Expectation Compensation with Respect to Negotiation Held not in Good Faith (Mala Fides)

Law of Contracts allows the violated party of a breached contract to claim various reliefs, among them: cancellation of the contract, enforcement and compensations. The compensation relief is divided into three: reimbursement of the consideration provided to the party committing the breach; return of expenses incurred to the violated party relying on entering into the contract (Incidental Damages) and a relief of compensation, intending to place the violated party in the situation he anticipated to be had the contract been complied with (Expectation Damages).

In everyday life, many cases of negotiations run aground prior to entering into an agreement between the parties. The negotiation stage is an essential stage, in respect of which it has already been determined in the past that the parties are to negotiate in good faith (bona fide).[1]

The traditional approach practiced by the Courts was that violating the duty acting in good faith after entering into an agreement allows the violated party to claim Expectation Damages, while violating the duty during the stage of the negotiations allows claiming the Incidental Damages. Good faith was determined while paying attention to the parties conduct and their compliance with the conduct level of a reasonable person. In this column, we will consider the change in the approach of the Court with respect to the type of damages awarded when breaching the duty of bona Fide at the negotiation stage.

The principle of bona fide in a pre-contractual negotiation means that each party to the negotiation is obligated to act out of loyalty towards the other party to the negotiation and with loyalty to the spirit of the transaction and its goal[1]. It has been further determined that all parties to the agreement are obligated to cooperate and act while keeping in mind their common interest in the contract[2].

The duty to maintain good faith governs the entire law branches and in particular the Law of Contracts. However, it appears that, at least from the linguistic aspect, there is a different attitude with regard to breaching the duty of good faith at the negotiation stage and breaching the duty at the contractual stage. Thus, with regard to breaching the duty at the negotiation stage the law determines that “In negotiations towards the conclusion of a contract, a person must behave in an acceptable way and in good faith. A party, failing to act in an acceptable way and in good faith, owes the other party compensation for the damage incurred to it due to the negotiations or due to entering into the agreement”[3]; whereas with respect to breaching the duty at the contractual stage the Law determines that, “With regard to compliance of an obligation arising from the contract, one must act in an acceptable way and in good faith, and the same applies to the use of an entitlement arising from a contract”[4].

Section 12(b) to the Law of Contracts determines that a party acting in mala fides in negotiations towards the conclusion of a contract must pay the other party (the violated party) compensation for the damage incurred to it due to the negotiation or due to entering into the agreement. The approach taken by the Courts in the past was that under this Section it is possible to claim solely Incidental Damages. In other words, the violated party cannot claim its damages, which could have incurred had the transaction been completed but only to restore the situation as it was at the eve of initiating the negotiations[5].

The purpose of the compensation ruled under clause 12(b) of the Law is to place the violated party at the same situation in which he would have been, had he not entered the negotiation at all[6]. This purpose relied on the basic perception according to which the Court does not conclude for the parties an agreement, which they themselves did not enter into – and there is not room for speculations as to the content of the agreement that would have been concluded if the parties had completed the negotiations. This rule prevailed until the judgment in the matter of Kal Construction.

The Kal Construction judgment and its implications

In the case of Kal Construction[7], the Court adjudicated on the matter, in which a company called for quotations for carrying out works within the framework of a tender, held negotiations vis-à-vis various bidders and summarized all the terms with the selected bidder, save the approval of the Board of Directors. The facts of the case led to the conclusion that the commercial and legal issues had been examined and approved and what remained was only to receive the approval of the Board of Directors. The Board of Directors decided not to approve the transaction, and instead, engaged in an agreement with a company that had not participated in the tender, relying on similar terms, which were agreed upon with the bidder. By this conduct, the company breached its duty to act in good faith.

In its judgment, the Supreme Court ruled that section 12 is not limited to Incidental Damages and where a contract has not been entered into due to mala fides (lack of good faith) of one of the parties, the violated party is entitled to Expectation Damages. This means that the violated party was compensated not only for lack of funds (meaning, expenses spent out of its own pocket), but was compensated for the prevention of profit he was expected to receive had the agreement been complied.

The Court ruled that at the final stage of the negotiations, which were not concluded by signing a contract due to mala fides on the part of the violating party, the damage caused to the violated party due to the negotiations is not only damage due to entering and holding the negotiations but also due to not entering into the contract, and consequently the loss of the profit therein.

It was ruled, that there are cases in which the negotiations between the parties have reached such an advanced stage, that the content of the contract is agreed and known, the contract terms have been consolidated, however due to mala fides the final refinement of the negotiation into a contract has been prevented. In such cases, the Court shall remove the barrier imposed by the violating party, mala fides, and give effect to the content of the settlement the parties have actually designed.

The Court determines that the appropriate balance between the freedom to design the content of the contract, on the one hand, and the duty to conduct the negotiations in good faith, on the other, lies in imposing a duty of “positive compensation” on the violating party. This rule was also mentioned in later judgments.[8]

Summary

There is a distinction between breaching the duty of bona fide at the negotiation stage and its breach at a stage following the conclusion of a contract. Whereas breaching the duty of good faith following the conclusion of a contract entitles the violated party to reliefs conferred upon it in any event of breaching the contract, breaching it at the stage in which negotiations are held may compensate it for Incidental Damages only.

Nevertheless, in exceptional cases, in which the negotiation is at its final stage, and only amala fides conduct on the part of the violating party prevents its final refinement into a contract, the Court may amend the injustice and put the violated party in the situation where it would have been had the mala fides conduct been prevented, and consequently, the contract would have been concluded. Thus, granting the violated party the option to claim Expectation Damages prevents the violating party from profiting in view of the mala fides conduct on its part.

The Court shall intervene in cases in which it is certain that if the duty of good faith had not been breached a contract between the parties would have been concluded; and where it is possible to assess the damages of the violated party (the profits denied thereof) and that the Defendant’s conduct was irreproachable.

The examination shall be case by case depending on its special circumstances. Thus weight should be given to the extent of mala fides demonstrated by the violating party, the stage in which the negotiation stand, the parties’ expectations with respect to the transaction, and to other information which might be relevant.