Basics of Letters of Intent
A Letter of Intent, or LOI, is a document drawn up when parties are considering a business transaction. Just about every type of commercial transaction can involve some sort of letter of intent, including purchases, leases, financing, mergers and acquisitions, and joint ventures. Its mentions of confidentiality or nondisclosure clauses and terms relating to exclusivity or best efforts typically imply material terms for possible agreements, such as price or other substantive issues, that are being held out as a basis for reaching a definitive agreement. A letter of intent in the context of a business deal is designed to let a party know whether it should invest the time and money needed to try to obtain a definitive agreement on material points. In the case of mergers and acquisitions, the rule of thumb in the realm of business deals is that parties may have reciprocal expectations regarding which issues they will agree to in a preliminary agreement . As a rough guideline, the following are some of the major points that might be addressed before a definitive agreement is forged: Businesses often use letters of intent to provide the legal framework for their negotiations. The written document can force parties involved in the negotiations to study certain business issues with care before proceeding. The letter of intent does not have to include every single detail of a deal but should at least contain the identity of the parties and the basic issues that are to be negotiated in the definitive agreement. Because a letter of intent represents mutual intent along with a general outline of the business deal under consideration, it will often indicate that the interested parties will merge their operations or follow a plan of acquisition agreement at a later time. Generally, when a letter of intent is negotiated and signed, a confidentiality agreement is also signed by the parties involved.
Legal Status of a Letter of Intent
There is no definitive test to determine whether or not a particular document is a binding agreement or non-binding, i.e., a letter of intent. The determination will turn on the particular facts in each case. In reaching a conclusion, a court will look at a number of factors, including, but not limited to the following:
- Whether the parties stated that they were or were not entering into a binding contract;
- Whether there was a definite agreement upon all the terms of the alleged contract;
- Whether the performance of the alleged agreement was conditioned on approval by any third party not affiliated with the parties;
- Whether the agreement contained a merger clause;
- Whether an attorney was used in preparing the alleged agreement and whether the attorney (if any) was aware that the document may be legally binding upon his or her client;
- Whether the party asserting that the agreement is binding has changed position to his detriment by relying on the alleged agreement;
- Whether the party asserting the existence of a binding agreement has expressly reserved the right to be bound only when the agreement is signed by all parties, and
- Whether the party received any consideration (monetary or otherwise) for an alleged agreement as opposed to just entering into a non-binding agreement to negotiate.
Essential Components of a Binding LOI
While LOIs are frequently assumed to be binding, the important question is what terms are binding. Many terms in an LOI will by their nature not be binding to the extent they do not yet represent the parties’ agreement on the subject matter. However, certain fundamental components of the LOI, such as the purchase price and the closing date (or at least a timeline for the closing), will likely amount to acceptance of an offer subject only to satisfaction of those conditions. Other factors that might bind a party include those relating to confidentiality, expenses (often referred to as obligation to reimburse the other for expenses incurred), "exclusivity", and brokers and agents. But it will depend on the unique circumstances, and the interpretation of the terms from the perspective of the ultimate fact finder.
For example, if I sign a letter of intent to purchase a car, the purchase price and closing date (as mentioned above) would likely be binding. However, if the LOI includes a provision that I am responsible for the cost of any repairs to the car that might be required in order for me to proceed with the closing of the transaction, those terms might arguably be binding as well, depending on the circumstances. On that basis, and using this analysis as an example, the following terms might likely be deemed binding in the context of a business transaction: (i) purchase price; (ii) time of the closing; (iii) confidentiality; (iv) expenses; and (v) exclusivity. Conversely, to implement the same analysis, the following terms might likely be deemed non-binding: (i) representations and warranties; (ii) due diligence; (iii) governing law; (iv) conditions precedent; (v) cross-conditions; (vi) termination, and indemnity.
If an LOI includes only a couple of these types of terms, it is more likely to be deemed non-binding if challenged. The legal enforceability of an LOI will depend on many factors which are not limited to, but do often include, the 8 components identified above. Of course, something that might help your piece of mind in this context is making sure the LOI clearly specifies what is to be binding and what is not.
Binding vs Non-Binding LOIs: Case Studies
In order to determine whether or not an LOI is binding or non-binding, the courts will look to the intent of the parties. Courts have held to the presumption that parties intended to create a legally binding document unless specific words or actions prove the intention otherwise.
The Higher Galaxy, Inc v. Skillstorm, Inc., an employer sought to enforce a non-competition provision when an employee left to work for a competitor. In this case, the court likened the LOI to an offer to "negotiate." The employer’s intention to enter into a contract was expressed by its willingness to enter into a provision equivalent to a non-competition agreement. Thus, when the employee terminated his employment and began working for a competitor, he violated the non-compete identified in the letter of intent.
On the other hand, in Dade County Commissioner v. Royal Caribbean Cruise Line, the court found an LOI binding despite clear statements that it was to be subject to certain conditions. In this case, the court noted that the letter contained the determinate of the agreement, being the lease terms that both parties signed . In addition, the LOI was a necessary condition in order to move forward with federal clearance. This in and of itself was enough to allow the letter to be deemed binding, as the letter was recognized as part of the agreement itself.
Alternatively, in Re/Max International, Inc v. Mason, the court held that an LOI was not binding where the following were missing: (1) plan for future negotiations; (2) time frame within which the parties were to act in order to enter into a final agreement. In this case, the LOI was not signed by the parties and contained a clause that the LOI be considered in the strictest confidence. After the plaintiff sent correspondence to the defendant alleging violation of the LOI, the defendant offered to execute an interim agreement until the final contract could be negotiated. The plaintiff refused this offer, reasoning that that they had already reached an agreement. The court held that the plaintiff’s interpretation that it had already reached an agreement was unreasonable. Instead, the court used the "reasonable person standard," and looked to the language of the LOI to determine intent. Based on these facts, the court found that the LOI was non-binding.
Best Practices for Drafting a Binding LOI
It is best practice when drafting a letter of intent to specifically include language which clarifies whether the letter is intended to be legally binding and/or non-binding. If it is meant to be binding, it is important to specify in what way: is it a binding agreement to agree in the future, or is it a binding contract? It is also essential that the parties be in agreement on whether the letter will be legally binding or not from the start, so each party should speak up if they object to such language.
If the letter of intent is not intended to be binding, the letter should say that or something similar, so there is no ambiguity in the event of litigation. Furthermore, it is helpful if the letter of intent also includes an expiration date, or states that it will remain in effect until terminated by one of the parties. Otherwise, it may very well be interpreted as a binding contract.
The most common type of dispute in connection with letters of intent is related to the parties’ expectations. The disputing parties often have different expectations regarding the value of a transaction at the outset of negotiations. If the expected results don’t match up, the parties can end up spending more money on counsel and other expenses than the deal would be worth at closing. The case law is clear that a deal which is not approved by a party’s board of directors (or the shareholders of a public company) will not be enforceable.
Legal Ramifications of a Binding LOI
The consequences of a Letter of Intent being binding may range from a party being forced to close a deal for which they no longer want to be bound, to a party being forced to disclose material information about a transaction that they had no intention of disclosing until a later date, simply because the other party has dismissed the transaction .
Further, a party relying on a binding LOI may be bound to devote considerable time and funds to a transaction they intend to pursue, which can create substantial financial risk for a party who is only conducting preliminary discussions regarding a potential transaction.
It is therefore important for parties to be advised as to the extent their LOI may be binding upon execution because such knowledge will allow the party to make an informed decision on whether to enter into the LOI at all.