Beware the Type II Preliminary Agreement

Preliminary agreements come in two types: (a) a preliminary agreement that contains all the “material terms” of a deal, but nevertheless contemplates the negotiation and execution of a more definitive agreement, but without making the execution of such a definitive agreement an express condition precedent to the formation of a binding contract (referred to by some courts as a “Type I” preliminary agreement); and (b) a preliminary agreement that similarly contemplates negotiation of a more definitive agreement, but which only sets forth some, not all, of the material terms of the deal (referred to by some courts as a “Type II” preliminary agreement). Type I preliminary agreements are fully binding upon the parties regardless of whether a subsequent definitive agreement is negotiated or executed. Type II preliminary agreements, on the other hand, are not fully binding upon the parties, but nevertheless require the parties to negotiate the missing material terms in good faith and not renegotiate the material terms that are set forth in the preliminary agreement, even though those stated terms are otherwise nonbinding. Thus, neither Type I nor Type II preliminary agreements are merely non-binding term sheets or letters of intent, even if they may appear to be.[1] And as the Delaware Supreme Court recently reminded us, in Cox Communications, Inc. v. T-Mobile US, Inc., 2022 WL 619700 (Del. Mar. 3, 2022), whether implied or express, “Delaware law recognizes that obligations to negotiate in good faith [pursuant to Type II preliminary agreements] are not worthless.”

In 2013, the Delaware Supreme Court famously determined, in SIGA Techs, Inc. v. PharmAthene, Inc., 67 A.3d 330 (Del. 2013), that the obligation to negotiate in good faith, expressly or impliedly, pursuant to a Type II preliminary agreement, has real teeth in Delaware. In many states that recognize Type II preliminary agreements, breach of the good faith negotiation obligation only permits reliance-based damages for breach (i.e., damages required to put the non-breaching party in the position it would have been in had the preliminary agreement never been entered into, which are essentially only the costs and expenses of pursuing the negotiations in an attempt to reach a deal) because the contract was only a contract to negotiate and the courts typically do not speculate as to what actual contract would have been entered into had there not been a breach of the obligation to negotiate in good faith. But in SIGA Techs, the Delaware Supreme Court determined that expectancy-based damages (i.e., damages required to put the non-breaching party in the position it would have been in had the parties actually negotiated in good faith and entered into a definitive agreement) are recoverable for breach of Type II agreements under Delaware law.

Following the Delaware Supreme Court’s 2013 decision in SIGA Techs, the case was remanded to the Court of Chancery to determine those expectancy-based damages. In early 2015, the Court of Chancery awarded damages of $113 million to PharmAthene based on SIGA Technologies’ alleged breach of an obligation to negotiate a license agreement in accordance with the terms of an otherwise nonbinding term sheet. Because the agreement claimed to have been breached was a Type II preliminary agreement, the Court of Chancery had been required to first determine what the definitive agreement would have looked like had it in fact been negotiated in good faith to then determine the expectancy-based damages that should be awarded to put the non-breaching party in the position it would have been had that agreement actually been entered into and not subsequently breached.[2] In SIGA Techs, Inc. v. PharmAthene, Inc., 132 A.3d 1108 (Del. 2015), the Delaware Supreme Court then upheld the Court of Chancery’s damages award notwithstanding that the damages model contained a number of speculative assumptions about the profitability of the business that would have resulted from an agreement that the court determined would have come into effect had both parties conducted the negotiations in good faith.

While the common law has long held that damages must be proved with reasonable certainty, the Delaware Supreme Court’s 2015 PharmAthene decision put a new twist on that rule: If the breaching party “caused uncertainty about the final economics of the transaction by its failure to negotiate in good faith, willfulness [by the breaching party] is a relevant factor in deciding the quantum of proof required to establish the damages amount.” Thus, according to the Delaware Supreme Court’s 2015 PharmAthene decision:

When a party breaches a contract, that party often creates a course of events that is different from those that would have transpired absent the breach. The breaching party cannot avoid responsibility for making the other party whole simply by arguing that expectation damages based on lost profits are speculative because they come from an uncertain world created by the wrongdoer. Rather, when a contract is breached, expectation damages can be established as long as the plaintiff can prove the fact of damages with reasonable certainty. The amount of damages can be an estimate.

The dissent in the Delaware Supreme Court’s 2015 PharmAthene decision pointed out that this result would not have been obtained in New York because although New York recognizes Type II preliminary agreements, it generally limits damages for their breach to reliance-based damages, not expectancy-based damages. The Delaware approach, by contrast, not only recognizes an enforceable good faith obligation to negotiate pursuant to Type II preliminary agreements (like New York), but (unlike New York) effectively “transforms an agreement to negotiate for a contract into the contract itself,” thereby providing the non-breaching “party the benefit of the bargain that was not reached.” According to the dissent, New York is not the only jurisdiction that limits damages for breach of a good faith negotiation obligation to reliance-based damages in most cases. Thus, according to the dissent, allowing expectancy-based damages, “now places Delaware out of step with other important commercial jurisdictions.”

In Cox Communications, the most recent decision by the Delaware Supreme Court regarding Type II preliminary agreements, the court was simply tasked with interpreting language in an agreement to determine whether it in fact created a Type II preliminary agreement requiring good faith negotiation, or was instead an agreement prohibiting a party from engaging in certain business at all, unless it did so with the party with whom it had agreed to negotiate a contract. The language in question provided that:

Before Cox or one of its Affiliates (the “Cox Wireless Affiliate”), begins providing Wireless Mobile Service (as defined below), the Cox Wireless Affiliate will enter into a definitive MVNO agreement with a Sprint Affiliate (the “Sprint MVNO Affiliate”) identifying the Sprint MVNO Affiliate as a “Preferred Provider” of the Wireless Mobile Service for the Cox Wireless Affiliate, on terms to be mutually agreed upon between the parties for an initial period of 36 months (the “Initial Term”).

