Scammers targeting Pennsylvania businesses have been hard at work this summer. The Pennsylvania Department of State reports that three separate direct mail campaigns have sought to get unsuspecting Pennsylvania  business owners to pay unnecessary fees:

• A mailing from a company calling itself “Division of Corporate Services – Compliance Division” urges companies to complete a form with officer and director information and return the form with a $150 payment.

• A postcard from a company calling itself “Business Compliance Division” urges owners to call a toll-free number “to avoid potential fees and penalties.” When that number is called, the owner is instructed to pay $100 by credit card to obtain a “certificate of existence” in order to comply with state regulations. The address for this company is the same as the address for the “Division of Corporate Services – Compliance Division” above. According to the Pennsylvania Department of State, this is the address of a UPS store in Harrisburg.

• A letter from a company calling itself “Pennsylvania Council for Corporations” instructs business owners to complete a form with names of shareholders, directors and officers and return it with a $125 fee.

These solicitations include citations to Pennsylvania statutes and look official, but they are not: they were neither prepared nor authorized by the Commonwealth. Essentially, these notices represent a business-generating effort from the sender to prepare generic annual minutes for unwitting companies.

The Department of State cautions that any official notices sent to businesses by the Pennsylvania Department of State or the Secretary of the Commonwealth’s office will contain letterhead and/or contact information for the Bureau of Corporations and Charitable Organizations. If you receive one of these notices or a similar solicitation, contact the Bureau at 717-787-1057, or feel free to call Sue Maslow, Joanne Murray or Michael Mills at 215-230-7500.

On July 1, 2015, the Pennsylvania Association Transactions Act (also known as the Entity Transactions Act) (the “Act”) went into effect. The primary purpose of the Act is to simplify the architecture of Title 15 of the Pennsylvania Consolidated Statutes by moving the provisions applicable to names, fundamental transactions and registration of foreign entities into a new Chapter 3. Presently, those provisions are spread out in numerous subsections applicable to each entity type (e.g., corporations, limited liability companies, etc.). The thinking was that since identical or nearly identical provisions already applied to most or all entity types, they should be moved to a new chapter to streamline the statute and hopefully simplify the process for undertaking fundamental changes. The Act adopts new terms to refer to various entity concepts, so practitioners will have to learn a new vocabulary. For example:

•  Association: a corporation for profit or corporation not-for-profit, partnership, limited liability company, statutory or business trust, or an entity or two or more persons associated in a common enterprise.
• Governor: a person by or under whose authority the powers of an association are exercised and under whose direction the activities and affairs of the association are managed (e.g., a corporate director, the general partner of a limited partnership, a partner of a general partnership, a manager of a manager-managed LLC, etc.).
• Interest holder: a direct or record holder of an interest (e.g., a shareholder, member, general or limited partner).
  
  While much of the Act is simply a reorganization of the statute, some changes are substantive. For example, the Act expands the use of conversions. In a conversion transaction, one Pennsylvania entity type converts to another Pennsylvania entity type. Until now, this result could be accomplished by using a 2-step process: forming a new entity of the desired type and merging the old entity into it. Alternatively, a business seeking to change its form would have to wind down its business and dissolve, then start again by forming a new entity type. Both approaches were cumbersome and can involve significant transaction fees and delays so the new one-step process is welcomed. But even the simplified conversions can have tax consequences, so a tax advisor should be consulted.
  
  At the opposite end of the transaction spectrum is the division transaction. Prior to the Act, an entity could only divide into like entity types. The Act permits an entity to divide into different entity types (e.g., a corporation can now divide into a corporation and a limited liability company). Once again, care should be taken to avoid unintended tax consequences.
  
  Another significant change is a new provision that allows for contractual dissenters rights where such rights would not otherwise be available under the statute. Additionally, the existing concept of share exchanges is expanded to include other association types and bundled into a new subchapter called “Interest Exchanges.”
  
  All of the transactions included in new Chapter 3 require a plan approved by the interest holders of the constituent associations, although the approval process and plan contents vary depending on the type of association. Many of these transactions have tax consequences for the entity and/or the interest holders, so the advice of tax counsel is critical.
  
  The Act is based on the Model Entity Transactions Act (known as META). The Pennsylvania Bar Association’s Section on Business Law, which drafted the Act, continues its work to modernize the remainder of Pennsylvania’s association statutes to make them consistent with the uniform laws passed in other states.

