Terms Sheets, MOUs, LOIs and Heads of Agreement

It is extremely common for the first formal step in an M&A transaction in Asia to be the signing of a preliminary document such as a terms sheet, Memorandum of Understanding (MOU), Letter of Intent (LOI) or Heads of Agreement (HoA), setting out some key terms that the parties have agreed as a framework for a transaction.

These key terms would typically include items such as price, a description of what is being sold, perhaps some key conditions and, possibly, some exclusivity arrangements for the negotiation period. There may also be an agreed timetable for the transaction. Generally, although not always, these preliminary documents are expressed to be “non-legally binding” except for certain limited specified terms. The most common legally binding provisions include confidentiality provisions, choice of law provisions, any exclusivity and break fee arrangements, and often an obligation to negotiate binding definitive documents (the “Negotiation Clause”).

The Negotiation Clause can take many forms, but it will often be something like:

The parties agree to act in good faith to negotiate definitive agreements consistent with the terms of this MOU/Letter of Intent/Terms Sheet/Heads of Agreement within [x] months of this document.

This clause is often expressed to be one of the legally binding provisions and, in my experience, commercial parties believe that this clause has some legal effect, although they usually realise that it does not guarantee an agreement will actually be reached.

However, as all commercial lawyers know, it is a long established principle of common law that “agreements to agree” are void for uncertainty (see for example May & Butcher Ltd v R [1929] All ER Rep 679;  Walford v Miles [1992] 2 AC 128). This principle has been reflected in numerous court decisions across a range of jurisdictions including England, Australia and Hong Kong. However, there are arguments made that a Negotiation Clause similar to the example above is not an “agreement to agree”, but rather an agreement between the parties to conduct themselves in a particular manner for a particular period and, in this way, a Negotiation Clause has the potential to be enforced. It is presumably for this reason that such clauses continue to be included in many preliminary documents.

It is also well established, at least under English common law, that there is no general duty to negotiate in good faith. In some ways this forms the whole basis of English contract law and the concept of freedom of contract. This is in contrast to the position in the US where section 205 of the American Restatement (Second) of the Law of Contracts provides that “every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement” and such a principle may apply to the performance of preliminary documents. This general common law position has arguably been watered down by various consumer protection and unconscionable contracts statutes in a range of jurisdictions and it is also possible that Equity may intervene where disproportionate bargaining positions exist or where an estoppel arises.

Against the backdrop of there being no general requirement to negotiate in good faith, it would seem totally reasonable for commercial parties who have reached an in principle agreement and committed to expending significant resources to pursuing a more definitive, detailed agreement,
to want to ensure that they deal with each other in a particular manner and consistently with that in principle agreement. This desire is likely to be even greater for a party which has agreed to exclusivity arrangements during the negotiation period.

Uncertainties

However, the courts in common law jurisdictions have struggled with this concept and continue to hark back to the principle that a Negotiation Clause is unenforceable. Over the last 15 years or so there have been a number of cases challenging this notion and the momentum appeared to be going in a more “commercial” direction. For example, Longmore LJ in Petromec ([2005] EWCA Civ 891) and Kirby P in Coal Cliff Collieries Pty Ltd v Sijehama Pty Ltd ([1991] 24 NSWLR 1) both noted that commercial parties clearly had something in mind when they agreed to include a Negotiation Clause (and, this would be even more clearly the case if they had gone to the effort of expressly naming it as a Legally Binding Provision). Longmore LJ noted that to decide that an agreement to negotiate “has no legal content … would be for the law deliberately to defeat the reasonable expectations of honest men”. In his view it was difficult for the law to “declare unenforceable a clause into which the parties had deliberately and expressly entered”. Kirby P was prepared to state that “provided there was consideration for the promise” (eg an exclusivity or break fee arrangement) then “a promise to negotiate in good faith will be enforceable depending on its terms”.

Moreover, such provisions are very similar in content to obligations to seek to settle disagreements in good faith obligations which are regularly contained in dispute resolution clauses and which are frequently found by courts to be enforceable. For example in Emirates Traveling Agency LLC v Prime Mineral Exports Private Ltd ([2014] EWHC 2104) the English High Court found that a provision requiring parties to undertake “friendly discussions” prior to commencing arbitration was enforceable.

Despite some positive movement towards giving some legal meaning to Negotiation Provisions, the pendulum now seems to have swung back the other way and, even though they continue to be frequently used in preliminary documents, there is real uncertainty as to the legal effect of such clauses.

Recent decisions in England and Australia indicate that courts are reluctant to enforce Negotiation Provisions, at least in most circumstances. Their general justification is that the clauses are too uncertain. It is unclear why such an obligation would necessarily be uncertain in a Negotiation Clause, but be enforceable as part of a dispute resolution clause. Arguably it is more certain in a Negotiation Clause, where there are at least some parameters that have been agreed and the parties have a legitimate expectation that any negotiation would at least be consistent with those parameters, unless there was a reasonable and justifiable
basis for departing from them.

For example, where the parties have specified in a terms sheet a particular price for shares and have also agreed to negotiate the definitive agreements in good faith, a party would be justifiably aggrieved if almost immediately after signing the terms sheet the buyer advised the seller that it was only prepared to pay a fraction of the purchase price previously specified. Similarly, a party would be justifiably disappointed if, having agreed an exclusivity period, the other party simply refused to engage in negotiations during that period.

