on the particular facts and circumstances of the case. For example, in Harsco Corp. v. Segui, the plaintiff Harsco Corp., acquired MultiServ. The acquisition agreement contained 14 pages of representations and warranties regarding MultiServ, an express disclaimer by MultiServ that it made no representations and warranties other than those in the agreement, and a “merger clause” that stated the agreement represented the entire agreement between the buyer and seller. After closing, Harsco sued for representations allegedly made outside of the agreement and argued, among other things, that the “no additional representations” and “merger clause” provisions of the acquisition agreement violated Section 29(a). In affirming the district court’s dismissal of Harsco’s claims in a 1996 decision, the Second Circuit Court of Appeals noted that although these provisions may have weakened Harsco’s ability to recover under Rule 10b-5, “in the circumstances of this case such a weakening’ does not constitute a forbidden waiver of compliance [under Section 29(a)] [since there was] a detailed writing developed via negotiations among sophisticated business entities and their advisers [which] we conclude defines the boundaries of the transaction.” However, the appeals court also stated that “[i]n different circumstances (e.g., if there were but one vague seller’s representation) a “no other representations” clause might be toothless and run afoul of Section 29(a).” Thus, in order to maximize the enforceability of a big boy letter, the representations should be made as specific as possible. This may be difficult, however, given the typically abbreviated nature of the representations and warranties in a typical big boy letter. Decisions by the Ninth and Tenth Circuit Courts of Appeals also provide support for the enforceability of “big boy”-type provisions. In Jensen v. Kimble, the Tenth Circuit in 1993 stated that “[w]e agree with the district court’s conclusion that the [defendant’s] omissions were not actionable under Rule 10b-5 because [defendant] specifically advised [plaintiff] of the non-disclosures and therefore [plaintiff] sold [his] stock with full awareness of [the defendant’s] omissions” and finding that defendant’s omissions could not “be fairly viewed as manipulative or deceptive.” Similarly, in McCormick v. Fund American Companies, Inc., the defendant specifically informed the plaintiff, a sophisticated businessman and former officer of the company whose securities were in question, of the nature of certain omissions in connection with the company’s repurchase of stock from the plaintiff. The Ninth Circuit, citing Jensen, concluded in a 1994 ruling that, “particularly in light of [plaintiff’s] sophistication … this quasi-disclosure was sufficient” and that “[plaintiff] knew that he didn’t know [the specific information omitted and, accordingly] while [such] information may have been material, defendant’s failure to disclose it was not misleading and hence not actionable.” The recent decision by the Third Circuit, however, raises questions as to whether the non-reliance provisions of big boy letters are in complete support of “reasonable reliance.” In AES Corp. v. The Dow Chemical Co. and Dynegy Power Corp., which involved the sale of a utility property, the Third Circuit, disagreed with the reasoning in the Harsco decision. It stated that although a typical “non-reliance” clause in a securities purchase contract could serve as evidence of the reasonableness of a plaintiff’s reliance, it was “unwilling to hold that the extraction of a non-reliance clause, even from a sophisticated buyer, will always provide immunity from Rule 10b-5 fraud liability.” The court went on to say that “to hold that a buyer is barred from relief under Rule 10b-5 solely by virtue of his contractual commitment not to rely would be fundamentally inconsistent with Section 29(a).” Given the Third Circuit’s divergence on this issue from case law in other circuits, the AES ruling represents a significant development in “big boy” jurisprudence. The ruling seems to provide a party who believes that it has been misled or that material information has been intentionally withheld with a basis for a cause of action and a defense against a motion to dismiss. It is also important to remain cognizant of the Third Circuit’s position on non-reliance provisions when drafting a big boy letter – in particular, the choice of law provision. The risks of trading in reliance on a big boy letter are significantly increased when the trade is effected indirectly through an intermediary, rather than in a direct transaction between only two parties. This risk is further increased when the identity of the ultimate buyer or seller is not disclosed, which makes it impossible to determine the sophistication level of the buyer and seller – a key consideration in drafting a big boy letter. R2 Investments LDC v. Salomon Smith Barney Inc., et al., a case pending in the U.S. District Court for the Southern District of New York, illustrates some of the potential risks involved when an insider relies on a big boy letter to shield it from liability in these types of transactions. Salomon Smith Barney Inc. sold notes to Jefferies & Co. on the basis of a big boy letter because Salomon, as a member of an informal creditors’ committee, had inside information regarding World Access Inc., which issued the notes. In a series of subsequent deals, Jefferies sold the notes to its agent, which resold the notes to an agent for R2 Investments, an offshore hedge fund, which subsequently sold the notes to R2. A big boy letter was not executed in connection with any of these subsequent sales. In addition, Jefferies did not disclose that it had purchased the notes from Salomon pursuant to a big boy letter or that Salomon may have been in possession of material non-public information on World Access. The notes fell sharply in value after World Access released certain information regarding its condition. R2 Investments then sued both Jefferies and Salomon for securities fraud in 2001 and the district court rejected a motion by Jefferies and Salomon to dismiss the complaint. While this case does not directly address the enforceability of big boy letters because R2 Investments was not a party to the big boy letter, it indicates that big boy letters cannot assure protection from the initiation of lawsuits stemming from trades executed through intermediaries. Effective Use of Big Boy Letters In light