Preliminary Agreements1 come into play when structuring and negotiating a broad spectrum of transactions and agreements. They are embraced by many market participants and are, at best, tolerated by others. They have been the source of litigation and, in some cases, very well-known litigation.2 A Preliminary Agreement manifests itself in many ways, ranging from a valuable nonbinding tool to frame a proposed transaction; to a set of principles agreed by representatives of counterparties who do not ultimately structure and negotiate a deal; to an unintended legally enforceable agreement with numerous ambiguous or missing terms; and, finally, to an intentionally enforceable agreement. What is certain is that the Preliminary Agreement is a widely accepted way to progress many commercial arrangements. They often bring focus to a proposed transaction, identify terms that may be deal breakers, provide a sense of commitment from the parties, and establish a timeframe in which the parties intend to finalize a negotiation. On the other hand, Preliminary Agreements can prove to add a layer of additional cost, cause the parties to get tied down to prospective deal terms set out in the Preliminary Agreement, and (in some jurisdictions) inadvertently create a duty to negotiate in good faith. Preliminary Agreements are commonly and successfully used for LNG sales, acquisition or divestiture of stock or assets, long term commodity (such as natural gas) sales, joint ventures, and many others. If common, and often fundamental, provisions are clearly documented and understood by the parties, a Preliminary Agreement will serve as a useful framework for structuring and negotiating a transaction, as opposed to a document that frustrates a definitive agreement of the parties.
Is it binding in whole or in part? Often the commercial (and some legal) terms of a Preliminary Agreement are not intended to be binding, but are intended to serve as the basis for future negotiation. However, in some circumstances, the parties elect to make the agreement binding in the event a definitive agreement is not achieved. There is rarely an agreement that is truly not binding at all – drafters clarify in the document the binding nature of various provisions. If the commercial terms in a Preliminary Agreement are intended to form the basis of future negotiation or serve as principles in future negotiations, such provisions are typically made expressly non-binding in the Preliminary Agreement. In these circumstances the provisions addressing the non-binding nature of the agreement, governing law, exclusivity (if applicable), term, confidentiality, assignment, notices and certain other miscellaneous provisions are, and should be, obligations of the parties to the agreement. Under some laws, in addition to concise language in the body of the Preliminary Agreement, it is important to also state at the top of the agreement that it is "Subject to Contract". In some jurisdictions the Preliminary Agreement will create an obligation to negotiate in "good faith". When a Preliminary Agreement is intended to be binding, it should be explicitly stated to avoid future disputes over the agreement's nature. In this case, it is critical that the agreement include the key commercial terms in sufficient detail that they are not left to later interpretation. It is also critical that governing law and sufficient non-commercial (legal) terms are also included to ensure some degree of certainty in interpretation and enforceability should there be a future dispute.
Is there an element of exclusivity? In some circumstances, such as an acquisition and divestiture, one motivating factor in entering into a Preliminary Agreement is to establish a period of exclusivity of negotiations. Both the seller and potential buyer are often highly motivated to "get the deal done" during the exclusivity period. The seller has agreed to deal exclusively with the potential buyer and the buyer has a limited period of time to reach agreement without competition. The terms surrounding exclusivity must be clearly established in the agreement and the exclusivity provision is made an enforceable clause in the agreement. Because of the exchange of sensitive information, costs involved, and discussion of commercial terms, the parties often discuss and document the circumstances in which an exclusivity period may be extended by one or both parties.
Is the term clearly defined? If the Preliminary Agreement is only partially enforceable (non-commercial terms and exclusivity, if applicable) a clearly defined term should be included. Typically if the parties fail to reach a definitive agreement by a specified date, the Preliminary Agreement will terminate. It is important that a specific termination date be included so each party to the Preliminary Agreement knows when the arrangement ends.
What are the not so obvious pitfalls in drafting? Negotiate in "good faith"? Detrimental reliance? Some legal jurisdictions impose an obligation to negotiate in "good faith" under a Preliminary Agreement. Despite a drafter's best efforts in making commitments under a Preliminary Agreement non-binding, seemingly harmless provisions that involve "good faith" can become litigated provisions. It is always best to specifically disclaim a duty to negotiate in good faith when drafting a Preliminary Agreement. The creation of specific milestones to be achieved under a Preliminary Agreement has resulted in an obligation to achieve them based on good faith negotiations if certain conditions have been met. If a party is required to perform certain actions under a Preliminary Agreement, consider whether a risk has been created that may give rise to a claim of detrimental reliance or promissory estoppel. Again, understanding the legal regime that applies to a particular Preliminary Agreement is critical.
What are the financial arrangements? Break-up fees? Costs and Expenses? Typically, a Preliminary Agreement will not create financial obligations among the parties. Each participant assumes responsibility for all costs and expenses it incurs in connection with the matters contemplated in the Preliminary Agreement. It is important to contractually obligate the parties in this regard as it minimizes the chance for a claim of detrimental reliance or promissory estoppel if the deal does not progress to a definitive agreement. Explicit provisions setting out this responsibility make it clear that each party was aware of its responsibility for its expenses, whether or not the parties are successful in reaching a definitive agreement. There are a couple of circumstances where the parties do intend to incur financial obligations under the Preliminary Agreement. This is seen when an agreement includes break-up fees or when the Preliminary Agreement is a limited "notice to proceed" with a specified scope of work (e.g., long lead items, preliminary engineering, etc.). If there are break-up fees or an authorized expenditure, the terms surrounding (and limiting) payment obligations should be clear, including the specific work scope that the payment is intended to cover. When contemplating break-up fees, the parties may elect to choose between a compensatory or a liquidated damages approach, depending upon whether one party may incur unusual or significant costs and expenses in connection with the negotiation. Anytime financial obligations are contemplated, a definitive maximum cap on liability and total commitment should be explicitly documented and the Preliminary Agreement should expressly state who has title to items purchased should a definitive agreement not be achieved.
What is the impact of the Confidentiality provision? Some parties execute numerous Preliminary Agreements as they investigate new business ventures. This practice could result in an inadvertent restriction on pursuing a similar transaction with a different counterparty. Depending on the nature of the business and underlying transactions, this practice may create future conflicts with respect to an asset or transaction. In the upstream oil and gas sector for instance, agreed restrictions on use of confidential information in a prior transaction could frustrate a deal with a future counterparty who also has an ownership interest in an asset. In drafting the confidentiality provision, care must be taken not to restrict a party's ability to evaluate an asset in connection with a prospective opportunity.
What are the benefits? When properly drafted, a Preliminary Agreement can provide significant upside to a proposed transaction. Preliminary Agreements are often used to bring focus to the early stages of a negotiation. The parties are able to determine early on whether there are deal breakers that cannot be resolved. The period during which a Preliminary Agreement applies can also be a time when the companies and negotiating teams develop a working relationship that enhances trust in the negotiation process and enhances the commitment of the parties to each other to work towards final agreement. In some industries or jurisdictions the Preliminary Agreement is so customary that the thought of moving forward without one creates an insurmountable obstacle to commencing negotiations.
Conclusion. If a Preliminary Agreement is properly drafted it very well may be the document that frames a transaction and paves the way for finalizing a transaction. Frustration results when critical provisions of a Preliminary Agreement are not well documented or well thought through. The agreement must clearly document its non-binding nature if that is the intention of the parties. Each party must understand the expense of preliminary negotiations and allocation of the costs and expenses.
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Kathryn Marietta
Houston
+1 713 276 7372
kmarietta@kslaw.com
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