I. Introduction. 

            Under New York law, preliminary agreements, like term sheets, that require further negotiation or further contracts generally do not create a binding contractual obligation unless certain conditions are met (1). In the Second Circuit, binding preliminary agreements fall into two categories: 1) Type I agreements, which are complete contracts enforceable per their terms; and 2) Type II agreements, which represent only an agreement to negotiate further (2). By contrast, the New York Court of Appeals simply looks to the parties’ intent without making a Type I/Type II distinction. Whether a preliminary agreement creates contractual obligations, or whether it is entirely non-binding, is an important and frequently litigated question.  

            This article describes how different preliminary agreements, like term sheets, may be formed. It also describes best practices in drafting preliminary agreements, depending on whether a party’s goal is to make it binding or non-binding.      

II. Type I and Type II Agreements.  

            A Type I preliminary agreement is a fully enforceable contract on all terms of the deal despite the parties’ agreement to memorialize it subsequently in a more formal document. Though it is referred to as a “preliminary agreement,” it is preliminary only in form:  the parties have already agreed, and demonstrated intent to be bound, on all the material points requiring negotiation (3).   

            To determine if a Type I agreement has been reached, courts in the Second Circuit consider four factors. First, and most importantly, courts consider whether there has been an express reservation of the right not to be bound (4). A clear expression that the parties do not intend to be bound will render a preliminary agreement unenforceable (5). Second, though not determinative by itself, courts may find that partial performance, or knowing acceptance of a counterparty’s performance, suggest that a party intended to be contractually bound (6). Third, the courts consider whether there are any open terms or call for future approvals. There is a strong presumption against finding a binding obligation when there are open, material terms (7). Fourth and finally, courts consider the customary form of the agreement in the industry, i.e., whether an agreement of that nature would normally be expressed more formally.  

            Unlike a Type I agreement, a Type II agreement does not commit the parties to their contractual objective (8). Instead, a Type II agreement only obligates the parties “to negotiate any open issues, in a good faith attempt to reach the objective within the agreed framework,” (9). While the parties must continue to negotiate in good faith, they are not required to reach a final agreement. The parties “may abandon the transaction if they have made a good faith effort to close the deal and have not insisted on conditions that do not conform to the preliminary writing,” (10).   

            To determine whether a Type II agreement exists, courts in the Second Circuit consider five factors, which overlap somewhat with the Type I factors, although they may be interpreted differently in this context (11). First, as with Type I agreements, courts primarily consider whether the preliminary agreement itself shows an intent to bound.  But in this context, the question is whether they intended to be bound to continue negotiating, as opposed to the final terms of the deal itself (12). Second, the courts consider, more narrowly, whether the negotiation history suggests an intent to be bound. Third, the courts consider whether there are any remaining open terms. But in contrast to Type I agreements, remaining open terms are more permissible in a Type II agreement, because Type II agreements are incomplete by definition. Fourth, as with Type I agreements, courts consider partial performance to be indicative of intent to be bound. Fifth, courts may consider “whether in the relevant business community, it is customary to accord binding force to the type of informal or preliminary agreement at issue,” (13). But this factor is not interpreted strictly against Type II agreements.   

            Notably, in contrast to the Second Circuit, the New York Court of Appeals has rejected the Type I / Type II distinction (14).  Instead, in the state courts, the essential question in determining whether a preliminary agreement is binding is if the agreement “contemplated the negotiation of later agreements and if the consummation of those agreements was a precondition to a party’s performance,” (15). A typical contractual analysis of the parties’ intent therefore controls (16). Courts will look to the four corners of the document, which is dispositive if it is unambiguous. In case of ambiguity, courts will look to extrinsic evidence.   

            If a court finds that a Type II agreement or the New York state law equivalent exists, the parties are bound to negotiate in “good faith,” but there is no obligation to reach a final agreement (17). Good faith negotiation requires honesty in the negotiation process.  However, while affirmative misrepresentations or misleading omissions are not permissible, full disclosure of all relevant circumstances (like the presence of competing bidders) is not required (18). Apart from dishonest conduct, a court may also find that a party has failed to negotiate in good faith if it outright refuses to negotiate or if it insists on terms contrary to the preliminary writing (19). 

