Contracting Accidentally through Preliminary Agreements

by Glenn Weston March 8, 2017

Abraham Lincoln is credited with the observation that calling a calf’s tail a leg does not mean the calf now has five legs.  The calf’s tail does not change its nature or function simply because we decide to call it a leg.  In the same way, a writing that objectively manifests agreement on all essential terms may well be a contract despite efforts to label it otherwise.  Indeed, one of the more litigated issues in transactional law is whether parties to a writing evidencing preliminary intent to proceed with a proposed transaction actually contracted and, if so, to what extent.  Two recent cases, one from England and one from New York, illustrate the difficulty this issue can present to deal professionals and their counsel.

In some sense, the term “preliminary agreement” is an oxymoron.  If the so-called agreement is truly preliminary, in the sense that it does not evidence a fully-baked deal, with agreement on all the essential terms, it really isn’t an agreement at all.  In both England and in the United States, an enforceable contract can only exist where there is an objective manifestation of assent by the parties to all essential terms of their agreement.  On the other hand, writings that clearly state that they are merely preliminary, and which do not include all of the essential terms necessary to constitute a binding contract, sometimes state that certain terms set forth in that writing are in fact binding.  And some preliminary agreements actually contain all essential terms necessary to constitute a binding contract, but nonetheless state that a further definitive agreement, which will detail additional terms, is expected to be entered into at a later date.

Federal courts applying New York law1 classify binding preliminary agreements by two types: A Type I preliminary agreement is a writing that contemplates negotiation of a more definitive agreement, but that nevertheless sets forth, and evidences assent by the parties to, all of the essential terms of a deal, even though other terms may remain open.  A Type I preliminary agreement is fully binding notwithstanding the expectation that a further more definitive agreement will be entered into and whether or not the contemplated further definitive agreement is ever in fact entered into (unless that preliminary agreement clearly makes the execution of the contemplated definitive agreement a condition precedent to formation of a contract).  A Type II preliminary agreement is a writing that similarly contemplates negotiation of a more definitive agreement, but only sets forth some of the essential terms of the deal, while leaving other essential terms open for the negotiation of the contemplated definitive agreement.  Notwithstanding that a Type II preliminary agreement would thus normally fail the test of being an agreement at all, New York courts will enforce an implied obligation to negotiate in good faith the terms of the contemplated definitive agreement consistent with the “general framework” set forth in that preliminary agreement.  In other words, despite the age-old rule that agreements to agree are nullities, a Type II preliminary agreement is in fact a binding contract to negotiate in good faith to attempt to agree to a deal.  But the obligation to negotiate in good faith imposed by a Type II preliminary agreement does not create liability for failing to enter into a definitive agreement despite good faith efforts to do so.  If there was bad faith in the negotiation, however, liability can result (typically for reliance-based deal pursuit costs, rather than expectancy-based damages).2Otherwise nonbinding letters of intent that contain express obligations to negotiate in good faith the terms of a definitive agreement can sometimes fall into the Type II preliminary agreement bucket.3

Unlike a number of other European countries, England does not appear to recognize an obligation like that recognized in New York with respect to a Type II preliminary agreement.  In England (like many U.S. states) a Type II preliminary agreement would simply constitute an unenforceable agreement to agree.  On the other hand, England, like most U.S. states, appears to recognize as binding what many cases applying New York law refer to as a Type I preliminary agreement—i.e., a preliminary agreement that evidences an intent to be bound to the terms agreed upon, which are sufficient in themselves to enforce the deal, even though there are other terms yet to be agreed.  As noted by Lord Clarke in RTS Flexible Systems Limited v. Molkerier Alois Muller Gmbh & Company KG, [2010] UKSC 14, at paragraph 45 (emphasis supplied):

Whether there is a binding contract between the parties and, if so, upon what terms depends upon what they have agreed.  It depends not upon their subjective state of mind, but upon a consideration of what was communicated between them by words or conduct, and whether that leads objectively to a conclusion that they intended to create legal relations and had agreed upon all the terms which they regarded or the law requires as essential for the formation of legally binding relations. Even if certain terms of economic or other significance to the parties have not been finalised, an objective appraisal of their words and conduct may lead to the conclusion that they did not intend agreement of such terms to be a pre-condition to a concluded and legally binding agreement.

Because “an objective appraisal of [the parties’] words and conduct” may result in the conclusion that the parties “intended to create legal relations and had agreed upon all the terms which they or the law requires as essential for the formation of legally binding relations,” even if one or both of the parties subjectively did not intend to contract, deal professionals and their counsel, on both sides of the Atlantic, are typically careful to include language, in writings evidencing the preliminary stages of a deal, that specifically states that such writings are nonbinding.4The goal in doing so is to avoid “surprise” or “gotcha” contracts by objectively evidencing that the parties do not in fact intend to contract by those preliminary writings or conduct.5

In England, one approach to manifesting intent not to be bound by a preliminary writing is to simply label it with the statement that it is “SUBJECT TO CONTRACT.”  This label appears to be universally understood in England as the equivalent of “this is nonbinding and no binding legal relationship will be created unless and until the parties execute a fully negotiated, definitive contract.”

