Non-binding preliminary agreements: the duty to negotiate in good faith and the award of expectation damages.

• Author: Foreman, Violeta Solonova

INTRODUCTION I DEVELOPMENT AND CATEGORIZATION OF PRELIMINARY AGREEMENTS II DUTY TO NEGOTIATE IN GOOD FAITH i. Historical Backdrop ii. Implied and Contracted Good Faith iii. Negotiation Tactics and the Duty Of Good Faith iv. The Enforcement of the Duty of Good Faith: Other Issues v. Exclusivity Exception III DAMAGES: EXPECTATION AND RELIANCE 31 IV SUGGESTIONS TO AVOID BINDING PRELIMINARY AGREEMENTS 36 CONCLUSION A gentlemen's agreement is an agreement which is not an agreement, made between two persons, neither of whom is a gentleman, whereby each expects the other to be strictly bound without himself being bound at all. (1)

INTRODUCTION

One of the most difficult and important areas of contract formation concerns the enforceability of letters of intent or other preliminary agreements. (2) Such agreements are used for a variety of reasons, including: to memorialize certain agreed upon terms to prevent misunderstanding and selective memory, to identify and resolve open issues of a deal through negotiations, or to test the other party's level of commitment. (3) A preliminary agreement is used as a precursor to the enforceable contract, and as such is drafted to make the majority of the provisions non-binding. The few binding provisions are typically not agreement terms; rather they concern the rights and obligations of the parties during the interim period between the signing of the preliminary agreement and the execution of the definitive contract. Preliminary agreements are not imperative to the negotiation process as parties can skip them entirely and begin the contractual process with due diligence and the negotiation of the definitive contract.

Although preliminary agreements were originally conclusively unenforceable, in recent history preliminary agreements, and specifically the duty to negotiate a preliminary agreement in good faith, gained traction in several jurisdictions. (4) Most recently, the subject was brought to the forefront by a seminal case, SIGA Techs, Inc v PharmAthene, Inc, (5) in which the Delaware Supreme Court not only enforced the duty to negotiate the preliminary agreement in good faith, but also awarded the heretofore uncommon remedy--expectation damages. (6) Although the enforcement of an agreement to negotiate is a relatively new development, (7) the award of expectation damages in SICA is extraordinary and controversial. (8) The appropriate measure of damages has been debated by scholars, but SIGA appears to be the first case in which the state's highest court awarded expectation damages for a breach of preliminary agreement to negotiate. (9) Indeed, while there have not been many instances of courts awarding expectation damages for breaches of preliminary agreements to negotiate, a ruling in the affirmative remains a possibility given the precedent of SIGA, Venture Associates Corp v Zenith Data Systems Corp, (10) and Network Enterprises, Inc v APBA Offshore Productions, Inc. (11)

The duty to negotiate in good faith should not be enforced in preliminary agreements because it is difficult to determine at what point this duty has been fulfilled and the parties may walk away from the deal after negotiations in good faith failed. Indeed, because many terms of the preliminary agreement have been left open, good faith negotiation will be subject to negotiation tactics and could lead to no contract at all. Moreover, an award of expectation damages for breaches of preliminary agreements to negotiate in good faith is inappropriate because it implies the existence of a contract where there is none. Parties cannot have a justifiable expectation of what a contract will be at the preliminary stage as there are many open terms and the other party may have countervailing expectations of the definitive agreement. Courts cannot place a party in as good a position as if the party acted in good faith because such an action would fill the preliminary agreement's heretofore missing terms, which are unknown to the court and even to the parties themselves.

In this article, I will first give an overview of the history and the types of preliminary agreements to provide context for the subsequent discussion. I will then argue in Section II that the duty of good faith as it concerns preliminary agreements is too vague and contravenes the very nature of negotiations that promote self-interest. In Section III, I will explain that expectation damages are a wholly inappropriate type of remedy because a court cannot place a party in as good of a position as if the breaching party acted in good faith, since the result of good faith actions would fill the contract's heretofore missing terms with provisions unknown to the court and often to the parties who agree to negotiate them in the future. Finally, in Section IV, I will discuss some suggestions that parties should implement, both if they do and if they do not, want to make a binding preliminary agreement.