No one (not even us legal corporate types) would ever suggest that bylaws are interesting. But recent Third Circuit and Delaware Court of Chancery decisions have highlighted the complexity of issues regarding a company’s fee advancement bylaws and policies. Some corporate indemnification provisions are mandated and other provisions are simply permitted under Delaware state law. In practice, adopted corporate bylaws refer to the right (or absence of a right) of officers and directors of a company to be reimbursed by the company for losses, including legal fees, incurred in legal proceedings that name individual officers or directors if those proceedings relate to their employment or activities on behalf of that company.   Mandated indemnification obligations under Delaware statutory requirements attach only to an “officer or director” but many companies nevertheless have bylaws and policies that permit indemnification to “any person” (including officers, directors, employees and agents) who act in good faith and in a manner they reasonably believed to not be opposed to the best interests of the entity. The Third Circuit, however, recently held that the definition of “officer” was ambiguous; an executive title like “Vice President” alone does not automatically prove eligibility for indemnification. And the Court of Chancery held that officers and directors need not prove that they will be indemnified to obtain fee advancement where bylaws tie fee advancement to indemnification. In other words, entitlement to advancement of fees under corporate bylaws is to be considered independently of indemnification entitlement. Examining the requirement that the conduct in question of any person seeking indemnification must be “by reason of the fact” of his or her officer/employment status, the same court determined that bylaws may not exclude entire categories of alleged wrongdoing for the purpose of fee advancement denial. If the alleged wrongdoing relates to an officer’s duties owed to the company (such as breaches of fiduciary duty), fee advancement may be required (even where the same bylaws require a clawback if the officer is ultimately found to have engaged in such wrongdoing).

Commercial lenders in Pennsylvania await action by the legislature to fix what appears to be an unintended byproduct of recent amendments to the Pennsylvania Probate, Estate and Fiduciaries (PEF) Code that went into effect earlier this year. You may be wondering what a statute that generally applies to trust and estate matters has to do with commercial lending transactions. The answer is that the recent changes applicable to powers of attorney generally could be interpreted to apply to powers of attorney granted in commercial loan documents, leases and other contracts (such as those granted in connection with confession of judgment clauses and certain other remedies). Historically, these statutory provisions did not apply to commercial agreements. It appears that the legislature was focusing on trust and estate documents when enacting this legislation and didn’t understand the impact of these amendments on commercial transactions.

These amendments are troubling from a lender’s perspective because they require that an agent must “act in accordance with the principal’s reasonable expectations to the extent actually known by the agent and, otherwise, in the principal’s best interest.” In a commercial loan transaction, the agent is the lender and the principal is the borrower, so the tension is obvious: a lender that is foreclosing on property, confessing judgment, collecting rents, or exercising Article 9 remedies  is not likely to be acting in the best interest of the borrower.

Pennsylvania House Bill #665 would amend the PEF Code to clarify that the power of attorney requirements do not apply to commercial transactions. This bill is presently in the Senate Judiciary Committee. Until this bill becomes law, lenders should consider making the following adjustments to commercial loan documents containing powers of attorney (typically these include documents with confessions of judgment, security agreements, assignments of rent, and mortgages):

• Include an acknowledgement by the borrower that its reasonable expectations include confession of judgment, foreclosure and other actions typically taken by a lender under the power of attorney;

• Include a waiver of the duties imposed by the PEF Code; and

• Add a notary page.

My wife doesn’t eat fish.  Chicken is the staple of the diet in our house.  Despite careful consideration, sometimes she gets tricked into consuming what looks like a tasty morsel only to be disappointed by the taste and texture of what comes from the sea.  She promptly, but of course gracefully, extracts the fishy culprit from her mouth thereby rescinding the transaction and restoring her being to non-seafood status.  Of course, a fishy business transaction cannot be so easily unwound.

