What is a Principal Agreement?
A principal agreement is a written document that outlines the foundational terms and conditions between parties that have not yet entered into a final agreement, such as an asset purchase agreement, shareholder agreement, operating entity agreement, inter-company agreement, stockholders agreement, shareholder agreement and corporate bylaw agreement. Principal agreements are typically referenced in business transactions, including stock purchases, asset purchases and security agreements. Depending on the jurisdiction, they are sometimes referred to as heads of agreement, letters of intent, letters of interest, memoranda of understanding, memoranda of agreement or terms sheets.
Typically, a principal agreement is the first step taken by parties to further a potential business transaction. Whether or not the parties are commencing due diligence, they will often wish to enter into a principal agreement, whether or not it is a binding agreement. Drafting parties often secure non-binding principal agreements to demonstrate to shareholders or to other third parties the parties’ intent to proceed with a transaction.
Common elements of a principal agreement include:
Whether or not it is binding, a principal agreement is a document that gives a sense of security to parties that an additional investment of time and money into a transaction is worthwhile. Further , once executed, the principal agreement can serve to block competing parties from a specific transaction.
However, safeguards should be built into principal agreements to ensure they do not inadvertently bind the parties to a specific transaction prior to extensive due diligence, particularly when it comes to contingent closing conditions and preconditions. In some states, including Delaware, courts routinely impose contractual obligations on a principal agreement even though it is labeled a "letter of intent" or "memorandum of understanding." A principal agreement should therefore include carefully drafted, well-thought-out provisions establishing which of its terms are binding and which are not. For instance, a principal agreement may be exclusively non-binding except for certain indemnification, governing law, exclusivity and termination provisions.
There are two types of principal agreements: (1) those that are completely non-binding (meaning they do not bind the parties at all) and (2) those that include both binding and non-binding provisions. Because principal agreements are often drawn with either of these options, it is important that the author drafts the principal agreement with this enforcement mechanism in mind.
Essential Terms of a Principal Agreement
The principal parties, who are defined in the schedule of the principal agreement, are the contracting clients and end supplier. The agreement binds not only the parties but also their successors in title.
The rights and obligations of the parties in a principal agreement are usually fairly comprehensive. In addition to obligations and conditions relating to the supply of goods, the parties are often bound by confidentiality, confidentiality, payment, dispute resolution and other customary contract clauses.
There are also provisions dealing with the risks and benefits flowing from the agreement. These clauses usually entitle the client to cancel the agreement when its business is impacted by an event beyond its control that was not within the reasonable control of the end supplier (such as a natural disaster) or when the business of the client or end supplier is undergoing a major change.
Such events may include:
Clients and suppliers participating in a principal agreement should be aware that the supplier is usually required to hold and maintain certain compulsory and/or recommended insurance policies (which are summarised in the schedule). Suitable insurance coverage can mitigate the impact of risks and should be arranged by the supplier.
Typical Uses of a Principal Agreement
Principal agreements find common application across a wide range of organizations, from start-up companies to large corporations with multiple shareholders. Regardless of a company’s size, industry or location, principal agreements, also known as buy-sell agreements, play an important role in resolving issues that may arise between owners. One common use for these agreements is in the event that an owner passes away. If a company is a closely-held corporation, meaning that it has few shareholders, the remaining shareholders may be forced to buy the deceased owner’s shares from his or her heirs in order to continue to run the business. A principal agreement can make this process easier by establishing the company’s right to purchase the shares, which can help avoid conflict. In addition, the agreement can be funded via life insurance, so that the corporation has the funds necessary to buy the shares from the deceased owner’s estate or heirs.
A principal agreement can also come in handy if an owner wishes to withdraw from the business. For example, one owner may want to retire while the business continues to operate. In this situation, the other owners may want to purchase the withdrawing owner’s shares, and a principal agreement can establish the process to do so. Similarly, shareholders may want to buy out an owner who wishes to sell his or her shares to a non-family member. In this scenario, the non-buying owners would be able to avoid being forced to work with the new buyer by using the principal agreement to secure the selling owner’s commitment to sell their shares to the remaining owners.
In addition, a principal agreement can be beneficial when a business is bought out by a third party. For example, a father who owns a share of a family business may decide to sell his interest to a third party after his son takes over the company. However, if the agreement does not include restrictions on the transfer of ownership, the son may have to work with the third-party buyer, resulting in significant conflict.
Principal agreements give the owners of a business a measure of control over the ownership and management of the company. A shared vision of what will happen to the company can help foster teamwork and the production of better financial results.
Crafting a Principal Agreement
Drafting any agreement involves laying out all of the details of the deal clearly and effectively. This is especially true when it comes to a principal agreement, as all parties will have obligations and expectations moving forward that should be clearly spelled out. As such, a principal agreement should cover all vital information such as:
• Name and contact information of the principal
• Name and contact information of the insurance agency
• Total commissions that will be paid to the agency
• Frequency of payments (i.e., monthly, quarterly, annually)
• Number of agents to be managed by the principal
• Unbundled fees, if any
• Total fees the principal can control
• Rate of fees for individual agents under the principal’s management
• Commissions to be paid on fee contracts
• Residual commissions with respect to certain policies
• Expenses that will be covered by the agency
• Amount of funds that the agency must hold in reserve
• Insamounts of coverage provided by the agency’s Professional Liability policy
• Procedures for handling claims against the agency
• Terms of the principal agreement
From an insurance and investor standpoint, it is often very difficult to strike a balance between maintaining appropriate profit margins and letting the agent build his or her own client base, as these two goals can easily be at odds with each other. As such, it is very important that a principal agreement is drafted clearly and concisely to ensure that both parties are on the same page regarding the relationship and its terms. If this agreement is unclear, it could lead to confusion and disputes further down the line.
