Agreements to Negotiate in Good Faith May Mean More Than You Think

Agreements to Negotiate in Good Faith May Mean More Than You Think

December 06, 2013

By Kevin Smith and Thomas Watson

Term sheets, letters of intent and other preliminary agreements are often useful in complex negotiations because they allow negotiating parties to focus first on the major deal issues before getting tripped up in the details.

While such preliminary agreements or term sheets are often expressly non-binding, contractual obligations to negotiate in good faith to reach a final deal based on preliminary terms are typically binding. A Delaware Supreme Court decision in a case called SIGA Technologies, Inc. v. PharmAthene, Inc. earlier this year puts parties on notice that any agreement to negotiate a final agreement based on preliminary non-binding terms that is governed by Delaware law may have more teeth than the parties realize or intend.

The court held that a breach of such an agreement to negotiate in good faith may, in certain circumstances, result in liability for expectation (“benefit-of-the-bargain”) damages from the breaching party, the same damages that would arise had the parties signed the final, definitive agreement.

Background

In late 2005, SIGA Technologies, Inc., a company engaged in biodefense research and development, was developing an anti-viral drug that had “enormous potential,” but it was having trouble financing the remaining development costs. It sought to partner with PharmAthene, Inc., another company engaged in biodefense research and development, to help fund these costs.

PharmAthene wanted a merger between the two companies, but SIGA preferred a license arrangement before discussing a merger because it needed an immediate cash infusion and prior merger talks between the companies had failed.

In January 2006, the companies reached an agreement on a license term sheet. The license term sheet was unsigned and the footer on each page had the legend “Non-Binding Terms,” but the term sheet included many material provisions of the license, including a worldwide exclusive license, upfront cash payments, funding guarantees, cash milestone payments, creation of a research and development committee and sublicensing rights.

After reaching agreement on the unsigned license term sheet, the parties began merger negotiations. Because of SIGA’s precarious financial position, it asked PharmAthene to provide bridge financing to continue development efforts while negotiating the merger.

In March 2006, SIGA and PharmAthene signed a merger letter of intent that attached the license term sheet and also entered into the bridge loan agreement that SIGA needed to cover costs during the merger negotiations. The bridge loan agreement was governed by New York law and contained a mutual covenant of the parties to negotiate a license agreement in good faith “in accordance with the terms” of the license term sheet (that was attached to the agreement) in the event the merger was not consummated.

The parties then focused on negotiating the terms of the merger and, in June 2006, entered into a definitive merger agreement that was governed by Delaware law. The merger agreement provided a substantially identical covenant to the covenant contained in the bridge loan agreement requiring the parties to negotiate a license agreement in good faith based on the license term sheet (that was attached to the agreement) if the merger was not consummated. It also included a covenant that the parties use their “best efforts” to consummate the transactions contemplated by the merger agreement. Those provisions, among others, were specifically identified as surviving the merger agreement’s termination.

Subsequent to the execution of the merger agreement, SIGA’s financial position improved and it began experiencing seller’s remorse.

SIGA received grants from the National Institutes of Health to fund the drug’s development and achieved several developmental milestones. By the time the merger agreement’s drop-dead date of September 30 arrived, the US Securities and Exchange Commission had not approved SIGA’s proxy statement, and PharmAthene asked for an extension of the drop-dead date. On October 4, SIGA’s board met and decided not to agree to an extension, but instead to terminate the merger agreement. Shortly thereafter, SIGA announced that it had received another NIH grant as well as other positive updates on development efforts. It then sold two million shares of stock at more than three times its 2005 share price.

After the merger agreement was terminated, PharmAthene quickly turned its attention to the license term sheet, and it sent a draft license agreement, based on the license term sheet, to SIGA’s outside counsel. SIGA responded by asking for a new partnership structure and for substantial revisions to the underlying economic terms to reflect the advances in the drug’s development process. The revised economic terms included, among others, a materially different profit split between the companies, upfront payments of $100 million (instead of $6 million in the term sheet), milestone payments of $235 million (instead of $10 million in the term sheet), significantly increased royalty payments and greater SIGA control over development and distribution. SIGA further made clear its intention to renegotiate the terms contained in the term sheet by issuing an ultimatum requiring PharmAthene to submit to negotiations “without preconditions” regarding the terms in the license term sheet by December 20. On December 20, PharmAthene filed suit in the Delaware Court of Chancery.

