Designing and Enforcing Preliminary Agreements

Abstract

Preliminary agreements—variously labeled as memoranda of understanding, letters of intent, term sheets, commitment letters or agreements in principle—are common in complex business transactions. They document an incomplete set of terms that the parties have agreed upon, while anticipating further negotiation of the remaining provisions. They often create legal obligations, particularly a duty to negotiate in good faith. This duty has been the subject of a substantial number of judicial opinions over the past few decades and yet continues to be regarded as a confusing and unpredictable issue in contract law. Legal scholarship is hamstrung in its analysis of the case law because it has focused on only one purpose for this good faith duty: protecting the parties’ reliance investments in the bargaining process. This paper broadens the analysis by introducing multiple goals that parties may seek in imposing legal obligations on their negotiation process and by shifting the focus to what the courts have identified as a necessary feature of the duty to negotiate in good faith: the expectation of some fidelity to the agreed-upon terms specified in the preliminary agreement. The ease with which the parties may deviate from these terms in their negotiations is the essence of the good faith standard. Once parties have searched for and chosen their respective contracting partner, they need the incentives and flexibility to tailor and optimize the terms of their deal, while also efficiently constraining value-claiming behavior and allocating exogenous risks. The recognition of such broader objectives (beyond protection of reliance investments) allow us also to justify how and why courts are willing to enforce the obligation with the more robust remedy of expectation damages, instead of the reliance damages that is advocated by prior scholarship. By choosing whether to impose the duty to negotiate in good faith and selecting the appropriate damages measure, we show how the parties can achieve the desired level of “stickiness” while addressing concerns about the uncertainty of a flexible legal standard.

Keywords: Preliminary Agreement, Letter of Intent, Memorandum of Understanding, Duty to Negotiate in Good Faith