What to Know About a “Pre-Contractual” Duty to Negotiate in Good Faith in Preliminary Agreements such as Term Sheets and Letters of Intent

What are some of the commonly used preliminary agreements and how can using these tools help your deal or transaction? A term sheet is a document that outlines the material terms and conditions of a proposed business agreement. A letter of intent (LOI) is very similar in purpose to a term sheet, in that it is a letter that outlines the terms of the agreement prior to the agreement being finalized.  Both term sheets and LOIs are forms of preliminary agreements.  Ordinarily, where the parties contemplate further negotiations and the execution of a formal instrument later (i.e., the contract), a preliminary agreement does not create a binding contract (but read on….of course it is more nuanced!).  Term sheets and LOIs are often used in financing agreements, purchase agreements, or other complex agreements.  Preliminary agreements, or “agreements to agree” are beneficial in a number of ways.  First, these tools help the parties to easily identify the terms and conditions that they agree and disagree on.  Second, preliminary agreements assist legal counsel to take the agreed upon terms and prepare the first draft of the contract that will govern the transaction.  Personally, I like using tools such as term sheets and LOIs, because they often simplify and organize the process of agreeing on terms, so that the terms are not being decided during the contract drafting phase. Depending on the complexity of the deal, it can be downright chaotic to have everything going on at the same time.

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All good right? Well, there’s more to consider. As wonderful and as helpful as term sheets and LOIs can be as pre-contractual tools for efficiency, it is important to know whether your preliminary agreements could create legal obligations for you – based on the governing contract law.  Even though term sheets and letters of intent are usually non-binding in Florida (in the absence of a specific statement otherwise) another duty may still exist.

Based on your jurisdiction, a term sheet or LOI may create a duty to negotiate the ultimate agreement in good faith. When I say “ultimate agreement” I mean the transaction you are hoping to complete in the end.  So if the term sheet or LOI is for a financing deal with an investor, depending upon the jurisdiction governing the term sheet/LOI, the term sheet/LOI could knowingly (or unknowingly) create a duty to give a sincere effort to fully and completely negotiate while working to reach a finalized financing agreement. How does this happen? A term sheet or LOI may include a provision regarding the parties’ obligation to negotiate in good faith. Alternatively, in some jurisdictions, even when this provision regarding the parties’ obligation to negotiate is not included in the term sheet, the duty may even be implied under certain circumstances.  Whether a provision on this obligation to negotiate in good faith is binding when explicitly stated or potentially implied when not included at all is a highly litigated issue with results that vary significantly among jurisdictions. For example, in some states, even when a term sheet contains an explicit agreement to negotiate in good faith, such provisions are not enforceable as a matter of law.  This is true in Texas and Virginia. However, in a number of other states, including Delaware, California, the District of Columbia, New York, and Illinois, a signed term sheet may be considered a preliminary agreement that, although not binding with respect to the proposed transaction, it still nonetheless obligates the parties to negotiate in good faith towards that objective. Interestingly, in these jurisdictions, this may even be implied when the preliminary agreement does not explicitly contain any explicit reference to this good faith obligation to negotiate. See for example, Brown v. Cara, 420 F.3d 148 (2d Cir. 2005) (upper court agreeing with the plaintiff’s argument that the preliminary agreement created an obligation to negotiate in good faith within the general framework provided by the document).

Where does Florida contract law stand on this issue? Well, it depends.  Here are some points to consider if your dealings are covered by Florida contract law.  The first point is that although this issue is highly litigated elsewhere, Florida law authorities (both state law cases and federal cases which use Florida contract law) surprisingly do not have as many cases that explore this issue as many of the other jurisdictions previously mentioned above.  Secondly, in the limited cases on point, INTENT seemed to rule the day.  For example in the case of Lafarge N. Am., Inc v. Matraco-Colorado, Inc., (S.D. Fla. 2008), the Southern District Court of Florida found that a lack of showing of an intent for the parties to be bound, especially in light of parties’ clear expression of an intent not to be bound in their letter of intent and term sheet. A big takeaway here is do not leave anything to chance.  Clearly state your intended obligations, and clearly state that which the parties do not tend to be obligated to do, in order to avoid contractual uncertainty under Florida contract law.

THINGS TO CONSIDER:

  • Choice of Law: When negotiating and drafting your term sheet or LOI, you will want to know what the law in your state is on this particular issue. This will help you to make a more informed decision when selecting jurisdiction or choice of law provisions in your term sheet.

  • Beware of Boilerplate: Be careful with boilerplate language stating that the parties agree to “negotiate in good faith.” Being cautious does not mean that parties intend to negotiate in bad faith, but including standard boilerplate calling for a duty to negotiate in good faith can arguably open the door to litigation when a deal falls through or other behavior the other party subjectively deems not up to par.

  • A Clearly Defined Out: In certain situations it may be helpful and desirable to have a way “out.” Perhaps even consider including clearly stated language in the term sheet that the parties can abandon the negotiations for any reason, or even no reason at all.

  • Seek Legal Counsel: The sooner your attorney is involved in the deal, even in the preliminary stages of the deal, the better it will be. Your attorney will help you determine the law in the applicable jurisdiction, and special facts that may determine special considerations for your term sheet and the pending deal.


**** This article is for educational purposes only and to provide a general understanding of the law, not to provide specific legal advice. By reading this blog post you understand that there is no attorney client relationship between you and TLA LAW. This blog or any article on the website should not be used as a substitute for obtaining competent personalized legal advice from a licensed attorney in your state.