What the Courts Said

After an 11-day trial, the Court of Chancery found under Delaware law that SIGA was liable for breach of its obligation under both the bridge loan agreement and the merger agreement to negotiate a definitive license agreement in good faith in accordance with the terms of the license term sheet. The court said SIGA was liable under the doctrine of “promissory estoppel,” or the idea that PharmAthene had already taken steps, like making a bridge loan, that SIGA wanted based on the expectation that SIGA would follow through on its promises, and it was now too late for SIGA to renege.

The court said the appropriate remedy was an equitable payment stream approximating the terms of the license agreement that the parties would have reached had they negotiated in good faith. SIGA appealed the decision.

The Delaware Supreme Court reaffirmed that an express contractual obligation to negotiate in good faith is binding on contracting parties under Delaware law. It said the express language in the bridge loan agreement and the merger agreement obligated the parties to negotiate a license agreement in good faith “in accordance with the terms” in the license term sheet. It said the trial record supported the Court of Chancery’s finding that, despite the fact that the license term sheet was unsigned and contained a footer stating “Non-Binding Terms,” the bridge loan agreement and merger agreement language created a duty for the parties to negotiate “a license agreement with economic terms substantially similar” to the terms of the license term sheet and was not merely intended by the parties to be a “jumping off point” for future negotiations.

The Delaware Supreme Court said the trial record also supported the Court of Chancery’s finding that SIGA’s counterproposal to the license agreement not only had dramatically different economic terms from those in the license term sheet, but that SIGA also made those counterproposals in bad faith. The Supreme Court overturned the Court of Chancery’s finding that SIGA was liable on the basis of promissory estoppel because promissory estoppel does not apply where an enforceable contract governs the promise at issue. The bottom line is SIGA breached its contractual obligations under both the bridge loan agreement and the merger agreement to negotiate the license agreement in good faith in accordance with the terms of the license term sheet.

The Supreme Court then turned to the question of proper remedy. There was previously some ambiguity under Delaware law as to what is the proper remedy for a breach of an agreement to negotiate in good faith. The court said that although Delaware law applied, New York law was instructive on the point. New York law distinguishes between “type I” and “type II” preliminary agreements. Type I preliminary agreements are fully binding agreements, where the parties agree on all points that require negotiation, but commit to memorialize their agreement in a more formal document. Type II preliminary agreements only list major terms and leave other terms open for further negotiation. Such an agreement commits the parties to an obligation to negotiate the open issues in good faith to reach the ultimate contractual objective within the previously-agreed framework.

The Supreme Court held that a party may recover expectation damages — that compensate the non-breaching party as if the breaching party performed the contract and include, in addition to direct damages, any incidental or consequential damages (as opposed to reliance damages that only compensate the non-breaching party for its actually incurred costs and expenses) — under a type II preliminary agreement where a court finds that the other party breached its obligation to negotiate in good faith and that the parties would have reached an agreement but for the breaching party’s bad faith.

It then held that expectation damages were warranted in this case based on the trial record. The record showed that the parties memorialized the basic terms of the license in the license term sheet and expressly agreed in both the bridge loan agreement and the merger agreement to negotiate a final license in good faith in accordance with those terms. It also suggested that but for SIGA’s bad faith negotiations, the parties would have entered into a definitive license agreement.

Key Takeaways

The SIGA opinion makes clear that Delaware courts will enforce agreements to negotiate in good faith and will award expectation damages for a party’s failure to do so. In SIGA’s case, it meant that they had to pay benefit-of-the-bargain damages as if the parties had actually executed the definitive agreement.

Not all states follow Delaware’s approach on this point. New York, for instance, enforces agreements to negotiate in good faith, but limits parties’ recovery to reliance damages, meaning in most cases just the costs of the negotiations. Other states will not enforce agreements to negotiate at all. Therefore, it is very important that companies understand and control which law will govern their preliminary agreements.

Further, companies should be wary of committing themselves to a contractual obligation to negotiate a definitive agreement in good faith with respect to transactions contemplated by a preliminary agreement because a failure to reach an agreement may result in liability for breach as if the definitive agreement had been reached.

When companies do commit themselves to negotiate a definitive agreement in good faith with respect to transactions contemplated by a preliminary agreement, they should consider, if desired, including provisions that qualify that obligation to ensure flexibility in negotiations, such as strengthening the disclaimer language to state expressly that the terms included in the preliminary agreement are non-binding and are open to further negotiation. They should also consider limiting the remedies available for breaches of the covenant to negotiate in good faith, such as providing exclusively for liquidated damages.