Third party vendors typically provide products and services that enable an investment firm to plot a trading strategy and conduct daily operations. Typical engagements include, but are not limited to subscription agreements, trading and risk management systems, software licenses, and risk management tools. The contracts that govern the terms and conditions of these transactions are not particularly sexy or exciting, but potential land mines within the documents can trap unsuspecting firms by locking them into unfavorable terms.
This article hopes to inform and educate a consumer of vendor services of thirteen common traps that may lock an investment firm into an unfavorable legal position.
- Automatic Renewal – Delete language that obligates a firm to additional annual terms
- Fee Increases – Retain the right to negotiate fees in the future
- Indemnity – Beware patent trolls and control the defense of a third party claim
- Limitation of Liability – Isolate liability to particular portfolios; Increase the cap on direct damages
- Termination – Try to include “termination for convenience” language if possible
- Liquidated Damages – Never agree to damages in advance
- Intellectual Property – Fight for the right to (i) distribute output and (ii) own customized deliverables
- Representations & Warranties – Make the vendor stand behind its products and services
- Confidentiality – Protect sensitive, non public information
- Publicity – No one needs to know which vendors the firm has chosen for services
- Barring a Claim – Don’t accept a private statute of limitation for claims against a vendor
- Governing Law & Venue – Don’t agree to the governing law and venue of a far flung region
- Assignment – Require consent before the vendor can transfer its obligations
Vendors love nothing more than to keep clients on the hook for services or licenses based on an automatic annual renewal, particularly if that client agrees to pay the vendor’s fee in full and in advance. Though vendors do provide clients with an opportunity to cancel the automatic renewal provision, they generally require the client to provide notice of cancellation between 60 and 90 days prior to the commencement of the renewal term (the “Notice Period”). Unfortunately, an operations manager may be so busy as with other issues related to the firm’s growth and management needs that he or she forgets to comply with a Notice Period notification requirement, missing the opportunity to cancel the renewal for services the client no longer intends to use. The failure to give notice results in the client’s obligation to pay the vendor another annual fee. Gotcha! This Firm recommends deletion of any automatic renewal language, preferring that the parties agree to extend the engagement upon their mutual agreement.
Vendors occasionally insert language that imposes automatic fee increases on a firm that may be extraordinary or contrary to the firm’s interests. Specifically, vendors may try to trap managers by; (i) automatically increasing fees pursuant to a specific stated annual increase or a predefined metric such as 5% over the CPI for the most recent twelve months, (ii) retaining the right to increase fees at the vendor’s sole discretion (sometimes citing “in conjunction with increased costs to the vendor”), or (iii) having the right to increase fees more often than once per annum. Gotcha! Though a firm may intend to renegotiate the fee for a renewal term at a later date, a vendor may be disinclined to renegotiate if its customer is locked in to a specific renewal price. This Firm advises its clients to insert language in its vendor agreements that enable a firm to renegotiate the fee in good faith with the vendor prior to the commencement of the renewal term.
The specter of patent trolls remains ever present. Trolls are third parties that obtain the rights to a patent in order to profit through licensing or litigation, rather than through a company that produces its own goods and services. More than threats of actual operating companies that make a claim against a competitor and its clients for infringement, patent trolls are a threat to any investment firm or hedge fund that licenses technology. Because patent trolls view these businesses as cash cows, they will not hesitate to send a firm a demand letter seeking compensation for the alleged use of its technology, which the firm had licensed or purchased from a third party vendor. Firms can protect themselves by demanding that vendors insert comprehensive indemnity provisions in all vendor agreements, requiring the vendor to “indemnify, defend, and hold harmless” the firm from any third party claim alleging infringement of the third party’s intellectual property rights. Without the indemnity clause, investment firms and hedge funds would have no recourse against a third party claim of intellectual property infringement. Gotcha!
Limitation of Liability
Clients should be concerned with two separate issues with respect to limitation of liability; (1) whether liability should be restricted to a specific strategy within an investment firm and (2) how much of a cap should the client accept on a vendor’s limitation of liability, if any. In the first instance, a firm may license an electronic trading system to execute transactions at the investment level, rather than by and among the firm’s different managers and strategies. Although each individual manger must have rights to use the platform, the contract should also specify that liability should be restricted to only the specific strategy responsible for a particular trade, isolating liability from the rest of the firm. Second, vendors generally try to impose a very limited cap on liability for its breach of the vendor agreement. Gotcha! This Firm recommends that vendors remain liable for any and all damages without a cap; however, if the absence of a cap is a deal breaker, the majority of vendors are willing to accept a mutual cap at fees paid by the firm over the twelve months preceding the claim for damages.
Many vendors don’t include a client’s right to terminate for any reason or for no reason, holding the client hostage through the entire term regardless of whether the client is satisfied with the vendor’s service. Gotcha! A firm’s right to terminate an existing contract for convenience is a powerful incentive to get the vendor to perform its duties. Unfortunately, the majority of vendors will not permit a convenience clause to be inserted into its agreements. As a result, managers should focus their attention to clauses that provide the right to terminate for a vendor’s breach of its obligations. Depending on the type of service being provided, a firm should have the right to terminate the agreement for an uncured breach of contract thirty days after notice is given to a vendor, specifying the breach. Upon termination for breach, the vendor should be obligated to provide the firm with a pro rata refund of any prepaid fees from the date of the claim.
