Preliminary
outlines of a proposed transaction –
whether styled as term sheets, letters of
intent, memoranda of understanding or agreements in principle – allow the
parties to sketch out the fundamental terms in a non-invasive document before
expending substantial resources on negotiating definitive agreements,
finalising due diligence, pursuing third-party approvals and other matters.
These documents appear simple and as something that can be advanced without
lawyers. The opportunities for later re-trades and selective lapses in memory
on key points are reduced, at least in theory. Furthermore, an ‘agreed’ term
sheet can facilitate discussions with the debt and equity financing providers,
as well as allow preliminary discussions and filings with antitrust and other
regulators. Lastly, it is often said that these documents can create deal
momentum and foster a moral and psychological commitment on the part of the
principals to do the deal or, at a minimum, work towards getting one done on
the outlined terms. In many cases where such arrangements come up in complex
corporate transactions, the parties are unlikely to think of themselves as
legally obligated to do the deal unless, and until, they get to a signed
definitive contract (and may view time and expenses spent in the process as a
sunk cost of exploring strategic alternatives).
Often the parties produce a
hybrid preliminary document that presents a non-binding outline of the main
transaction points with certain binding provisions (such as exclusivity/no-shop
and confidentiality provisions, as well as termination, governing law, choice
of forum, waiver of jury trial and other miscellaneous provisions).
There are
also downsides. While these types of documents may save time and expense in the
long run, they have as much chance to absorb the deal team in long and
protracted negotiations on the short-form terms. And time is the greatest enemy
of every deal. Substantial expenses may already be run up. Management time and
focus may already be diverted. Alternative strategic opportunities may be
passed up, markets may move against the parties in the meantime and the world
could change. In some cases, as one commentator noted, ‘[i]n a panic, with good
intentions or out of sheer frustration, the parties reduce their total lack of
understanding and lack of workable transactional framework’ into a preliminary
agreement, with a hope of papering over differences, kicking the can and
praying to make progress later.
As a broader point, the parties may have only a
general idea about what their status is and where they are heading, or
divergent views and expectations that are not well articulated. In some cases,
public disclosure obligations may be triggered. Then there are leaks, of
course, coupled with desire on certain parties’ sides to tout the term sheet
voluntarily to the world, or shop it to other bidders. An even greater risk,
however, is that, if things go sour, a court concludes that the preliminary
outline of terms is, in fact, something more than a free pass – either a fully
binding agreement in and of itself, capable of being enforced with specific
performance or awards of expectation damages, or an agreement to negotiate in
good faith within the agreed parameters for some period of time.
There is, of
course, also a converse risk of a court failing to enforce what the parties may
have thought was a binding agreement or certain of its portions that they
assumed would bind – although this fear is usually secondary to being trapped
in an unwanted marriage.
The risk of being entrapped in a binding relationship
may be particularly surprising in a cross-border context where the
walking around assumption for most principals is that – unlike in certain
European and other jurisdictions – US law immunizes transaction participants
from precontractual liabilities and duties of good faith (including a duty to
work in good faith to try to do a deal on the basis of an agreed term sheet).
That is not the law, however. As the Delaware Court of Chancery in Global Asset
Capital, LLC v Rubicon US REIT, Inc noted, ‘parties enter into [letters of
intent] for a reason. They don’t enter into them because they are gossamer and
can be disregarded whenever situations change. They enter into them because
they create rights.’ So a term sheet can lead the parties down the path of
pleasure or pain. And the latter alternative is not academic. Case reporters
are full of litigation, which is not just limited to dealings among the
unsophisticated and the under-advised. Disputes arise out of high-profile acquisitions,
financings, commercial and licensing transactions and settlement negotiations.
There is no one uniform rule that governs the enforceability of such documents.
The question is largely a function of state common law and, consequently,
differs from state to state; with respect to laws of a specific state, there
are divergences of tone, approach and, sometimes, outcome between state courts
and federal courts applying such state’s law, as well as evolving views that
are sometimes difficult to spot and reconcile.
And within a jurisdiction, the
application of the law can be inconsistent and turn on nuanced facts that make
advance planning difficult. Despite – or because of – evolving jurisprudence on
the topic, Professor Farnsworth’s observation that ‘[i]t would be difficult to
find a less predictable area of contract law’ has held up well these last
couple of decades. Litigation over these matters is typically very
fact-intensive and, therefore, potentially long, expensive and unpredictable.