Business transactions come in all shapes and sizes.  From multi-million dollar mergers involving teams of lawyers and accountants to small asset purchases effectuated by only a bill of sale scribbled on a napkin.  Most fall somewhere in between.  Almost all involve disclosure of financial and business information in advance of closing in a “due diligence” period of evaluation and investigation.  Due diligence is the means by which a buyer attempts to verify what the seller has to sell; the ongoing revenue stream and the customer pipeline.  Sometimes the performance of the business after closing sharply contrasts the results of operations depicted in financial information exchanged in due diligence.  The new owners are left without a roadmap to ascertain the disparities in performance.  The investigation can be all consuming and require substantial attention and money at a time when the business is already in a period of transition.  The new owners must balance examination of the transaction and results of operations against the focus required to conduct the daily activities of the business which, of course, remain pressing and are likely made more complex by the unexpected performance levels. 

Hopefully, any agreements reached between the parties contain representations and warranties which could benefit the purchaser.  The terms of the agreement are the best place to start the analysis of potential legal action.  Generally, such agreements will represent and warrant the financial information exchanged in due diligence was accurate and adequately described the performance of the business. For example, often tax returns, profit and loss statements and balance sheets will be exchanged in due diligence and subject to specific representations and warranties.  Examination of what documents were specifically referenced as included in the representations and warranties is critical. Where the prevailing agreements contain integration clauses, the representations and warranties are of paramount importance as integration clauses can prohibit reliance upon statements and information not specifically incorporated into the four corners of the documents and bar claims such as negligent misrepresentation and, potentially, fraud. 

Determining whether the profit and loss statements and balance sheets contain material mis-statements of operations can be complicated.  The investigation must begin with securing all documents subject to due diligence and the verification that those documents were the same documents that were prepared in the ordinary course of business.  Ensure that any financial records or tax returns produced by the seller match financial records available from a different source such as a broker, accountant or internal revenue service.  Of course, information becomes more available after the commencement of litigation by virtue of the discovery process.

The forensic analysis involves testing the information set forth in summary form in the financial statements against whatever other information is available.  Quickbooks reports can reveal adjustments made to performance results.  The reality however, is that most business owners, and for that matter attorneys, lack the requisite expertise to effectively conduct the necessary investigation.  Accordingly, a forensic accountant skilled in fraud examination and detection is a valuable member of the analytical team.  Certainly, there is a cost associated with that service, which cost must be incurred before the results are clear, but the expertise of the investigation will often control the outcome.  The forensic accountant is trained to identify inconsistencies such as whether payroll was accurately stated, whether inventory and costs of goods sold were appropriately booked and whether income as stated on the financial records is impacted by other unspecified factors.  A preliminary forensic investigation is essential to the decision to pursue costly litigation.

A buyer must also consider the potential parties, their financial positions, and the types of claims that can be raised.  In seller financed transactions, as opposed to bank financed transactions, the buyer’s leverage is significantly enhanced.  In the former, the buyer may apply pressure to a seller by discontinuing payments.  In the latter the bank generally has no regard for any claims the buyer may possess against the seller and simply demands its’ payment each month.  Generally, no court will interfere with the bank’s rights to security and payment as same are not dependent on the result of any claims possessed by the buyer as against the seller.  The ability to recover in litigation must also be considered.   The distribution of purchase price, whether distributed to creditors or held in joint accounts in a tenancy by the entireties state can impose additional obstacles to recovery and necessarily impacts litigation strategy.  Identification of potential defendants and causes of action is also essential.  Pennsylvania recognizes the torts of negligent misrepresentation in certain circumstances including preparation of financial information for the reliance of others, aiding and abetting breach of fiduciary duty and conspiracy. Accordingly, to the extent a seller was assisted in the preparation of false financial information, those who assisted may also be appropriately identified as defendants when the facts are supportive of liability. Potential claims against a seller include breach of warranty, fraud, misrepresentation, conversion, unjust enrichment and, under the right set of fact, claims for punitive damages.  Breach of warranty claims are often the best chance of success as the issue of intent (or lack thereof) has no bearing on proof of a breach of warranty claim.  

Finally, consider the measure of damages.  Under the right circumstances, lost profits can be claimed. However, post-closing failure (or alternatively, success), management issues and other factors can complicate the damages analysis.  In the absence of a lost profits claim, the difference between the valuation of the company in accordance with the financial information presented and the financial information eventually uncovered may result is a simpler damage calculation.  Of course, any such analysis also requires the assistance of a business valuation expert in addition to the forensic accountant referenced above. A buyer must also be wary of any damage limitations internal to the agreements between the parties as well as any internal statutes of limitations which may be set by agreement. 