The Court of Chancery held that, although the above quoted language included a Type II preliminary agreement (i.e., the agreement to negotiate a definitive MVNO agreement with Sprint for an initial term of 36 months if Cox were to enter into the Wireless Mobile Services market), it also prohibited Cox from entering into the Wireless Mobile Services market at all, unless it made a deal with Sprint. In other words, even if Cox was found to have negotiated in good faith and nonetheless failed to conclude a definitive deal with Sprint, Cox was in violation of this provision when it entered into a deal with anyone else. But the Delaware Supreme Court disagreed and construed the language as only constituting a Type II preliminary agreement, which imposed a good faith obligation for Cox to negotiate a definitive agreement within the framework set forth in the provision (i.e., a 36 moth initial term), but did not prohibit Cox from entering into an alternate deal with another party if good faith negotiations failed to result in a deal between Sprint and Cox. Accordingly, the Delaware Supreme Court remanded the case to the Court of Chancery to make a factual determination as to whether Cox had in fact negotiated in good faith with T-Mobile, Sprint’s successor, prior to entering into a deal with Verizon.

This post is less about the particular facts or holding in Cox Communications, and more about the sometimes hazy lines between unenforceable “agreements to agree,” actual agreements that are nonetheless “preliminary,” preliminary agreements containing certain terms that while non-binding may nonetheless impose an enforceable obligation to negotiate a deal in good faith consistent with those expressed terms and non-binding expression of mere intent. Many times parties use non-binding term sheets and letters of intent as a means of providing a road map for the deal that the parties then contemplate, but with the understanding that the chosen route described in the term sheet or letter of intent could well change and that the parties are not binding themselves to the stated route or destination. If the outlined terms are to be converted into a fully-baked deal by the court and then damages assessed based on breach of that deal to the extent there is a finding that one of the parties failed to negotiate in good faith, the risk is that those damages could far exceed the actual damages that may have been available to the non-breaching party pursuant to a fully-negotiate definitive agreement that, for example, contained a damages limitation provision.

To avoid accidentally committing to a specified route or destination with potential liability for failing to follow that route or arrive at the specified destination, parties need to do more than simply disclaim the intent to enter into a binding agreement regarding the specified outline of terms—they should also include a disclaimer of any obligation to negotiate in good faith if possible. After all, Type II preliminary agreements can expressly require good faith negotiation but, even when there is no express good faith negotiation obligation, one is typically implied. In other words, notwithstanding the age-old rule that “agreements to agree” are nullities, a Type II preliminary agreement can, in some states, be a binding contract to negotiate in good faith to attempt to agree to a deal, even in the absence of an express good faith obligation to negotiate.If the parties intend that result then all is well, but even if that obligation is intended and understood, the issue of liability for an alleged failure to negotiate in good faith should nonetheless be considered.

And it may be that this is an area where New York is more favorable than Delaware, at least to the party that is alleged to have failed to negotiate a Type II preliminary agreement in good faith. So consider choice of law carefully in these arrangements. Otherwise the damages arising from breach of a Type II preliminary agreement to negotiate in good faith to enter into an agreement could well be worse than those arising from the breach of a definitive agreement that was in fact entered into.

And in case you are looking for a sample provision that attempts to keep a non-binding letter of intent or term sheet completely non-binding (by avoiding its classification as either a Type I or Type II preliminary agreement), consider the following:

The terms set forth in this letter do not constitute all of the essential terms upon which agreement must be reached by the parties in order to form a binding and enforceable contract, and no binding and enforceable rights or obligations in favor of either party hereto are intended to be created hereby. No correspondence, oral statements or course of conduct between the parties shall alter the non-binding nature of this letter or the parties dealings, and either party shall be free at any time to terminate discussions or negotiations for any reason or no reason in its sole discretion (and neither party shall have any obligation to initiate or continue negotiations on any basis). A binding and enforceable contract between the parties shall only be created if a definitive written agreement is signed by both parties (and the execution and delivery of such a definitive written agreement by both parties shall be an express condition precedent to the formation of any contract between the parties, and the terms of any such contract shall be limited to the terms specifically set forth in such definitive written agreement).

Remember, “[u]nder Delaware law, language that an agreement’s terms are non-binding does not alone relieve a party of an obligation otherwise created to negotiate in good faith.”[3] Indeed, such language may only be viewed as having disclaimed the intent to form a Type I preliminary agreement, not disclaimed the formation of Type II preliminary agreement.[4]

Finally, for those of you who need a refresher on avoiding traps for the unwary in this hazardous area of the M&A deal world (including a comparison of the approaches used in a number of different states), I highly recommend a 2012 Weil-branded piece, entitled, CYA On That LOI—Avoiding Liability Under Preliminary Agreements, which while written pre-SIGA Techs remains highly relevant and useful.

Endnotes    (↵ returns to text)
  1. See generally, Glenn West, Contracting Accidentally through Preliminary Agreements—A Writing “Subject To Contract” May or May Not be a Contract, Weil Insights, Weil’s Global Private Equity Watch, March 8, 2017, available here.
  2. It is important to note that the term sheet in SIGA Techs was unusually detailed and therefore lent itself more readily to a determination of what an actual definitive agreement would have looked like if it had been negotiated in good faith.
  3. Cambridge Capital LLC v. Ruby Has LLC, 2021 WL 4481183, at *11 (S.D.N.Y. Sept. 30, 2021).
  4. See id.