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Recent Delaware Supreme Court Decision Affirms Enforceability of Duty to Negotiate in Good Faith

Posted on Nov 13th, 2013

A recent Delaware Supreme Court decision in SIGA Technologies v. PharmAthene reaffirmed established Delaware law that an express promise to negotiate an agreement in good faith may be enforceable.   The Court also held that expectation damages may be awarded under Delaware law if a trial court can conclude that the parties would have reached an agreement but for a defendant’s bad faith.  Since term sheets are such a key part of the venture capital and M&A process, the SIGA decision illustrates the importance of carefully thinking through the details (or lack thereof) of a term sheet and their specific wording.  In particular, if at the time of a term sheet the parties are unsure of their intent, or wish to leave the negotiations open, to avoid potential damages awards appropriate disclaimers to any duty to negotiate in good faith should be included.

Of important note, in light of the SIGA decision, the Term Sheet for the NVCA Model Legal Documents has been updated to point out that the choice of law governing the term sheet should be considered more carefully.  (See footnote 1 (pasted below) to NVCA Term Sheet, found here).

If you have any questions about this topic, please feel free to email us.

Background

The SIGA decision arose in the context of negotiations between SIGA and PharmAthene (PA) relating to a potential collaboration.  At the outside of the process, SIGA was in a troubled financial state and was interested in licensing to PA rights to SIGA’s drug relating to smallpox.  While PA expressed interest in a merger, SIGA was not ready to commit to a merger process at that time.  The parties spent a number of months negotiating a detailed term sheet for a license agreement (“LATS”) which provided for a material terms, including those describing the worldwide exclusive license and sublicensing rights, various forms of upfront and milestone cash payments, funding guarantees and governance procedures. The LATS was not signed and had a footer that stated “Non Binding Terms.”

To add complexity to the matter, following the LATS, as the parties continued to negotiate, they entered into additional agreements.  PA provided SIGA with a $3 million bridge loan to provide SIGA with working capital while the merger negotiations proceeded.  The bridge loan agreement (governed by New York law) contained a provision obligating the parties to negotiate in good faith a license agreement “in accordance with the terms” set forth in the LATS if the merger were terminated.  Thereafter, SIGA and PA also into a Merger Agreement (governed by Delaware law) that contained the same provision as in the LATS requiring the parties to negotiate a license agreement in good faith in accordance with the terms LATS if the Merger Agreement were terminated.

After signing the Merger Agreement, SIGA’s financial position and prospects improved and it ultimately terminated the Merger Agreement.  While the parties then proceeded to negotiate the terms of the definitive license agreement, SIGA responded to a PA’s draft by proposing significant changes from the deal contemplated by the LATS.  The changes included a different profit splits, increased upfront payments ($100 million instead of $6 million, as specified in the LATS), and increased milestone payments ($235 million instead of $10 million, as specified in the LATS).  After SIGA conditioned any further discussions on PA’s agreement to negotiate without any preconditions regarding the binding nature of the LATS,  PA sued in the Delaware Chancery Court, asserting claims under theories of breach of contract, promissory estoppel and unjust enrichment.  After the Chancery court held in favor of PA on various grounds, SIGA appeal.

Legal Analysis

The Delaware Supreme Court held that that an express contractual obligation to negotiate in good faith is enforceable under Delaware law.  The Court affirmed the Chancery Court’s determination that SIGA acted in bad faith when it negotiated the license agreement in breach of its obligations under the Merger Agreement and the Bridge Loan Agreement.  The Court recited the standard for bad faith under Delaware law “is not simply bad judgment or negligence, but rather … the conscious doing of a wrong because of dishonest purpose or moral obliquity; it is different from the negative idea of negligence in that it contemplates a state of mind affirmatively operating with furtive design or ill will.”

Looking to precedent from both Delaware and New York, the Court reasoned that parties that bind themselves to a concededly incomplete agreement “accept a mutual commitment to negotiate together in good faith in an effort to reach final agreement within the scope that has been settled in the preliminary agreement.”  While good faith differences in the negotiation of open issues may prevent reaching a final contract, a counterparty cannot in that case insist on conditions that do not conform to the preliminary agreement.

On that basis, the Court interpreted the language “in accordance with the terms set forth [in the LATS]” to mean that the parties had a duty to “negotiate toward a license agreement with economic terms substantially similar to the terms of the LATS (or at least not inconsistent with the LATS’s terms),” as opposed to using the LATS only a “jumping off point.”  Although the LATS was not signed and had the “Non-binding” footer language, the fact that it was incorporated into the Bridge Loan Agreement and Merger was evidence of intent to negotiate toward a license agreement with substantially similar economic terms in the event the merger was not closed.

 

This decision also establishes that under Delaware law, contract expectation damages are an appropriate remedy where parties have preliminarily agreed to the major terms of an agreement (a Type II agreement, as discussed) and have agreed to negotiate its conclusion in good faith, and the record supports that they would have reached agreement but for bad faith.

To reach its holding, the Court looked to decisions under New York law interpreting preliminary agreements, which provide for two types of such agreements: a “Type I” agreement and a “Type II” agreement.

