The Delaware Supreme Court recently decided that an agreement that the parties “will negotiate in good faith with the intention of executing a definitive License Agreement in accordance with the terms set forth in the License Agreement Terms Sheet” gave rise to an enforceable contract and a right to recover full contract damages, notwithstanding the fact that every page of the Term Sheet was labeled “Non Binding Terms.” The case, SIGA Technologies, Inc. v. Pharmathene, Inc., 2013 WL 2303303 (Del.Supr. May 24, 2013), creates new risks that a party might find itself committed to a transaction when it thought it had the right to walk away from the bargaining table at any time and for any reason. Letters of intent and other preliminary agreements are often used in connection with software implementation projects or information technology outsourcing relationships when the parties decide that work should begin before they have finished negotiating a definitive agreement. This article will address how a customer can avoid unintended commitments and better control the negotiating process to achieve its objectives.
The Delaware Case
SIGA Technologies Inc. (“SIGA”) was engaged in developing an antiviral drug for the treatment of smallpox. SIGA required additional financing to continue its project and turned to Pharmathene, Inc. (“Pharmathene”) for funding. Initially, the parties contemplated structuring the capital infusion in the form of a technology license. A license agreement term sheet (LATS) was negotiated that included most of the economic terms of the deal. Each page of the terms sheet was stamped with the legend “Non binding Terms.” Later, the parties decided that Pharmathene would acquire SIGA in a merger. The merger agreement provided that if the merger was terminated, the parties agreed to negotiate in good faith a definitive license agreement in accordance with the terms of the LATS.
After the merger agreement was executed but before the transaction closed, SIGA started to obtain substantial funding from the federal government. As a result, SIGA was no longer interested in consummating the merger and refused to extend the closing date, thereby terminating the merger agreement. SIGA and Pharmathene then began negotiating the license agreement. Because SIGA’s financial condition had improved since the economic terms in the LATS had been negotiated, SIGA proposed substantial changes to those terms. Ultimately, the parties reached an impasse in the negotiations. Pharmathene sued SIGA to enforce the agreement to negotiate the license agreement in good faith in accordance with the original terms of the LATS.
The trial court concluded that if the parties had negotiated the open terms not included in the LATS in good faith, the parties would have reached agreement on those terms. The court also concluded that, as a matter of law, the agreement to negotiate in good faith required SIGA not to propose material changes to the economic terms that previously had been agreed upon and included in the LATS. Therefore, the trial court held that SIGA had breached the agreement to negotiate in good faith and was liable for full contract damages, including the profits Pharmathene would have realized if the license agreement had been executed according to the original economic terms in the LATS.
The court also concluded that, as a matter of law, the agreement to negotiate in good faith required SIGA not to propose material changes to the economic terms that previously had been agreed upon and included in the LATS.
The Delaware Supreme Court affirmed the trial court’s decision and explained several principles of Delaware law applicable to the enforcement of preliminary agreements. First, where the parties enter into a preliminary agreement to negotiate in good faith a definitive agreement in accordance with the terms of the preliminary agreement, neither party can subsequently propose terms inconsistent with those established in the preliminary agreement. Second, the parties are not obligated to reach agreement on the terms that were not included in the preliminary agreement, and a good faith disagreement as to the open terms will preclude enforcement of a definitive agreement. Third, the court will make a factual determination as to the reasons that the parties failed to reach a definitive agreement. If the court concludes that the parties failed to reach a definitive agreement because one of the parties no longer was willing to be bound by the terms in the preliminary agreement, the court will find that party to be acting in bad faith. Finally, where the court determines that, but for the defendant’s bad faith negotiations, the parties would have reached an agreement on the open terms, the plaintiff will be entitled to recover contract expectation damages, including lost profits, based upon the terms of the preliminary agreement.1
Contract-Drafting Lessons Learned— General Principles
- If you enter into a preliminary agreement to negotiate in good faith to reach a definitive agreement in accordance with the terms of the preliminary agreement, you ultimately may be bound by the terms of the preliminary agreement.
