By UpCounsel Attorney Alex Wall
A letter of intent (LOI) is a common way for companies to set forth expectations as they work out the final details of a deal that may become a binding contract.
LOIs are also sometimes referred to as term sheets, memorandums of understanding or a list of terms, among other less formal titles. The title usually depends upon the industry and the purpose of the document.
LOIs are sometimes intended by the parties to draw a binding outline of an agreement, with the details to be fine-tuned later, and sometimes an LOI is intended just as a nonbinding launch point for negotiations. Letters of intent are utilized in deals across many legal areas, including business ventures, licensing deals, mergers, private equity, intents to vacate, commercial real estate sales and leasing. The detail and extent of letters of intent vary widely with the marketplace. An LOI is a common way for companies to set forth expectations as they work out the details of a deal.
An LOI is a common way for companies to set forth expectations as they work out the details of a deal.
Alarmingly, a “nonbinding” letter of intent, even if it states in bold caps “NON-BINDING,” (1) certainly imparts a duty of good faith and fair dealing among the parties and (2) sheds light on what may be considered good faith and fair dealing in any subsequent dispute.
But a non-binding LOI also (3) can create premature disclosure obligations to the SEC in public company mergers and (4) in some factual situations and jurisdictions, may become totally binding. If found to be binding, an LOI breach may support expectation damages, such as lost profits, or the amount a party would have made had it not been for the breach of the LOI.
Why to Use a Letter of Intent: The Pros
LOIs can be very useful means of smoothing out a deal process and eliminating the kinds of sudden surprises that cause parties to lose trust in one another.
For example, in a commercial lease, a timetable for producing documentation of rent for a property on the seller side and providing proof of financing on the buyer side allows parties to know what kind of proof to expect and how much time is reasonable in order to provide it.
LOIs often serve as checklists of important documents and obligations prior to a merger or major asset purchase. They sometimes also include clauses that are intended to be binding, while the specifics are not.
For example, the exact price of a real estate purchase may depend upon further information about title or zoning that neither party has yet had time to investigate, but the parties are certain that they want to commit to exclusively working together until they have reached an agreement (or not) in good faith. Alarmingly a “nonbinding” letter of intent may become binding or determined binding by a court.
Alarmingly a “nonbinding” letter of intent may become binding or determined binding by a court.
An LOI also helps parties identify “deal breakers,” or the threshold issues that can make or break a deal early in the negotiation process. Other uses for LOIs include focusing negotiations away from irrelevant details, enhancing both parties’ commitment to the deal, laying out important contingent regulatory and third-party contractual approvals and even educating a less sophisticated party on the numerous issues that may need to be considered.
Why Not to Use a Letter of Intent: The Risks
There are non-legal risks to using an LOI, such as the time and cost involved in drafting an additional document, the perception that the document complicates or slows a deal from consummation, the weakening of a party’s negotiating position by providing too much information to the other party too early and an obligation to disclose information to the public under a regulatory scheme.
But the primary risk of using an LOI is that it may create an enforceable obligation to negotiate in good faith toward the general terms in the LOI and can sometimes create other legally-binding commitments.
When using an LOI as a tool in a deal, it’s very important to understand that the legal import of an LOI is uncertain and very fact-dependent. Unlike a contract with a clause stating that it is the entire agreement, an LOI will usually cause an inquiry into the surrounding facts and statements made previous to signing (known as “parole evidence”). The primary risk of LOIs is that they can create enforceable legally-binding commitments.
The primary risk of LOIs is that they can create enforceable legally-binding commitments.
For instance, a court will try to determine whether the parties intended some clauses to be binding and others not. In general, a legal dispute requiring fact-finding is going to tend to cost more to litigate than a dispute that can be resolved by a reference to a clear and well-drafted contract.
This together with recent verdicts, means that the legal risk of utilizing LOIs has been increasing.
An LOI should be drafted, as with any legal document, with the specific purpose in mind – whether the parties intend for the LOI to be binding, partially binding or a checklist for the purpose of memory.
Delaware and Oregon Supreme Court Decisions Emphasize Risks in Letters of Intent
Last year, the Delaware Supreme Court sent a signal in SIGA v. PharmAthene that it’s willing to award substantial expectation damages in a breach of good faith (particularly in the case of a merger or acquisition), even when an LOI is labeled “non-binding” and even after extreme changes in the economic assumptions underlying the deal between the time of execution of the LOI and point at which one party no longer wants to go through with the deal.
In Oregon, the author’s home jurisdiction, it is well-established law that various terms in a “nonbinding” LOI can become binding.
In Logan v. Sivers, the Oregon Supreme Court found that a merger LOI that promises to negotiate in good faith, and provide reasonable due diligence materials, and to abide by a non-solicitation provision will provide a basis for an award of reliance damages. In so doing, the court found that “unless those terms are so indefinite that a court cannot determine what the parties intended, such clauses can form a contract that is binding.”
