19 Dec 2017

Drafting Advice: Avoiding Accidental Contracting

By: Timothy Murray, Murray, Hogue & Lannis

THERE IS A STAGGERING AMOUNT OF LITIGATION involving disputes over whether a binding contract was formed during contract negotiations. In a typical case of this kind, the parties agree on many issues while negotiating a deal, but they intend to execute a formal document and never get around to doing it before their relationship unravels for one reason or another. Litigation erupts. One party claims there is a binding contract and that the failure to execute that final document doesn’t matter. The other party claims he or she didn’t intend to reach a final agreement. In the contract law milieu, there are few scenarios more common—or more damaging to the careers of the parties accused of entering into accidental contracts.

Contract formation does not always follow the same trajectory, and sometimes it ends with a document that, at first blush, looks preliminary in nature—perhaps not like a contract at all. Documents that typically are not intended to reach the parties’ ultimate contractual objective—including proposals, term sheets, memoranda of understanding, and letters of intent—can, in fact, be legally operative contracts that do just that.¹ Accidental contracting often arises in connection with these so-called preliminary agreements. The first important suggestion is to disregard the labels slapped on a document. Whether it is called a letter of intent, a term sheet, or, for that matter, a ham sandwich, it can still be a binding agreement on the parties’ ultimate contractual objective. Courts decide the legal effect of such documents based on “the keystone of all contract law,” the parties’ intent.²

The legal concepts discussed in this short article are the kinds of things we learned in first year contract law class, so why does this issue crop up in case after case after case? It crops up because, too often, parties mistake their subjective intentions with the kind of intentions the law cares about. Contract law gives effect to the parties’ outward and objective manifestations of assent, not their subjective intentions. As with most contract law disputes, accidental contracting can almost always be avoided by careful drafting. If the parties desire to delay contract formation until a final document is executed, that intention ought to be plainly manifested in writing.

To discern whether a preliminary agreement reaches the parties’ ultimate contractual objective, two overriding questions are paramount:

Have the parties agreed on all essential terms of the transaction with sufficient clarity to allow a court to enforce the agreement in the event of a breach?
Does a party know or have reason to know that another party to the proposed transaction desires to delay contract formation until something else happens?

Have the Parties Agreed on All Essential Terms of the Transaction with Sufficient Clarity to Allow a Court to Enforce the Agreement in the Event of a Breach?

Every contract needs to have agreement on certain terms in order to be an enforceable contract, and the terms vary depending on the type of contract. For example, for the sale of goods, the description of the product and the quantity are essential terms (though for requirements or output contracts, quantity is determined based on the buyer’s requirements or the seller’s output). Beyond that, parties are free to designate terms they deem essential. If a party manifests an intention not to be bound in the absence of agreement on a particular term—even if that term typically would not be considered essential—no deal is possible absent agreement on that term. In a case involving the question of whether a settlement agreement was enforceable, the court defined the essential terms in accordance with the parties’ intentions, based on the terms they actually negotiated.³

It is very common for the parties to expressly leave open one or more essential terms to be agreed upon later—this is the classic agreement to agree, a legal conclusion that means there is no binding agreement because the agreement lacks enough terms for a court to know whether a breach has occurred or to be able to enforce the contract in the event of a breach. Where the parties have not come to agreement on an essential term, there can be no contract—and there is little danger of accidental contracting.

But doesn’t the law routinely imply terms the parties have left open in order to make an agreement a binding contract? Yes, but the law won’t imply essential terms—terms specific to the deal that the parties must agree upon in order for a court to be able to enforce it, such as description of the product and quantity in a contract for the sale of goods. Nor will a court imply a term that the parties intend to agree upon but just haven’t gotten around to yet (example: parties don’t have to agree on price for the sale of goods but almost always do). But where the parties have agreed on essential terms, are not still haggling over one or more terms important to one of the parties, and intend to have a contract, courts imply default terms for the ones the parties have left open. For example, in connection with a transaction for the sale of goods governed by the Uniform Commercial Code (U.C.C.), if the parties have left open the remedies to be provided, the default remedies set forth in the U.C.C. will be implied, and contract formation will not be withheld in the absence of express agreement on those terms. (Tip: if you are the buyer, silence is typically better than negotiating remedies provisions; the U.C.C. remedies favor buyers.)

