Letters of Intent: Use Caution in Drafting to Avoid the Unintended
By: Jack P. Baron
Though not every transaction commences with a letter of intent (LOI), the use of letters of intent has become more frequent, particularly given the uncertain economic environment during the last several years. An LOI can be a useful preliminary step in the negotiation of commercial transactions, which often require substantial time, due diligence and expense prior to the parties proceeding to a formal agreement.
Use of a well-drafted LOI to confirm expectations regarding certain key aspects of the transaction, often will provide the parties the requisite level of comfort needed before investing the time, effort and expense of moving the transaction beyond the LOI stage. As an example, a potential purchaser of a business may be reluctant to incur the costs associated with the drafting and negotiation of a contract, as well as the obligations arising thereunder. An LOI containing a due diligence period, among other provisions, may provide the purchaser with sufficient information and confidence to proceed to the next stage of drafting and negotiating the contract.
Inasmuch as many clients and practitioners may be more familiar with drafting the definitive acquisition documents (such as an asset purchase agreement or stock purchase agreement), they may underestimate the importance of properly drafting the LOI, so that neither party is subject to unintended obligations, liabilities or consequences. In addition, practitioners may be under the misimpression that an LOI is not binding, when, in fact, the LOI may be binding, in whole or in part, either by design or as the result of inartful drafting.
To What Extent, if Any, is the LOI Binding?
Whether an LOI is binding on the parties depends on the intent of the parties. “If the parties intend to be bound by their preliminary agreement and view the later written contract as merely a memorialization of their agreement, they are bound by the preliminary agreement.”1 “On the other hand, if the parties intend that their preliminary agreement be subject to the terms of their later contract, they are not bound by the preliminary agreement.”2 The language of the preliminary agreement, the course of dealing between the parties before and after the preparation and execution of the preliminary agreement, and the facts surrounding its preparation are factors a court will consider in determining whether the parties intended to be bound by the preliminary agreement³.
On the one hand, parties to a transaction frequently are concerned that the LOI will constitute a binding contract, requiring them to proceed with and consummate the underlying transaction. On the other hand, the parties often want to be bound by specific provisions of the LOI, such as due diligence, confidentiality, exclusivity and various other provisions.
Avoiding Construction of the LOI as a Binding Contract
If it is the intent of the parties not to be bound by the LOI, the following points should be considered when drafting an LOI in order to avoid creating a binding contract:
1. The LOI should clearly, unambiguously and unequivocally state that the LOI is not intended to be a binding contract, is not an offer to proceed to contract, and should not be construed as a contract or offer to contract.
2. The LOI should also state that the parties do not intend to be bound by the terms of the LOI, unless and until the parties agree upon and execute a definitive agreement (such as an asset purchase agreement or stock purchase agreement, as the case may be).
3. Limiting the inclusion of material terms likely indicates that the parties intend not to be bound by the LOI, but rather by a formal, definitive agreement following the LOI. Examples of such material terms and details would be purchase price, representations and warranties, terms of indemnification, closing date and the like. The LOI should specify the terms that have not been agreed upon, and that are subject to further negotiation. The LOI should further provide that the parties intend not to be bound unless and until all terms have been negotiated and agreed to in an executed definitive agreement.
4. Similarly, deferring inclusion of certain key aspects of a transaction from the LOI stage to the signing of the definitive agreement tends to indicate that the parties intend not to be bound by the LOI. Examples of such elements would include commencement of the due diligence period, undertaking of search and title work and tendering of the deposit. The deferral of due diligence may be unacceptable to the purchaser given that many purchasers want to commence due diligence once the LOI is signed.
5. Specify a deadline by which the definitive agreement must be reached. Further provide that if the parties fail to negotiate a definitive agreement within the specified time frame, negotiations shall cease and the parties shall have no further obligation to one another.