The current position in most common law jurisdictions is that there is not much that the disgruntled party can do in such a situation. There have been a number of cases where the courts seem to make a distinction between such obligations in respect of “negotiation” and obligations in respect of “performance”. See for example Barbudev v Eurocom Cable Management Bulgaria EOOD ([2012] EWCA Cir 1560) and Shaker v Vistajet Group Holdings SA ([2012] EWHC 1329 in England, Hyundai Engineering and Construction Company Ltd ([2005] 3 HKLRD 723) in Hong Kong, and Baldwin v Icon Energy Ltd ([2015] QSC 12) in Australia. This distinction seems to be based on misguided notions that during negotiation there is not a “valid and enforceable contract”, there is too much uncertainty and that the Negotiation Clause was intended by the parties to be interpreted as an obligation to reach agreement, ie it is an agreement to agree.

Can negotiation provisions be binding?

If the preliminary document is drafted properly, then none of these notions need be correct. Firstly, a preliminary document (even with a number of non-legally binding terms) can clearly meet the requirements of a valid and enforceable contract: It can clearly involve an offer and acceptance and there can be an exchange of promises amounting to the passing of consideration. Indeed, parties who have entered into a preliminary agreement which contains confidentiality obligations, exclusivity provisions and break fees would be incredulous if they were told that none of those provisions were enforceable. Whilst the preliminary agreement may concern a very small number of terms compared to the final “long form” sale and purchase agreement, it is simply not the case that it cannot be a valid and enforceable contract.

The second limb that courts have often referred to is the argument that there is too much uncertainty around Negotiation Provisions (see Watford v Miles for example). Whilst this may be correct for certain Negotiation Clauses, it is not necessarily the case in others. For example, if the parties have merely entered into a Letter of Intent which does no more than express an intention (or even an “agreement”) to negotiate the terms of an agreement in good faith, then it is easy to see how a court would struggle to give any meaning to that “agreement”. However, if the parties have negotiated a detailed terms sheet that sets out a number of key terms (such as price) and includes an obligation that the parties will seek to negotiate long form / definitive agreements consistent with those key terms, it would seem that a complete departure by one party from those specified terms with no reasonable justification, or a refusal to engage in negotiations at all, would be a failure to act in the manner that has been agreed.

The courts in Australia and England have, to an extent, left the door slightly ajar in relation to this line of argument. Drawing on the approach taken towards the application of dispute resolution clauses, there are a number of judgments which suggest that if there are sufficient identifiable parameters included in Negotiation Provisions then these provisions could be enforceable. These parameters could include specifying a negotiation agenda, details of required attendees, a meeting schedule and other procedures for achieving specified outcomes.

Finally, the notion that the intention of the parties is that the Negotiation Provision is simply an agreement to agree or an agreement to negotiate should be dependent on the language that the parties have chosen to use in the negotiation provision, rather than a prima facie position applied to all negotiation provisions. It is certainly possible to draft the provision so that it is no more than an agreement to negotiate. However, it is also possible to draft it in a manner which ensures that there is some positive obligation to meet particular parameters and to take a series of negotiating steps in good faith.

At least for the foreseeable future it will be impossible to guarantee that a court will enforce a Negotiation Clause but the chances of them being enforceable can be maximised if these principles are considered when drafting the provisions.

If it's enforceable then how do you enforce it?

If it is the case that Negotiation Provisions can be drafted in a manner that means that they will be legally enforceable, then what does that mean? What are the consequences if a party does not comply with those provisions?

Of course, in these circumstances the aggrieved party is unlikely to be very happy with an outcome where all it receives is an award of damages, and it may not be a particularly satisfying outcome from a commercial perspective – but that is a common issue when suing for breach.

One thing is clear: A failure to comply with a Negotiation Provision will not result in a court granting an order to “make the agreement” for the parties. This is so anathema to the traditions of the common law that no common law court would take such an approach and a Negotiation Provision will never be interpreted by a court as a promise by the parties that they will reach an agreement.

Nor will a court force the parties to sit down and reach agreement. First of all, such an order would require the court to play a significant supervisory role, which they will not do, and secondly, it would have all of the problems that arise from an agreement to agree.

However, I do not see why a court could not find that a party has failed to honour its obligations to negotiate in a particular manner (presuming those obligations are certain enough) and that, as a result, the other party has either missed opportunities to reach agreement with other parties (this is especially the case if the preliminary document contains exclusivity provisions) or incurred expenses in pursuing a negotiation on the basis of legitimate expectations as to the other party’s behaviour.

In these circumstances, injunctive relief is unlikely. However, it is conceivable that the aggrieved party could demonstrate a real loss and have a legitimate claim for damages. Exactly how those damages would be calculated is yet to be seen, but it is certainly not beyond the realms of possibility.

Of course, in these circumstances the aggrieved party is unlikely to be very happy with an outcome where all it receives is an award of damages, and it may not be a particularly satisfying outcome from a commercial perspective – but that is a common issue when suing for breach.

The moral force of the clause - negotiation provisions as a tactical tool

Of course, there are indeed instances where the parties do not expect a Negotiation Provision to be legally enforceable, and where it is understood to be no more than a moral obligation or a show of good faith. This does not mean that it has no value and should not be included. There is certainly in most negotiations a real fear at a senior management level of the consequences of diverting from pre-agreed terms that the parties negotiated and included in a preliminary document such as a terms sheet. To deviate from these terms can have a significant impact on a party’s credibility during negotiations, and can cause the other party to
take a less reasonable approach towards the remaining negotiation or even question whether it wants to continue negotiations with a party that, in its view, cannot be trusted. For these reasons parties will generally try to comply with Negotiation Provisions, even if they have no legal force.

In this sense, even if the Negotiation Provision is not enforceable its inclusion may have significant tactical value in negotiations.