III. Best Practices.   

            Based on the preceding case law, there are certain best practices that are helpful to keep in mind when putting together a term sheet. 

            If you want the term sheet to be binding, make that as clear as possible in the text. First, use words like “binding,” and mandatory words like “must” and “shall,” which convey an intent to be bound.  Second, include all material terms, or as many as possible at the time. Third, define any special or unclear terminology to avoid the argument that the terms are too vague to be enforced. Fourth, obtain dated signatures on behalf of all bound parties. And fifth, include a New York choice of law or forum provision, both to ensure that the expected rules apply and to show that the parties viewed the document as enforceable in court or arbitration. 

            Conversely, if you do not want the term sheet to be binding, make that as clear as possible. First, use very clear disclaimers labeling the writing as “non-binding.” Second, specify that any terms described therein can only become enforceable upon negotiation and execution of a future contract. Third, specify that it is not an agreement to agree and that there is no obligation to negotiate or consummate a final contract, to avoid any finding of a Type II agreement. Fourth, use non-mandatory words such as “may” or “intend” or “propose.” And fifth, do not refer to the document as a “term sheet;” consider calling it a “non-binding letter of intent,” or a “proposal” or a “draft” or a “memorandum of understanding.” 

Written by Mark Cuccaro and Brachah Goykadosh.

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(1)   See Shann v. Dunk, 84 F.3d 73, 77 (2d Cir. 1996). 

(2)  See Teachers Ins. & Annuity Ass’n of Am. v. Tribune Co., 670 F. Supp. 491 (S.D.N.Y. 1987); Murphy v. Inst. of Int’l Educ., 32 F.4th 146, 151 (2d Cir. 2022).   

(3) Tribune, 670 F. Supp. at 498; Adjustrite Sys., Inc. v. GAB Bus. Servs., Inc., 145 F.3d 543, 548 (2d Cir. 1998).   

(4)  Brown v. Cara, 420 F.3d 148, 154 (2d Cir. 2005); Singer v. Xipto Inc., 852 F. Supp. 2d 416, 423 (S.D.N.Y. 2012).  See also Gromulat v. Wynn, No. 20-cv-10490 (VB), 2022 WL 445779, at *3 (S.D.N.Y. Feb. 14, 2022). 

(5)  See Cohen v. Lehman Bros. Bank, 273 F. Supp. 2d 524, 528 (S.D.N.Y. 2003) (holding that a provision that a lender was under “no obligation” to consummate a loan was dispositive).   

(6)  Bear Stearns Inv. Prod., Inc. v. Hitachi Auto. Prod. (USA), Inc., 401 B.R. 598, 619 (S.D.N.Y. 2009). 

(7)  Murphy, 32 F.4th at 152. 

(8)  Brown, 420 F.3d at 157. 

(9)  Id. 

(10)  Adjustrite, 145 F.3d at 548.   

(11)  Tribune, 670 F. Supp. at 499.   

(12)  See, e.g. Brown, 420 F.3d 148 at 15 (commitment to “work together” to develop a property supported the finding of a Type II agreement, but not a Type I agreement.); Network Enterprises, Inc. v. APBA Offshore Prods., Inc., 427 F. Supp. 2d 463, 484 (S.D.N.Y. 2006) (language stating that unresolved terms over specific timing of TV broadcast “shall be mutually agreed to by the parties” supported finding a Type II agreement).   

(13)  Tribune, 670 F. Supp. 491 at 503. 

(14)  IDT Corp. v. Tyco Grp., 13 N.Y.3d 209, 215 n.2 (2009) (“While we do not disagree with the reasoning in federal cases, we do not find the rigid classifications into ‘Types’ useful”). 

(15)  Id.   

(16)  Id. at 214.  

(17)  IDT Corp., 23 N.Y. 3d at 497. 

(18)  Gas Nat., Inc. v. Iberdrola, S.A., 33 F. Supp. 3d 373, 382, 385 (S.D.N.Y. 2014). 

(19)  Id. at 308.