Friday, July 22, 2011

Enforceability of “Side Letters”

Background

It is customary for parties to enter into “side letters” in corporate and commercial transactions. Side letters are documents which are ancillary to the principal transaction documentation. There are a number of reasons why parties could potentially enter into side letters, rather than include their subject matter in the principal documentation. Side letters are useful when parties wish to complete the transaction without finalizing the terms of certain aspects of the deal, the broad contours of which may be included in a side letter for formalization post-closing. They are used to set out private inter-se arrangements between some (but not all) of the parties to the principal documentation. It may not altogether be unreasonable for parties to omit certain terms from the principal documentation and include them in side letters instead if those terms contain sensitive information that cannot be put out in the public domain (for example those that may confidential in nature or those that could be subject to misuse by competitors).

Despite the seeming usefulness of side letters, they generate uneasy legal issues on their enforceability. For example, is a side letter a legally binding contractual arrangement that is enforceable in a court of law? Does a side letter vary or amend the terms of the principal documentation (in case parties are the same)? While there are no straightforward answers to these questions, courts in different jurisdictions have had the opportunity to consider some of them, and here we discuss one recent judgment of an English court in Barbudev v. Eurocom Cable Management Bulgaria [2011] EWHC 1560 (QBD, Comm) that decided upon the enforceability of a side letter.

Facts and Decision

Barbudev had been the CEO and 40% shareholder of a Bulgarian cable television and internet company (target company). The target company was acquired by ECMB, which was a part of the Warburg Pincus group. During the negotiations for the acquisition, Barbudev expressed his keenness on taking a stake in the purchaser company. However, the parties were unable to agree upon the terms of Barbudev’s investment in the purchaser before the acquisition for the target company was complete. Hence, the parties agreed to enter into a side letter, the principal terms of which were as follows:
Investment Agreement

In consideration for you agreeing to enter into the Proposed Transaction and to sign the Transaction Documents, the Purchaser hereby agrees that, as soon as reasonably practicable after the signing of the Agreement by all Parties, we shall offer you the opportunity to invest in the Purchaser on the terms to be agreed between us which shall be set out in the Investment Agreement and we agree to negotiate the Investment Agreement in good faith with you. Such terms shall include, without limitation the following:

1. you shall invest an aggregate amount of not less than Euro 1,650,000 in consideration for a combination of shareholder debt and registered shares which shall represent ten (10) per cent. of the registered share capital of the Purchaser on the date of the Investment Agreement;



3. tag along and drag along provisions which are customary for a transaction of this nature shall be included in the Investment Agreement. [Emphasis supplied]
Subsequent to the acquisition of the target company, certain other issues arose due to which the parties were unable to negotiate and finalise an Investment Agreement as contemplated in the side letter. In the meanwhile, ECMB even sold its investment in the target company.

Barbudev brought an action before the court seeking to enforce the terms of the side letter against ECMB. The court in this case ruled in favour of ECMB and refused to enforce the side letter.

On the issue of whether the side letter constituted a legally enforceable contract, the court examined “three questions – whether the Side Letter was intended to create legal relations, whether it was an agreement to agree, and whether it was a sufficiently complete and certain contractual agreement”. Each of these questions was dealt with separately:

1. Intention to create legal relations

The court examined the language of the side letter as a matter of construction and found that the Side Letter was not intended to be legally binding. The fact that it made a reference to an Investment Agreement (to be entered into between the parties) showed that only such a concluded agreement was intended to be binding. Moreover, an agreement can be intended to create legal relations only if it is legally enforceable (based on the conclusions to the other two questions below).

2. Agreement to agree

The court reiterated the principle under English law that “an agreement to agree is legally unenforceable”. [Note that the Indian position would be similar by virtue of section 29 of the Contract Act, 1872 which treats certain agreements as void for uncertainty.] Even though the broad terms of the investment were set out in the side letter (as extracted above), the court was not convinced of its certainty and sufficiency. It observed (at para. 103):
As a matter of construction of the document, I consider that the agreement to negotiate in good faith extends not merely to the proposed Investment Agreement, but to the price to be paid by Mr. Barbudev and the percentage to be acquired as well. The reason is that the terms of the letter (“not less than”) allowed for negotiation of an amount of more than Euro 1.65 million, and did not settle how the combination of shareholder debt and shares representing 10% of the share capital was to be made up. Even on those key terms, therefore, although the parties had agreed in principle, there was no finality. … [T]he terms of the document as well as surrounding circumstances make it clear that they had not actually reached agreement.
3. Certainty of terms

The court held that in order for an agreement to be enforceable, it must be sufficiently complete and certain on all essential terms. In other words, it must be a self-effectuating document. If it does not contain matters that are essential to its implementation, then it would be invalid as it is too incomplete or uncertain to enforce.

For the reasons set forth, the court refuse to enforce the side letter in this case.

Analysis

This case involves an intricate area of the law where there are judicial decisions both ways. In the Barbudev case, the court has sought to emphasise some of the issues to be considered while determining the enforceability of side letters. In doing so, it has followed another recent English case in Dhanani v. Crasnianski [2011] EWHC 926 (Comm.) which also held that an agreement to agree and negotiate further is not legally binding.

The principles enumerated above provide some indications in terms of the nature of drafting that goes into side letters. This discussion would also equally extend to other types of documents which do not fully set forth the terms of a transaction – these customarily include documents such as letter of intent, memorandum of understanding, term sheet, comfort letter, and the like. In essence, courts would construe the nature of these documents and the intention of the parties from a construction of the document itself. Hence, it pays to include as much clarity as possible into such documents as regards the intention of the parties, i.e. whether they intend it to be enforceable or not. If the intention of the parties is to have the document bind the parties, then it is prudent not only to expressly state so but also to include all the essential terms that are required to perform the terms of the agreement. On the other hand, if parties do not intend it to be binding, the simplest solution to avoid subsequent disputes is to expressly state that the document will not be legally binding. It is silence (of the nature we see in the Barbudev side letter) that creates ambiguity as to whether it is enforceable or not, although it is entirely possible that parties may sometimes find it in their interests to prefer ambiguity over certainty and clarity and therefore to remain silent (which must nevertheless be a conscious choice).

2 comments:

Anonymous said...

Very good article!!!

Anonymous said...

I think the law on enforcement of such arrangements through side letters, MoUs etc. under principles of contract law is fairly settled through case laws and there is nothing novel about this case. However not sure, if there are case laws exploring the possibility of obtaining damages under tort law for fradulent misrepresentation or negligent misstatement arising out of the side letter, MoUs etc.