In contrast to the ease by which my wife can expel inadvertently consumed sea food, rescission in a business transaction is unlikely.  The very idea of rescission, placing the parties back in their respective conditions, may be impossible based on post-sale performance.  Claims for money damages are far more often the claims that proceed to conclusion.

Certainly, pursuit of litigation concerning the purchase of a business can be expensive and complicated.  Any such decision must weigh the likelihood of success and the cost of that success, against the distraction such litigation may cause and potential impact of that distraction on business operations.  That being said, sometimes a buyer simply has no choice and sometimes what smells rotten really is just that; rotten.    

Reprinted by permission of Catalyst Center for Nonprofit Management.  Further duplication without permission is prohibited.

Childhood victimization and other abuses of our most vulnerable citizens unfortunately remain a much too prevalent and tragic issue of our times.  Particularly offensive is the possibility of physical or emotional abuse of those susceptible because of age, disability or circumstance while receiving services of a nonprofit. Safety efforts to protect the very people being served by a nonprofit, regardless of size, must be constantly monitored.

Even the smallest nonprofit should adopt safety-related policies based on nationally recommended guidelines developed by experts.  Such policies and guidelines help protect both the recipients of the nonprofit’s services and the integrity of the nonprofit’s programs.  Every nonprofit that serves children and youth has the obligation to exercise “reasonable due diligence” with regards to screening as part of its hiring and vetting programs for members of the nonprofit’s Board, staff and volunteers. Without such screening or gate-keeping vigilance, the very people the nonprofit is trying to serve are more likely to be unprotected and the reputation of the nonprofit (not to mention its fiscal health) are at unnecessary risk.

Business divorce, just like traditional matrimonial divorce, can occur for many reasons.  Many times, business divorce is occasioned by underperformance and the need to separate an underperforming owner.  However, the opposite circumstance, a business that has done well, can also spur desire for change in structure.  Just like matrimonial divorce, business divorce can be a long, painful and expensive proposition.  Consideration of trigger events for dissolution and setting an exit strategy before commencing the business venture can manage the expectations of the parties and facilitate transition when it becomes necessary.  And it almost always does.

One of the primary considerations is trust.  Consider the level of trust you place in a business partner on so many levels.  Trust ranges from the basics of whether you can trust your partner not to have a hand in the cookie jar, to more esoteric questions of whether you can trust your partner to share your long term vision.  All too often clients come to us with stories of unexplained payments for personal expenses which are only discovered by accident.  What are the rights and obligations of the company and the business partners in such event?  These  rights should be spelled out in the agreement between the parties, otherwise the company, and the innocent shareholders, are left to argue common law claims and may be without a way to specifically extract the untrustworthy owner.

Trust goes deeper than the simple situation of defalcation (misuse of funds).  Can you trust your business partner to have the same desire to grow your business and increase sales and performance metrics over an extended time?   Business entities generally have perpetual existence.  Can you trust that your partner will continue to make the requisite investments of time, energy and money that are necessary to bring the success you work so hard to achieve?  If the agreements between the parties do not provide for a mechanism to remove that partner, or at least monetarily induce that partner to voluntarily separate, what strategy is available to accomplish the necessary change? 

If extraction of a non performing owner is one side of the coin, the terms of voluntary separation are the other.  Even in the absence of material differences between owners and managers, time and circumstance often require parties to go their separate ways.  The terms of voluntary separation can be every bit as complex as forcible removal.  Often, the most problematic inquiry is the right to be compensated in consideration of separation.  Such terms of separation can vary based on valuation methodologies such as “market” or “book” values, timing of payments, reductions or additions to value based on subsequent conduct.  In the absence of advance planning, the parties are almost certain to find dispute.   

Post-employment obligations and fiduciary duties are also fertile ground for dispute.  Corporate officers and directors have fiduciary obligations to the business.  Partners, shareholders and members may have fiduciary obligations to each other.  A departing shareholder may or may not be permitted to directly compete either during or after termination of the business relationship.  Certainly, issues arise with respect to client/customer relationships and confidential information.  More substantial issues may arise when the business develops a new technology or intellectual property which one party seeks to exploit in a different way.  Agreements between the parties can address such possibilities and preserve rights by contract which might otherwise be ambiguous. 