Vendors may try to slip a clause into their agreements, obligating a firm to pay a specific fee if the firm terminates the contract for any reason other than for the vendor’s breach. Gotcha! By requiring a firm to pay a negotiated, set amount upon termination, a liquidated damages clause acts as a deterrent to a firm’s termination options. For example, should a firm wind down operations, a vendor should not have the right to profit off the firm’s investors by claiming a right to a portion of the firm’s fees through the end of the term. But if the vendor will not relent, a manager should ensure that the amount being claimed has a legitimate basis with respect to the overall fees being paid to the vendor rather than an amount that is extravagant or unconscionable. This Firm recommends that any liquidated damages language be struck from the contract.
Vendors rightfully claim ownership of the proprietary tools used to create deliverables for their clients. But managers should be wary of the following issues; (1) entering into a license that is overly restrictive; (2) ownership of the firm’s proprietary information used by the vendor to develop its own charts and analytical tools; and (3) rights to customized deliverables created by the vendor. In some cases, vendors overreach on ownership of intellectual property assets. Gotcha! On the first issue, mangers should fight for the right to distribute vendor output internally or in excerpts in reports, presentations and graphs to current and prospective clients. For fund data used in the creation of a new vendor product, managers should specifically retain its rights to the information and state that a license is being granted to the vendor to use the data, even if such usage is to be perpetual and irrevocable. Finally to the extent that a firm hires a vendor to create a specific, customized deliverable, the firm should acquire all right, title and interest in and to such deliverable.
Representations and Warranties
Vendors generally disclaim (or would prefer to disclaim) any and all liability related to all of its products and services, (Gotcha!) and furthermore, they disclaim liability for trading decisions made based on its products and services. This Firm is not opposed to the disclaimer of liability for a fund’s trading decisions based on information from a vendor product, but this Firm recommends that vendors stand behind their products and services, at least for some defined term. In the absence of a tight indemnity provision, a comprehensive representations and warranties clause is the best possible defense to a claim against the originality of a vendor’s products and services.
Proprietary business information containing highly sensitive data is one of the most important assets that a firm owns. As a result, extra attention should be given to confidentiality provisions both within vendor agreements and in stand-alone non-disclosure agreements. Agreements submitted by vendors may omit specific types of business information such as strategies and investor lists that a firm should lock down. Gotcha! In addition a confidentiality provision within a vendor agreement may not cover its clients’ non-public information; therefore, the firm should insert appropriate language if the vendor will have access to investor information. Another Gotcha! Finally (and this recommendation may seem counter intuitive), investment firms should consider inserting an expiration of its confidentiality obligations. Generally, the value of confidential information erodes over time in comparison to the resources that are needed to maintain the confidentiality of that information; therefore, depending on the information being exchanged with a vendor, the firm should consider whether an expiration date for its confidentiality obligations after termination of the vendor engagement is appropriate.
The issue of publicity goes hand in hand with confidentiality, though the issue is tangential in nature. Generally, a firm prefers to conduct its business practices under the radar. In many vendor agreements though, the vendor desires visibility and may insert a provision in its contracts enabling the vendor to publicize the relationship with its client, particularly on the vendor’s website. Gotcha! This Firm cautions its clients to review vendor agreements for clauses or verbiage that would enable a vendor to use a firm’s name or logo to solicit potential clients.
Barring a Claim
In some agreements, vendors impose a time limit on a firm’s ability to prosecute a claim against the vendor. Gotcha! If the firm cannot negotiate a deletion of this private “statute of limitations”, the firm should extend the time period in which it can bring a suit against the vendor for as long as the parties can agree.
Governing Law & Venue
Each vendor agreement should include a clause covering the law and venue governing the resolution of disputes. Firms should review the clause to ensure that the governing law and venue are fair for both parties. For example, a contract for services to be performed in New York should probably use the laws and courts located in New York, rather than the law of some far flung city or country (Gotcha!) that disproportionally favors one party over the other or uses a different legal system entirely.
Vendors can make life difficult for a firm if it retains the right to assign the agreement to third parties without the firm’s consent. Gotcha! Third party assignees may not have the expertise or the financial backing to service the client adequately. This Firm advises its clients to negotiate the assignment provision by including any or all of the following concepts; (1) retain the right to require consent to any assignment of the contract by the vendor, (2) require the vendor to guaranty third party obligations, and/or (3) permit the firm to terminate the agreement immediately.
Paying attention to detail when reviewing a vendor agreement should enable an investment firm or hedge fund to avoid any of the vendor traps presented above. This Firm will make one other general recommendation on how a firm may be able to avoid being tied to unfavorable terms; namely the insertion of a “Most Favored Nations” clause”. A most favored nations clause enables a client to take advantage of the best terms a vendor has to offer to its clients. The insertion of such a clause rarely happens, but when it does, the benefit to the firm is substantial in that many of the Gotcha! issues go away. It has come to the attention of this Firm that some investment firms and hedge funds have the mistaken impression that the large vendors are not willing to budge on terms, citing that they cannot deviate from standard provisions. This Firm has had contrary experiences on this issue, negotiating vendor agreements with Thomson Reuters, Bloomberg, Moody’s, MSCI Barra and many, many others. But it is a truth that if a firm doesn’t request a concession, it will definitely not get one. So negotiate terms in order to avoid Gotcha! situations.