When a 'standard' is raided, ask why

"That's just the way it's done." "It's always that way." "That's market." Simple refrains like those — authoritative, direct, unwavering — capture the response to many a legal situation or interaction. Whether it's an indemnification question in an M&A transaction, the typical "credits" to a dividend basket in a set of financial covenants, the "materiality" of a matter under Securities and Exchange Commission regulations, or the parameters for an executive compensation program, many discussions, negotiations or client advice conclude with some form of canned, assertive comment intended to cut off further dialog. In what situations and under what circumstances should the "market standard" suffice? And how does one, whether lawyer or client, discern that so-called standard? When can one willingly rely on the assertion that something is standard?

Comments from a recent article detailing the experience of Snap Inc.'s founders offer a constructive context. "When we were first getting started and took financing, our lawyers would take us through the documents and they'd say: 'Oh, don't worry about it. It's all standard.' I've since learned that standardmeans either the person who's walking you through documents doesn't understand them or you could be getting taken advantage of(emphasis added)," Evan Spiegel, founder of Snap, is quoted as saying. Spiegel goes on to state that "[w]hen someone says something is standard, just ask why, and why and why and why, until you really understand intricately, I think, how the deal is structured." See "Snapchat Founders' Grip Tightened After a Spat With an Early Investor," New York Times (Feb. 23, 2017).

That admonition — "just ask why, and why and why and why" — applies both to lawyer-to-lawyer negotiations and lawyer-to-client advice. It applies especially when so-called "standards" are introduced, the use of which should immediately raise questions regarding the source and genesis of those standards. What underpins the purported standard? How has the standard evolved to reflect changing economic conditions or a changing legal landscape? How many "standards" exist? Are there other standards? Those are the questions that any young lawyer should understand as a predicate to negotiating with opposing counsel. They are the questions that should be understood before offering advice to any client. And they are the questions that should animate any engaged client when interacting with counsel.

In the case of Snap, the New York Times reported that an early venture investor obtained "the right of first refusal to invest in a future round of funding and the ability to increase its share of the company in that round. Such terms effectively let [the investor] have veto power over investment at Snap. It also made Snap an unattractive investment for other investors — who would not be able to take as large a stake as they would like in the company." It was those "standard terms" to which Spiegel referred when noting that his counsel advised him "not to worry" about them.

Understanding why standard terms are purportedly "market standard," how they may have evolved, and how they would likely affect the company's future financial flexibility should have formed the foundation for a substantive client discussion with Snap. Spiegel should have been advised on those matters in the ordinary course. Spiegel should himself, as an informed client, have asked those, or similarly penetrating, questions and demanded answers. In today's world, discovering the market standard and evaluating its applicability requires diligence and legwork. It is not impractical, however, to ascertain for either lawyer or client, if it's important.

Why does a standard develop? Presumably to make transactions more efficient. To eliminate incessant discussion about issues that have been previously considered, addressed and resolved across multiple transactions over multiple years. It offers an accepted framework for decision making. So, it would follow, that if terms are asserted as "standard," they should be readily reflected in precedent documents and discernible from a review of those precedent documents. How the standard is "discerned" may differ for lawyer and client.

For counsel, law firm databases, document repositories and related resources provide appropriate building blocks for this exercise, if properly and effectively used. Review of one precedential document, however, is not adequate. Nor should review of two suffice. A review of "precedent" requires a thorough reading, analysis and understanding of more than one, more than two, and more than three precedents. It requires a "substantial" review of precedential documents, and tangentially related documents, to enable counsel to advise in an informed manner. Junior lawyers need to understand that essential approach. Beyond that, counsel must understand how precedents evolved through negotiation. She must understand how they changed from the first, untouched draft to the final negotiated version. Reviewing the final work product, without understanding the embedded history and appreciating the hidden back-and-forth, does not allow for sage advice.

For the client, while perhaps a bit more difficult, self-education can be easily pursued. A none too taxing Google search may offer relevant information. A broad based review of the SEC's website, which offers extensive access to many different types of exhibits (and, therefore, precedents) filed by companies already public and those going public, will likely offer interesting background. A simple, direct request to external counsel for sample precedents will also provide a good starting point for a client self-assessment of purported standards. There should be no hesitance by any client to make that request of outside counsel.

Discussions of standard terms infuse diverse subjects. In the venture capital sector, it is not acceptable for the young venture capital lawyer simply to incorporate "standard" weighted average anti-dilution protections in start-up documentation without fully understanding the mathematical consequences that flow from its selection. Can counsel effectively explain the mathematical differences that would have resulted by selecting a full ratchet anti-dilution standard? It is not acceptable simply to say that "average weighted anti-dilution protection" is market. Was that the market standard several years prior? Did it change to reflect new risks in the economy? In this context, it is imperative that counsel understand the underlying mathematics of the anti-dilution protections, be able to communicate alternative anti-dilution formulations, and be familiar with how market standards may have changed.

In a merger transaction, it is not acceptable for counsel simply to deliver to the client a form acquisition document that includes materiality qualifications in every other sentence. It is not acceptable to push extensive limitations and qualifications in an agreement without a full appreciation of the effects that those limitations and qualifications may have on risk allocation. Can counsel effectively explain how the "standard" materiality qualifications in the representations and warranties affect the form indemnification provisions or the "standard" closing conditions? Why does a 10 percent cap on potential indemnification from the sell-side matter, and why isn't it 15, 25 or 50 percent? Counsel's statement that "10 percent" is just standard is not adequate. Counsel must be able to discuss these issues with the client and not default to a mere assertion of "practice" or "it's the standard." Why are the limitations and qualifications as proposed? And why in this transaction?

Standards, customs and conventions permeate legal practice. They are critical to efficient transactions. But their assertion should not obviate counsel's obligation to understand the reason they are being used or how they have developed. "How standard is the standard"? Any informed client seeking an effective partnership with counsel should be prepared to undertake their own evaluation. Any client should challenge the rote use of standards and seek a full, informed understanding of their use. Standards can, and should, be helpful so long as lawyer and client know the "whys" underlying their application.

Scott M. Wornowis the former chief legal officer of Atmel Corporation.