So, when the English Court of Appeal, in Global Asset Management, Inc. v. Aabar Block S.A.R.L, 2017 EWCA Civ. 37, was recently asked to consider whether a contract to purchase certain loans had been created based on an offer letter that was labeled “WITHOUT PREJUDICE—SUBJECT TO CONTRACT,” together with a series of conversations and written communications respecting that offer letter, the conclusion should have been fairly straight forward.  But it wasn’t.  Indeed, the lower court had refused to grant summary judgment in favor of the party alleging that there was no basis upon which the other party could establish that a legally enforceable contract had been made by the parties.  While the Court of Appeal overruled the lower court based in part on the principle that an offer “subject to contract” could not in fact be accepted and thereby become a contract, the court suggested that the parties, through their subsequent conduct, could in fact ‘waive the subject to contract status of their dealings.”  Although English courts will not find such a waiver lightly, over-reliance upon the subject to contract nature of ongoing dealings between parties based on a mere label, where conduct or other oral or written communications evidence a change in that status, may be fraught with peril, even in England.  And in the U.S., even more caution is advised.

In a recent case also involving allegations of a contract having been concluded respecting the sale of a loan, despite the existence of language in the acceptance of a bid that proclaimed it was “[s]ubject to mutual execution of an acceptable [agreement],” the New York Court of Appeals, in Stonehill Capital Management, LLC v. Bank of the West, 2016 NY Slip Op 08481 (Dec. 20, 2016), reached the opposite conclusion from that reached by the English Court of Appeal.  Admittedly the facts were decidedly more favorable to the party urging the existence of a binding contract notwithstanding the seemingly subject to contract status established by the bid accepting correspondence.  But, while acknowledging that, in New York, “when a party gives forthright, reasonable signals that it means to be bound only by a written agreement, courts should not frustrate that intent,” the Court of Appeals stated that:

Such a forthright, reasonable signal is not obvious from the mere inclusion in an auction bid form of such formulaic language that the parties are “subject to” some future act or event. Less ambiguous and more certain language is necessary to remove any doubt of the parties’ intent not to be bound absent a writing.

Based on the facts of this particular case, the Court of Appeals held that instead of the “subject to contract” language establishing that that the execution of a definitive agreement was a condition precedent to the “formation of a binding agreement” by virtue of the bid acceptance, it merely established that the execution of a subsequent agreement was one of the “post-agreement requirements necessary for the consummation of the transfer [of the loan], …post-agreement requirements the parties were obliged to perform pursuant to an existing agreement.”  According to this Court of Appeals:  “The fact that the parties anticipate and identify future events necessary to close the sale is not the legal equivalent of an intent to delay formation of a binding contract absent the passage of those events.” And under the facts of this case, the court held that the terms of that subsequent agreement to be executed had in fact been agreed.

No one wants to accidentally contract based on objective manifestations of intent that do not in fact match one’s subjective intent.  The key to avoiding that outcome is to clearly and objectively manifest intent not to be bound, and then conduct oneself consistent with that manifested intent. There is better language than simply relying on the label “subject to contract” to manifest that intent in the first instance.  The following is just one possibility:

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).

Make sure that the nature and function of your preliminary writings match the labels you give them. Better yet, “remove any doubt of [your] intent not to be bound absent a [fully negotiated definitive agreement]” by agreeing in unambiguous and certain language, rather than mere labels, that the preliminary writings you are entering into with your counterparty are not and will never become a contract absent a fully negotiated definitive agreement.

1. New York courts, however, have not necessarily accepted this rigid classification of preliminary agreements into “types.” See IDT Corp. v. Tyco Group, 13 N.Y.3d 209, 213 n.2 (2009) (rather than attempting to classify the preliminary agreement into a type, the court thought ‘it is enough to ask in this case whether the agreement contemplated the negotiation of later agreements and if the consummation of those agreements was a precondition to a party’s performance. In the instant matter, it clearly was.”).
2. But see the discussion of Delaware’s approach to liability for alleged bad faith negotiation of an otherwise nonbinding term sheet in an earlier blog post: Adam Dickson, Beware of “Non-Binding” Term Sheets, Weil Insights, Weil’s Global Private Equity Watch, April 25, 2016, https://privateequity.weil.com/insights/beware-non-binding-term-sheets/.
3. See EQT Infrastructure Ltd. v. Smith, 861 F.Supp.2d 220 (S.D.N.Y. 2012); SIGA Technologies, Inc. v. PharmAthene, Inc., 67 A. 3d 330 (Del. 2013).
4. See Emma Robinson, Getting out of a Bind: Making Sure Your Non-Binding Letter of Intent Is Actually Non-Binding, Weil Insights, Weil’s Global Private Equity Watch, March 24, 2016, https://privateequity.weil.com/features/getting-bind-making-sure-non-binding-letter-intent-actually-non-binding/.
5. See Miller v. Flegenheimer, 2016 VT 125, at 5-6.