The following scenario is not atypical in the business world. Assume you own a successful business which you decide to expand by seeking to purchase a competitor (which we’ll designate the Target). Initial discussions take place with the principal of the Target and the two of you agree to a non-binding letter of intent that sets out the basic business terms of the proposed transaction. Before calling your lawyer and incurring the cost of preparing a formal contract of purchase and sale, you request that the Target send you its financial statements and customer lists so that you can confirm that the verbal representations regarding the business of the Target are true.

The Target’s principal agrees to supply the confidential information provided you sign a confidentiality agreement. This consists of three or four pages and, since you have no intention of disclosing the confidential information to third parties other than to your advisors and possibly your banker (which is expressly permitted by the terms of the confidentiality agreement), you sign and return it.

The confidential information arrives and it does not take you long to realize that the verbal representations made by the Target’s principal are not reflected in the financial statements and do not support the price that you have agreed to pay for the Target. In addition, you realize that the Target is in financial difficulty and would not be able to compete with you if you decide to expand your business into the territory in which the Target is currently carrying on its business. So you return the confidential information and subsequently take steps to expand your business into the Target’s territory. The Target reacts by serving you with legal process in the form of an injunction to prevent you from undertaking this expansion.

On what basis, you ask yourself, can the Target prevent you from competing with it? The answer is that, in addition to the terms and conditions relating to maintaining the confidentiality of the information given to you relating to the Target, the confidentiality agreement contains this sentence: “The purchaser [you] will not use the confidential information except for the purpose of preparing an offer to purchase the Target’s business.” A condition like this is frequently found in confidentiality agreements of this type.

The Target has a bona fide concern that you maintain the confidentiality of the information it has provided to you. However, your signing of the confidentiality agreement may result in you suffering unintended legal consequences (such as the legal action referred to above) if the negotiations do not result in a contract of purchase and sale. For example, the Target, in an attempt to keep you from competing with it, may take the position that you are in breach of your obligations contained in the confidentiality agreement. It can argue that you used the confidential information to reach a decision to compete with the Target instead of your stated purpose of preparing an offer to purchase its business. As a result, your expansion plans may be put on hold until the dispute is resolved or, worse, your expansion plans are thwarted entirely.

To put this chain of events into a more general context, there have been actual occurrences when this scenario has been reversed. A company in financial difficulty has been aware that one of its competitors wants to expand its business into the troubled company’s territory. Using this knowledge, it has initiated contact with the competitor in order to explore the possibility of selling itself. As part of the negotiations, it has asked the potential buyer to sign a confidentiality agreement containing the language described above. If an agreement is not made to sell the company’s business, the company can then prevent its competitor from engaging in certain direct competitive activities with it.

In most situations, the company wishing to sell its business is acting in good faith and enters into negotiations in the expectation that it will  achieve its goal. To return to our scenario: notwithstanding its good intentions, the terms and conditions contained in the Target’s confidentiality agreement should be examined carefully by both the prospective seller and buyer with the assistance of legal advice. Some considerations include:

If you are already operating in the Target’s territory and wish to expand your business by purchasing the Target, you may refuse to put any limitation on the use of the confidential information, other than to maintain its confidentiality.

If you are planning to expand into a new territory, but only if you can purchase the Target, then you might have to accept the following: if you sign a confidentiality agreement and do not conclude the purchase, you will not be able to expand into the Target’s territory for an agreed period of time. This proviso will significantly dilute the usefulness of the confidential information.

You could agree that the confidential information only contains generic information. For example, the names of customers might be deleted. This middle ground, however, tends not to satisfy the legitimate commercial interests of either the Target or you, the intended purchaser.

If the use of the confidential information is at issue, then you may decide to incur the cost of preparing a formal contract of purchase and sale which may contain representations and warranties as to the Target’s business based on the verbal assurances of its principal. This information can be verified by the delivery of the confidential information after the contract of purchase and sale is signed—but prior to the actual completion of the purchase and sale.

If the confidential information is consistent with the Target’s representations and  warranties, you will have a legal obligation to complete the purchase of the Target’s  business. On the other hand, if they are not true, you have legal remedies available:  among them, and at your option, is a decision not to complete the purchase of the Target  but instead to proceed with an expansion of your business into the Target’s territory.

Whenever confidentiality issues arise as set out in the above scenario, the parties to any proposed transaction should take care that, if a confidentiality agreement is to be entered into, its terms do not contain any unintended legal consequences because they may have unexpected business consequences.