In Logan, a jury found that a term in an LOI that required a draft purchase and sale agreement to be delivered within “approximately fifteen (15) days” was satisfied by the plaintiff’s actual delivery within 21 days. The court affirmed a lower court finding that the wording intended flexibility in the exact number of days. The court also decided that the term, although ambiguous and in need of a jury’s interpretation, was not too indefinite as to be unenforceable. The Oregon Supreme Court found that a merger LOI could be the basis for an award of damages.
The Oregon Supreme Court found that a merger LOI could be the basis for an award of damages.
Although the court did not award expectation damages (lost profits) in this case, it is important to note that the Logan dissent contained a strong argument supporting an award of lost profits in the event that the plaintiff was able to prove that, had it not been for the breach of the LOI, the parties would have fully performed the contract.
Strikingly, the majority opinion noted that the dissent was “thoughtful” and “interesting” and even “might have some pertinence” in a letter of intent that was drafted less narrowly.
In summary, although the Supreme Court of Oregon did not think that the Logan matter was the proper vehicle to create a rule for awarding expectation damages, the majority appeared to leave the door open for expectation damages in a future decision, given the right case.
Oregon is not obligated to follow Delaware’s precedent, but Delaware is nevertheless a very important jurisdiction for business matters due to its sophisticated judges and wealth of case law. The commentary in the Logan case combined with the Delaware SIGA case could be enough persuade an Oregon court to award expectation damages, depending upon the facts.
When to Use and Not Use Letters of Intent
Do not use an LOI, if you don’t actually plan to complete the deal. Do not take letters of intent or term sheets lightly. In Schwanbeck v. Federal-Mogul Corp., the court found that any written memorandum of understanding between parties carries with it a duty to conduct oneself in good faith (as do all contracts). You should never sign, acknowledge, agree to or draft a letter of intent, unless you, in good faith, intend to make an honest effort to move forward with a deal.
This can be true, even if the LOI does not state that the parties intend to negotiate in good faith. In some cases – like in Channel Home Centers, Div. of Grace Retail Corp. v. Grossman – courts will presume the parties’ intention based upon their course of conduct.
If you do not seriously intend to pursue a negotiation, or wish to avoid commitment, you’re better off skipping the term sheet or letter of intent. You should never agree to or draft a letter of intent, unless you intend to make an honest effort to move forward with the deal.
You should never agree to or draft a letter of intent, unless you intend to make an honest effort to move forward with the deal.
Use a letter of intent if you’re fairly certain you want to move forward, and you desire to bind both parties to negotiate toward a common goal in good faith. A letter of intent helps to identify deal-breakers early, keeps discussions on track, stabilizes commitment on both sides and educates both sides, and it also may be a formality that is customary in an industry.
9 Provisions to Include in a Letter of Intent
1. Summarize the transaction. By explaining the purpose and the general expectation for how a deal is going to go, a description or summary can avoid misunderstandings from the start (and also guide a court in interpreting the deal).
2. Key dates or a timeline. A proposed closing date, an expiration date of the negotiation period and any proposed deadlines for completion of due diligence can help keep parties on track.
3. Responsibility for related expenses. You should clearly state who is responsible for brokers, accountants, attorneys and other necessary professional fees. This also relates to who will do the actual drafting of the final agreement – which could be quite detailed and expensive.
4. Binding, partly binding or nonbinding? Indicate exactly which terms are intended to be binding and which are not. As previously stated, a statement that an LOI is not binding will not cause it to be entirely nonbinding. But it may ensure that certain less important terms are nonbinding. It is likely impossible to negate the duty of good faith with a contractual provision, but a nonbinding provision can prevent terms from being taken literally.
5. Scope and procedure for due diligence. Clearly identify which documents and repositories will be checked and the size of the “box” that contains all of the asset and liabilities of the thing being purchased. A nonbinding provision can prevent terms from being taken literally.
A nonbinding provision can prevent terms from being taken literally.
6. Exclusivity. If the parties intend to negotiate exclusively until a deal is completed, in good faith, it is best to say so in the LOI.
Confidentiality or restrictions on announcements. In many cases, confidentiality may be critical for the smooth consummation of a transaction, particularly if public knowledge could cause dramatic market shifts in value prior to closing. Any confidentiality involved should be clearly stated.
7. Tax Treatment. It may be wise to include the parties’ intentions regarding tax treatment.
8. Examples. When the transaction is complicated or includes a formula, an example calculation can be very helpful to help the parties avoid awkward or even disastrous misunderstandings at closing.
9. A description of what still needs to be decided. Clarify what the letter of intent is not intended to cover, or whether additional points may be raised in the future.