October 31, 2013

DELAWARE INSIDER: Delaware Courts May Award Expectation Damages for a Breach of an Obligation to Negotiate in Good Faith

Under the laws of many jurisdictions, expectation damages for breach of an agreement to negotiate in good faith are viewed as inherently speculative and thus generally not an appropriate measure of damages. In Delaware, the question of whether expectation damages, which attempt to estimate the profits the promisee expected to generate under the to-be-negotiated contract, were an appropriate remedy for a breach of an obligation to negotiate in good faith had not been definitely resolved by the Delaware Supreme Court until recently. Nevertheless, the Delaware courts appeared to follow the law in other jurisdictions that such damages were not an appropriate remedy for a breach of an agreement to negotiate in good faith due to their speculative nature. 

In SIGA Technologies, Inc. v. Pharmathene, Inc., 67 A.3d 330 (Del. 2013), however, the Delaware Supreme Court reversed the Court of Chancery’s holding that expectation damages could not be awarded for breach of an agreement to negotiate in good faith because they were inherently speculative and held that, under Delaware law, an express contractual obligation to negotiate a definitive agreement in good faith is enforceable, and that expectation damages are an appropriate remedy for a breach of that obligation if they can be proven with reasonable certainty and the court determines that the parties would have reached an agreement but for the bad faith conduct of the defendants. 

Expectation Damages Prior to SIGA v. Pharmathene 

Prior to the Delaware Supreme Court’s SIGA decision, it was generally believed that, under Delaware law, in connection with a breach of an agreement to negotiate in good faith, expectation damages were too speculative and uncertain, since the final terms of the contract had not been agreed upon and thus whether the parties would have reached agreement, what the terms of that agreement may have been, and the future profits expected to be generated by such agreement were not certain. Rather, reliance damages, which reimburse the promissee for out-of-pocket expenses and can generally be measured with reasonable certainty, were considered to be a more appropriate remedy for a breach of an agreement to negotiate in good faith. Indeed, the Court of Chancery in the SIGA case found that Pharmathene’s claims for expectation damages in the form of a specific sum of money representing the present value of the future profits it would have received absent SIGA’s breach of its obligation to negotiate in good faith was “speculative and too uncertain, contingent and conjectural” because a definitive licensing agreement between the parties was not consummated and, even if it were consummated, the licensing agreement would have contained the risk that Pharmathene would receive no profits. 

Other jurisdictions hold similar views regarding the appropriate damage award for breaching an obligation to negotiate in good faith. For example, New York courts have held that an award of expectation damages for breach of an obligation to negotiate a definitive agreement in good faith would effectively transform an agreement to negotiate into the definitive agreement itself. Similarly, New York courts have held that reliance damages, as opposed to expectation damages, are the appropriate remedy for a breach of an agreement to negotiate in good faith, because a court could not reasonably determine what agreement the parties would have reached if the parties had negotiated in good faith. 

SIGA v. Pharmathene 

During 2004, SIGA Technologies, Inc. (SIGA), a biodefense company involved in the development of pharmaceuticals, acquired and began developing an antiviral drug for the treatment of smallpox (ST-246). By late 2005, due to financial difficulties as well as difficulty developing ST-246, SIGA began discussing a potential transaction with Pharmathene, Inc. (Pharmathene) through which both companies would collaborate to develop and commercialize ST-246. Accordingly, the parties began negotiating a licensing agreement term sheet to set forth certain terms and conditions of a formal licensing agreement between the parties in order to support further development of ST-246. As a result, the parties produced a two-page licensing agreement term sheet (the LATS), which included a description of the scope of the license and certain economic terms. The LATS, however, was not signed by either party and contained a footer on each page providing that its terms were non-binding. 

Following the negotiation of the LATS, the parties, at the request of Pharmathene, began to discuss a merger between the companies. To ensure its control over ST-246 if the merger ultimately did not close, Pharmathene also sought to have the formal license agreement negotiated simultaneously with the negotiation of the merger agreement. In order to avoid the additional costs involved with negotiating and drafting two sets of documents simultaneously, SIGA instead suggested that the parties attach the LATS to the merger agreement. 

