A promise to negotiate in good faith can be enforced

A letter of intent can be nonbinding as to the sale and still binding as to the promise to negotiate. Delaware and New York enforce that promise. Neither orders the deal closed. Under Delaware law, a buyer who negotiates in bad faith against an agreed term sheet can owe you the value of the lost deal, once proved.

Which parts of a letter of intent are actually binding?

Most letters of intent are hybrids. Confidentiality, exclusivity, expenses, publicity and governing law are the paragraphs usually carved out as binding, and they bind only because the document says so. Price and structure do not bind. Between them sits the promise to negotiate the definitive documents in good faith.

Owners tend to read that promise as decoration. It is not. It is a covenant with its own subject matter, and that subject matter is not the sale of your company. It is how the buyer may behave between signature of the letter of intent and signature of the purchase agreement.

The carve-out does the work. If the binding-provisions paragraph says nothing about the good faith covenant, you are asking a court to read it back in. Get it into the list, by number.

That distinction sets the remedy. A court asked to enforce a promise to negotiate will not order the buyer to buy. It asks whether the buyer negotiated in good faith, and if not, what that cost you.

What is a Type I versus a Type II preliminary agreement?

The preliminary-agreement framework comes from a 1987 federal decision applying New York law. A Type I agreement is complete: the parties have settled everything and intend only to memorialize it, so it is enforceable as the deal itself. A Type II agreement leaves terms open and binds the parties only to negotiate those open terms in good faith.

The court there held a lender’s commitment letter to be a binding preliminary commitment. Both sides had to try to conclude a final loan agreement on the agreed terms, negotiating in good faith over the customary open terms. The borrower’s reservation of board approval did not make it free to walk away. It broke off negotiations by insisting on an accounting condition outside the agreed framework, after rates fell. Breach.

The same opinion draws the remedy line. Under a Type II agreement, a party cannot demand performance of the ultimate objective. It can demand good faith negotiation toward the final contract, and no more. If both sides negotiate in good faith and still fail to agree, no enforceable rights survive.

The Second Circuit, applying that decision, weighs five things, and the first dominates:

• The language of the document itself, and whether it reserves the right not to be bound absent a later signed agreement
• The context of the negotiations
• How many material terms remain open
• Whether either side has begun to perform
• Whether transactions of this kind are customarily reduced to a formal signed writing

Note what is missing: the heading. Calling it a letter of intent decides nothing. The operative words inside decide it.

One qualification. New York’s Court of Appeals has said it does not find the rigid sorting into Types useful, asking instead whether the document contemplated later agreements and whether signing them was a precondition to performance. The substance survives the labels.

Law: Teachers Insurance and Annuity Association of America v. Tribune Co., 670 F. Supp. 491 (S.D.N.Y. 1987); Arcadian Phosphates, Inc. v. Arcadian Corp., 884 F.2d 69 (2d Cir. 1989); IDT Corp. v. Tyco Group, S.A.R.L., 13 N.Y.3d 209 (2009).

What did Delaware hold in SIGA Technologies v. PharmAthene?

Delaware holds that an express contractual obligation to negotiate in good faith in accordance with an agreed term sheet is enforceable, even where the term sheet itself is labeled nonbinding. The Delaware Supreme Court held so in SIGA Technologies v. PharmAthene, and permitted expectation damages where the trial judge found the parties would have reached agreement but for bad-faith negotiation.

These are the facts of a retrade. Two companies agreed a license term sheet, every page footed “Non Binding Terms.” It was attached to a merger letter of intent, a bridge loan agreement and the merger agreement. Each signed document provided that if the merger was not completed, the parties would negotiate in good faith a license agreement in accordance with the attached sheet.

The merger did not close. By then the underlying drug had become far more valuable, helped by federal development funding, and the party holding it no longer needed a partner. It came back proposing license terms substantially different from the attached sheet, and far better for itself.

The Court of Chancery found bad faith. The Supreme Court affirmed liability and stated the rule: agree to negotiate in good faith in accordance with a term sheet, and that obligation is enforceable. It reversed the promissory estoppel holding, because a promise expressed in a fully enforceable contract cannot support promissory estoppel. Equitable theories are not a substitute for a clause you failed to negotiate.

The label on the term sheet did not control. The covenant to negotiate against it did.

The damages history is the part to read twice. Chancery first refused a lump sum as too speculative and awarded a payment stream instead. Only after remand did it enter lump-sum expectation damages of roughly $113 million, affirmed on appeal as proved with reasonable certainty. The January 2015 judgment reached about $195 million with interest, costs and fees.

Take the rule and leave the number. The number came from a federally funded drug program with years of projected profits and duelling experts.

Law: SIGA Technologies, Inc. v. PharmAthene, Inc., 67 A.3d 330 (Del. 2013); SIGA Technologies, Inc. v. PharmAthene, Inc., 132 A.3d 1108 (Del. 2015); Final Order and Judgment, Del. Ch., January 15, 2015.

Can you recover the lost deal, or only your costs?

Damages for a broken promise to negotiate depend on the governing law. Delaware allows expectation damages, meaning the value of the bargain, where the court is reasonably certain the parties would have signed but for the bad-faith conduct. New York, in Goodstein Construction Corp. v. City of New York, refused lost profits and left the plaintiff to its out-of-pocket expenses.

