In 2004 the Winklevoss brothers sued Facebook saying they were robbed. Under a deal resulting from mediation they got a reported $US65 million (in a combination of shares and cash). In return Facebook bought, and subsequently closed, their competing social network, ConnectU. The deal was consummated in a February 2008 “Terms Sheet and Settlement Agreement”.

In April 2010 the Winklevoss brothers commenced appeal proceedings seeking to unravel that Agreement. Why?

The Wall Street Journal simplifies (or incorrectly reports) the basis for the latest court action (registration required) as having two claims below. In fairness it’s a good article, and with a different focus.

  1. The Winklevoss brothers claim the valuation of the Facebook business used was inappropriate. They question the external valuation  used for their above financial settlement and point to an internal Facebook valuation. The external or known valuation was derived from an October 2007 public transaction in which Microsoft bought Facebook shares at a company valuation of $US15 billion. The internal valuation was secret and much higher, apparently based on internal pricing of stock options. The Wall Street Journal says it’s the difference between valuation of Facebook at $US8.88 a share versus $US35.90.
  2. The Winklevoss brothers claim the deal should have been a merger not a sale, to minimise tax they are apparently otherwise required to pay on the settlement.

"facebook_screenshot_phone"In fact there are many more claims (see the brief here) such as claimed breaches of securities laws, but they are outside the focus of this commentary.

We are focusing here on contract drafting lessons that can be drawn from the litigation faced by Facebook.

My guess is that the Agreement was lacking in its recitals and perhaps in its defined terms. If I’m right, then here’s why.

What are recitals? Recitals are the statements that appear before the operative clauses of a contract. Typically they are on the first page. Sometimes they go for many pages. Sometimes they appear under a heading “Recitals”, other times “Background” or “Introduction”. Decades ago lawyers often began a recital sentence with “Whereas”.

Are recitals legally mandated? No requirement exists for contracts to have recitals. The risk of a “just operatives clauses” approach is uncertainty and other difficulties that might arise in interpretation of the contract.

A lawyer should understand the background and fuller circumstances of a matter or dispute  to draft an effective and appropriate contract. The same applies for recitals and definitions. The recitals light the way for subsequent readers of the contract to understand or interpret why it was prepared. Judges and other new readers come to it fresh, with otherwise no background. Not to have recitals requires them to reverse engineer the purpose of the contract. The risk of incorrect interpretation may then be greater.

Sometimes a relatively simple contract needs only a bare one sentence recital, eg “The parties have agreed to the terms and conditions set out in this Agreement”. My experience is that litigation settlement agreements always should have detailed recitals. But time and time again I see particularly litigation lawyers preparing minimal recitals in settlement contracts. Ignorance about the role, importance and value of recitals is commonplace.

"signature_good_luck_bow"What’s the best process for drafting recitals? It’s usually best to prepare a rough set of recitals and then focus on drafting operating provisions before returning to finalise the recitals.  However, for more complex transactions if you can’t settle the recitals it is a sign that you don’t have a clear enough understanding of the intent of the parties, or there are key gaps in the intent, or a lack of clarity about the intent.

I often find myself drafting and redrafting a few paragraphs of recitals to a greater degree than several pages of operative provisions. This is because good recitals can frame a contractual legal relationship. They can capture subtle and potentially valuable points. I also often find I can only finalise recitals after I come back to them having drafted all the operative clauses.

Make recitals like Hollywood movies. In the contract drafting workshops I’ve run for lawyers and managers, I have described recitals as comparable to the opening scene of a standard Hollywood movie. That’s when you find out who is doing what with whom, and what motivates each. Sometimes missing the opening can spoil the experience, but Hollywood usually reminds viewers (over and over) about character motivations and plot lines.

In the workshops I go on to say that when recitals are lacking the contracts are more like a European movie. In European movies as the characters appear one or more of them seem to ask “What is the meaning of life?” These movies move on, often entertainingly, to their end even though the character motivations and plot lines can be vague. I say the movies end, rather than come to a conclusion, because at the end the very same question is often asked “What is the meaning of life?”

"Social_network_film_poster"Don’t sign a contract that resembles a European movie! In contract drafting apply the Hollywood style of story telling. Make first impressions count. Be concrete and clear, even at the risk of being boringly detailed. Provide as full an explanation as appropriate.

Use this recital writing checklist. Use these non-comprehensive questions to test the quality of your recitals:

  • What facts, events and communications led to the agreement?
  • What are the interests of each party affected by the transaction?
  • What is the purpose, scope and intended outcome of the agreement?
  • What does each party bring to the table?
  • What are the key risks, issues and problems?
  • What approach should be taken to the transaction?

In Facebook’s litigation, the dispute became a Hollywood movie, The Social Network. But perhaps Facebook’s lawyers did not do enough to avoid the real life dispute turning into a European movie with no clear conclusion.

Contact us with any questions or requests.

Noric Dilanchian