US District Court Finds Possible Breach of Letter of Intent for Failure to Disclose Condition to Sale | Practical Law

US District Court Finds Possible Breach of Letter of Intent for Failure to Disclose Condition to Sale | Practical Law

The US District Court for the Southern District of New York in EQT Infrastructure Limited v. Smith denied a motion to dismiss a claim that an agreement to negotiate in good faith in a letter of intent was breached by the potential sellers as a result of their failure to disclose a condition that they would only enter into a final agreement if they could find a buyer for a separate business.

US District Court Finds Possible Breach of Letter of Intent for Failure to Disclose Condition to Sale

by PLC Corporate & Securities
Published on 29 Mar 2012 • New York
The US District Court for the Southern District of New York in EQT Infrastructure Limited v. Smith denied a motion to dismiss a claim that an agreement to negotiate in good faith in a letter of intent was breached by the potential sellers as a result of their failure to disclose a condition that they would only enter into a final agreement if they could find a buyer for a separate business.
On March 20, 2012, the US District Court for the Southern District of New York denied a motion to dismiss a claim of breach of contract brought by a party to a letter of intent (LOI). The court found that:
  • The LOI between the potential buyer and sellers plausibly constituted a Type II preliminary agreement under Second Circuit precedent.
  • The LOI therefore contained a binding obligation of the parties to negotiate in good faith.
  • The potential sellers plausibly breached their covenant to negotiate in good faith when they did not disclose to the potential buyer that they would only sell the business that was the subject of their negotiations if they could sell a related business to another buyer.

Background

The Negotiations

In the fall of 2009, the plaintiff, EQT Infrastructure Limited (EQT), commenced negotiations with the defendants, several Connecticut and Delaware entities owned by an individual residing in Connecticut (the sellers). The negotiations revolved around the potential sale of the sellers' bulk-storage business to EQT. The sellers also owned a marine-services business that EQT, as a foreign entity, was legally prohibited from buying. EQT and the sellers all understood that EQT was prohibited from buying the marine-services business.
Throughout the winter and spring of 2010, EQT and the sellers continued their negotiations, with EQT gaining access to a physical data room for due diligence. After eventually coming to an agreement on price, EQT and the sellers entered into an LOI on August 6, 2010. The LOI contemplated a "Possible Transaction" for the sale of the bulk-storage business, explicitly excluding the marine-services business, at a price of $110 million.

The Letter of Intent

The LOI contained several provisions common to preliminary M&A agreements, including:
  • An agreement to negotiate with EQT in good faith and on an exclusive basis until the earlier of September 8, 2010 and the date that EQT would terminate discussions.
  • A no-shop covenant by the sellers for the duration of the exclusivity period.
  • A condition that the obligation to complete the transaction was subject to execution of a definitive purchase agreement and related agreements on terms reasonably satisfactory to the parties.
  • An acknowledgment that EQT would be spending considerable time and expense on the Possible Transaction.
  • A "non-binding effect" provision stating that the LOI did not create a binding obligation to enter into a definitive purchase agreement or to effect the sale, but that the exclusivity provision and covenant to negotiate in good faith were binding.
  • A New York governing-law provision.
The LOI did not state that the Possible Transaction was conditioned on the sale of the marine-services business to a buyer other than EQT.
After entering into the LOI, EQT went on to conduct due diligence, began drafting the purchase agreement, worked on obtaining the necessary approvals for the deal and otherwise spent over $1.5 million on legal and financial advice.

The Sellers Request a Price Increase

In a letter to EQT dated October 19, 2010 (after expiration of the exclusivity period), the sellers' counsel advised EQT that the sellers were not prepared to sell the bulk-storage business at the agreed price because they could not find a suitable buyer for the marine-services business. The sellers therefore asked for an increase in the purchase price from $110 million to $125 million, which EQT refused to pay.

EQT Files Suit

On January 21, 2011, EQT sued the sellers, alleging fraud and breach of contract. EQT claimed that the sellers had breached the covenant to negotiate in good faith by carrying on negotiations for the sale of the bulk-storage business when it knew it would not sell that business unless it could find a buyer for the marine-services business.
The sellers moved to dismiss the complaint, arguing that:
  • The term in the LOI for a $110 million purchase price was not binding.
  • The disagreement over price amounted to a failure to satisfy the condition to a final deal that the LOI did make explicit: to reach agreement on a definitive purchase agreement on terms reasonably satisfactory to the parties.
  • In any event the agreement to negotiate in good faith had expired on September 8, 2010 with the expiration of the exclusivity period.

Key Litigated Issues

The court's analysis of the claim of breach of contract focused on the following issues:
  • Whether the LOI qualified as a Type II preliminary agreement under relevant Second Circuit precedent (the parties agreed that the LOI was not a Type I agreement). If it did, the parties would be required to negotiate in good faith.
  • Whether the obligation to negotiate in good faith expired on September 8, 2010 with the exclusivity period or extended beyond that date.
  • Whether the sellers' failure to disclose the condition of the sale of the marine-services business and request for a price increase constituted a breach of the agreement to negotiate in good faith or were permissible under the non-binding provisions of the LOI.