What if it all goes wrong?  Again, business entities are generally established to have a perpetual existence, so termination must be accomplished by agreement or statutory procedure.  What kind of consent is necessary to effectuate dissolution?  Must all of the shareholders or members agree?  Agreements can specify events and effect of dissolution including specific assignments in distribution of assets according to differing methodologies or factual circumstances.  In circumstances where one party is opposed to liquidation or dissolution, the situation can become even more complex.  Occasionally, only the appointment of a receiver can effectuate liquidation or dissolution; a generally unappealing circumstance as such an appointment necessitates the loss of control.

The questions posed and circumstances described above underline the importance of careful consideration prior to establishment of business entities.  Such considerations during the business “engagement” and before business matrimony are necessary to prevent significant hardship when expectations are not managed.  Advance planning though counsel can address many of the issues potentially faced by business owners and help the parties realize their expectations when circumstances change.    

Commercial lenders were left shuddering in the wake of a September 6, 2013 Pennsylvania Superior Court decision that affirmed a $3.6 million Bucks County jury verdict in favor of a local developer against an area bank. In County Line/New Britain Realty, LP v. Harleysville National Bank and Trust Company, the developer successfully argued that the term sheet provided to it by Harleysville was in fact a binding contract notwithstanding evidence of the parties’ intent to execute subsequent, more detailed agreements. The court also upheld the lower court ruling that Harleysville’s decision not to fund the loan described in the term sheet constituted a breach of contract. The court dismissed Harleysville’s claim that the term sheet did not contain the essential terms of a loan agreement (such as the closing date, how interest would be calculated, a repayment schedule, representations and warranties, and defaults and remedies) and therefore was not enforceable. The court held that the term sheet contained sufficient terms to create a binding contract, such as the identities of the borrower and lender, the principal amount of the loan, interest rates, the term, the manner of repayment, the names of the guarantors, and an identification of the collateral. The court acknowledged that the evidence showed that the parties intended to execute subsequent agreements but nevertheless held the term sheet to be binding.

Harleysville also argued that the developer did not meet all the loan conditions specified in the term sheet, so Harleysville was not required to fund the loan. Specifically, Harleysville asserted that two conditions were not met: (i) a satisfactory review by the lender of an “environmental assessment” of the parcels, and (ii) a satisfactory review by the lender of all specifications, engineer reports and government approvals. It argued that the trial court impermissibly allowed the jury to consider evidence regarding industry custom and practice, the course of dealing between the parties, and evidence of Harleysville’s motives in evaluating whether these loan conditions had been met. The Superior Court found that the term sheet did not articulate these conditions in sufficient detail and that it was appropriate for the jury to consider additional evidence in order to interpret the parties’ intent. This extrinsic evidence was particularly damning to Harleysville because it showed that Harleysville lost interest in making the loan shortly after the term sheet was issued, due in part to its desire to reduce the amount of commercial real estate loans in its portfolio and its precarious position as a result of the recent bankruptcy filing of its largest customer.

By William T. MacMinn, Esquire Reprinted with permission from August 13, 2013 issue of The Legal Intelligencer. (c)
2013 ALM Media Properties. Further duplication without permission is prohibited.

But He Asked Me First!

Is that a good defense to an alleged breach of a non-solicitation agreement?  In a recent decision a Pennsylvania trial court said that it was.

In Marino, Robinson & Associates, Inc. v. Robinson, 2013 Pa. Dist. & Cnty. Dec LEXIS 18 (Jan 2013) Judge Wettick of the Allegheny County Court of Common Pleas entered summary judgment dismissing the case against Defendant who allegedly violated a non-solicitation clause.  Plaintiff acquired Defendant’s accounting practice.  The contract signed by the parties included clauses prohibiting Defendant from competing with the Plaintiff or soliciting any of her former clients.  The non-compete was not implicated in the case because, while the Defendant provided competing accounting services, she did so outside of the geographic limits imposed by the covenant.  However, she provided those services to several of her former clients, each of whom unilaterally approached her and asked her to continue on as their accountant. Plaintiff alleged that by providing services to these former clients, the Defendant violated the non-solicitation clause of the contract which prohibited Defendant from “Solicit(ing) in any manner any past clients … for a period of ten (10) years from closing”.  The Court, following cases decided in other states, agreed with the Defendant that she was not required to turn away former clients who, unsolicited, approached her to request that she provide services. The Court held that solicitation required conduct on the part of the Defendant designed to awaken or incite the desired action in the former client. Where, as in this case, the former client approached the Defendant unilaterally, the Defendant did not violate the non-solicitation clause.

