Is the Term Sheet a Binding Contract?

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP

Does an agreement in principle on a term sheet amount to a contract?

A number of cases have considered the question whether an agreement in principle on a term sheet amounts to a contract of some sort. For example, assume an investing entity backs out of financing a start-up company. The start-up company claims that the investing entity had made binding legal promises in the term sheet, including particularly the promise to invest money, and should be liable in the event of breach. Generally, the relevant cases have arisen in the context of a lender-creditor relationship; indeed, the cases concerning promises at the preliminary stage are grouped under the general heading of "lender liability," upon which there has been a good deal of commentary. [1] An illustrative case that raises the alarm systems of investor's counsel if Judge Duffy's opinion in Penthouse International Ltd. v. Dominion Federal Savings & Loan Assn. [2] In that case, since reversed by the Court of Appeals, [3] Dominion Federal was held liable to the applicant debtor for $112 million in lost profits for failure to fund its promise to advance a $35 million participation in a loan made by another lender to construct an Atlantic City casino. [4] If one construes the term sheet as equivalent to a lender's commitment letter, then the problems are apparent, including particularly the zany measures of damages that juries award in cases such as Penthouse International and Texaco v. Pennzoil. [5] On the other hand, there may be a recent defendant oriented trend building in reaction to stretches such as Judge Duffy's. Thus, the Seventh Circuit in 1989 held against the notion that a letter of intent is a binding contract, [6] the letter of intent being expressly conditional on acceptance by the boards of both corporations, which in the defendant's case did not occur. The district court made findings that the parties did not intend the letter of intent to be a binding obligation. The court also rejected, again on the specific facts, the allegation that the defendant had failed to negotiate in "good faith."

The author's firm has conjured with language such as the following that investing entities should consider including in term sheets whenever the issue is in doubt: The parties expressly agree that no binding obligations will be created until a document entitled "final agreement of purchase and sale" is executed with the requisite formality and delivered by both parties. Without limiting the generality of foregoing, it is the parties' intent that, until that event, no agreement shall exist between them and that there be no obligations whatsoever based on such as parol evidence, extended negotiations, "handshakes," oral understanding, or courses of conduct (including reliance and changes of position). No legally binding obligations whatsoever are to be created, implied, or inferred, until a document explicitly entitled ''final'' has been executed and delivered.

In addition, neither party is under any obligation to negotiate in good faith or to use any quantum of effort, including but not limited to "best efforts," to reach an agreement. Either party is free to negotiate with a third party at the same time it is negotiating with the other party to this document and, except as explicitly herein provided, to solicit interest from any available source. Either party may reveal information, whether labeled "confidential" or otherwise, obtained in the course of the transaction unless there is a specific agreement, signed by both parties with the requisite formality, to keep a particular item of information confidential.

It is notable in Penthouse that the default by the defendant, Dominion Savings & Loan, was in its posture as a member of the syndicate and not the lead investor, leading one to conclude that perhaps even a secondary investor involved in presenting a term sheet could be as liable. [7] Parenthetically, it is an article of faith in venture capital that start-up companies can be ruined by the propensity of venture capitalists to pursue a "now you see it, now you don't" commitment to fund the company. A final note: the recent precedents on the issue of "term sheets vs. contracts" are much more numerous when the defendants, like Dominion Federal, are lenders (versus investors). One wonders why, other than the populist notion that bankers are skinflints, debt commitments (or so alleged) are more easily distilled out of conduct and incomplete papers versus alleged promises of equity.

[1] See the authorities collected in the bibliography accompanying Kriz & Kavanah, Up-Date On Lender Liability, 3 Rev. Fin. Servs. Reg. 189, 195 (Nov. 4, 1987); see also Goodman, Note, Confirming Bank Liability in Letter of Credit Transactions: Whose Bank Is It Anyway? 51 Fordham L. Rev. 1219 (May 1983).

[2] 665 F. Supp. 301 (S.D.N.Y. 1987).

[3] Id., rev'd, 855 F.2d 963 (2d Cir. 1988), cert. denied, 490 U.S. 1005, 109 S. Ct. 1639 (1989).

[4] 665 F. Supp. at 311-12.

[5] 729 S.W.2d 768, 787 (Tex. App. -- Houston 1987, writ ref'd n.r.e.), cert. denied, 485 U.S. 994,108 S. Ct. 1305. See Shannon, Texaco and the $10 Billion Jury (1988).

[6] A/S Apothekernes Laboratorium v. I.M.C. Chem. Group, 873 F.2d 155 (7th Cir. 1989). See also Empro Mfg. Co., Inc. v. Ball-Co. Mfg., 870 F.2d 423 (7th Cir. 1989); Arcadian Phosphates, Inc. v. Arcadian Corp., 884 F.2d 69 (2d Cir., 1989), discussed in 4 Corporate Couns. Wkly. (BNA) 1 (Sept. 13, 1989). For cases to the contrary, see Temkin, When Does the "Fat Lady" Sing? An Analysis of "Agreements in Principle" in Corporate Acquisitions, 55 Fordham Law. Rev. 125 (Nov. 1986).

[7] 665 F. Supp. 301, 311-12 (S.D.N.Y. 1987). The reversal of Judge Duffy's opinion does not mean that the issue is behind us. The problem in that case was, in part, that the judgment would have compelled yet another S&L to liquidate.

Joseph W. Bartlett, Special Counsel,

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