The Duty to Negotiate in Good Faith and its Application to Term Sheets and Letters of Intent

Here is a scenario that may be familiar to you:  You have been negotiating an important deal.  A term sheet has been signed.  Drafts of the definitive agreements have gone back and forth and are beginning to pile up on your desk.  Negotiations break down. You move on.

Then, the lawyers for the other side send a sharply-worded letter informing you that they are suing for breach of contract. You laugh and respond “breach of what? The term sheet says on its face that it is nonbinding!”

Who wins?

You may be surprised to learn that your case is not as much of a slam dunk as you might have thought.

Corporate lawyers putting together a deal typically draft a term sheet, a memorandum of understanding or a letter of intent to spell out the terms of the deal.  This preliminary type of agreement, whatever form it takes, contains the important business provisions of the deal, making sure that the interested parties are – quite literally – on the same page as far as those provisions are concerned.  The MOU, LOI or term sheet (collectively referred to here for the sake of convenience as the “preliminary agreement”) usually also contains several standard legal clauses, including recitations that the preliminary agreement is “non-binding”, that closure of the deal is subject to the fulfillment of certain conditions, such as the execution of definitive agreements and the completion of satisfactory due diligence, and lastly, a recitation that the parties “agree to negotiate in good faith.”

Although most corporate lawyers give little thought to the inclusion of a good faith clause and incorporate it into their preliminary agreements as a matter of course, the duty to negotiate in good faith is a duty that courts have, of late, taken quite seriously.  Indeed, in certain circuits, breach of this duty is clearly recognized as a cause of action.  This article will explore the extent to which the duty to negotiate in good faith may be upheld in court – sometimes even without the inclusion of the standard clause in a preliminary agreement.

Deals That Go South and the Difference Between Causes of Action They Inspire

As a starting point, it must be recognized that the question of the duty to negotiate in good faith generally arises when a deal has fallen apart; that is, there is a disgruntled party that brings a lawsuit after it has signed some kind of preliminary agreement with another party, when the deal it was anticipating doesn’t happen for some reason.  The factual scenario usually goes like this:  A and B sign a term sheet to do a deal together.  A reneges.  B sues A.

B may sue A for breach of the preliminary agreement between them.  This is a conventional cause of action for breach of contract, which will turn on whether the parties did, indeed, enter into a contract.  In the event that the preliminary agreement recited specifically that it was “non-binding” or contained conditions precedent that were unfulfilled (the standard clauses typically inserted into a preliminary the agreement), courts will have a difficult time finding that there was an enforceable contract between the parties.  If the court has a difficult time finding an enforceable contract (and the likelihood is that this will be the case), then the breach of contract claim will perish.  It will not matter that the preliminary agreement contained an enforceable duty to negotiate in good faith to reach a definitive agreement and close the deal – if there is no contract, then there is no breach of contract.  See, e.g., Reprosystem, B.V. v. SCM Corp., 727 F.2d 257 (2d Cir. 1984), cert denied 469 US 828 (1984).

However, an action based on a preliminary agreement may not fail if B moves away from the conventional breach of contract cause of action and brings an action specifically for breach of the failure to negotiate in good faith.

In this type of cause of action, the fact that the preliminary agreement does not constitute an enforceable contract will not necessarily condemn B’s suit to fail.  Many courts now recognize a breach of the duty to negotiate in good faith and are willing to award damages on this basis, though different courts have taken different approaches to reach this same result.  Some courts have held that even when the duty to negotiate in good faith arises out of an unenforceable preliminary agreement it should still be upheld.  Some have skirted the issue when the preliminary agreement does not explicitly contain a duty to negotiate in good faith, reaching the desired result by reading a duty to negotiate in good faith into all contracts.  Each of the cases examined below takes a different route, but gets to the same result.

A Brief Examination of the Leading Cases

The Seventh Circuit’s decision in Venture Assoc. Corp. v. Zenith Data Sys. Corp., 987 F.2d 429, 433 (7th Cir.1993) makes the clear distinction between the conventional breach of contract claim and a claim for breach of the duty to negotiate in good faith.  In this case, a letter of intent for the sale and purchase of a Zenith subsidiary was sent by Venture Associates to Zenith.  The LOI explicitly stated as follows:

It is understood that this is merely a letter of intent subject to the execution by Seller and Buyer of a definitive Purchase Agreement (except for the following paragraph of this letter, which shall be binding…) [and] does not constitute a binding obligation on either of us.

