What is a Residuals Clause?
A residuals clause is a legal exception to confidentiality under non-disclosure agreements or other agreements containing confidentiality provisions. For instance, let’s assume you (the “discloser”) disclose highly sensitive information to a receiving party (the “recipient”) under a non-disclosure agreement (“NDA”) and the NDA states the recipient can solely use the information for a narrowly defined purpose (for example, evaluating whether to license your company’s technology). Now, if the recipient were to use the confidential information outside such permitted scope (and did not have any other legal right to do so), you would expect a court to deem such use as a breach of contract, correct? Well, this may not be the case if there is a residuals clause in the NDA protecting the recipient from liability if the recipient used the information from memory. I can guess what you are thinking. How can one prove whether or not the recipient used the information merely from memory? Welcome to the slippery slope of residuals clauses. Let’s dig a bit deeper into the issue.
A Sample Residuals Clause Follows:
It is not uncommon for language such as the following to be included in agreements from, for example, large U.S. tech companies.
“Recipient shall be unrestricted in its use of Residuals for any purpose, including, without limitation, use in the development, manufacture, promotion, sale, and maintenance of its products and services. The term “Residuals” means information of a general nature, such as general knowledge, ideas, concepts, know-how, professional skills, work experience or techniques that is retained in the unaided memories of recipient’s employees who have had access to discloser’s information pursuant to the terms of this Agreement. An employee’s memory is unaided if the employee has not intentionally memorized the information for the purpose of retaining and subsequently using or disclosing the information.
Can You Spot the Issues?
- How should one go about differentiating between information of a general or specific nature?
- How can one reasonably prove whether recipient intentionally memorized information for the purpose of retaining and using or disclosing the information?
In essence, the discloser’s ability to ever prove misuse of confidential information becomes extremely unlikely. This is why companies perceiving themselves as having a superior bargaining position may aim to have residuals clauses included. Residuals clauses are clearly for the benefit of recipients. If sensitive information is primarily flowing from your company to a counterparty, such a residuals clause will substantially operate against your company’s interests.
So, How Can Disclosers Mitigate Risks?
A discloser’s starting point should always be to delete the proposed clause altogether without providing any explanation as to why. In our experience, this is often sufficient (even with counterparties of scale).
If this approach does not work, cite the virtual impossibility of ever proving a recipient employee’s memory was “aided” in any way and that accepting a residuals clause is nearly tantamount to giving away your sensitive information.
Further, it may also prove helpful to place the burden of explanation onto the counterparty. Essentially asking “what specific situations are you attempting to protect yourself against?” Moreover, if valid concerns are raised (a big “if” here) you can then question whether there are other more reasonable mechanisms to safeguard such interests.
If the counterparty still stubbornly refuses to withdraw the clause (and you need to close the deal), it is now time to incorporate as many of the following limiting terms as possible into the clause:
(a) rights under any patent(s) and/or copyright(s) are excluded from the residuals clause. You should also try to exclude trade secrets from the clause but this can prove difficult. Finally, you can exclude specifically defined items of information to be absolutely sure the items will not slip into the black hole of residuals;
(b) no recipient employee having access to the confidential information shall be permitted to work on any competitive projects during the term of the agreement in question (you can also try to prohibit the entire recipient company from engaging in any competitive development but such broad language is rarely accepted, especially with large counterparties);
(c) names of each recipient employee that will have access, his/her position, and his/her purpose for access. It is also wise to limit the number of persons who will be permitted access. We have succeeded in obtaining this level of detail from major multinational companies when highly sensitive information (e.g. source code) is disclosed to the recipient. We have also experienced counterparties withdrawing the demand for a residuals clause when this employee reporting is required; and
(d) require all information be destroyed or returned to your firm immediately upon termination of the agreement (and this is a rather standard requirement).
Finally, if reasonable limitations on the residuals clause cannot be achieved and there is a foreseeable risk of the recipient engaging in competitive activity (directly or indirectly), you may have to decline to collaborate with the recipient company in question and find an alternative partner. Always bear in mind that potential acquirers of your company review key agreements during the due diligence phase, and your company’s exposure to residuals clauses may be a basis for the acquirer to attempt to drive down the acquisition price (i.e. claiming that your company’s intellectual property is not as pristine as it would otherwise be if free from such residuals clause exposures).
If you do elect to move forward with the recipient company and the residuals clause is fully in place, consider limiting the information you disclose and keep the time period for recipient’s access as short as possible.
In closing, it is always best to either exclude residuals clauses or have legal counsel carefully craft exceptions thereto. We hope this article has provided you with a better understanding of the risks and possible workarounds in relation to residuals clauses.
At Synch, our mission is to simplify clients’ business / legal needs whether domestic or international.
Gary Guttenberg (California Lawyer in Synch Stockholm Office)
David Leffler (Swedish Lawyer in Synch Stockholm Office)