Enforcing Preliminary Agreements

Contract formation in commercial transactions can be an expensive and intricate process involving multiple stages and players, as well as significant investments in expertise and information.  In complex asset purchases, leases, corporate acquisitions, or venture financing transactions, to name just a few types, it is practically impossible for the parties to execute a fully stipulated and binding contract in a single meeting or over a very short period of time.  Negotiations of these transactions are typically sequenced, with a subset of issues being addressed at each stage and by numerous agents with different expertise.  The parties frequently enter into preliminary agreements midstream through their negotiations, often labeled memoranda of understanding, agreements in principle, commitment letters, letters of intent, or term sheets.  These agreements document the parties’ agreement-to-date on some or all of the core provisions for the underlying transaction, but they also contemplate, and to some extent regulate, the parties’ remaining negotiation.  Preliminary agreements should therefore be thought of as setting ground rules for negotiations, which may include obligations of confidentiality, disclosure, and exclusivity.  Significantly, these agreements can also create either express or implied legal duties to negotiate in good faith.  The invocation of the good faith (or similar) standard invites the court to police the parties’ negotiations, especially if they break down.

Over the past few decades, a significant volume of litigation has arisen over the enforcement of duties to negotiate in good faith.  Although contract law polices bargaining activity that leads to concluded contracts (such as through the doctrines of misrepresentation, coercion, duress, unconscionability, and unjust enrichment), U.S. law does not have a general duty to bargain in good faith that courts would enforce if negotiations break down before an enforceable agreement has been reached.  Nevertheless, parties have the ability to invoke such a duty in a preliminary agreement, and the duty to negotiate in good faith in the U.S. law is rooted in the parties’ intent.  Courts are called on to determine whether the parties have in fact agreed to legally binding good faith obligations, what is required by their good faith standard, and the remedy for breach.  Despite many judicial opinions addressing these questions, the law in this area has not been satisfactorily explained or rationalized.  In particular, the existing legal scholarship has been hamstrung in its ability to explain the law of preliminary agreements because of its focus on one purpose: encouraging relationship-specific or deal-specific investment in the contemplated transaction, including due diligence investigation into whether the transaction is profitable and expenditures in contract design that increase its profitability.  The current scholarly explanation is that the enforcement of a good faith obligation protects such investment from opportunistic hold-up by the non-investing party in subsequent stages of negotiation.

Although this rationale appears in some judicial opinions, it seems to be only a small part of the explanation of the existence and enforcement of obligations to bargain in good faith.  Parties opt into a standard such as good faith because it can cover a variety of other actions and goals.  Had the protection of reliance investment been the sole objective, more straightforward methods could protect reliance expenditures: for example, a simple promise to reimburse reasonable expenses if negotiations fall through.  We also observe that courts are willing to enforce the good faith duty with expectation—rather than just reliance—damages if the plaintiff shows that a contract would have been closed if the defendant had acted in good faith.  Moreover, the facts of many judicial cases reflect that parties agree to negotiate in good faith even when anticipated investments after the preliminary agreement are small.  The presence of other goals is reflected in several fact patterns and features of the case law and can be explained by analyzing the parties’ motivations to stage their negotiations.

By focusing on the protection of reliance, legal scholarship leaves unexplained a number of important features of preliminary agreements in practice and in the courts.  In a recent paper, Enforcing Preliminary Agreements, we introduce and describe a more robust and complete framework of the motivation for preliminary agreements and the duty to negotiate in good faith.  We suggest that these agreements are tools for regulating the negotiation process when parties, following search and diligence activity, are reasonably confident that they have found the partner with whom they wish to deal.  In these circumstances, they seek to regulate their negotiations in one or more of the following respects beyond the protection of reliance investments.  In addition to encouraging value-creating reliance investment, the parties wish to discourage attempts or investments by either side to improve its bargaining position and thereby claim a larger share of the transaction surplus.  It is noteworthy in this respect that express promises to negotiate in good faith or with best efforts are often seen in agreements complementing more explicit exclusivity promises not to shop an offer or negotiate with any other prospective party for a specified duration of time.  Finally, the preliminary agreement provides the means by which the parties can efficiently allocate selected risks of changed circumstances that would affect the distribution of surplus from the deal.  Although time may be needed to complete the terms of the contract, it may be valuable for the parties to allocate some risks sooner.  A relevant example is a preliminary agreement in a loan commitment that pegs the interest rate while the parties negotiate other terms of the debt such as representations, warranties, and covenants.  Indeed, the enforcement of preliminary agreements in a series of leading cases in the Second Circuit was motivated by the allocation of interest rate risk and not the protection of reliance investments.

The aforementioned goals of promoting efficient specific investment, discouraging value-claiming activity, and efficiently sharing exogenous risks must be balanced against the flexibility needed to reach optimal agreement on the remaining terms or to respond to previously unforeseen contingencies.  We argue that a contextual contract standard—whether good faith or best efforts—can be well-suited to address this multi-faceted regulation of the negotiation process that parties often wish to invoke.  Properly structured and construed, the duty to negotiate in good faith or with best efforts can provide incentive to the parties to undertake reliance investment that creates value, minimize the incentive to engage in surplus extraction, and efficiently allocate risks while maintaining flexibility on initially agreed-upon terms.  The parties (or the court) would be correspondingly unlikely to create such duties in a preliminary agreement when reliance, risk allocation, or danger of rent extraction are minimal or absent.  Once we recognize the beneficial role that a contextual standard can play under the right circumstances, we can justify the court’s enforcement of such an open-ended promise with a stronger remedy than reliance damages, including the award of expectation damages.  Drawing from prior work in which we explain how parties can exploit the benefits of standards and avoid the potential costs of litigation and judicial error, we respond to the concerns of lawyers and scholars about the litigation of vague standards.

This post comes to us from professors Albert H. Choi at the University of Virginia Law School and George G. Triantis at Stanford Law School. It is based on their recent paper, “Enforcing Preliminary Agreements,” available here.  In a companion paper, Relationship-Specific Investment, Asymmetric Information, and the Role of Good Faith Obligations, using game theoretic modeling, the authors  explore the role played by the good faith obligations more broadly in mitigating the problems of asymmetric information and bargaining failure and in promoting beneficial relationship-specific investment.