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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 decision by Massachusetts Supreme Judicial Court Strictly Construes Transfer Restrictions and Co-Sale Rights in S Corporation

Posted on Apr 19th, 2013

 

Since the 1974 landmark decision in Donohue v. Rodd, Massachusetts courts have held that majority stockholders in close corporations owe minority stockholders a fiduciary duty akin to that owed in a partnership. This type of duty has been relied up to protect minority shareholders from squeeze-out or freeze-out scenarios. It has also been used as an offensive tactic to argue for implied rights of shareholders that are not expressly provided in the corporate documents, such as the articles of organization, bylaws or shareholder agreements.

In Merriam, et. al. v. Demoulas Supermarkets, Inc., the Supreme Judicial Court refused to extend the duties provided under Donohue v. Rodd to restrict stock transfers that were not expressly restricted under the Corporation’s governing documents.

While a fiduciary duty may exist, the Court encouraged shareholders of close corporations to enter into a shareholder agreement or specify in the corporate bylaws “rights, protections, and procedures that define the scope of their fiduciary duty in foreseeable situations.” The Court held that good faith compliance with the specific terms will not implicate that fiduciary duty. “A claim for breach of fiduciary duty may arise only where the agreement does not entirely govern the shareholder’s actions.”

In this case the plaintiffs attempted to use the concept of fiduciary duty in a creative way to prevent the transfer of stock because the corporation was an S corporation and the transfer could blow the S election. After reviewing the shareholder agreement and bylaws, the Court held that the challenged actions fell within the scope of those agreements – which did not restrict such a transfer – and that the fiduciary duty was not implicated in this case.

The court also rejected the argument that the fiduciary duty could be used to create an implied right of first offer or co-sale rights on a transfer to a third party. Transfer restrictions are to be construed narrowly in Massachusetts, and the Court reasoned that had the parties intended to create such rights and restrictions, they would have stated so expressly in their shareholder agreement.

Certainly, this decision does not present any major news to most corporate practitioners. While it is nice to know that shareholder agreements are still given weight in Massachusetts, the key takeaway is the importance of having such an agreement in the first place. Close corporations, particularly those with employee shareholders, should be strongly encouraged to enter into detailed shareholder agreements to provide for situations dealing with transfers, rights of first refusal, preemptive rights and potential divorce and dissolution. Majority stockholders may feel some reluctance to spend money and time on such a document, when the protection is often for their fellow stockholders. However, as shown by this decision, not having such an agreement will subject everyone to the vague principles of applicable fiduciary duties, which could have wide-ranging and negative implications.

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