Pre-contractual liability in M&A transactions

Negotiations are not a no man's land

An M&A transaction does not begin when the contract is signed. It is preceded by months of negotiation: the letter of intent, access to the data room, management sessions, drafts exchanged between lawyers. During this phase the parties invest time and money, forgo alternatives and share confidential information.

It is widely believed that, until signing, each party is free to do as it pleases. That is partly true: nobody is obliged to enter into a contract it does not consider worthwhile. But the freedom not to contract does not license negotiating unfairly.

Italian law requires the parties to act in good faith already during negotiations. A party that breaches this duty is liable for the loss caused to the other, even if the contract is never signed, or if it is signed on terms different from those that proper disclosure would have produced.

The legal framework

The basic rule is art. 1337 of the Italian Civil Code: in conducting negotiations and forming the contract, the parties must act in good faith. Art. 1338 gives a specific application: a party that knows or ought to know of a ground of invalidity of the contract and fails to disclose it to the other party is liable for the loss the latter suffers by relying on the validity of the contract.

Pre-contractual good faith translates into some concrete duties:

• not to break off advanced negotiations without just cause;
• not to start or continue negotiations without a genuine intention to conclude;
• to inform the counterparty of relevant circumstances it cannot discover with ordinary diligence;
• to safeguard the confidential information received and use it only to assess the transaction.

For a long time pre-contractual liability was treated as a tort (art. 2043 of the Civil Code). Since 2016, however, the Court of Cassation has characterised it as liability arising from "qualified social contact", contractual in nature (Cass. no. 14188/2016). The difference is not merely theoretical. It brings a ten-year rather than a five-year limitation period and a burden of proof more favourable to the injured party, although the issue continues to be debated in academic writing and in later case law.

Unjustified breaking off of negotiations

The most frequent case is a sudden withdrawal from advanced negotiations. The courts generally require three elements:

1. Negotiations at an advanced stage, such as to give the other party a reasonable expectation that the contract will be concluded. In M&A transactions typical indicators are the signing of a letter of intent, the grant of exclusivity, the completion of due diligence and the circulation of near-final drafts.
2. Withdrawal without just cause. Just causes include, for example, the discovery of significant liabilities during due diligence, failure to obtain the expected financing or the refusal of an authorisation. A change of heart without reasons, or a better offer kept hidden, is not.
3. A loss causally linked to the frustrated reliance: the costs incurred and the alternative opportunities lost.

In competitive auctions the picture is partly different. A seller running a process with several bidders is not obliged to conclude with any of them, and the process letter usually says so expressly. The seller must nonetheless comply with the process rules it has set and treat all participants fairly.

Information, data room and non-disclosure

The second front concerns information. In M&A transactions information asymmetry is structural: the seller knows the company, the buyer discovers it through the data room and management's answers.

The Joint Divisions of the Court of Cassation have made clear that breach of pre-contractual disclosure duties can give rise to liability even when the contract is concluded and valid (Cass., Joint Divisions, nos. 26724 and 26725/2007). This is the case of the contract that is "valid but disadvantageous": the buyer buys, but at a price it would not have accepted had it known the truth. The remedy is compensation for the additional loss, that is, the difference between the price paid and the price that would have been agreed with proper disclosure. The mechanism is close to that of incidental fraud (art. 1440 of the Civil Code).

For the seller this means some practical precautions:

• the data room must be complete on the relevant issues, orderly and documented, with a reliable index of the documents made available and their upload dates;
• answers to the buyer's questions should be given in writing and kept;
• known problems must be made evident, not buried among thousands of documents.

The buyer, for its part, cannot rely on the seller's silence for matters it could have discovered through diligent due diligence. The quality of its review therefore affects the protection it will enjoy.

The documents of the preliminary phase

The pre-contractual phase of an M&A transaction is marked by documents that are not yet the contract but have legal effect. Their content directly affects the risk of liability.

Confidentiality agreement. This is the first document signed. It defines the confidential information, who may receive it and the permitted use. It often includes undertakings not to solicit employees and customers. Breach gives rise to contractual liability in the full sense.

Letter of intent. It sets out the essential terms of the transaction: price or pricing criteria, structure, timetable, conditions. As a rule it states that it is not binding, but its characterisation depends on its content and not merely on its heading. A very detailed letter that leaves no points open risks being treated as a preliminary contract. Even when it does not oblige the parties to conclude, its signing marks a point at which the parties' reliance becomes reasonable.

Exclusivity. This is the most important clause of the letter of intent, and it is normally binding. The seller undertakes not to negotiate with third parties for a set period, so that the buyer can invest in due diligence. Breach of exclusivity is a breach of contract, not merely a breach of good faith.

Process letter. In auctions it governs timing, how bids are submitted and the rules for data room access. It reserves to the seller the freedom to choose the bidder or to halt the process, but does not exempt it from complying with the rules it has set.

Recoverable loss

A party suffering an unjustified break-off of negotiations cannot claim to be put in the position it would have been in had the contract been concluded. Damages cover the so-called negative interest, that is, the loss resulting from having relied on the conclusion of the contract. This comprises two heads.

• The costs incurred in the negotiation: legal, financial and tax advisers, due diligence, valuations, the cost of structuring the financing.
• Lost opportunities: the concrete alternatives the party gave up in order to pursue the negotiation. These must be specifically proved, by showing that another transaction was genuinely available.

The profit that would have been made from the transaction, the so-called positive interest, is not as a rule recoverable.

Where the contract is concluded but disadvantageous, by contrast, the loss is measured by the lesser benefit or the greater economic burden suffered: in essence, the difference between the terms obtained and those that would have been obtained with proper disclosure.

Proof of loss is often the weak point of these claims. This is why the parties sometimes prefer to regulate the financial consequences of withdrawal in advance, for example with cost reimbursement or a break fee.

How to prevent disputes

Pre-contractual liability cannot be eliminated by a clause, but it can be managed with clear documents and consistent conduct. These are the points to keep in mind in every transaction.

1. State precisely the nature of the letter of intent, distinguishing the non-binding provisions (the terms of the deal) from the binding ones (exclusivity, confidentiality, costs, governing law and jurisdiction).
2. Set a duration for exclusivity and provide for what happens on expiry or if negotiations break down.
3. Regulate the costs of the negotiation: each party bears its own, save for reimbursement or a break fee in defined circumstances.
4. Specify the conditions that justify breaking off, such as a negative due diligence outcome, failure to obtain financing or refusal of authorisations.
5. Document the data room and management's answers, so as to be able to show later what was disclosed and when.
6. Raise difficulties promptly. A reasoned change of course announced in good time carries far less exposure than prolonged silence followed by a sudden withdrawal.
7. Coordinate the pre-contractual phase with the final agreement. Entire agreement and non-reliance clauses reduce the risk, but do not cover fraud or gross negligence (art. 1229 of the Civil Code).

Negotiations conducted transparently protect both parties. If the deal closes, the contract rests on solid foundations; if it does not, each party goes its own way without litigation in its wake.