To address SIGA’s continuing financial difficulties during negotiation of the merger, the parties entered into a bridge loan agreement pursuant to which Pharmathene loaned SIGA $3 million to, among other things, continue to develop ST-246. By June 2006, SIGA and Pharmathene signed a definitive merger agreement. Both the bridge loan agreement and the merger agreement attached the LATS and included a provision that, if the merger agreement is terminated, the parties agree to negotiate in good faith with the intention of executing a definitive licensing agreement in accordance with the terms of the LATS. 

After the execution of the bridge loan agreement and during the negotiation of the merger agreement, however, ST-246 achieved several important milestones which increased its value, including an agreement to perform the first human test and an award of $16.5 million for the further development of the drug. Due to these significant developments, SIGA no longer needed Pharmathene’s collaboration in the development or commercialization of ST-246. Accordingly, when the approval of SIGA’s draft proxy statement delayed the closing of the merger past the deadline set forth in the merger agreement, SIGA exercised its right to terminate the merger agreement. 

Shortly thereafter, Pharmathene sought to negotiate the terms of a formal licensing agreement with SIGA in accordance with the terms of the LATS and prepared a draft licensing agreement in accordance therewith. SIGA, on the other hand, took the position that the terms of the LATS were not binding and instead proposed a partnership between the parties with economic terms that differed significantly from the terms set forth in the LATS in a manner that was more favorable to SIGA. Eventually, SIGA refused to continue negotiations for a licensing agreement unless Pharmathene agreed to negotiate without regard to the terms of the LATS. Because negotiations between the parties were no longer productive, Pharmathene filed suit in the Delaware Court of Chancery alleging, among other things, that SIGA breached its obligation to negotiate a license agreement with Pharmathene in good faith and in accordance with the terms of the LATS, and seeking expectation damages as a remedy for such breach. 

After a full trial on the merits, the Court of Chancery ruled, among other things, that (1) SIGA had a duty to negotiate in good faith the definitive licensing agreement with terms similar to the LATS; (2) SIGA’s attempt to negotiate an agreement that disregarded the economic terms previously negotiated by the parties in the LATS and instead contained drastically different and self-serving economic terms was an act of bad faith; and (3) Pharmathene was entitled to equitable damages in the form of a stream of future payments, if and when commercial sales of ST-246 commenced, to approximate the terms of the licensing agreement to which the court found that the parties would have ultimately agreed but for defendants’ breach. As discussed above, the Court of Chancery denied Pharmathene’s request for an award of expectation damages as a remedy for SIGA’s breach of its duty to negotiate in good faith because such an award would be too speculative and uncertain under the circumstances. Following the Court of Chancery’s ruling, both parties appealed to the Delaware Supreme Court. 

As an initial matter, the Supreme Court reaffirmed that, under Delaware law, an express contractual obligation to negotiate in good faith is binding on the contracting parties. While acknowledging that the LATS included language suggesting that its terms were non-binding, the Supreme Court found that the parties’ incorporation of the LATS into enforceable, fully integrated contracts (i.e., the bridge loan agreement and the merger agreement) reflected the parties’ intent to negotiate a licensing agreement on terms substantially similar to the LATS if the merger were not consummated. 

Further, the Supreme Court upheld the Court of Chancery’s factual conclusions that SIGA acted in bad faith in its negotiations with Pharmathene regarding the licensing agreement and that, but for SIGA’s breach of its obligation to negotiate in good faith, the parties would have reached an agreement on terms consistent with the LATS. The Chancery Court’s conclusions were supported by the fact that (1) SIGA’s negotiating position differed substantially from the terms of the LATS in a way that significantly favored itself; (2) SIGA refused to continue negotiations with Pharmathene until it agreed that the parties’ negotiations were not constrained by the terms of the LATS; and (3) SIGA began experiencing seller’s remorse due to key achievements in the development of ST-246 which significantly increased its value. 

The Supreme Court then turned to the appropriate remedy for a breach of an agreement to negotiate in good faith where the court finds that, but for the defendant’s breach, the parties would have reached an agreement. The court noted that past Delaware precedent left open the question as to whether expectation damages are an appropriate remedy for such a breach. In addition, the court noted that there is no consensus on the issue among other jurisdictions. The court, however, found the analysis applied by federal courts interpreting New York law regarding binding preliminary agreements to be instructive. In particular, the court noted that these federal courts recognize two types of binding preliminary agreements – Type I and Type II preliminary agreements. A Type I preliminary agreement is a fully binding preliminary agreement used when the parties agree on all points of the transaction that require negotiation. Parties create a Type II preliminary agreement when the parties agree on certain major terms but leave other terms open for future negotiation. In connection with a Type II agreement, the parties can bind themselves to the terms of the preliminary agreement by committing to negotiate the final agreement in good faith within the scope of the preliminary agreement. 