Does a Party Know or Have Reason to Know That Another Party to the Proposed Transaction Desires to Delay Contract Formation Until Something Else Happens?

If either party knows or has reason to know that the other party does not intend to have an enforceable contract until something else happens, “the preliminary negotiations and agreements do not constitute a contract.”⁴ The something else can be practically anything—including the execution of a more formal written memorial of the deal, approval by a party’s home office, or agreement on one or more issues that have not been resolved.

It is often the case that the parties reach agreement on all essential terms but also contemplate that they will execute one or more additional documents as part of their deal. This is where accidental contracting often occurs.

If a party makes clear during negotiations that there will not be a legally operative contract unless and until the parties execute a formal memorial of the deal, that is the end of the inquiry—there is no contract absent that document. Those are the easy cases.

But it is very common for parties to mutually agree that they will execute a more formal agreement. (A common example: a settlement agreement reached on the courthouse steps the day of the trial. In connection with that settlement, the parties’ attorneys typically agree that one of them will later draft a formal settlement agreement.) Generally, in most jurisdictions, even though the parties intend to execute a formal written document, if they have agreed on all the essential terms with sufficient certainty that the agreement may be enforced, and if neither party knows or has reason to know that the other intends to condition contract formation on the execution of a formal written memorial, courts generally find that a binding contract has been entered into.⁵ A subsequent failure to come to terms on a formal agreement cannot undo their prior, less formal agreement.⁶

This is a question of the parties’ intent. The greater the complexity of the deal, the more likely it is that the parties intend to execute a formal written memorial of their transaction.⁷ But many significant transactions are concluded in the absence of a final, formal document. There is no bright line.

Sometimes, one of the parties misconstrues the parties’ mutual intention to execute a more formal agreement to mean there can be no contract without one. The difference can be subtle, and it is a recipe for accidental contracting. In many situations, it is not easy to tell the difference between an enforceable agreement and an unenforceable agreement to agree. In Gurley v. King, ⁸ the plaintiff, a recording artist, signed a memorandum of agreement with a manager stating that the artist “will sign an exclusive management contract with [the manager] for three years” to begin when his contract with his current management company ends, or earlier if the manager could arrange it. The manager would receive a 15% commission on the artist’s gross income. The memorandum concluded, “The details of the agreement will be worked out later but basically will follow the same arrangement currently in place with [the artist’s current manager].” When the artist refused to honor the agreement, the manager sued. The court noted it is possible for parties to make an enforceable contract binding themselves to execute a subsequent final agreement, but only if the initial agreement expresses all essential terms to be incorporated in the final document, which would be a mere memorial of the agreement already reached. The question of whether the parties had a binding agreement was a question of fact to be resolved by the trier of fact.

The U.S. Court of Appeals for the Ninth Circuit’s opinion in Facebook, Inc. v. Pac. Northwest Software, Inc., ⁹ presents a striking example of some of the concepts at issue. Identical twins Cameron and Tyler Winklevoss, along with Divya Narendra (collectively, the Winklevosses) claimed that Mark Zuckerberg stole the idea for Facebook from them. They sued Facebook, and Facebook countersued them, and eventually the parties mediated their dispute in 2008 and appeared to enter into a settlement agreement. Specifically, the Winklevoss’ competing social networking site, ConnectU, Facebook, and the Winklevosses signed a handwritten, one-and-a-third-page Term Sheet & Settlement Agreement in which the Winklevosses agreed to give up ConnectU in exchange for cash and a percentage of Facebook’s common stock. The settlement agreement also stated: “Facebook will determine the form & documentation of the acquisition of ConnectU’s shares [ ] consistent with a stock and cash for stock acquisition.” The settlement agreement also purported to end all disputes between the parties. The parties agreed to grant each other “mutual releases as broad as possible,” and the Winklevosses represented and warranted that “[t]hey have no further right to assert against Facebook “ and “no further claims against Facebook & its related parties.” The parties stipulated that the settlement agreement was binding.

