What Constitutes a Letter of Intent?
A letter of intent is a "preliminary agreement" that communicates the mutual agreement of contracting parties to enter into a transaction. The terms of the LOI should evidence the parties’ intention to complete a particular transaction. For example, an LOI may outline the business deal to be finalized, the proposed terms of the transaction and the structure of the transaction. An LOI is typically signed before numerous other agreements (e.g., a definitive agreement) are executed.
An LOI is very useful because it gives detailed expression to the preliminary understanding that the parties have of a particular deal. It initiates the flow of information and negotiation by allowing those involved in a transaction to further consider negotiation points that need to be addressed in drafting a definitive agreement . In some cases, however, the LOI can be so detailed that it becomes a complete agreement in itself. You should pay particular attention to ensure that an LOI you are contemplating entering into is not inappropriately comprehensive because the goal is to create only a preliminary agreement.
LOIs are commonly used in real estate transactions such as in connection with lease agreements and the sale of property.
In managing the risks associated with an LOI, you should clearly express intent to not be bound by the LOI unless formal definitive agreements have been executed. If you choose, your LOI can be non-binding. However, in some situations, "a binding contract may be formed despite the parties’ contractual language" if there is a clear intention to be bound.
The Legal Standing of a Letter of Intent
The legal status of a Letter of Intent depends on the intention of the parties with respect to the particular transaction. If the parties intend to be bound by a LOI, they may well be bound. On the other hand, if they do not intend to be bound, the LOI may be non-binding.
In this regard, it is possible for a LOI to be binding in certain respects and non-binding in other respects. For example, even in a LOI that is wholly non-binding, it may contain binding confidentiality provisions or it may require a deposit which is binding on the parties. For example, a LOI for a lease for premises may expressly survive any failure to agree on a lease or to compel settlement of a lease, so as to be binding in respect of a right of first refusal to lease the premises, but non-binding with respect to an obligation to enter into a lease.
If a LOI stipulates the conditions under which it would be binding (such as the execution of a definitive agreement, satisfaction of due diligence or receipt of required approvals), there is no general rule that an offer made conditional upon the execution of another agreement cannot be binding.
In piercing the ‘veil’ of non-binding transactions, the predominant approach has been that the status quo established by the parties with respect to their relations is considered to be contractual, with concomitant obligations. This will expose the parties to potential damages claims if the transaction is not finalized and the party is suffering damages as a consequence due to the costs of aborting the transaction, the cost of other abortive transactions and damages for a lawful purpose not achieved as a consequence of aborting the deal.
Important Elements of a Letter of Intent
Letters of intent can vary significantly in length and detail based on the purpose for which they are being used. At the outset, you should include the parties involved. If the parties intend to have further negotiations, then the letter should ideally state that the letter is not a fully formed and complete contract. It should indicate that the letter is merely an outline or expression of mutual interest between the parties, and should state that the letter should not be construed as binding on the parties, unless the parties intend to be bound.
Additionally, letters of intent do not necessarily include all the necessary contract terms, but contain some basic terms that both parties consider to be vital to the transaction. For instance, many letters will state the basic requirements of a deal. Are any down payments required? Are there any contingencies on a real estate deal? If such basic terms are not included in the letter, the parties run the risk that neither party may remember them if not included in writing.
The drafting party should take careful steps to ensure that the reader of the letter does not interpret the letter as a fully formed contract, unless that is the express intent of both parties.
Significance of Letters of Intent in Contract Disagreements
Courts generally view letters of intent as invitations to continue negotiations rather than as binding agreements. Thus, if a buyer attempts to enforce a letter of intent against a seller, a court will likely look beyond the text of the letter to consider whether the buyer and seller intended to enter into a contract based on the agreement. Among the factors that courts might consider in making this determination is the transaction’s complexity. The more complex the transaction, the less likely a court may be to accept an argument that a letter of intent should be binding (i.e., its enforcement would contradict the parties’ intention) when there remain material issues that the parties have yet to negotiate. By contrast, if a transaction is relatively simple with only a few remaining issues, the court may be more inclined to enforce the parties’ letter of intent if the remaining issues do not appear sufficiently material to negate the parties’ intent to be bound.
Whether a party intended to be bound by a letter of intent also turns on other factors, with courts looking to the extent to which the parties’ conduct might suggest that they are treating the letter of intent as binding (for example, by engaging in a due diligence process, seeking formalities, or performing contractual obligations despite the fact that they have not yet entered into a definitive agreement). Moreover, courts have similarly held that a party’s act of preparing and submitting a merger application to a regulatory agency was also inconsistent with an intent not to be bound by a letter of intent.
