Assessing New Risks in Letters of Intent: Delaware Supreme Court Creates Increased Exposure by Recognizing a Duty to Negotiate in Good Faith
Prior to entering into a definitive commercial agreement, parties often enter into a letter of intent, a term sheet or a memorandum of understanding (a preliminary agreement). Some of the provisions in the preliminary agreement may be intended to be binding on the parties (e.g., no-shop clauses) while others are not. Problems arise when negotiations falter and the prospective deal breaks down. A party that feels jilted may argue that the preliminary agreement created binding obligations that the other party did not expect. Among the potentially binding obligations that may be pressed in these situations is the duty to negotiate a definitive agreement in good faith based on the terms of the preliminary agreement.
In related decisions (the SIGA decisions), the Delaware Supreme Court signaled an increased risk exposure for parties that enter into preliminary agreements. The Supreme Court established that (i) an agreement between the parties to negotiate in good faith in accordance with a letter of intent is an enforceable obligation, and (ii) a court may award expectation damages if the record supports a finding that an agreement would have been reached but for the defendant’s breach of its obligation to negotiate in good faith. In the SIGA decisions, the Supreme Court upheld expectation damages of $113 million based on SIGA’s breach of its duty to negotiate a definitive agreement based on the terms set forth in the preliminary agreement.
With 2015’s record-breaking M&A volume expected to continue into 2016, those entering preliminary agreements should keep the SIGA decisions in mind. Provisions explicitly addressing the duty to negotiate in good faith, the binding nature of key terms and the availability of expectation damages, among other things, should be considered.
Specific Teachings of the SIGA Decisions
The Supreme Court applied a bifurcated framework for analyzing preliminary agreements, where binding preliminary agreements fall into one of two categories: Type I or Type II.
Type I: All essential terms have been agreed upon in the preliminary agreement, no disputed issues are perceived to remain, and a further contract is envisioned primarily to satisfy formalities. Type I preliminary agreements are fully binding.
Type II: The parties recognize the existence of open terms, even major ones, but, having agreed on certain important terms, agree to bind themselves to negotiate the terms remaining open. Type II preliminary agreements are binding only to a certain degree.
SIGA and PharmAthene, the parties involved in the SIGA cases, entered into a merger agreement providing that if the merger was not consummated for any reason, then the parties would negotiate in good faith to enter into a license agreement based on the terms of a term sheet attached to the merger agreement. Although the footer of the term sheet labelled it as “non-binding,” the Supreme Court found that, based on the circumstances, it was a Type II preliminary agreement. The merger was not consummated, and SIGA sought to negotiate the license agreement on significantly more favorable terms than those provided in the term sheet. The Delaware Court of Chancery found that SIGA, in bad faith, refused to negotiate a license agreement when the merger was terminated. The Supreme Court affirmed that holding, but remanded the case with instructions for the Court of Chancery to reconsider whether PharmAthene was entitled to expectation damages.
Importantly, the Supreme Court established a lower standard for awarding expectation damages in the context of the breach of a preliminary agreement. As the Supreme Court explained, “the injured party need not establish the amount of damages with precise certainty ‘where the wrong has been proved and injury established.’” Under this lower standard of determining expectation damages, only the fact of damages (not the amount of damages) must be proved with reasonable certainty. Relying on this more lenient standard for awarding expectation damages, the Supreme Court affirmed the Court of Chancery’s $113 million damages award.
Protecting Against Increased Risk Exposure Under Preliminary Agreements
When entering into a preliminary agreement, carefully and clearly express the presence or absence of the parties’ duty to negotiate in good faith a definitive agreement based on the terms of the preliminary agreement. Consider expressly disclaiming any duty to act in good faith and providing that either party may discontinue negotiations at any time for any or no reason.
The preliminary agreement should explicitly state the extent to which it is intended to be binding. The express agreement of the parties will generally determine whether a provision is binding, but simply labeling a preliminary agreement as non-binding does not always make it so. In SIGA, for example, the term sheet was labelled non-binding, but the merger agreement provided that the parties would negotiate in good faith based on the term sheet. This, along with other factors, led the court to treat the term sheet as binding.
When a preliminary agreement contains an obligation to negotiate in good faith, consider expressly stating that, in the event of a breach, expectation damages will not be available.
The Delaware courts considered post-breach evidence and the willfulness of the breach in determining the reasonable expectation of the parties in calculating damages. In light of the heightened risk of expectation damages, take care to comply with any obligations to negotiate in good faith and remember that communications (both internal and external) may be used as evidence in determining whether a party willfully breached its obligation to negotiate in good faith.
The Delaware Supreme Court’s SIGA decisions, SIGA Techs., Inc. v. PharmAthene, Inc., 67 A.3d 330 (Del. 2013), and SIGA Techs., Inc. v. PharmAthene, Inc., 2015 WL 9467037 (Del. Dec. 23, 2015), can be found here and here, respectively.