However, notwithstanding the foregoing, this letter is intended to evidence the preliminary understanding which we have reached regarding the proposed transaction and our mutual intent to negotiate in good faith to enter into a definitive Purchase agreement.

The letter of intent was not signed by Zenith, but Zenith did respond by mail that it would negotiate the sale of the subsidiary according to the terms and conditions of the LOI.  The parties exchanged drafts and negotiated for almost a year, but no purchase agreement was ever signed.  After this period of negotiations, Zenith increased the purchase price for the subsidiary.  Negotiations broke down.  Venture Associates then brought suit against Zenith alleging breach of contract and breach of the promise in the letter of intent to negotiate in good faith.

The Seventh Circuit, applying Illinois law, affirmed the district court’s dismissal of the breach of contract claim, finding that no binding contract for the sale of the subsidiary had been entered into.  Id. at 432.  The court held that the language of the LOI evinced a clear intent not to be bound to the sale of the subsidiary until agreement had been reached on all details and a comprehensive contract signed.  Id. at 433.  However, the court refused to dismiss Venture Associates’s claim that the parties were compelled to negotiate in good faith, even though it was based on the preliminary agreement.  It found that the terms of the LOI, including the promise to negotiate in good faith, had been accepted by Zenith.  As such, Zenith’s injection of new demands – the increase in price – late in the negotiating process could constitute bad faith in some circumstances.  Id.  It remanded the case for further proceedings.  Ultimately, no bad faith was found in Zenith’s actions, but the cause of action for breach of the duty to negotiate in good faith was further discussed and the concept affirmed.  See 887 F. Supp. 1014 (N.D. Ill. 1995), aff’d 96 F.3d 275 (7th Cir. 1996).

In Channel Home Ctrs. v. Grossman, 795 F.2d 291, 298-300 (3rd Cir.1986) the plaintiff understood the shortcomings of a conventional breach of contract claim based on the preliminary agreement.  Plaintiff did not claim that a letter of intent to enter into a lease was binding – either as a lease or as an agreement to enter into a lease.  Instead, the plaintiff’s position was that the letter of intent was enforceable as a mutually binding obligation to negotiate in good faith, despite the lack of specific language in the agreement.  The Third Circuit accepted this claim.

The letter of intent at issue was one for the execution of a lease agreement by Channel Home Centers for space in a mall in a suburb of Philadelphia.  Id. at 292 n.2.  It provided that Grossman, the landlord, would withdraw the property from the rental market and negotiate the leasing transaction with Channel to completion.  After extensive negotiation, including site inspections and drafts of the lease agreement, the landlord informed Channel that he was terminating negotiations due to Channel’s failure to submit a mutually acceptable lease agreement.  The very next day, the landlord signed a lease with Mr. Good Buys, a competitor of Channel’s, under an agreement that gave landlord more than double the amount of guaranteed cash (although without the percentage of sales to which Channel had agreed).  Channel sued, claiming that the landlord had acted in bad faith.  Id. at 296.

The Third Circuit analyzed the facts in terms of enforceability of the letter of intent under Pennsylvania law, asking whether the parties intended to be bound by the LOI, whether its terms were sufficiently definite to be enforced, and whether there was consideration.  It ruled that the record supported a finding that the landlord’s promise to withdraw the property from the market and negotiate the proposed transaction to completion constituted a binding agreement to negotiate in good faith – even though the letter of intent did not specifically contain this language.  See id. at 299-300.  The Third Circuit reversed judgment for the landlord and remanded the case for trial on Channel’s claim of breach of the duty to negotiate in good faith.  See id. at 292.

Another court that reached this result, also in the absence of specific language in the preliminary agreement, was the California Appellate Court in Copeland v. Baskin Robbins U.S.A., 96 Cal. App. 4th 1251, 1253 (2002).   In this case, the court found that as a practical matter, the law was required, for public policy reasons, to recognize and enforce agreements to negotiate.

