Good Faith: The New Frontier of Agreements to Negotiate

Negotiating a term sheet, LOI, or other preliminary document can sometimes feel a bit like the Wild West: local laws and unintended consequences can vary from town to town. Even a concept as seemingly straightforward as agreeing to negotiate in good faith can yield extremely different results depending on jurisdiction. The Delaware Supreme Court’s recent decision in SIGA Technologies, Inc. v. PharmAthene, Inc. is a warning shot to investors and deal makers that, unlike most other states in the US, Delaware will award expectation (i.e., “benefit-of-the-bargain”) damages for the breach of an agreement to negotiate. What this means in practical terms is that, in certain circumstances, failure to fully negotiate a deal based on a non-binding but detailed term sheet could result in full damages as if the parties had actually signed up a deal.

Lay of the Land

Depending on the jurisdiction, an obligation to act (or negotiate) in good faith could be implied by the formation of any contract. For example, in a recent New York case, EQT Infrastructure Ltd. v. Smith, a binding exclusivity clause in an otherwise non-binding term sheet survived summary judgment as a possible agreement to negotiate in good faith following expiration of exclusivity. In the EQT case, the post-exclusivity requests of the seller to increase the purchase price and include conditions to closing that were not reflected in the term sheet were viewed by the court as possible evidence of bad faith negotiation. With at least one state generating this sort of precedent, it is important to understand and control which law governs your preliminary document.

Absent an explicit choice of governing law clause in a preliminary agreement, facts such as the location of the parties, the location of negotiations, or the subsequent actions of the parties could negate, create, or modify enforceable obligations. As with all travel to foreign lands, you should always ask a local. If you are dealing with parties outside of your home state, negotiating in another state, or following counsel’s advice to use one state’s governing law over another, you should ensure that your counsel actually understands local law. Several states (e.g., California, Delaware, Illinois, New York, and Washington) have long enforced agreements to negotiate, but have typically limited parties’ recovery to reliance damages such as legal and other advisory and professional fees. Many other states (e.g., Georgia, Hawaii, Kentucky, Michigan, Minnesota, Nebraska, Tennessee, Texas, Utah, and Virginia) have refused to enforce agreements to negotiate at all, citing the inability of courts to craft a sufficient remedy for breach. Many other states have muddled case law or no precedent on the issue.

Delaware – A New Frontier?

The Delaware Supreme Court’s recent decision in SIGA Technologies, Inc. v. PharmAthene, Inc. will turn many heads, as it explicitly established a right under Delaware law to seek expectation damages for certain bad faith breaches of an agreement to negotiate. Specifically, SIGA Technologies was required to honor the terms of a non-binding term sheet with PharmAthene because the Delaware Court of Chancery held (and the Delaware Supreme Court affirmed) that (i) SIGA contractually agreed to negotiate in good faith based on the terms set out in the term sheet and (ii) “the parties would have reached an agreement but for [SIGA]’s bad faith negotiations.” This decision and its financial result are an obvious hammer to those found to have acted in bad faith, and these potential consequences are likely a surprise to many deal professionals and attorneys. Interestingly, the SIGA decision is not the first to award expectation damages for breach of an agreement to negotiate.

At least one federal court has previously interpreted New York law to provide full “benefit-of-the-bargain” damages for breach of an agreement to negotiate. [1] Similarly, a Washington state court of appeals has upheld expectation damages for bad faith breach of an agreement to negotiate, essentially allowing a jury to decide what the agreed terms would have been if the parties had negotiated in good faith. [2]

One key factor in each of the above-described decisions is the specificity of the underlying term sheets. Each term sheet was extremely detailed and left little to the imagination or to future negotiation. An extremely detailed term sheet is indispensable if you want to embody progress and an agreement in the making, but often less is more if you intend the term sheet as merely a starting point for negotiations.

Be Careful When Crossing the River

If the above examples are disconcerting, consider Washington, DC, where simply crossing the river (i.e., ending up in federal court in Virginia rather than in Washington, DC) could invalidate an agreement to negotiate. In Virginia Power Energy Marketing, Inc. v. EQT Energy, LLC, a Virginia federal district judge invalidated a purportedly binding exclusivity clause based on language in the exclusivity section requiring the parties to negotiate in good faith. Agreements to negotiate are unenforceable in Virginia and, in this case, poor drafting negated an otherwise binding exclusivity clause. In complete contrast, just over the river, the District of Columbia Court of Appeals has upheld a lower court’s order specifically enforcing an agreement to negotiate by judicially ordering the recalcitrant party to sign the final agreement. [3]

In light of the state-to-state uncertainty, the surest way to avoid unintended state law consequences of a preliminary document is to knowingly use the governing law of a state with clear case law on the subject. In California, for example, parties cannot obtain expectation damages for breach of an agreement to negotiate. In Texas, things are even clearer: there are no enforceable agreements to negotiate and there is no implied covenant of good faith read into most arms-length commercial contracts.

Key Take-Aways

• If you intend to create a binding obligation to negotiate, be sure to choose a state governing law that permits such agreements (e.g., California, Delaware, Illinois, New York, and Washington) and understand the potential consequences of doing so.
• If you only intend to create exclusivity, as opposed to an obligation to negotiate in good faith, keep in mind that binding exclusivity creates an implied duty of good faith in some states.
• If a fully non-binding term sheet is truly intended, use express language to (i) explicitly reserve the right not to be bound by any term (whether or not included in the term sheet), (ii) disclaim any intent to be bound by any listed terms or future actions, and (iii) explicitly permit negotiation or renegotiation of any and all terms or conditions, including those described in the term sheet and those not described.

Endnotes:

[1] Network Enters., Inc. v. APBA Offshore Prods., Inc.
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[2] Columbia Park Golf Course, Inc. v. City of Kennewick.
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[3] Stanford Hotels Corp. v. Potomac Creek Assocs., L.P.
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