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Traps for the Unwary — The Potential Consequences of Agreements to Negotiate in Good Faith

October 12, 2011
Morris James LLP
Delaware Business Court Insider

Agreements to negotiate in good faith can create issues for the unwary. The potential traps of such an agreement appear in the Court of Chancery's Sept. 22 decision in PharmAthene Inc. v. SIGA Technologies Inc.

The PharmAthene case arose from a dispute between two companies over the development of a smallpox drug. Defendant SIGA Technologies Inc. was developing the drug, but ran into financial difficulties. Plaintiff PharmAthene Inc. and SIGA discussed collaborating to develop the drug. Because the parties had previously engaged in unsuccessful merger negotiations and SIGA felt PharmAthene backed out of a merger because of cold feet, SIGA insisted on working out a licensing agreement before engaging in more merger discussions.

The parties agreed on a term sheet for the license agreement that was never signed and contained a footer stating "non-binding terms." The parties then began negotiating a merger agreement with the understanding that they would negotiate a license agreement if the merger did not occur and PharmAthene would make a bridge loan to SIGA while they negotiated a merger agreement. PharmAthene made the loan and the parties negotiated a merger agreement. The license term sheet was attached as an exhibit to the merger term sheet, merger agreement and bridge loan agreement. All of those agreements expressly provided that if the merger was not consummated, the parties would negotiate in good faith a license agreement in accordance with the term sheet.

SIGA subsequently terminated the merger agreement and the parties attempted to negotiate a license agreement. By the time the merger agreement was terminated, SIGA's finances had greatly improved and the drug had passed a number of milestones, making it more valuable. SIGA proposed license agreement terms strikingly different than the term sheet, including a draft limited liability company agreement, and PharmAthene eventually sued SIGA for, among other things, breaching the license term sheet, failing to negotiate a license agreement in good faith and promissory estoppel.

Although the Court of Chancery found that the license term sheet was not a binding agreement because the parties did not intend to be bound and because it lacked essential terms, it did find that SIGA had failed to negotiate in good faith a license agreement in accordance with the term sheet. SIGA's attempt to renegotiate previously contested and compromised terms was an unambiguous act of bad faith. Specifically, the court found SIGA acted in bad faith by increasing the upfront payment from PharmAthene to SIGA from $6 million to $100 million, raising PharmAthene's milestone payments from $10 million to $235 million and doubling the royalty rates charged to PharmAthene.

Even in the absence of language requiring good-faith negotiations, the court would have found SIGA liable to PharmAthene. The court held PharmAthene was entitled to relief under the doctrine of promissory estoppel because SIGA had promised PharmAthene it could receive control over the smallpox drug through a license agreement with terms similar to the term sheet. In reliance on that promise, PharmAthene made a bridge loan to SIGA and provided operational support to SIGA.

SIGA paid for its actions, both in damages and in stock price (its stock price dropped 35 percent after release of the decision). While specific performance — requiring the parties to negotiate in good faith a license agreement in accordance with the term sheet — would seem like the most obvious remedy for SIGA's breach, the court found this remedy too impractical. The parties' contentious history over the subject matter of the dispute and the nature of a specific performance order requiring good-faith negotiations would require the court to take an active, supervisory role in the negotiations. Thus, the court exercised its discretion to deny PharmAthene's request for specific performance. The court did note, however, that under different circumstances specific performance could be an appropriate remedy for breach of an agreement to negotiate. For example, if the parties could not negotiate in good faith due to one side lacking sufficient information, the court could require the other side to provide that information.

Instead of specific performance, the court awarded expectation damages. Calculation of those damages was tricky because the nature of the subject matter, a drug that was still being tested and had not received FDA approval, meant that PharmAthene might not profit even if it executed a license agreement with SIGA. The court held it could not award PharmAthene the present value of its lost profits on a license agreement that was never executed and might never result in profits, because such an award would be too speculative. The court was willing, however, to award damages based on the present net value of what the parties had or would have agreed to exchange at the time of the breach in the form of an equitable payment stream similar to a constructive trust or equitable lien on a share of the proceeds from the smallpox drug.

The court did not rely solely on the license term sheet to calculate damages, but instead focused on what reasonable cash flows PharmAthene would have received in a good-faith negotiation of a license agreement. During negotiation of the license agreement, PharmAthene had agreed to consider making an upfront payment of $40 million to $45 million instead of $6 million as set forth in the term sheet and a 50/50 profit split on all sales instead of just government sales with a profit margin of 20 percent or more as set forth in the term sheet. The court held that once SIGA earned $40 million in net profits or margin from net sales, PharmAthene was entitled to 50 percent of all net profits from such sales for 10 years from the first commercial sale.

Practitioners seeking to avoid the consequences of PharmAthene need to think long and hard before agreeing to a provision requiring good-faith negotiations in accordance with a term sheet. Slapping "non-binding" form language on an unsigned term sheet attached to executed documents won't protect a party from a promissory estoppel claim enforcing the term sheet. The safest approach would be to execute a final, binding agreement. If timing or circumstances make such an agreement impossible, then the parties need to negotiate carefully the critical terms in any term sheet and/or expressly provide for leeway to renegotiate certain terms.

The parties also need to consider carefully whether to attach a term sheet to any other documents. For parties wishing to take advantage of an agreement to negotiate, they might be better served not to appear as if they are willing to make any significant concessions from the provisions of a term sheet. In negotiating the license agreement, PharmAthene had agreed to consider economic terms that differed somewhat from the economic terms in the term sheet and the court ultimately based its award on the revised terms. Thus, PharmAthene is instructive to parties who wish to enforce an agreement to negotiate in good faith or a term sheet as well as to parties who to wish avoid such obligations.