The most prudent way for either an insurance agency or a principal to ensure that a principal agreement is drafted correctly is to have it reviewed by a legal professional. Legal professionals can provide consultation based on the circumstances of the principal agreement. They can guide the agreement drafting process based on experience so that all pertinent information is conveyed and all important details are accounted for before execution. Having the counsel of a professional with experience drafting principal agreements can be incredibly valuable in preventing future conflicts and problems associated with your agreement from arising.
Potential Issues and Considerations
Any contract that a school may entertain for the purchase of services or property could contain pitfalls and end up being declared a nullity, particularly if not carefully drafted. For example, in any commercial operation, including a charter school, the school should be mindful of the fact that it does not possess authority to enter into contracts without prior approval of the State or local Board of Education. Thus, if such has not been obtained, the contract may well be void. In addition, a charter school not-for-profit corporation must comply with the not-for-profit corporation law, as well as all applicable statutes or regulations that govern the conduct of charter schools, in entering into an agreement or contract. Those governing statutes or regulations may pertain to the charter itself, the organization of the school, its fiduciary duties (e.g., conflict of interest, procurement policies, etc.), or otherwise. Any director of the not-for-profit corporation which operates the charter school must comply specifically with corporation law in regard to his or her fiduciary duty to the corporation, including acting in good faith and in the best interests thereof, in order to avoid personal liability.
Additional issues to consider are whether a principal agreement will obligate the school to begin construction (if so, what kind of contingencies would permit the school to abandon such plans?), how long the property will be under lease, what happens at the end of that period, and what conditions may permit the school to terminate the agreement. Is the failure to develop the property (on time and in compliance with the principal agreement) a breach that would give the owner the right to accelerate payments (and make them due to the owner in a lump sum)?
Clearly , the negotiation of the transaction and its documentation are paramount in every way, but particularly in regard to the potential for future litigation. The more vague or general the language in the documents, the more focus will be placed upon the surrounding circumstances by a court of law or a jury in their determination of the rights of the parties. Accordingly, it is important to have counsel draft and scrutinize all documents, and enter into only those agreements which have been prepared in a manner that is clear and unambiguous.
The law in this area continues to evolve, and differing interpretations of governing law may exist, or emerge, depending upon the jurisdiction or court. While most courts will defer to the provisions of a validly-executed agreement, the standard of review employed may well impact the outcome. If a dispute arises under the principal agreement, including if any litigation is contemplated, the intention and requirements of the agreement will be enforced, and the standard of proof and evidence required to support a claim or defense will closely depend on the jurisdiction in which the case is being decided. For example, while some courts require clear and convincing evidence to demonstrate that the party seeking the enforcement of a contract is the proper party to receive that benefit, others have held that the doctrine of substantial performance is not available for a party to recover damages by the value of the intended benefit of the bargain. A school Board in one jurisdiction may reach an agreement that grants absolute discretion for the length of a principal agreement, while in another, a Board of Education may not have such authority. Some jurisdictions may, for example, refuse to review whether an equitable distribution of proceeds was fair to the school Board and is enforceable against the Bond Trustee.
Dispute Resolution in Principal Agreements
Disputes may arise during the supply process. For example, the supplier owed an obligation and did not fulfil it. The question is, how do you resolve the dispute? A good supply agreement will decide that question. A badly worded supply agreement may not address that question at all.
Often, the parties will go to mediation. So that everyone has legal protection, each party can spend some time with their lawyer before the mediation and the lawyer can then attend the mediation with their client. If mediation fails, usually parties will be required to use an arbitral system, probably the UNICITRAL Arbitrational System, before they end up in court.
Recent Developments in Principal Agreements
There have been a number of recent developments in the use and structure of principal agreements. One notable trend is the increased willingness of parties to include representations and warranties relating to the representation and warranty insurance policy, or R&W Policy, in their principal agreements. Recent years have seen a number of investments experiencing claims under the R&W Policy. In perhaps the most noteworthy of these claims, the underwriter, AIG, has very publicly sued to enforce an indemnification provision contained in the agreement. The agreement states that the seller shall indemnify the buyer against all losses it suffers as a result of the inaccuracy of the representations and warranties. After submitting the claim under the policy, the buyer refused to advance the retentions required under the policy. AIG sued to enforce this indemnification provision and received a final judgment in its favor. Given this precedent, we would not be surprised to see the inclusion of the R&W Policy in future principal agreements.
Another trend has been the increasing preference for "market-out" termination clauses, whereby a principal may terminate a contract if a contractual partner’s rating falls below a certain threshold . Some contracts have even included provisions where the contractual partner is required to notify the principal if it receives notice of falling below a threshold rating. This trend can also be seen in the world of green terms with the reliance on ratings classifications to trigger compliance.
The material adverse change clause, or MAC clause, continues to see increased usage in principal agreements and has generated some discussion. Similar to the "floodgate" concern affecting the use of the MAC clause in the insurance context, the concern among principals is whether such a clause will be interpreted broadly by the courts in determining if a contract should be terminated. Courts have developed a number of tests to determine materiality, and principles such as those set forth in the Re-Accord case – that a principal has discretion in deciding if there is a material change – are not always applied. The general concern is that, should the MAC clause be invoked, it may prove difficult to show that there has been a "material" change. If this occurs, a principal may be forced to grant a contractual partner a waiver to continue as a partner. Given this, one potential trend we might expect to see is more principal agreements become bilateral. This would increase the risk of litigation among the contractual partners, and thus may provide parties with more settlement opportunities.