  • A Type I agreement “is a fully binding preliminary agreement, which is created when the parties agree on all the points that require negotiation (including whether to be bound) but agree to memorialize their agreement in a more formal document. Such an agreement is fully binding….”
  • A Type II agreement is where parties “agree on certain major terms, but leave other terms open for further negotiation. … — a concededly incomplete agreement accept[ing] a mutual commitment to negotiate together in good faith in an effort to reach final agreement within the scope that has been settled in the preliminary agreement.”
    • A Type II agreement “does not commit the parties to their ultimate contractual objective but rather to the obligation to negotiate the open issues in good faith in an attempt to reach the alternate objective within the agreed framework.” A Type II agreement “does not guarantee” the parties will reach agreement on a final contract because of “good faith differences in the negotiation of the open issues” may preclude final agreement. A Type II agreement “does, however, bar a party from renouncing the deal, abandoning the negotiations, or insisting on conditions that do not conform to the preliminary agreement.

 

1.  NVCA Term Sheet FN. 1.  ”The choice of law governing a term sheet can be important because in some jurisdictions a term sheet that expressly states that it is nonbinding may nonetheless create an enforceable obligation to negotiate the terms set forth in the term sheet in good faith.  Compare SIGA Techs., Inc. v. PharmAthene, Inc., Case No. C.A. 2627 ( (Del. Supreme Court May 24, 2013) (holding that where parties agreed to negotiate in good faith in accordance with a term sheet, that obligation was enforceable notwithstanding the fact that the term sheet itself was not signed and contained a footer on each page stating “Non Binding Terms”);  EQT Infrastructure Ltd. v. Smith, 861 F. Supp. 2d 220 (S.D.N.Y. 2012); Stanford Hotels Corp. v. Potomac Creek Assocs., L.P., 18 A.3d 725 (D.C. App. 2011) with Rosenfield v. United States Trust Co., 5 N.E. 323, 326 (Mass. 1935) (“An agreement to reach an agreement is a contradiction in terms and imposes no obligation on the parties thereo.”); Martin v. Martin, 326 S.W.3d 741 (Tex. App. 2010); Va. Power Energy Mktg. v. EQT Energy, LLC, 2012 WL 2905110 (E.D. Va. July 16, 2012).  As such, because a “nonbinding” term sheet governed by the law of a jurisdiction such as Delaware, New York or the District of Columbia may in fact create an enforceable obligation to negotiate in good faith to come to agreement on the terms set forth in the term sheet, parties should give consideration to the choice of law selected to govern the term sheet.”


Recent Delaware Chancery Court Decisions Opines on Arbitration Clause in Merger Agreement

Posted on Oct 1st, 2013

A recent letter opinion by the Delaware Chancery Court in a case between Shareholder Representative Services (SRS) and a buyer of a business processing business raises an interesting interpretation of an arbitration clause in a merger agreement. The case can be read here.  The dispute between the parties arose from indemnification claims brought by the buyer under the merger agreement, which SRS claimed did not comply with the requirements of the merger agreement.  While the merger agreement contained a mandatory arbitration provision, it also provided that the Arbitrator did not have authority to grant “injunctive relief, specific performance or other equitable relief”.  Relying on this provision, SRS brought various claims in the Chancery Court, including a claim for injunctive relief to stop buyer from a breach of the merger agreement by seeking indemnification to which it did not have a right.  The court disagreed with SRS and compelled arbitration.

The court first noted that since the arbitration clause did not explicitly commit the determination of substantive arbitrability to the arbitrator, the court had jurisdiction to decide on this specific issue.  In a footnote, the court noted that these issues are presumptively determined by a court.  (One drafting note from this determination is that parties that wish to avoid any court proceedings altogether may want expressly cover the issue of substantive arbitrability in their agreement.)

The court cited a 2002 Delaware Supreme Court decision for the steps to be taken by a Delaware court to assess an arbitration clause:

  • First, the court must determine whether the arbitration clause is broad or narrow in scope.
  • Second, the court must apply the relevant scope of the provision to the asserted legal claim to determine whether the claim falls within the scope of the contractual provisions that require arbitration. If the court is evaluating a narrow arbitration clause, it will ask if the cause of action pursued in court directly relates to a right in the contract. If the arbitration clause is broad in scope, the court will defer to arbitration on any issues that touch on contract rights or  contract performance.

The court cited a few examples of a “broad” arbitration clause:  “any dispute, controversy, or claim arising out of or in connection with the …Agreement” and “any unresolved controversy or claim arising out of or relating to this Agreement” (the language at issue in the parties’ merger agreement). Finding this clause to be of the broad category, the court ruled that the determination of whether the indemnification claims were time-barred should be made by the arbitrator.