There, a developer held an exclusive right to negotiate a land disposition agreement with the City. The City ended the designation. The developer sued for $800 million, all but about $1 million of it lost profits. The out-of-pocket claim was not in dispute on appeal. The profits claim failed because those profits depended on a final agreement never executed and approvals never given.

New York’s background rule points the same way. A mere agreement to agree, with a material term left to future negotiation, is unenforceable. That rule does not defeat an express promise to negotiate. It defeats the promise to reach a deal.

So the governing-law line is a substantive choice about the size of your remedy, not boilerplate. Buyer’s counsel will propose the buyer’s home state. Ask why, and price the answer.

Law: Goodstein Construction Corp. v. City of New York, 80 N.Y.2d 366 (1992); Joseph Martin, Jr., Delicatessen, Inc. v. Schumacher, 52 N.Y.2d 105 (1981).

What does bad faith look like in a deal negotiation?

Bad faith in a negotiation covenant is not hard bargaining. It is conduct inconsistent with the agreed term sheet: reopening economics the sheet already fixed, or demanding terms materially worse than what was agreed, with no diligence finding that justifies the change. Hard positions on genuinely open terms remain permitted.

In practice, the pattern looks like this:

• A price cut announced without a written diligence finding behind it
• A sudden escrow, holdback or seller note that the term sheet did not contain
• Recharacterizing agreed economics as “subject to confirmatory diligence” after the fact
• Proposing a definitive agreement whose economics bear little relation to the attached exhibit

I ask for the buyer’s written diligence finding, with the supporting numbers, before I respond to any change in the economics.

Two limits keep this honest. A buyer who finds a real problem in diligence and asks to reprice it is not negotiating in bad faith. Nor does the duty run forever. New York’s Court of Appeals has held that parties who agree to negotiate are not bound to negotiate indefinitely, and that a good faith impasse ends the obligation without a breach by either side.

Law: IDT Corp. v. Tyco Group, S.A.R.L., 23 N.Y.3d 497 (2014).

Does the good faith promise bind you as the seller too?

The obligation to negotiate in good faith is symmetrical. A seller who signs it is bound to negotiate toward the attached term sheet on the same standard as the buyer. Sellers who treat the clause as one-way armor create exposure. Pushing price up mid-diligence is the seller’s retrade.

The scenarios are ordinary. A competitor calls with a higher number three weeks into exclusivity. A strong quarter closes and you decide the multiple should apply to a new trailing figure. A key employee resigns and you want a larger rollover. Each is a change to terms the attached sheet already fixed, and each, made without a stated basis, is the conduct Delaware condemned, pointed the other way.

This clause is the closest thing your letter of intent gives you to a defense against a retrade. It is also the closest thing it gives the buyer.

Should you attach the economic term sheet to the letter of intent?

Attaching a detailed term sheet raises the stakes in both directions. Definite economics give a court something concrete to enforce, which is what made the promise valuable in the Delaware litigation. That same definiteness becomes the yardstick for your own conduct.

Attach the economics when your numbers hold up to a stranger reading them. Keep the sheet shorter when the books are still being cleaned up, or when one customer concentration issue could legitimately move price. Audited statements are uncommon on sales this size, so the practical test is whether your internal numbers reconcile to your tax returns and deposits. Either way, say which items are settled and which are open.

Items commonly settled in an attached sheet at this size: price and form of consideration, asset or equity structure, escrow or holdback amount and term, any seller note terms, the non-compete term, and the treatment of real estate and owned vehicles. Working capital is the item to watch. A fixed dollar target with a stated calculation method is a lower-middle-market practice, not a universal one, and on smaller deals it is often one line or excluded outright. Items commonly left open: indemnity caps and baskets, survival periods, and employment terms for retained staff.

What should you do before you sign the letter of intent?

Before signing the letter of intent, read the binding-provisions paragraph, the governing-law line and the attached term sheet together, as one instrument. Those three items decide whether the good faith promise is enforceable, what it is measured against, and what a breach is worth. The price on page one decides nothing until those are settled.

I read the binding-provisions paragraph and the governing-law line before I read the price.

• List, by number, every paragraph the document says is binding. If the good faith covenant is not in that list, ask for it in writing.
• Say what the negotiation is measured against: a definitive agreement “consistent with the terms set forth in Exhibit A.” A bare promise to negotiate, with nothing attached, gives a court little to work with.
• Choose the governing law on purpose, knowing the remedy is wider in Delaware than in New York. Expect the chosen state to have some connection to the parties or the business. A court applies a choice-of-law clause; it does not rubber-stamp one.
• Tie exclusivity to performance. Require any change to the agreed economics in writing, with the diligence finding behind it, and have exclusivity terminate at your option if the buyer proposes terms materially inferior to the exhibit without one.
• Keep the file. Dated drafts, markups and emails are the evidence of what was agreed and when it changed.
• Read the clause against yourself once, and decide whether you can live with it if a better offer arrives in week three.

Case law on preliminary agreements is state-specific. Confirm the rule in the state whose law your letter of intent actually selects before you rely on either line of cases.