June 13, 2013

The Duty of Good Faith in Negotiation

Posted in Corporate Litigation, Negotiation by Gene Killian |

One of the best negotiation teachers in the world, in my humble opinion, is Professor Gerald Williams of the Brigham Young University Law School.   One of Professor Williams’s basic tenets is that there essentially are two types of negotiators:  the “cooperative” and the “aggressive.”  Cooperative negotiators view negotiation as an open, collaborative process in which the goal is a “win/win” solution (basically, the “Getting to Yes” approach made famous by Roger Fisher and William Ury).  Aggressive negotiators, on the other hand, view the process as a battle to be won.  The goal of a cooperative negotiator is fairness.  The goal of an aggressive negotiator is to triumph at any cost.  Not surprisingly, aggressive negotiators are more willing to bend the rules (if there are “rules” to a negotiation) and engage in strategic withholding (or misrepresentation) of information, which they deem to be an acceptable and expected part of the exercise.  That sort of behavior infuriates cooperatives, who view it as underhanded.  Although the full analysis is more complicated, the bottom line is that aggressives play well with other aggressives (because they’re both playing the same game), and cooperatives play well with other cooperatives, while cooperatives don’t play well with aggressives.

But is there actually a “duty of good faith” in negotiation?  A cooperative might think so, but, absent a contractual “good faith” provision of some kind,  the aggressive is correct:  there is generally no legal duty to tell the truth to your negotiating partner, or to treat him or her fairly.  (Caveat:  if you’re a lawyer, you may be under an affirmative duty to tell the truth.  In New Jersey, for example, Rule of Professional Conduct 4.1 prohibits attorneys from making “a false statement of material fact or law to a third person.”)

In a recent case in which one of the sides “better-dealed” the other, a Delaware court had some instructive things to say about the contractual duty of good faith negotiation.  The facts: A company named SIGA acquired the rights to a highly effective smallpox treatment.   Unfortunately, SIGA was running out of money and couldn’t effectively develop and market the drug.  Requiring a substantial cash infusion, SIGA began negotiating with another company, PharmAthene, and the two companies entered into a term sheet under which SIGA would license the drug to PharmAthene.  Note:  A “term sheet.”  Not a document captioned “Agreement.”   

PharmAthene also wanted to discuss a merger arrangement with SIGA, and the parties prepared a term sheet as to a potential merger as well.  From PharmAthene’s perspective, the idea was that if a merger could not be concluded, PharmAthene would at least have a license with respect to the drug.  In anticipation of concluding some sort of  deal, PharmAthene advanced a $3 million bridge loan to SIGA, which SIGA (gladly, I assume) accepted.

The term sheets prepared by the parties stated that the parties would “negotiate in good faith with the intention of executing a definitive License Agreement.”

Oscar Wilde once wrote, “I can resist anything except temptation.”  Such was the case with SIGA’s executives, who, after the term sheets were executed, learned that the drug was worth significantly more than they had imagined.  The National Institutes of Health, in fact, issued a $16.5 million grant to SIGA to develop the drug.  Suddenly, financial help from PharmAthene wasn’t as important, and a license or merger wasn’t as attractive.  So SIGA began insisting upon onerous provisions from PharmAthene that weren’t listed in the original term sheets, such as increasing PharmAthene’s upfront payment from $6 million to $100 million, and drastically increasing royalty payments as well as SIGA’s share of the profits.  Negotiations broke off, and PharmAthene sued for breach of contract.

In reaching its decision, the Court discussed the impact of term sheets, differentiating between “Type I” and “Type II” preliminary agreements.  A Type I agreement “is a fully binding preliminary agreement, which is created when the parties agree on all points that require negotiation (including whether to be bound) but agree to memorialize their agreement in a more formal document.  Such an agreement is fully binding.”  [Citations omitted.] A Type II agreement, on the other hand, is created when the parties “agree on certain major terms, but leave other terms open for further negotiation.”  In a Type II agreement, “the parties can bind themselves to a concededly incomplete agreement in the sense that they accept a mutual commitment to negotiate together in good faith in an effort to reach final agreement within the scope that has been settled in the original agreement.”  A Type II agreement “does not commit the parties to their ultimate contractual objective but rather to the obligation to negotiate the open issues in good faith in an attempt to reach the alternate objective within the agreed framework.”  [Citations omitted.]

Here, the Court found that the case involved a Type II agreement, and that SIGA had breached its obligation to negotiate in good faith:  “Bad faith is not simply bad faith or negligence, but rather it implies the conscious doing of a wrong because of dishonest purpose or moral obliquity; it is different from the negative idea of negligence in that it contemplates a state of mind affirmatively operating with furtive or ill will…Not only did SIGA’s negotiating position differ substantially from the [term sheet’s] terms, but...SIGA took that position in bad faith…SIGA disregarded the [term sheet’s] terms and attempted to negotiate a definitive license agreement that contained economic and other terms drastically and significantly more favorable to SIGA than those in the [term sheet].”  [Citation omitted.] 

So, what happens if, like SIGA, the other party breaches its obligation to negotiate fairly in the “Type II” situation?  Do you get the full benefit of the deal, on the assumption that, had the other side been negotiating in good faith, a final contract would have been struck?  That seems to involve a bit of speculation, but here, the Court said yes:  “Where the parties have a Type II preliminary agreement to negotiate in good faith, and…the parties would have reached an agreement but for the defendant’s bad faith negotiations, the plaintiff is entitled to recover contract expectation damages.”

A few observations on this topic.  First, years ago, I lost a trial on facts similar to those in the SIGA case (the defendant tried to “better deal” my client in the sale of a recycling company after a term sheet had been executed), with one major exception.  During the trial that I handled, the testimony cast doubt on the ability of  my client to close the transaction.  Here, PharmAthene not only had the wherewithal to conclude the items on the term sheet, but it had already advanced $3 million to SIGA.  So, if there’s a term sheet and your negotiating partner is ready, willing and able to bring things to fruition, proceed with caution – you may be exposed if you back out.  Second, be very careful about documents generated during the negotiation process.  A “term sheet” can be a binding agreement and may contain a requirement to continue to negotiate in good faith.  And third, whether or not you have the right to misbehave isn’t necessarily the issue.  If you behave in an underhanded way (such as by insisting on additional and different onerous terms at the eleventh hour), it could come back to bite you, if not now, then in in a later negotiation.  

You can read the full SIGA Technologies v. PharmAthene decision by clicking here.

-         Gene Killian