How to Write a Successful Letter of Intent
In drafting a letter of intent, both practical business realities and legal considerations can play prominent roles. This is particularly the case when parties enter into a letter of intent on a non-exclusive basis, meaning that either party is free to engage in discussions with other parties regarding its transaction. Under these circumstances, most parties prefer a negotiated agreement that addresses the terms of the proposed agreement in substantially greater detail than a letter of intent. This can discourage parties from engaging in discussions regarding the subject matter of the transaction. Further, when the parties are coming together for the first time, each will likely be wary of revealing too much information. Nonetheless, best practices for drafting a letter of intent include the following:
Best Practices
1. Include a "no shop" clause or a negotiated exclusivity period. If it is important that the parties spend exclusivity negotiating the deal, include a "no shop" clause. A no shop clause will typically provide that for a set period of time, neither party shall discuss the transaction with any third party.
2 . Include a statement that nothing in the LOI (or LOI/MOU) shall be construed as creating a legally binding obligation of either party to effectuate the transaction except those sections denoted as binding. Many parties designate the limited provisions of the letter of intent setting forth the scope of the proposed transaction, the transaction’s structure, information both parties wish to receive and information they will provide, conditions precedent, liabilities agreed to be assumed, confidentiality provisions and the like as non-negotiable and binding against them.
- Include a provision that any amendments must be signed in writing by both parties.
- Seek to negotiate a broad, open period to allow the parties to conduct their business and protect their business interests. That includes a provision that provides that either or both of the parties can change, add or omit items from the letter of intent.
- Include a provision that provides that a party can terminate negotiations at any time and for any reason. Because there can be substantial costs tied up in the transaction process, this provision may prove helpful to either party if the other party has been unwilling or unable to finalize the agreement.
Common Pitfalls and Errors
Owners often mistakenly believe that a letter of intent is only something companies create when its time to begin negotiating a contract. A poorly constructed letter of intent can lead to litigation. It’s important to note that these letters are not boilerplate and should be customized to the particular purpose at hand. Owners, suppliers, and contractors make these mistakes over and over again:
- Failure to disclose: it isn’t enough just to provide an owner with a range – the letter should reveal all significant factors that make the project risky. Owners should avoid trying to hide the fact that there are problems with the project that may be uncovered later.
- Failure to provide sufficient detail: it might be simpler to pull a form from the internet, instead of consulting with an attorney specifically about the provisions that your project requires. Some owners like the idea that they were able to save money and use a ‘form’ instead of having attorneys draft the language academically in wording. The truth is, these forms might not include scope, including scope is even more important when there are many unforeseeable risks.
- Final Terms: too many owners use a letter of intent as if it were the final contract. The LOI may be used as the contract just without much thought from owners or suppliers. However, you have to remember that the letter of intent is not a final contract and should specify that it is a non-binding agreement. Moreover, if the document is being used as the contract, and not just an LOI, the parties must remember to fill any gaps in the agreement. It’s best to create the contract after the negotiating process is finished.
- Failing to consult with counsel: Owners and contractors are too often tempted to simply continue the negotiation for far too long using the letter of intent as the contract during that time. It’s a money saver to do this and delay hiring an attorney until the very end of the negotiating process but, without failing to include certain important elements, you can make a letter of intent without lawyers and still be taking a risk of litigation.
Real-Life Examples: Letters of Intent
A letter of intent is a tool that has been used all over the world. In May 2006, The Economist reported on a deal between Air China and Shanghai Airlines Ltd. that began with an LOI. Because the two companies needed approval from the Ministry of Commerce in China before finalizing their agreement, the transaction dragged on until a final deal was signed last September. Because the LOI imposed far-reaching obligations on the parties (including a standstill clause), and because one of the major purposes cited for entering into the agreement had changed since 2006 (the entry of China into the WTO), the original document is still being cited before the arbitral tribunal by both sides as if it were the final contract.
In 2002, Hewlett Packard entered into an LOI with Compaq regarding a merger. However, a year later in September 2003, HP announced that it had decided to pull out of the merger. The two companies had not finalized their deal, but because their letter of intent contained a standstill provision that forbade either party to disclose their plans to any other company, the parties found themselves in litigation after HP made its announcement. HP settled with Compaq in August 2005, paying $635 million to avoid further litigation.
Similarly, before a $4 billion merger between Lucent Technologies and Siemens A . G. – which involved a letter of intent – both companies’ stock prices dropped after HP announced that it would be withdrawing from its own merger. Lucent and Siemens demanded a $1 billion breakup fee from HP as well as rebates on other business deals that were damaged as a result of the failed merger. Genting Berhad sought to cancel their $1.5 billion merger with Star Cruises even before they could enter into an LOI. The parties had signed a letter of agreement that contained the same terms as an LOI, but that agreement was never passed by Genting Berhad’s shareholders. Star Cruises sued for $1.75 billion.
All of these cases make clear how important letters of intent can be in protecting the parties to a merger against bad publicity and shareholder actions. However, the two most recent cases also show how much pressure parties can be under when they sign a binding letter of intent. In letter written to stockholders in response to a shareholder lawsuit, Genting Berhad chairman Lim Keong Guan expressed his concern that Genting’s shareholders were severely disappointed at the delay caused by HP’s announcement of its withdrawal from a separate merger. Lim blamed the costs of a possible lawsuit against HP for the company’s decision to withdraw from a proposed merger of their own with Star Cruises.