A similar result obtained in Meyer-Chatfield v. Century Bus. Servicing, Inc., 732 F. Supp. 2d 514, 517-518 (E.D. Pa. 2010)  where the Court decided that the meaning of the word “solicit” was not ambiguous and applied the parole evidence rule to bar evidence regarding the meaning of the term.  In Meyer-Chatfield, Plaintiff’s Vice-President of Sales and Marketing left his employment with Plaintiff and accepted a similar position with Defendant.  An agreement, which included non-solicitation provisions, was negotiated between the parties.  Shortly thereafter the parties engaged in negotiations for the acquisition of Plaintiff by Defendant.  Those negotiations failed.  Subsequently (and after he was terminated by Plaintiff) one of Plaintiff’s sales persons accepted employment with Defendant and took with him other employees (who were part of his sales team) with the result that several significant customers of the Plaintiff eventually began doing business with Defendant. Plaintiff brought suit alleging violation of the non-solicit provisions in the solicitation of both the employees and the customers.

The language at issue prohibited the direct or indirect “…solicit(ation) of any of Plaintiff's employees, agents, representatives, strategic partnerships, [or] affiliations.” The contract did not define the word “solicit.”  The Court looked to the common meaning of the term, citing the Black's Law Dictionary definition:

"To appeal for something; to apply to for obtaining something; to ask earnestly; to ask for the purpose of receiving; to endeavor to obtain by asking or pleading; to entreat, implore, or importune; to make  petition to; to plead for; to try to obtain; and though the word implies a serious request, it requires no particular degree of importunity, entreaty, imploration, or supplication. To awake or incite to action by acts or conduct intended to and calculated to incite the act of giving. The term implies personal petition and importunity addressed to a particular individual to do some particular thing."

The Court also cited the Webster’s definition of the word: “to entreat, importune . . . to endeavor to obtain by asking or pleading . . . to urge.”

The issue before the Court was whether the word “solicit” was ambiguous permitting parole evidence of its meaning.  In holding that it was not, the Court reviewed Akron Pest Control v. Radar Exterminating Co., Inc. 216 Ga. App. 495, 455 S.E.2d 601 (Ga. App. 1995), in which the Court held that an agreement “not to solicit, either directly or indirectly, any current or past customers” requires more than “[m]erely accepting business [to] constitute a solicitation of that business.” A party is not required to turn away uninvited contacts of former customers. The Court also cited Maintenance Co. v. West, 39 Cal. 2d 198, 246 P.2d 11 (Cal. 1952) in which it was held that neither the act of informing former customers of one’s change of employment, nor the discussion of business upon the invitation of the former customer constitutes solicitation.  Finding no ambiguity, the Court prohibited testimony regarding the parties’ understanding of the term. 

It seems clear that the Court will apply the ordinary meaning of the word “solicit” which has been repeatedly found to require some overt act of entreaty on the part of the former employee designed to induce the former customer to action.  Responding to an uninvited inquiry from a former customer, even where that inquiry is for the purpose of discussing business, and where that inquiry ultimately results in doing business with that former customer, will not be sufficient to support a finding of a breach of a non-solicitation agreement. Of course, doing business with a former customer may well violate the provisions of a non-compete clause and, in such cases, the Courts have not been reluctant to enforce such provisions.  Although research has found no cases directly on point, the reasoning of the cases suggests that advertisements or social media posts informing the general public or one’s social media circle of new employment circumstances would also not constitute the type of targeted action required to support a finding that a non-solicitation agreement has been breached.

Those of us routinely asked to draft or review letters of intent (LOI), memorandum of understanding (MOU) and initial term sheets have a new challenge.  The use of conventional text clearly stating “this is non-binding” to be sure a preliminary document memorializing negotiations does not give rise to the risk of unintended enforcement apparently is no longer sufficient.  As a result of the Delaware Supreme Court’s decision in SIGA Technologies v. PharmAthene, Inc., No 314, 2012 2013 Del. LEXIS 265, 1-2 (Del. May 24, 2013), it is now suggested that counsel negotiating LOIs, MOUs and even term sheets designated as final include a specific negation of good faith.  Text specifically stating the parties agree that neither party shall have a duty to negotiate in good faith is now considered appropriate.  Getting both sides to agree to include such a forbidding sentence, however, is a significant challenge.