Outcome

Preliminary Agreements under New York Law

As the court explained, the Second Circuit has interpreted New York law as having two types of preliminary agreements that create binding obligations:
  • Type I Agreements. Complete meetings of the mind that bind both sides to the ultimate contractual goal, even though the parties contemplate executing a more formal agreement.
  • Type II Agreements. Reflecting agreement only on major terms and therefore binding only to a certain degree, but leaving other terms open. These agreements do not bind the parties to the ultimate contractual goal, but do bind them to negotiate the open issues in good faith.
If the parties have a Type II agreement, then they may abandon the transaction if the definitive agreement is not executed, on condition that they have made a good-faith effort to reach agreement and "not insisted on conditions that do not conform to the preliminary writing."

The Finding of a Type II Agreement

The sellers and EQT agreed here that their LOI was not a Type I agreement. The sellers disputed whether the LOI amounted to even a Type II agreement. The court followed a five-step test to determine whether a Type II agreement existed:
  • Whether the parties' intent was revealed by the language of the agreement.
  • The context of the negotiations.
  • The existence of open terms.
  • Partial performance.
  • The necessity of putting the agreement in final form.
Most of these factors were relatively straightforward to apply to the facts of the case. For example:
  • The parties obviously intended to enter into a more formal agreement.
  • There were open terms still left to be finalized.
  • EQT had completed many preliminary steps such as due diligence and seeking government approvals.
The harder and more important question was determining the parties' intent on the basis of the language of the LOI.
In arguing against a finding of a Type II agreement, the sellers emphasized that the "non-binding effect" provision rendered the purchase-price term non-binding. However, the sellers admitted that the covenant to negotiate in good faith was made binding by the terms of that same provision. The court considered that covenant more critical for the finding of a Type II agreement. In so finding, the court noted that EQT's contention was not that the sellers breached the pricing term, but that they breached the negotiation covenant.

The Expiration of the Exclusivity Period

The court acknowledged that the question of whether the LOI obligated the parties to negotiate in good faith beyond the expiration of the exclusivity period was a closer call. At the stage of ruling on a motion to dismiss, the court determined that the LOI's reference to the sellers' obligation to work with EQT in good faith and on an exclusive basis until September 8, 2010 was only intended to delineate a time frame for exclusivity, not to suggest that the parties would be free to negotiate in bad faith after that date. The fact that the parties had negotiated for a period of nine months before entering into the LOI buttressed the court's rationale that the parties intended to continue negotiating after the LOI's term and therefore were bound to do so in good faith.

The Breach of the Agreement

The court's opinion did not address as a separate matter whether the failure to disclose the condition of the sale of the marine-services business was severe enough to amount to bad faith. Having found that the LOI qualified as a Type II agreement, the court did not hesitate to find that the sellers' failure to disclose qualified as a breach. The main question for the court was whether the sellers' breach (through their letter of October 19, 2010) occurred only after expiration of the agreement. However, because the court ruled that the parties had a Type II agreement past the September 8 date, it could find that the letter of October 19 breached the agreement.
The court added that even if the obligation to negotiate in good faith in fact expired with the exclusivity period, there was still enough evidence for a plausible finding that the sellers intended before the expiration date to only sell the bulk-storage business if they could find a buyer for the marine-services business. This amounted to a breach of the Type II agreement before the September 8 expiration date, even though the sellers only revealed their condition explicitly in October.

Practical Implications

Although the court's decision was reached at a preliminary stage of the proceedings, its finding of a plausible breach of the LOI in this case is notable. The question of whether an agreement to negotiate in good faith has been breached is often thought to arise if a party maintained "radio silence" during the exclusivity period (see Legal Update, Delaware Court of Chancery Confirms Contractual Rights in Letter of Intent) or otherwise totally ignored the terms outlined in the LOI or term sheet. Yet in this case, there was no allegation that the sellers were not serious about the negotiations or that they were looking for an excuse to avoid the proposed sale. Ultimately, the sellers' breach was caused by a request for a 13.6% price increase. Although the impetus for the request was the failure of a condition that the sellers never made explicit in the LOI, it is not hard to picture other transactions failing to proceed from term sheet to agreement because of failure to meet a party's similarly internally held expectations. Still, the court here found it plausible that EQT could prove bad faith on the sellers' part because they did not explicitly reveal the related-sale condition.
Although EQT may not eventually prevail on its claims, practitioners wishing to avoid this litigation scenario in New York would be well advised to make explicit in terms sheets and LOIs any conditions that their clients deem necessary to be met before they can proceed with the transaction. This is a better path than attempting to defeat a characterization of the preliminary agreement as a Type II agreement, as many preliminary agreements frequently contain an explicit covenant to negotiate (for example, see Standard Document, Exclusivity Agreement: Drafting Note, Agreement to Negotiate, and for further discussion of when courts find an agreement to negotiate, see Practice Note, Term Sheets: Binding or Non-binding: Duty to Negotiate in Good Faith).
To the extent that the preliminary agreement is confusing about whether the expiration date limits only the exclusivity period or the agreement to negotiate in good faith as well, practitioners should also make this language clear. Under New York law, in Type II preliminary agreements, the agreement to negotiate in good faith is not assumed to expire with the exclusivity period. Consequently, even when the seller becomes free to negotiate with different buyers, it does not become free to negotiate in bad faith.

Court Documents