The lack of clarity complicates planning and compounds transaction costs. It
can also introduce an element of strategic behaviour and moral hazard. If a
party continues to like the deal, it can claim that the term sheet was binding
and use it as potentially cheap insurance; if not, it can argue that it was
never intended to bind.
It is equally important not to overstate the issue.
There are a number of tools available to informed and well-advised parties who
decide to prepare a preliminary agreement for sound commercial or other reasons
that are likely either to mitigate the potential for a dispute or, if one does
come to pass, demonstrate to a court what the intentions of the parties were
and how to enforce them. While it is tempting to say – and is true to some extent
– that most litigation results from ambiguous drafting, that is not always the
culprit. There are many term sheets that are labeled as ‘not binding’ (often in
bold face with flashing lights) that end up being litigated. What is critical
is to establish and coordinate – across all phases of the discussions and all
deal workstreams – a consistent tone that represents the intent of the parties.
HISTORICAL BACKGROUND
In Venture Assoc Corp v Zenith Data Sys. Corp, Judge
Posner has called this space ‘one of the most difficult areas of contract law’.
The relationship between the parties before there is a signed definitive
contract in place is nuanced and slippery and difficult to describe in practice
and, consequently, as a matter of law. Historically, however, the question of
precontractual liability under American common law (and its English roots) was
generally binary. Preliminary manifestations of assent did not create binding
obligations. Parties were free to negotiate at will, make offers and
counteroffers and manoeuvre at will until such time as a legally cognisable
contract crystallised. In this light, term sheets and other preliminary
agreements can seem as neither fish nor fowl from that perspective – parties
may not be in pure exploratory negotiation mode by the point they settle on a
preliminary outline of a deal, but not committed to do the transaction either
until more work takes place. Towards the end of the 20th century, however,
courts began to shift away, albeit somewhat reluctantly, from this ‘all-or-nothing’
approach. There was a recognition that complex staggered guts of deal-making
and negotiations, and the preliminary agreements that arise out of them, are
something different, something that needs recognition. As one California court
noted in Copeland v Baskin Robbins, ‘[c]ontracts today are not formed by
discrete offers, counteroffers and acceptance. Instead they flow from a gradual
flow of information between the parties followed by a series of compromises and
tentative agreements on major points which are finally refined into contract
terms’. The courts, even those that have noted the need for a more pragmatic
assessment of the economic realities and role of preliminary agreements in
transactional practice, have generally struggled with the task. As the US Court
of Appeals for the Second Circuit put in Adjustrite Systems, Inc v GAB Business
Services, Inc, the challenge lies in the twin concerns of, on the one hand,
‘trapping parties in surprise contractual obligations that they never intended’
and, on the other hand, enforcing certain preliminary agreements, ‘for it is
the aim of contract law to gratify, not defeat, expectations’.
IS THERE A
BINDING CONTRACT TO DO THE UNDERLYING DEAL?
However elusive the law may be,
each case is generally rooted in the principle that the objective outward
intent of the parties is the key factor. Those courts that will entertain the
enforceability of a term sheet generally consider a wide array of factors to
discern the intent of the parties with respect to the underlying transaction
outlined in a term sheet (courts often have less difficulties with respect to
specific provisions, such as the non-shop/exclusivity and confidentiality
provisions, that are clearly designated as being binding). These factors differ
from case to case and often turn on the specific facts. No consistent weighting
is assigned to any one factor. Here are the issues that come up:
´ Drafting helps, although
there are no magic words and phrases that end the inquiry in all cases. Clear
and unambiguous disclaimers (or affirmations) of binding effect will be very
important and possibly dispositive, although they may not ultimately be
controlling in all jurisdictions. Calling the document a ‘term sheet’,
‘agreement in principle’ or ‘letter of intent’ (rather than a ‘contract’) is
unlikely to be dispositive in isolation, although cases differ. The degree of
formality and use of contract terms and language is also of interest.
´ A clear indication that
the parties envisioned that a final definitive contract would be executed is
accorded some weight as evidence of their intent not to be bound, although that
is not conclusive.
´
Inclusion of all essential terms of the transaction will not necessarily lead
to a conclusion that the document is binding, absent other facts, and vice
versa. Some courts will not enforce an agreement if it leaves essential terms
open for future negotiations; other courts are willing to recognise that a term
sheet need not have settled with utmost certainty all of the points and may
supply the missing terms if the agreement is to be enforced. ´ Further corporate or
regulatory approvals required in order to consummate the underlying transaction
are relevant, although their presence may not automatically lead to the
conclusion that the preliminary arrangements were not binding.