In SIGA Technologies, the court held that expectation or “benefit of the bargain” damages (and not just out of pocket, reliance damages) were appropriate where (1) the parties had a term sheet; (2) the parties expressly agreed to negotiate in good faith in a final transaction in accordance with those terms; and (3) but for the breaching party’s bad faith in trying to improve the terms, the parties would have consummated a definitive agreement with the terms set forth in the term sheet.

The SIGA Technologies decision might have been appropriate in light of the specific facts before the court but it leaves transactional lawyers at a loss.  Business lawyers have been advising clients since the beginning of time that there is, and should be, a great difference between incomplete and preliminary letters, drafts and other communications clearly understood as non-binding (with the exception of specifically identified provisions, such as those relating to confidentiality and exclusivity) and  final, mutually executed contracts with an integration clause.  The former should have no legal effect other than as a basis to start the hard drafting process for definitive agreements. LOIs, MOUs and term sheets referring to the parties’ intent to finalize binding documents later are to be used as support for financing efforts and strategic planning and not evidence of a final oral or implied agreement between the parties.  Exceptions to this rule were, until recently, very narrowly applied and usually only if the parties made an effort to carve out the intended exceptions with clear language (non-disclosure, exclusivity or no-shop provisions).  Efforts by counsel for either party to impose a written duty of good faith and fair dealing on the other party are normally met with resistance with the better practice perceived to be silence on this point and text that allows either party to halt negotiations at any time for any reason as long as there is no breach of the binding confidentiality and/or exclusivity provisions.  Termination fees are sometimes added to encourage good faith negotiations and cover out of pocket costs incurred as a cost of freedom to abandon those negotiations.

To avoid imposition of a SIGA Technologies penalty, many corporate advisors are now insisting the only safe course is to explicitly refute the presence of good faith.  And yet, most clients do not want to suggest that they would ever negotiate in bad faith. Worse, most clients do not want to agree to allow the other party to the proposed transaction to abandon all pretenses of good faith and fair dealing.  Who wants to go to the dance with a partner who asks for permission to humiliate you while there and tells you of his or her plan to possibly leave you without a ride home?

Bad faith in the midst of negotiations has historically been perceived as bad form but not an exception to the “non-binding” rule and certainly not the basis for expectation (lost profits) damages. To make this area even more challenging, a judicial determination of one company’s bad faith (e.g., trying to improve terms if the circumstances have become more favorable for the company) can easily be deemed by the shareholders/members of the same company to be the exercise of management’s fiduciary duty to maximize equity holders’ return.  Failure to push for the best possible terms in the face of a non-binding term sheet could be found by another court to be a breach of that duty.

Whether bad faith should support an exception to the “non-binding” rule as a matter of law is an interesting question but the philosophy of law is rarely a topic businessmen and women wish to explore.  Any number of things can make a deal that seemed attractive at a given point unacceptable some time later.  Negotiations with respect to terms not included in the preliminary documents can be filled with real dispute; due diligence may reveal greater risks than anticipated; the industry-wide market may shift; or business may suddenly improve supporting more favorable terms for one party and less favorable terms for the other.  Where the risk of the business enterprise does not begin to shift until after the execution of a definitive document, why should either party get the benefit of a preliminary bargain when the facts and circumstances supporting the transaction have changed? 

While no one should be conducting negotiations in bad faith, the imposition of an implied duty of good faith and fair dealing in preliminary “non-binding” documents unless the parties specifically negate that obligation seems problematic.  In contrast, once agreements are fully negotiated and signed, the covenant to act in good faith and engage in fair dealings is appropriate between business partners of all kinds. As found in other Delaware decisions, even where the contracting parties appear to have agreed to limit the scope of their common law and statutory fiduciary duties in a final document, good faith and fair dealing have an important role that should be implied and enforced by the courts.  But, only after a final document is signed and sealed, however, should we be insisting a party trying to maximize their position “Did a bad, bad thing.”