In support of its argument, SRS cited a 2006 decision involving an arbitration clause in a LLC operating agreement where the parties also sought injunctive relief from the court to compel a member to assent to a capital contribution.  The court distinguished this situation from the instance case, finding that SRS’s claims were really legal claims, not equitable ones, and colorfully noted that “[s]emantic legerdemain does not transform a legal claim into an equitable claim.”  The court reasoned that the relief that SRS has requested requires an analysis of the merits of the claims, which is legal (as opposed to equitable) in nature.   Accordingly, a plaintiff cannot “convert a claim for money damages arising from a breach of commercial contract . . . into a claim maintainable in equity by the expedient of asking that the defendant be enjoined from breaching such duty again.”

This decision is a useful reminder that boilerplate provisions such as arbitration clauses (and carveouts to those clauses) should be carefully considered in the context of any agreement, especially one relating to the sale of a business or other major transaction of a company.  While there may be varying opinions on the benefits of arbitration over litigation, once a path is chosen, the parties should carefully review these provisions to reduce ambiguity around any substantive and procedural issues that may arise.

If you have any questions about this topic, please feel free to email us.

 


Massachusetts Supreme Judicial Court interprets Investor’s Right to Recover for Misstatements

Posted on Aug 12th, 2013

A recent SJC decision involving a personal investment by Jack Welch in a failed Massachusetts hedge fund. The full decision can be read here.  Welch sued the fund and its manager for their failure to disclose that the manager was involved in a civil litigation (a landlord-tenant dispute over a former residency of the manager in New York), claiming that if he had known about that matter, he never would have invested.

The SJC upheld the summary judgment entered against Welch, holding that omission ultimately was not material enough to find the fund liable.
This case is interesting for its confirmation of certain provisions under the Massachusetts law on the following issues:

  • The statutory standard of a misstatement or omission is material  under the Massachusetts Securities Act is whether there is a “substantial likelihood” that the omitted information would have “significantly altered the ‘total mix’ of information” available to the ordinary reasonable investor.
  • A “material” fact is oneA “material” fact is one to which a reasonable person would attribute importance for his or her choice of action in the transaction at issue. Zimmerman v. Kent, 31 Mass.App.Ct. 72, 78 (1991).
  • The court also held that if there is finding in this regard under the Uniform Securities Act, then there cannot be a finding that the actions were deceptive under Chapter 93A.
  • The decision also provides a helpful summary of Massachusetts common law on fraud and negligent misrepresentation:
    • Intentional misrepresentation (or “deceit”): (a) an intentional or reckless (b) misstatement (c) of an existing fact (d) of a material nature, (e) causing intended reasonable reliance and (f) financial harm to the plaintiff.
    • Negligent misrepresentation: (a) a provision, in the course of the defendant’s business, profession, employment, or in the course of a transaction of his pecuniary interest, (b) of false information for the guidance of others in their business transactions, (c) without the exercise of reasonable care or competence in the acquisition or communication of the information, (d) causing justifiable reliance by, and (e) resulting in pecuniary loss to, the plaintiff.

If you have any questions about this topic, please feel free to email me directly.   My email address is dimitry.herman@hermanlawllc.com.

 

 


Recent NY Court Decision on Rescission of Stock Option Agreement

Posted on May 12th, 2013

Employee stock options are an essential component of compensation in technology companies.  Options and other equity incentives allow employers to attract and retain talented personnel who hope to profit from a successful sale of the business that they help create.  While there has been substantial attention in recent years to the manner in which options are awarded, a topic less often discussed, but equally important, is how they may be rightfully terminated by an employer following a separation.  A recent decision by a New York appellate court’s decision in Lenel Systems Intl. v. Smith illustrates what can arise if this issue is not expressly addressed in the option agreement.

In Lenel, an employer sought to terminate an employee’s stock options who had violated his noncompetition agreement after leaving Lenel’s employment.  While the stock option agreement did not have an express provision entitling the company to terminate the agreement, it did provide that the employee’s agreement not to compete was consideration for the options.  Not having the express right to terminate, the employer sought to rescind the option on equitable grounds.

The court summarized that rescission is an equitable remedy that allows a court to declare a contract void from its inception.  As a general rule, rescission of a contract is permitted where there is a breach of contract that is material and willful, or so substantial and fundamental “as to strongly tend to defeat the object of the parties in making the contract.”  The court rejected the defendant’s argument that an express forfeiture clause in the option agreement was required in order for option to be subject to rescission.  Instead, the court reasoned that the noncompetition covenant was the sole consideration for the option agreement, and when the defendant chose to compete with Lenel “in violation of the only material condition of the agreements,” he would give up his right to the stock options promised in exchange.

In is also worth noting that two of the appellate judges dissented from this decision, arguing that the consideration for the option consisted of two parts, one being the compliance with the covenant during the term of employment and the other part for the post-termination period.  The dissent reasoned that since the defendant did comply with the covenant during his six years of employment with Lenel, it cannot be said that he did not provide any consideration for the option, thereby reducing the argument in  favor of rescission.

As a lower appellate court decision, the Lenel case is more likely to lead an academic interest than to have an binding impact on the law on this issue.  However, the case illustrates that while rescission may be available as a remedy for employers, it is a difficult path to travel and that addressing termination rights in the option agreements may be advisable.