Prior to entering into a final contract, parties frequently memorialize certain key deal points in preliminary agreements. These preliminary agreements often contain both non-binding provisions and binding provisions. When a party breaches a binding provision in an otherwise expressly non-binding preliminary agreement, the question inevitably arises: What is the proper measure of damages?
Although courts addressing this issue have generally held that the proper measure of damages is limited to out-of-pocket or reliance damages, dicta in an influential opinion by Judge Richard Posner leaves open the door for an award of “benefit of the bargain” or expectation damages such as lost profits. Judge Posner’s opinion in Venture Associates Corp. v. Zenith Data Systems Corp., 96 F.3d 275 (7th Cir. 1996), which has been favorably cited by a number of commentators, injects enough uncertainty into the damages analysis to expose unsuspecting parties to hundreds of thousands or even millions of dollars in damages, or, at the very least, subject them to litigation that is not easily or inexpensively resolved based on a preliminary agreement that a party thought to be non-binding.
Because only a handful of courts have addressed the precise issue of the proper measure of damages for the breach of a deemed-to-be binding provision contained in an otherwise non-binding preliminary agreement, the possibility remains that a court faced with this issue for the first time may adopt the approach taken by Judge Posner in Venture.
The Venture “Rule.” Venture involved the proposed acquisition by Venture Associates Corporation of certain assets of Zenith Data Systems Corporation. Venture sent a letter to Zenith proposing terms for the acquisition. The letter stated that it was not a binding obligation on either party but was rather “merely a letter of intent” subject to execution of a definitive purchase agreement, except for a paragraph in the letter stating that the parties agreed to negotiate in good faith to enter into a definitive purchase agreement, and that pending execution of a definitive purchase agreement, the seller would not negotiate with other companies. The seller responded to the letter, agreeing to negotiate for the sale of the company and agreeing in principle to the purchaser’s proposed terms. The Seventh Circuit found that the exchange of letters “established a binding agreement to negotiate in good faith toward the formation of a contract of sale.”
What Judge Posner’s opinion in Venture does, perhaps unwittingly, is create an expedient means for plaintiffs to survive summary judgment in lawsuits seeking expectation damages based on the breach of a binding provision of an otherwise expressly non-binding preliminary agreement. If a non-breaching party can convince a court that a binding provision “found” in an otherwise non-binding preliminary agreement carries with it an obligation to negotiate in good faith toward a final deal, then the non-breaching party can argue under Venture that it is entitled to expectation damages because “but for” the breaching party’s bad faith, a final deal would have been reached.
The problem with applying the Venture “rule” to binding provisions contained in expressly non-binding letters of intent is manifest: It holds the parties to the terms of a contract to which they expressly disavowed any intent to be bound. This fundamental problem is magnified by the fact that Venture’s analysis makes it difficult to obtain summary judgment or other pretrial resolution in such cases because the “but for” causation standard it adopts typically involves factual disputes to be resolved by a jury.
The scope of the Venture “rule” is limited. Although the Venture case creates uncertainty, breaching parties do have recourse to a body of case law that rejects the notion that “benefit of the bargain” or expectation damages are available for the breach of binding provisions of expressly non-binding preliminary agreements.
First, the rule of Hadley v. Baxendale, 9 Exch. 341, 156 Eng. Rep. 145 (1854), requires that contract damages be the “natural and necessary consequence” of the breach and must have been in the contemplation of the parties at the time the contract was made. When parties expressly disavow any intent to be bound by the substantive terms outlined in a preliminary agreement, it runs counter to Hadley and defies logic to suggest that the non-breaching party’s “benefit of the bargain” damages were within the contemplation of the parties at the time the agreement was made, because those are the same damages that would be available for a breach of the completed contract. In effect, the parties’ intent not to be bound by the terms in the preliminary agreement should shield them from the liability that would attach for a breach of the final agreement.
Second, only damages that can be proved with reasonable certainty are recoverable. Damages cannot be based on speculation and conjecture. Two layers of speculation inhere in every claim for damages based on the breach of a binding provision contained in a non-binding letter of intent: First, because the parties never agreed to be bound, it cannot be determined without resort to speculation and conjecture that a final deal would have been reached absent the breach; and, second, because the letter of intent, by its very nature, did not set terms, it cannot be determined without resort to speculation and conjecture what the final terms of the deal would have been.
Even if it could be assumed that a final deal would have been reached without a breach, plaintiffs face the further challenge of proving what the terms of the deal would have been. No doubt, they will point to the terms outlined in the preliminary agreement as a guidepost for what the terms of a final deal would have been, but because those terms are expressly non-binding, the court must once again necessarily resort to speculation—either that the preliminary terms would have been the final terms, despite the parties’ expressed intent not to be bound by those terms, or that some other set of terms would ultimately have been agreed to by the parties.
Steps to avoid application of the Venture “rule.” To avoid an argument that there is a binding obligation to negotiate in good faith, thus bringing the provision within the purview of Venture, parties should expressly state that there is no such duty. In addition, proper care should be taken to avoid “contract-like” language in letters of intent. For example, the non-binding provisions should refer to the “potential transaction” or the “possible deal,” or other terms or conditions that “would” be applicable. Within any non-binding provision, care should be taken to avoid the use of words such as “shall,” “will,” or “must.” The cumulative effect of such precision is to draft a preliminary agreement that expressly states it is not an agreement to negotiate in good faith and that does not contain any language capable of being interpreted as creating a binding obligation to negotiate in good faith, rendering the rationale from Venture inapplicable.
Parties should include language that expressly limits recovery for the breach of the binding provision to the non-breaching party’s reliance damages or, alternatively, provides for a specific breakup fee. Such language may be included in conjunction with a provision expressly stating that no liability will attach for the breach of any of a letter of intent’s expressly non-binding provisions.
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This article is an abridged and edited version of one that originally appeared in the online magazine Business Law Today, October 2010.
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