- Even if you do not use the term “good faith” in the preliminary agreement, you may be bound to negotiate in good faith if other language in the preliminary agreement indicates that the parties intended to enter into a final agreement and only reserved the right to resolve open issues through subsequent negotiation.
- If you want to preserve the right to terminate negotiations at any time and for any reason, then you should not agree in the preliminary agreement to negotiate in good faith, and you should expressly state that the parties have the right to terminate negotiations at any time and for any reason and not be bound by the terms of the preliminary agreement.
- Stating that the terms of a preliminary agreement are non-binding and that a definitive agreement is necessary to bind the parties may not be sufficient to avoid a duty to negotiate the definitive agreement in good faith. Again, it is safer to expressly state that the parties may terminate negotiations at any time for any reason and not be bound by the terms of the preliminary agreement.
- If you want the parties to be bound in certain respects so that work can proceed before a full, definitive agreement is negotiated and executed, be specific about what is agreed to be done and what are the consequences of terminating the negotiations. For example, it is better to know that termination will cost “x” dollars than to have uncertainty as to whether you have agreed to negotiate the full agreement in good faith and, as a result, may be liable for full contract damages, including lost profits, if you terminate negotiations.
Application to IT System Implementations and Outsourcing Transactions
Frequently during the course of negotiations for IT system implementations and outsourcing transactions, one party—typically, the vendor—will propose to start work immediately, before the full contract is complete, through a signed preliminary agreement or letter of intent (LOI).
Examples of reasons given by vendors for executing an LOI include the following:
- The business terms are settled, so there is no need to hold up work to let the legal details catch up.
- The vendor’s delivery team is ready now, and the customer risks losing the best resources if it waits for completion of the final agreement.
- To meet a customer deadline, equipment needs to be ordered now, and any delay in the start of the project will result in a day-for-day delay past the customer’s deadline.
- The customer should provide some show of commitment, even if the LOI is non-binding, before the vendor makes the effort to complete the final documentation. (This is often pitched by the sales team as a plea to help alleviate pressure from the vendor’s management to get the full deal signed up immediately.)
Before addressing the validity of those reasons, it is important to note that, as between the parties, any signed LOI to begin temporary work will result in a loss of leverage for the customer with an offsetting gain in leverage by the vendor for the upcoming detailed negotiations. After all, once work has begun and the vendor is entrenched within the customer organization and in the project itself, it will be very evident to both parties that there are few, if any, issues that could constitute a “deal-breaker” resulting in a stoppage of work, a loss of value for work already performed and a loss of internal reputation for the customer team that agreed to proceed. A skilled vendor will exercise its new-found leverage to maximize its revenues on a “sure deal” and minimize its risk and exposure to failure through negotiation of the final terms.
Any signed LOI to begin temporary work will result in a loss of leverage for the customer with an offsetting gain in leverage by the vendor for the upcoming detailed negotiations.
In many cases, the vendor’s reasons for requiring an LOI may be illusory or simply window-dressing to maximize that leverage. Or, the vendor will present challenges that have a kernel of truth, but that can be addressed or mitigated without the parties signing an LOI. For example, a vendor’s suggestion that it will pull the “A” team from the customer’s account without an LOI to start temporary work could be strategic positioning only raised in order to pressure a customer. Likewise, there is rarely, if ever, a requirement in a bidding process for a customer to evidence its commitment to a vendor before finalizing the full detailed agreement.
Once a customer agrees to enter into an LOI, the vendor’s initial draft will typically seek to bind the customer for the entire term of the full deal, identifying rates and pricing. While this pricing is commonly attached as an exhibit to the LOI, detailed descriptions of the services and/or the “solution” being created by an implementation—in other words, the vendor’s commitments—are rarely included, on the theory that those details are “understood” well enough by the technical teams and will be captured in the final agreements. While customers are frequently successful in pushing back on the vendor to make the LOI non-binding and limit their commitment to only negotiate in good faith, they are typically not in a position to attach the detailed requirements for what they are buying. The customer is left with clear pricing but no commitment to scope or legal terms.