´ The customs and practices
of the specific parties and in their industries, as well as those applicable to
the relevant types of deals. The courts often recognise that large complex deals cannot
be done off the back of a napkin or even a ten-page term sheet, although they
will not necessarily use that as a bar to enforcing the terms if the intent to
be bound is otherwise determined.
´
The sophistication of the parties. ´
What steps the parties took to perform the arrangements outlined in the
preliminary agreement. Unilateral partial performance, in and of itself, is not
sufficient to establish the binding nature of a preliminary agreement. ´ Contemporaneous conduct
among the parties and members of the deal team. Gratuitous oral assurances (‘We
have a deal!’), handshakes and/or hugs, joint publicity, co-ordination of
business activities and the like may all be relevant, especially to a jury.
´ Whether there are
provisions that the parties intended to be legally binding that are clearly
delineated from the nonbinding terms. ´
Whether the binding terms included a no-shop or an obligation to negotiate
exclusively and/or in good faith and whether there are time limitations on
those obligations (indicating that the parties intended to negotiate for some
time more and part ways if there was no agreement).
´ Some courts may also consider
the impact of the statute of frauds, as well as review other traditional
objections to contract formation and enforcement, such as lack of mutuality of
obligations and consideration.
Federal courts applying New York law have
developed an influential framework for analysing the issue. The courts look at:
(a) whether there was an express reservation of the right not to be bound; (b)
whether there has been partial performance; (c) whether all of the terms of the
agreement have been agreed upon; and (d) whether the agreement is usually the
type that is committed to a more formal writing. Depending on where this
exercise comes out, the parties could be found to have formed a fully binding
contract (a so-called ‘Type I’ agreement) that is self-executing and
enforceable. These courts noted that ‘there is a strong presumption against
finding obligation in agreements which include open terms, call for future
approvals and expressly anticipate future preparation and execution of contract
documents’ (this presumption may be sufficient to lead to summary judgment for
the defendant).
IS THERE AN OBLIGATION TO WORK IN GOOD FAITH TOWARDS THE
UNDERLYING DEAL?
Finding a binding contract to do the underlying deal off the
back of a term sheet is not an everyday occurrence. If there is not a binding
contract, some more traditional courts will end the inquiry. Others may go on
to try to give the preliminary document a more nuanced effect. Certain courts
may infer or imply a duty to negotiate in good faith to reach the definitive
contract. They can imply this duty on top of a generic exclusivity/no-shop
provision or otherwise arrive at it on the basis of other weakly worded or
ambiguous provisions, or imply it in face of total silence.
Other courts will
only enforce an explicit contractual undertaking to that effect, but decline to
impose a duty to bargain in good faith in a term sheet that is otherwise
silent. For example, using a modified version of the test described above
developed by federal courts applying New York law, a court could find that the
parties have agreed on some major terms and accepted a mutual commitment to
negotiate together in good faith to reach final agreement based on the
parameters laid out in the preliminary agreement (a so-called ‘Type II’
agreement). The test for the latter inquiry is slightly different – the courts
would generally look at: (a) the language of the agreement; (b) the context of
the negotiations; (c) the existence of open terms; (d) partial performance; and
(e) the necessity of putting the agreement in final form.
Other courts will not
imply a good faith obligation in the absence of an otherwise binding contract.
Where the preliminary agreement has expressly disclaimed such duties, courts
have enforced it in certain cases and declined to imply a stand-alone duty of
their own. The scope of good faith is largely a factual question. The courts
will often look to the terms of the preliminary agreement to examine what the
parties intended to be the parameters of their good faith obligations – the
more specific the document is, the less room a party will have to introduce new
demands. It is reasonably clear that the obligation permits some degree of
commercial leeway – the obligation is less than Justice Cardozo’s ‘punctilio of
an honor the most sensitive’ and does not require the parties playing their
cards face up. But the question is typically one for the trier of facts. If the
parties negotiate in good faith for a reasonable period of time and no
agreement is reached, there should generally be no liability.
REMEDIES
If the
term sheet is deemed to be a binding agreement with respect to the underlying
transaction, then the losing party could be liable for full expectation or
‘benefit of the bargain’ damages. A court could also order specific performance
of the contract. Suffice it to say that either of those outcomes would be
severe (and rare). For breaches of an agreement (or duty) to negotiate in good
faith towards a final contract in an otherwise non-binding document, recovery
is typically limited to reliance damages such as out-of-pocket costs incurred
in preparing to do the transaction. In such cases, the courts have cast doubt on
the efficacy of ordering parties to negotiate in good faith.
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