Protecting the Underdog: Why You Need "Candor" and "Bad Actor" Clauses in Your Business Contracts

Women entrepreneurs have recently been talking about the concept of a "candor clause" in their contracts with investors.  In order to combat the history of harassment and discrimination from angel and VC investors, a candor clause requires investors to disclose prior allegations of discrimination or sexual harassment upfront. The idea is to expose and evoke discussion around an investor's involvement with discrimination claims as part of the long-term business relationship. The concept need not be limited to women entrepreneurs.  Everyone in a business relationship, particularly where there is an imbalance of power (usually economic), could benefit from including a "candor clause" in their contracts.

Almost all commercial contracts contain a section called "Representations and Warranties."  In this section of a contract, the parties disclose and confirm important information about themselves and the premise of the deal.

Specifically, a "representation" is an assertion of fact, true on the date the representation is made, that is given to induce another party to enter into a contract or take some other action. A "warranty" is a promise of indemnity if the assertion is false.  Representations may be qualified by disclosure of specific information.  For example, a representation may state, "The company is not currently a party to any pending or impending lawsuits."  Or it may state, "The company is not currently a party to any pending or impending lawsuits except as set forth in Schedule E."

In financing documents (such as loan agreements) representations and warranties are given by the borrower to induce the lender to make loans. Once the loans are made, if a representation is no longer true, the lender has the right to enforce certain remedies against the borrower, such as accelerating the debt.

In other business transactions, such as a business acquisition, the representations and warranties allocate risk between the parties and serve as the foundation for an indemnification claim in case of a breach or inaccuracy. A breach or inaccuracy of a representation or warranty can also provide the other party with a right to terminate or refuse to close the transaction.

A candor clause is a representation that the company has not been subject to any claims of discrimination or sexual harassment or that the company has not been subject to any claims of discrimination or sexual harassment except as specifically set forth in the agreement.

This requirement of disclosure can be helpful, particularly to women entrepreneurs, in two ways.  First, any business partner unwilling to engage in discussions due to the requirement of having to make the candor clause representation is eliminated from consideration.  This could considerably narrow the field of prospective partners but also ensures that the parties still in contention are not dogged by claims of harassment or discrimination.  Second, potential partners who make the representation, even with specified exceptions, are known entities.

This is particularly important for women-owned businesses since, according to All Raise, a group advocating for women in business, 85% of partners at venture capital firms are men, and a large majority €” 71% €” have no female partner at all.  The disparity in power between the largely male venture capital firms and the nascent women-owned businesses forms the historical paradigm for harassment and/or discrimination.  The candor clause can close that power-gap and generate healthy discussion between like-minded partners from the onset.

Further, such contractual provisions are likely to be legally enforceable by courts.  As an analogy, the high-stakes lending community has long used "bad actor" clauses, also known as "bad boy" clauses or "recourse carve-out" guaranties, to invoke personal liability against guarantors for improper acts of the company.  For example, in the case of - CSFB 2001-CP-4 Princeton Park Corporate Center, LLC v. SB Rental I, LLC, 980 A.2d 1 (N.J. App.Div. 2009) - the New Jersey appellate court held that a such a provision was enforceable.

That case involved a $13 million business loan where the business was the only responsible debtor (a non-recourse loan).  The principals of the business signed a guaranty promising to pay the loan only where certain circumstances had occurred (a "bad actor" clause).  During the term of the loan, the business took out a second lien without the first mortgage holder's consent in violation of one of the provisions of the bad actor clause. In less than a year, the borrower paid off this second loan but ultimately defaulted on the first loan. The lender invoked the bad actor clause to obtain a judgment against the principals of the business personally. The appellate court found the provisions were enforceable as part of a commercial transaction negotiated by sophisticated parties. Furthermore, the fact that the default was later cured did not alter the fact that the bad actor provisions had already been triggered, potentially affecting the property and adversely affecting the lender's security in the collateral.

Similarly, any breach of a candor clause representation (i.e., any harassment claim that is not disclosed) potentially affects the parties' business relationship and adversely affects the women-owned business and its association with the investor.  Thus, the candor clause should have some teeth to it, and not just be a way for investors to pacify their women-owned partners.

Use of candor and bad actor clauses in your business contracts provide both information and protection and hopefully, will become more widely used in both the investing and lending sectors.