Setting aside the inherent losses of leverage for a customer in entering into an LOI, the recent SIGA ruling compounds the risks of an LOI to a customer in two ways:
- First, teams that are agreeing to a non-binding, good faith negotiation LOI typically view that LOI as a low-risk proposition that will not require or presume completion of a final deal. With that perspective, the content of an LOI is often pulled together hastily and is not given the level of review and consideration that is reserved for other signed contracts. The SIGA ruling places a burden on the customer, once it has signed an LOI, to complete negotiations in accordance with the LOI terms or risk a claim of bad faith negotiations. Failure to live up to the terms of the LOI could ultimately make that customer liable for the vendor’s expectation damages for the full deal (including contemplated profits on the full deal) if negotiations terminate prior to execution of that deal.
- Second, per the SIGA ruling, after an LOI is signed, a party may be prevented from proposing terms that are inconsistent with those established in the LOI. As noted above, in LOIs, there is a focus on rates and pricing (i.e., the revenue stream for the vendor) that is favored over describing the value that the customer will receive for that pricing. As a result, a typical LOI-bound customer is like a car buyer who has committed to a price before knowing the make or model of the car or its features. If an LOI identifies clear pricing for an undefined system or project, then the SIGA ruling suggests that good faith negotiations must take place regarding the system or project details only, because pricing will be interpreted as having been settled already. The customer is constrained from proposing materially lower pricing as it learns more about what is excluded from the features of the system or the scope of the project, out of fear that any such proposal could be perceived as negotiating in bad faith.
In summary, for IT and outsourcing arrangements, the SIGA ruling makes the already-suspect contracting tool of the LOI that much more unattractive to a customer who is seeking to contract for value and sustain leverage in negotiations with a vendor.
Mitigating Risks Where an LOI Is Unavoidable
In spite of the many reasons described above for a customer to resist agreeing to an LOI with a vendor, there may be times when, for good business reasons, a customer will need a vendor to begin work on a project immediately in order to meet a business-driven or technically required deadline. Sometimes, even the loss of leverage for the remaining negotiations will be more palatable to a customer than a missed deadline. In those cases, the drafting principles identified earlier in this article will be particularly important when negotiating the LOI. Specifically, the LOI should exclude any commitment by the parties to negotiate in good faith with the intention of executing a final agreement, expressly reserve the right of each party to end negotiations for any reason and clarify that all points of the final deal (e.g., price, scope and legal terms) remain subject to further negotiation.
[I]t is critical that the LOI account for all possible outcomes and scenarios if the LOI is terminated prior to completion of the final agreement.
Finally, it is critical that the LOI account for all possible outcomes and scenarios if the LOI is terminated prior to completion of the final agreement. This includes describing the disposition and responsibility for all critical elements of that temporary work, including the following:
- Identifying which portions of the temporary services, if any, will be billable to the customer if negotiations fail.
- Identifying who will be responsible for any ordered equipment, software or other stranded assets that cannot be returned.
- Determining whether the customer will be allowed to retain the planning documents and materials that are developed prior to cancellation of the temporary services.
Addressing these issues and other similar concerns will minimize the risk of unintended consequences flowing from a terminated LOI. Even if the LOI is not terminated, good guidelines will assist the customer in retaining some amount of leverage after signing the LOI, particularly if the terms are designed so that the vendor risks losing some portion of the revenue for the temporary services performed if the larger deal falls apart.
1 Although this decision is based upon Delaware law, the Delaware Supreme Court relies heavily on decisions by New York state courts and federal courts construing New York law. The rules discussed above most likely will also apply to disputes governed by New York law.
To read this complete article visit Business & Technology Sourcing Review - Issue 19.