Newsletter - Terminated negotiations

Terminated negotiations

An agreement is the culmination of an offer and acceptance. This premise is not always valid in cases where complex negotiation involving national and international corporate law practice enters the equation. In practice, an agreement is often shaped by degrees in the course of the negotiations, even if that is not always what the parties intended. They can shape the agreement during the negotiation phase by signing letters of intent and preliminary or framework agreements. Regrettably, negotiations often end in claims for compensation instead of the agreement originally envisaged. The question examined in this newsletter is how far negotiations can progress before their termination results in the obligation to pay compensation or comply with the result of the negotiations.

Contractual freedom

Under Dutch law, parties are free to enter into contracts, and to determine the conditions for those contracts. This means that, in principle, negotiations can be terminated without any obligation on the terminating party to pay compensation. 

The Supreme Court has elaborated the principle of contractual freedom, ruling that it is possible for negotiations on an agreement to have entered “a phase at which” their termination must be deemed to be contrary to the good faith on which each of the parties might base its expectation that some sort of contract would be forthcoming. An obligation to compensate loss of profits could be appropriate in this type of situation. 

The Supreme Court also determined that it is not necessary that both parties have a legitimate expectation that a contract will be formed. The Supreme Court ruled that “other circumstances of the case” can also restrict freedom to terminate the negotiations. Literature and jurisprudence show that relevant circumstances might be:

I. the importance of the agreement (for example to prevent a strike);

II. (illegitimate) motives for termination;

III. the relationship between the parties;

IV. stipulated obligations to continue negotiations;

V. unwillingness to reimburse the costs of the other party.

Consequences of terminating negotiations

Jurisprudence draws distinctions between different phases of the negotiating procedure, with an increasing “lack of contractual freedom” and increasingly serious consequences for parties that withdraw from negotiations. Generally, the procedure is distinguished in three phases:

1. the phase in which termination is permissible;
2. the phase in which termination without compensation is not permitted;
3. the phase in which termination is not permitted.

In practice, the line between the various phases is difficult to pinpoint. The phase reached by the parties depends, inter alia, on how many concrete agreements have been made between the parties; whether unforeseen circumstances have arisen; the duration of the negotiations; the extent to which and the manner in which the terminating party contributed to the legitimate expectation of the other party and the legitimate interests of the other party.

For example, phase II would apply if a party continued to negotiate, in the knowledge that he intended to withdraw, and allowed the other party to incur high costs in the interim. It is also conceivable that the terminating party would have acquired valuable information from the negotiations which would strength his competitive position. That information should not be free of charge.

The other party can bring more claims in phase III, such as compensation for damage and loss of profits, whether in combination with an order to continue negotiations and a ban on negotiations with third parties or otherwise.

Obligation to compensate damages or to comply: how can this be avoided?

In order to frame their own legal relationship, commercial parties often conclude agreements to govern the pre-contractual phase (sometimes referred to as letter of intent, memorandum of understanding, or term sheet). The aforementioned agreements frequently contain suspensory conditions which are intended to form an obstacle to any agreement if the conditions in question are not fulfilled. A restriction can also be specified in the form of a resolutory condition. Thus the obligations of the agreement exist, but cease to be valid if a resolutory condition is fulfilled.

It is the exception rather than the rule that contract negotiations between commercial parties contain one or more restrictions, which could conceivably include the restriction that a written agreement be concluded, the restriction that approval is granted by a corporate body (e.g. the supervisory board) or a financing restriction. Other familiar examples include approval by authorities enforcing competition law or the works council, or due diligence results.

The doctrine of pre-contractual liability applies to agreements which are entered into under a condition. In principle, an unequivocal and clearly-formulated reservation prevents any legitimate expectation on the part of the other party that a contract will be formed unless the condition in question has been fulfilled, and hence provides no cause for liability to compensate potential damages. However, following jurisprudence, liability for costs incurred is not excluded automatically. and we therefore recommend that a specific exclusion clause in relation to costs be included in preliminary agreements.

The standards of reasonableness and fairness govern not only the pre-contractual phase but also the phase in which the restrictions must be fulfilled. A restriction implies that the party in whose interests a restriction is included has an obligation to use its best efforts to ensure that the condition is fulfilled (suspensory condition) or prevented (resolutory condition). Non-compliance with that best-efforts obligation implies that it might be unacceptable, by the standards of reasonableness and fairness, to invoke the condition in question. Compensation can, however, be excluded even if the terminating party has not complied with its best-efforts obligation; this would apply if it can be demonstrated that the condition would not have been fulfilled, even in the event of adequate efforts.

The terminating party will also have to inform the other party why it is invoking a particular condition. The extent of the duty to inform depends on the nature of the restriction: if, for example, a financing restriction is invoked, clarification must be provided on which banks were approached and what restrictions and conditions were imposed by those banks.

Should an (internal) approving body be closely involved in the negotiations, it can be expedient to stress that it is permitted to impose a final “overall appraisal”, and that it may withhold its approval of the transaction for any reason. It is advisable to keep drawing the attention of the other party to the existence of such a restriction throughout the negotiations procedure.