In that connection, the Supreme Court held that “where the parties have a Type II preliminary agreement to negotiate in good faith, and the trial judge makes a factual finding, supported by the record, that the parties would have reached an agreement but for the defendant’s bad faith negotiations, the plaintiff is entitled to recover contract expectation damages.” Further, the court found that the factual conclusions made by the Court of Chancery support a finding that the LATS was a Type II preliminary agreement and that SIGA and Pharmathene could not, in good faith, propose terms of the definitive licensing agreement that were inconsistent with the LATS. Because this was the first time the Delaware Supreme Court addressed whether Delaware law recognizes Type II preliminary agreements or whether a plaintiff is entitled to recover expectation damages in connection with a breach of an obligation to negotiate a definitive agreement in good faith, the Supreme Court reversed the Court of Chancery’s damages award for reconsideration consistent with its ruling. 

The Court of Chancery has not yet ruled on whether Pharmathene is entitled to expectation damages as a result of SIGA’s breach of its obligation to negotiate in good faith. Since the case has been remanded, the Court of Chancery has permitted the parties to reopen the record to allow Pharmathene to introduce a limited amount of evidence regarding the profits SIGA has generated on ST-246 over the past seven years since the case was filed and to allow SIGA to respond to such evidence. Delaware courts calculate expectation damages based on the reasonable expectations of the non-breaching party at the time of the breach. The court, therefore, has expressed doubt about whether such new evidence will ultimately be relevant to its decision on the damage award. 

Expectation Damages Post-SIGA 

While the Delaware Supreme Court’s holding in SIGA is based on the specific and unique factual circumstances at issue in that case, its ruling serves as an important reminder that a breach of an agreement to negotiate in good faith could result in a substantial damage award. Expectation damages typically set the upper limit for damage awards and can be several times higher than an award of reliance damages. 

Although the Court of Chancery has yet to determine on remand in SIGA whether there is sufficient evidence to support an award of expectation damages to remedy SIGA’s breach of an agreement to negotiate in good faith, previous decisions of the Delaware courts where expectation damages have been awarded to remedy a breach of contract provide some guidance as to what type of evidence is sufficient to prove expectation damages with reasonable certainty. In that regard, Delaware courts have found that evidence of the expectations of the non-breaching party as to value of the business transaction, such as projections, prepared at the time the transaction was being negotiated and provided to a third party is a fair representation of the expectations of the non-breaching party sufficient to support an award of expectation damages. 

For example, in WaveDivision Holdings, LLC v. Millennium Digital Media Systems, L.L.C., 2010 WL 3706624 (Del. Ch. Sept. 17, 2010), after finding that Millennium breached its contractual obligations to WaveDivision, the Court of Chancery determined that expectation damages could be calculated with reasonable certainty. The court calculated the damage award based on the profits that WaveDivision expected to generate from the transaction as set forth in projections that were prepared by WaveDivision and that were provided to its lenders in connection with its attempt to obtaining financing for the transaction. The court determined that the projections provided to the lenders were a “sound, conservative estimate as to Wave’s expectations at the time.” The reliability of the projections was enhanced because the projections were relied upon by a third party with an interest in getting repaid and because they were not materially different than projections previously prepared by Millenium’s financial advisor. While more aggressive internal projections were not prepared by WaveDivision, the court did not rule out that such projections could be considered in determining the damage award if the projections had been prepared professionally and were in tangible form at the time of the deal and that lower projections were only used to provide a more conservative estimate to its lenders. 

Conclusion 

SIGA highlights a difference between the damages potentially available to a party breaching an obligation to negotiate in good faith under the laws of Delaware and the laws of New York and other jurisdictions. Persons drafting term sheets and other contractual obligations should be aware of the potentially larger damage awards under Delaware law for breach of the obligation to negotiate in good faith.