The parties could not agree on the form of the final deal documents. Facebook moved to enforce the settlement agreement and asked a district court to order ConnectU and the Winklevosses to sign more than 130 pages of documents, including a stock purchase agreement and a mutual release agreement. Facebook’s transactional attorneys claimed that the terms in these documents were “required to finalize” the settlement agreement, and Facebook’s expert opined that they were “typical of acquisition documents.”

The district court enforced the settlement but refused to require that the stack of documents drafted by Facebook’s lawyers be executed. The Ninth Circuit affirmed. It rejected the Winklevosses’ argument that because the parties had not come to agreement on the terms that Facebook claimed were required to complete the transaction, there was no legally operative settlement agreement. The court explained that, in fact, the agreement is enforceable so long as its terms are sufficiently definite for a court to determine whether a breach has occurred and order damages or specific performance. “This is not a very demanding test, and the Settlement Agreement easily passes it: The parties agreed that Facebook would swallow up ConnectU, the Winklevosses would get cash and a small piece of Facebook, and both sides would stop fighting and get on with their lives,” the court said.

What about the fact that the parties had not yet agreed on some important terms—terms that may affect the value of the bargain? The court explained that the settlement agreement itself specified how to fill in the material terms that the Winklevosses claimed were missing from the deal: “Facebook will determine the form & documentation of the acquisition of ConnectU’s shares [ ] consistent with a stock and cash for stock acquisition.” That clause, the court explained, “leaves no doubt that the Winklevosses and Facebook meant to bind themselves and each other, even though everyone understood that some material aspects of the deal would be papered later.”

“The Winklevosses’ contractual delegation is valid,” the court concluded, “because the Settlement Agreement obligates Facebook to draw up documents ‘consistent with a stock and cash for stock acquisition.’ And, if Facebook should draft terms that are unfair or oppressive, or that deprive the Winklevosses of the benefit of their bargain, the district court could reject them as a breach of the implied covenant of good faith and fair dealing. . . . The district court got it exactly right when it found the Settlement Agreement enforceable but refused to add the stack of documents drafted by Facebook’s deal lawyers.” The court added: “At some point, litigation must come to an end. That point has now been reached.”¹⁰

Avoid Accidental Contracting with Clarity in Drafting

Given the difficulty in discerning whether the parties have reached a final agreement, if a party desires to postpone forming a final contract until a more formal document is executed, he or she should state this intention in writing with clarity. A letter of intent or other preliminary agreement should state that there can be no contract on the ultimate contractual objective until the parties have entered into a subsequent, final, formal statement of their deal. It could include language such as the following:

Notwithstanding completed negotiations on every material or essential aspect of the agreement, and regardless of any informal public or private statements emanating from any representative of the buyer or seller, the parties hereby emphasize their intention that neither party will be legally bound to any contract for the purchase and sale of the stock or assets of the Acme Corporation, or be subject to any other liability whatsoever on any legal theory concerning such a purchase and sale, until a subsequent, final document evidencing the complete and exclusive contract of the parties is signed by the presidents of both the buyer and seller as well as the chair of the boards of the buyer and seller.

No one has ever heard a judge complain that a writing is too clear for him or her. Given the sometimes enormous risks posed by accidental contracting, and considering how frequently the issue arises, clients ought to be counseled to include such statements in their communications as a matter of course.

Timothy Murray, a partner in the Pittsburgh, PA law firm Murray, Hogue & Lannis, is coauthor of the Corbin on Contracts Desk Edition (2017) and writes the biannual supplements to Corbin on Contracts

To find this article in Lexis Practice Advisor, follow this research path:

RESEARCH PATH: Commercial Transactions > General Commercial and Contract Boilerplate > Articles

Drafting Advice: Avoiding Accidental Contracting

Have the Parties Agreed on All Essential Terms of the Transaction with Sufficient Clarity to Allow a Court to Enforce the Agreement in the Event of a Breach?

Does a Party Know or Have Reason to Know That Another Party to the Proposed Transaction Desires to Delay Contract Formation Until Something Else Happens?

Avoid Accidental Contracting with Clarity in Drafting

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