In a vacuum, the mere notion of giving a rival company access to your business’s confidential and proprietary materials would be unthinkable.  After all, this is the “secret sauce” that has helped expand your company, drive market share, and generate immense value.  If a competitor gained access to your trade secrets, the very foundations of your success could be in peril.

This is doubly true when one considers the value of “secrecy” in any trade secret litigation.  Indeed, it is axiomatic that a ‘trade secret’ requires secrecy.[1]  And courts consistently hold that trade-secret protection will not attach to materials that a plaintiff does not take sufficient measures to protect.[2]    Consequently, allowing unfettered access to your business’s proprietary material can be fatal to later attempts to assert that such material was, in fact, proprietary and legally protectable in the first place.

But what about when your business is for sale?  In order to achieve the most value for your company, you must disclose to potential suitors—who may themselves be industry rivals—the very trade secrets that make your business worth the cost of acquisition.  And from the buyer’s perspective, gaining insight into what, exactly, your business is purchasing is critical.  No one will buy what they can’t first see.

The potential pitfalls in this situation are as obvious as they are dangerous.  Consider just one nightmare scenario.  A competitor-to-competitor acquisition falls through at the eleventh hour, after the seller has disclosed its most valuable and proprietary intellectual property to its rival.  After backing out, the potential buyer uses the trade secrets gleaned via the inchoate acquisition process to unfairly compete.

This is not merely the stuff of nightmares.  Less than a year ago, cosmetics giant L’Oreal was stung with a $50m damages award when a federal jury found the company absconded with the trade secrets of Olaplex, LLC; a hair care company that L’Oreal previously sought to acquire.[3] The jury found that L’Oreal created knock-off versions of Olaplex’s products using proprietary information gleaned from the acquisition process, and in violation of an NDA.  Ultimately, the risks created by these scenarios are real, and create perils to parties on both sides of the transaction.

Businesses must therefore understand effective ways to mitigate the existential dangers posed in acquisition situations where trade secrets must be disclosed.  Importantly, these scenarios do not simply create risk for the seller. As the L’Oreal case makes clear, prospective buyers also need protection from back-end litigation based on claims of misappropriation when deals fall through.  To that end, both parties to any sophisticated corporate transaction should implement measures to reduce uncertainty and allow for the secure and monitored disclosure of a company’s proprietary material in the context of a potential acquisition. In any such transaction, the following steps should be mandatory for all sides:

1. Understand the law of what constitutes a trade secret and the protections they are afforded under the relevant statutory scheme. What items comprise your trade secrets? What value do they generate? What are you doing to protect them? Before beginning any acquisition, a business must answer these basic questions.  Simply put, a business cannot protect what it doesn’t identify and understand.  And only by understanding the legal landscape can a business take adequate measures to protect itself.  The buyer should ask similar questions, albeit from a different perspective.  What comprises the seller’s proprietary material?  How is that material being valued in the transaction? What steps is the seller taking to protect the material—and how can you (the buyer) ensure compliance and cooperation with those measures to reduce the risk of future litigation in the even the transaction falls through?
2. Draft appropriately specific and enforceable NDA’s that are tailored for the circumstances, and taking into account the nature of the parties’ business, the proprietary information at issue, and the structure of the transaction. For example, while certain NDA obligations can be limited in time, an effective NDA should bind all recipients of proprietary information in perpetuity with respect to the use or disclosure of trade secrets, until and unless the information becomes public in an independent manner.  Further, any NDA must have a “destruction on demand” clause, requiring the recipients of a business’s trade secrets to confirm the destruction of all such material.
3. Conduct effective diligence on the parties to a transaction (both the buyer and the seller) to mitigate unnecessary risk from the outset of the transaction. This can include structuring pre-acquisition investigations and inquiries to ensure that trade secrets are only delivered in the context of deep negotiations where both parties are deadly serious about closing the deal.
4. Create a leveled transaction and diligence structure, whereby proprietary information is held back until only the most serious bidders remain. Given the amount of risk involved, neither party to a potential transaction should want to disclose or (in the case of the buyer) receive proprietary information until it is absolutely necessary and negotiations cannot proceed further in its absence.
5. Use electronic tools such as data rooms to restrict and monitor a potential buyer’s access to the seller’s trade secrets. Clean rooms must be a standard practice. And well-implemented digital security measures can ensure no copying or downloading occurs. Moreover, clean rooms allow parties to create and preserve activity logs, evidencing when documents were accessed, by whom, and for how long. This ‘digital trail’ is vital in case anything—suspected or actual—goes awry.
6. Agree upon ‘clean teams’ of highly-select individuals from the buyer who are allowed to view the seller’s trade secrets as part of the diligence process. While time-consuming and difficult, best practices include thorough vetting of who is receiving the seller’s information, why those individuals ‘need to know,’ and then insuring each of them are individually bound by the NDA. In short, every party to a transaction should have a clear understanding of who is seeing what and why. In certain instances, parties should consider retaining agreed-upon independent/third-party consultant experts to view the seller’s most proprietary material. By doing this, the seller can prevent disclosure of its trade secrets to in-house personnel of the buyer/competitor. Conversely, the buyer can limit its risk for future liability while still receiving thorough analysis and insight into what is truly on offer.

In the context of a competitor-to-competitor acquisition, risk can never be wholly eliminated.  But by understanding and implementing the above steps, companies will have more effective protections during the acquisition process. Ultimately, these measures may help prevent a simple failed transaction from becoming an existential nightmare.

Finally, and importantly, whether a buyer or a seller, businesses should consult outside counsel before embarking on the acquisition journey.  And having both transaction and litigation attorneys involved in this process can effectively help businesses understand, and minimize, the end-to-end risks presented in these situations.

FOOTNOTES

[1] American Precision Vibrator Co. v. National Air Vibrator Co., 764 S.W.2d 274 (Tex. App.-Houston [1st Dist.] 1988, no writ).

[2] Sands v. Estate of Buys, 160 S.W.3d 684 (Tex. App.–Fort Worth 2005, no pet.) (where it was not shown that client lists were adequately protected, and where the lists were known to employees and others in the business, trade secret protection did not attach);  Rugen v. Interactive Business Systems, 864 S.W.2d 548 (Tex. App.–Dallas 1993, no writ) (before information can be termed a trade secret, there must be a substantial element of secrecy);  Computer Associates Intern. v. Altai, 918 S.W.2d 453 (Tex. 1994) (“the nature of trade secret property rights … requires an owner to vigilantly guard the secret from the world in order to preserve its rights”) (emphasis added).

[3] Liqwd Inc. v. L’Oreal USA Inc. Case No. 1:17-cv-00014 (D. Del. 2019)