In Copeland, the plaintiff spent months negotiating a deal under which he would purchase the assets of an ice-cream manufacturing plant from Baskin Robbins.  A letter of intent was signed in which Baskin Robbins agreed to sell the plant for $1.3 million and would agree to a co-packing arrangement (where it would purchase ice cream produced by Copeland in the plant) subject to a separate agreement “and negotiated pricing.”  Id. After two additional months of negotiating the terms of the co-packing deal, Baskin Robbins broke off talks. Copeland sued.  However, he did not claim that the parties had reached agreement on a co-packing contract and that Baskin Robbins had breached it; rather, he claimed that the letter of intent constituted a contract to negotiate the remaining terms of the co-packing agreement, and that Baskin Robbins breached this contract by refusing to continue negotiations or by failing to negotiate in good faith.

The California Court of Appeal held that where parties enter into a contract to negotiate the terms of an agreement, their failure to agree in and of itself will not constitute a breach of the agreement to negotiate.  However, a party will be liable “if a failure to reach ultimate agreement resulted from a breach of that party’s obligation to negotiate or to negotiate in good faith.”  Id. at 1257.  Even though the letter of intent between Copeland and Baskin Robbins did not contain a good-faith clause, the court held that “a covenant of good faith and fair dealing is implied in every contract” under California law, including a contract to negotiate.  See id. at 1253, 1260 & n.18.  It distinguished decisions where courts focused on the enforceability of the underlying substantive contract instead of whether the agreement to negotiate the terms of that contract was enforceable in its own right.  Id. at 1257.

In recognizing a claim for breach of an agreement to negotiate in good faith, Copeland articulated the “sound public policy reasons for protecting parties to a business negotiation from bad faith practices by their negotiating partners.”  Id. at 1262.  The court noted that modern-day deals are time-consuming and costly, “the product of a gradual process in which agreements are reached piecemeal on a variety of issues in a series of face-to-face meetings, telephone calls, e-mails and letters involving corporate officers, lawyers, bankers, accountants … and others.”  Id. In this environment, the court felt, “the parties should have some assurance their investments in time and money and effort will not be wiped out by the other party’s footdragging or change of heart or taking advantage of a vulnerable position created by the negotiation.”  Id. (internal quotation marks omitted).

Other cases where an obligation to negotiate in good faith has been recognized include Arcadian Phosphates, Inc. v. Arcadian Corp., 884 F.2d 69 (2d Cir. 1989) (unlike substantive obligations, an obligation to bargain in good faith is obviously intended to begin immediately and is not contingent upon formal contract documents); The Original San Francisco Toymakers, Inc. v. Trendmasters, Inc., 2003 WL 22384771 (N.D. Cal. 2003) (following Copeland v. Baskin Robbins, supra, and applying it to the case of an oral contract); Thompson v. Liquichimica of America, Inc., 481 F.Supp. 365, 366 (S.D.N.Y.1979) (an agreement to use best efforts is a closed proposition, “discrete and actionable”, and does not require that the agreement sought be achieved, but does require that the parties work to achieve it actively and in good faith); see also Coachella Valley Water Dist. v. Imperial Irr. Dist., 2007 WL 2822766 (Cal. App. 4th 2007).

In closing, it should be noted that Judge Posner, the Chief Judge of the Seventh Circuit Court of Appeals, has called the issue of enforceability of letters of intent and other preliminary agreements “one of the most difficult areas of contract law.”   Venture Associates Corp. v. Zenith Data Systems Corp., 96 F.3d 275, 276 (1996).  Judge Posner suggests, in this opinion (affirming the district court’s decision, on remand, that there was no bad faith in the case cited above), that a more proper rubric than contract law for making sure that parties negotiate in good faith might be promissory estoppel.  Id. at 277 (citing cases).  He also recommends that instead of relying on the “vague” duty to negotiate in good faith, which to his mind rests on “somewhat shaky foundations,” businesspeople incorporate a deposit, or a “kill fee” into the term sheets of their deals.  Though these approaches may be more direct and head-on, there is by now enough case law to make a court’s decision to find a duty to negotiate in good faith a much more comfortable one.

The information contained in this publication is not intended as legal advice or as an opinion on specific facts.

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