of the unsettled state of the law and the lack of any judicial precedent or SEC guidance, it is clear that big boy letters cannot entirely eliminate the risk of trading securities in cases when material non-public information is withheld. Indeed, certain investment banks will no longer trade, as buyer or seller, with a big boy letter. This is likely due in part to the regulatory scrutiny that these banks have faced in unrelated areas over the past several years and their desire to avoid any practice that could result in additional adverse investigations. But it also suggests that others in the industry are aware of the potential shortcomings of big boy letters. However, a properly drafted big boy letter should at least mitigate the risk of liability for a violation of the federal securities laws, particularly if conditions set forth below are satisfied: The parties are “qualified institutional buyers” The likelihood that a court will uphold the enforceability of a big boy letter is increased when the letter contains representations that both sides are “Qualified Institutional Buyers” that are sophisticated and are able to bear the economic risks associated with the trade. Fiduciary responsibilities A big boy letter cannot remedy a breach of a fiduciary duty that the insider may owe to the source of the information. Accordingly, the insider should ensure that it does not owe such a duty before trading, selling or acquiring securities on the basis of a big boy letter. Duty not to disclose The big boy letter should state that the insider may be in possession of material non-public information that it cannot disclose to the non-insider and the non-insider or seller should acknowledge it is not getting everything. It is also helpful if this statement includes specifics as to any relationship between the insider and the issuer of the securities that has given the insider access to this information. There is a risk, however, that this representation can work against an insider. For example, R2 Investments argued that this representation constituted an admission by Salomon that it did, in fact, possess material non-public information at the time of the trade. Thus, it is preferable for the big boy letter to state that the insider “may be” in possession of material non-public information to avoid being deemed that it made such an admission. In light of applicable case law, a big boy letter also should specify the general categories of information that the insider may know about but cannot disclose. For example: “[Insider] may be in possession of material non-public information regarding [Issuer] including, but not limited to, information regarding financial forecasts, future capital expenditures and business strategy, which it cannot disclose to [counterparty], and [counterparty] acknowledges such non-disclosure.” Non-reliance provision and claim waiver The big boy letter should include a non-reliance provision and “claim waiver.” It should state that neither the insider nor any person affiliated with it has made any representations or warranties, express or implied, regarding any aspect of the transaction except as set forth in the big boy letter, and that the non-insider or buyer is not relying on any representation or warranty excluded from the big boy letter. Given the Second Circuit’s opinion in Harsco and subsequent case law in that circuit, it is important to make the “no representations” disclaimer as specific as possible, although this may be difficult given the typically abbreviated nature of representations and warranties in big boy letters. Severability provision The big boy letter should include a “severability” provision. As discussed above, it is questionable whether a “claim waiver” will be enforceable because of the prohibitions in Section 29(a) of the Exchange Act. If a “claim waiver” provision is deemed to be unenforceable, the “severability” provision is important. The insider or seller then can ensure that even if the “claim waiver” provision is unenforceable, the other provisions of the big boy letter will remain in effect. In particular, it is crucial that the non-reliance provision of a big boy letter remain in effect, because it alone may be sufficient to counter a plaintiff’s “reasonable reliance” argument and, in turn, defeat its securities fraud claim. Conducting business directly The enforceability of a big boy letter will be more likely if the transaction is directly between the buyer and seller without the involvement of intermediaries. Salomon’s predicament in R2 Investments demonstrates the risk that the use of one or more intermediaries in a trade will decrease the likelihood that a big boy letter will be enforced. If a buyer or seller is unable to determine whether intermediaries are involved and still wants to do the trade, the big boy letter should state that: * The buyer is not purchasing securities for the specific purpose of reselling them to another party. * “Big boy”-type representations and warranties will be obtained from the “ultimate” counterparty, and that the buyer or seller can rely on them. Favorable governing law A big boy letter should always include governing law and submission to jurisdiction provisions. When choosing the jurisdiction that will hear a dispute and whose law will govern, it is important to keep in mind that certain Federal circuits – the Second, Ninth, and Tenth Circuits, for example – have looked more favorably on “big boy”-type provisions than others, notably the Third Circuit. Conclusion The bulk of current case law, particularly in the Second Circuit, seems to indicate that even if the “claim waiver” provision of a big boy letter is deemed to be void under Section 29(a) of the Securities Exchange Act, an insider still can look to the non-reliance provision of a big boy letter to: * Defeat a 10b-5 claim at the motion to dismiss stage, or * Make it difficult for a plaintiff to prove “reasonable reliance” on a motion for summary judgment or at trial. Accordingly, a carefully drafted big boy letter that incorporates the considerations set forth above can be an effective tool to limit the risk of liability under the federal securities laws. Stephen E. Older is a Partner in the New York office of the law firm of Akin Gump Strauss Hauer & Feld LLP and co-chair of the firm’s Corporate Finance Group. Joshua M. Bloomstein is an Associate in the firm’s New York office. Copyright 2003 Thomson Media Inc. 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