Canada: Letters Of Intent And The Obligation To Act In Good Faith

In the course of the acquisition or the sale of a business, buyers and sellers will typically sign a letter of intent ("LOI") to set forth the key terms of the deal which forms the basis on which buyer and seller will negotiate the terms and conditions of the definitive contract. Buyers and sellers will often ask their legal counsel about the legal implications of signing an LOI, and in particular, about its effects on their right to terminate negotiations. In answering such questions, it is important to bear in mind that there is an important difference between Quebec and the common law provinces. In Quebec there is a statutory obligation to act in good faith during the pre-contractual phase1 whereas in the common law provinces, absent certain exceptional circumstances, there is no general duty to act in good faith during the pre-contractual phase.

The Friedman v. Ruby Decision

Recently, in Friedman v. Ruby (2012 QCCS 1778), the Superior Court of Quebec considered what it means to act in good faith during the course of negotiations where the parties signed a non-binding LOI for the sale of a business but failed to come to a final agreement.

In that case, Jeffrey Friedman ("Buyer") and Stephen Ruby ("Seller") started negotiating the terms of an LOI regarding the sale of a software company in late 2007. Between February and May 2008 the parties signed an LOI and started negotiating a draft of the purchase agreement. During this period, only Buyer's attorney was involved. Seller had, with Buyer's knowledge, decided not to involve his attorney until May 2008 when the second draft of the purchase agreement was circulated by Buyer. After several drafts of the purchase agreement were exchanged in June 2008, Seller advised Buyer that he could not go ahead with the agreement as provided in Buyer's latest draft. In July 2008, Seller's lawyer sent a revised draft with changes to many provisions as well as a letter explaining the changes. Buyer's attorney responded that (i) the Seller's latest draft was unacceptable, (ii) Seller's actions showed bad faith, and (iii) Buyer would not consummate the transaction contemplated by the LOI but reserved the right to sue for damages. Notwithstanding Seller's subsequent communications to Buyer advising Buyer that he remained open to negotiate, Buyer started court proceedings against Seller.

The Court noted that, as suggested by its drafting, the LOI was not a binding contract for the sale of the company but rather a pre-contractual agreement which entails an obligation to act in good faith. The Court reiterated that "[a]s long as a party acts in good faith and reasonably, it may withdraw from ongoing negotiations if it comes to the conclusion that it is no longer in its interest to conclude the proposed agreement." Citing a prior decision, a breach of the obligation to act in good faith during the pre-contractual phase was described as ending negotiations "without valid reason or in an abusive manner which causes damages to the other party." The Court noted that a breach of the obligation to act in good faith does not require bad faith but merely the lack of good faith. In determining whether a party lacked good faith a court will compare the conduct of the party alleged to be lacking good faith to that of a reasonable person facing the same circumstances and acting in a prudent and diligent manner.

In the case at hand, the Court found that Seller did not breach his obligation to act in good faith during the course of negotiations based on the following factors:

  • signing an LOI even with the knowledge that it is not binding does not amount to a lack of good faith;
  • a party's failure to consult with his attorney from the early stages of negotiations does not amount to a lack of good faith especially where the other party is aware of it and accepts it;
  • the involvement of a party's attorney only at the later stages of negotiations does not amount to a lack of good faith where the other party fails to incorporate elements previously discussed, even if such involvement results in significant changes in most of the terms of the contract (it may in fact show the party's intent to proceed with the transaction and be viewed as reasonable prudent and diligent behavior in the context);
  • the breakdown of communications between the parties' attorneys does not amount to a lack of good faith; and
  • finally, it is difficult to imply a lack of good faith where the party alleged to be at fault shows that he (i) remained open to negotiations even after the other party withdrew from negotiations, and (ii) never acted in such a manner as to bring the negotiations to an end.

Conclusion

In Quebec, following the signing of a non-binding LOI, the parties thereto should act with caution as they have an obligation to negotiate in good faith. The obligation to negotiate in good faith does not imply that a party cannot pursue its own interest, rather it means that, in its dealings with the other party, it has to act reasonably, with prudence and diligence. Whether a court will find that a party has acted reasonably, with prudence and diligence during the negotiation process, or in ending the process, will depend on the facts and circumstances. The consequences of not acting in good faith during the negotiation process can lead to liability for damages and, where a court finds that the parties had agreed on the essential terms of the deal and the party found to be lacking good faith is the one who walked away from the negotiation process, a court may, under certain circumstances, impose the sale of the business if the aggrieved party so desires. In order to avoid such consequences, when beginning the negotiation process it is best to consult legal counsel to help you prepare an LOI and guide you through the negotiation process.

Footnote

1. See Articles 6, 7 and 1375 of the Civil Code of Quebec.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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