I DEVELOPMENT AND CATEGORIZATION OF PRELIMINARY AGREEMENTS

Historically Anglo-American common law did not recognize agreements to agree, and by implication the duty to negotiate in good faith. (12) Indeed, in the nineteenth century a member of the House of Lords explained that:

An agreement to enter into an agreement upon terms to be afterwards settled between the parties is a contradiction in terms. It is absurd to say that a man enters into an agreement till the terms of that agreement are settled. Until those terms are settled he is perfectly at liberty to retire from the bargain. (13) Courts preferred an aleatory view of contract negotiations, one where a party who enters negotiations hoping to gain from the ultimate agreement bears the risk of any loss resulting from broken off negotiations by the opposing party. (14)

In the mid-twentieth century however, this understanding that agreements to agree are not enforceable contracts witnessed a volte-face. (15) In the leading case, Itek Corp v Chicago Aerial Indus, (16) the Delaware Supreme Court found that if the parties so intended, a letter of intent could be a binding contract and as such would impose a duty to bargain in good faith to achieve the definitive contract that the letter of intent contemplated. Itek was the beginning of an attempt by courts to balance competing interests of avoiding trapping parties in unintended contractual obligations, while at the same time enforcing those agreements that the parties intended to be binding. (17)

Not long after Itek, scholars began categorizing preliminary agreements into two basic types--(1) preliminary agreements where no final deal has been reached, but the parties agree to continue negotiating about open terms in good faith, and (2) preliminary agreements where the deal has been reached but it is subject to the completion of many details. (18) In particular, Judge Pierre N. Leval's bimodal formulation of preliminary agreements in Teachers Insurance and Annuity of America v Tribune Company, (19) gained considerable traction.

Under Judge Leval's formulation a Type I, preliminary agreement exists where "parties have reached complete agreement (including an agreement to be bound) on all the issues perceived to require negotiation." (20) Such an agreement is preliminary "only in the sense that the parties desire a more elaborate formalization of the agreement." (21) There are four considerations for determining whether a Type I preliminary agreement is binding:

1. whether there has been an express reservation of the right not to be bound in the absence of a writing;

2. whether there has been partial performance of the contract;

3. whether all of the terms of the alleged contract have been agreed upon; and

4. whether the agreement ... is the type of contract that is usually committed to writing. (22)

   If a court that follows Judge Leval's formulation finds that the parties have entered into a Type I preliminary agreement, the parties will be held to be "fully bound to carry out the terms of the agreement even if the formal instrument is never executed." (23)

   A Type II preliminary agreement, however, does not commit parties to the ultimate contractual objective, but does require them to "negotiate the open issues in good faith in an attempt to reach the alternate objective within the agreed framework." (24) Courts that enforce Type II agreements "bar a party from renouncing the deal, abandoning the negotiations, or insisting on conditions that do not conform to the preliminary agreement." (25) To determine whether a Type II preliminary agreement is binding, courts that use Judge Leval's formulation apply the following five factor test:

1. the language of the agreement;

2. the context of the negotiations;

3. the existence of open terms;

4. partial performance; and

5. the necessity of putting the agreement in final form, as indicated by the customary form of such transactions. (26)

   If a court that follows Judge Leval's formulation finds that the parties have entered into a Type II preliminary agreement, the parties will be "bound only to make a good faith effort to negotiate and agree upon the open terms and a final agreement." (27)

   A finding of a Type I or Type II agreement can yield very different results depending on the jurisdiction. (28) Indeed, some jurisdictions are adamant in refusing to enforce Type II agreements. For example, courts in Texas, (29) Massachusetts, (30) Georgia, (31) Hawaii, (32) Kentucky, (33) Minnesota, (34) Nebraska, (35) Tennessee, (36) and Virginia (37) refuse to enforce agreements to negotiate (Type II agreements). (38) Courts in New York, (39) Delaware, (40) California, (41) Illinois, (42) and Washington, (43) however, enforce both Type I and Type II preliminary agreements. Courts also vary with regards to the damages awarded for breach of a preliminary agreement. Traditionally courts limited parties' recovery to reliance damages, but this trend may be shifting as the recent seminal Delaware Supreme Court's decision in SIGA...