Another Reason for M&A Due Diligence: Ignorance of Contract Provision is No Excuse for Non-Performance

There is a well-established principle of California law that “ignorance of the contents of a contract” does not excuse performance. The idea that one might not know what is in a contract might seem surprising since one is expected to read a contract before signing. However, even in a business setting where the parties are sophisticated and corporate attorneys are at hand, there are many reasons why a company might not know what is in a contract. The most common is simply passage of time. A contract was signed some number of years ago; it is in the proper file folder; the various employees who negotiated and signed the agreement have moved on; and no one has read the contract since then. This is one reason for an occasional contract review. A good San Diego corporate lawyer can help.

In the context of mergers and acquisitions (“M&A”), this is another reason that due diligence is so important. Depending on how the deal is structured, the acquiring company might be assuming all of the contracts of the target company. Some business executives get impatient with the need to read and review every contract. The thought is: “Let’s get on with running the business and making money”. Because “ignorance of the contents” is not an excuse, it is crucial to read and review all the contracts as part of the due diligence process. Here is a quick rundown on the legal principles.

San Diego Corporate Law: Ignorance of the Contents is Not an Excuse

Two California Court of Appeals cases — both captioned Zamora v. Lehman — provide good examples of the rule. In the 1990s, three executives signed employment agreements with their corporate employer, e4L, Inc. (“e4L”). At the time, e4L was a direct marketing company that made and promoted 30-minute infomercials for a wide variety of products via television, radio, and the internet. e4L was a big provider at the time, broadcasting more than 3,000 programs to television households in the US and to more than 70 countries worldwide.

Stephen C. Lehman was the chairman and chief executive officer of e4L and he was one of the employees who signed an employment contract.

However, e4L had financial troubles and filed for bankruptcy in 2001. As an aside, acquiring bankruptcy properties are another circumstance in which a business can acquire contracts without necessarily knowing what is in the contracts in advance.

In any event, the bankruptcy trustee — Nancy Zamora — took over the control and operation of e4L in 2002. Eventually, in late 2005, she sued Lehman and the other two executives in California state court asserting various claims related to corporate mismanagement, breach of fiduciary duties, and other similar claims. The employment agreements contained two provisions of note. First, they all contained an agreement to arbitrate any disputes. Second, they all contained a provision requiring that notice of any claim must “be presented in writing by the claiming party…”

After being sued by Zamora, the executives engaged in various legal actions in the state court but then “remembered” that they were entitled to arbitration. They then filed a request with the trial judge asking that Zamora be compelled to arbitrate. The court said “no,” finding that the executives had waived their right to arbitrate by waiting and by engaging in various activities like discovery. In affirming this holding, the Court of Appeals said that “Lehman’s and Weiss’s failure to remember that their employment agreements contained an arbitration provision does not preclude a finding of waiver … [C]ourts do not take a defendant’s forgetfulness into account.” See Zamora v. Lehman, 186 Cal. App. 4th 1 (Cal. App. 2nd Dist. 2010) (Zamora I).

After the case was returned to the lower court for more proceedings, the executives then filed a request with the trial judge — on summary judgment — asking that Zamora’s case be dismissed because she did not send notice as required by section 8.04 of the agreements listed above. Zamora responded by arguing that she did not know about the notice provisions until long after the one-year notice provision had elapsed. The trial court granted the dismissal and, again, the Court of Appeals affirmed. See Zamora v. Lehman, 214 Cal. App. 4th 193 (Cal. App. 2nd Dist. 2013) (Zamora II). In affirming, the court noted that in Zamora I they had not excused the executives’ ignorance of their arbitration rights. The court held that Zamora’s ignorance was no excuse either. As the court stated: “What is good for the goose is good for the gander: The law does not excuse ignorance of a contractual limitations period either.”

It is important to note that Zamora might have been excused had she filed her lawsuit very soon after taking over e4L in 2002 since she would only have just received copies of the contracts. However, she did not sue Lehman and the other executives until late 2005 long after she should have read the contracts and become aware of the notice provisions. Zamora I and Zamora II make three things clear:

• Read and understand your contracts before signing
• Review contracts regularly particularly if there is significant employee turnover
• Do the full due diligence before, during, and after M&A

Contact San Diego Corporate Law

For more information, contact attorney Michael Leonard of San Diego Corporate Law. Mr. Leonard has many years of experience handling all aspects business law, including business formations, transactional matters, employment, private equity offerings, and other corporate matters. To schedule a consultation, contact Mr. Leonard via email or call at (858) 483-9200.

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