Letters of Intent: The Backbone of a Successful Commercial Transaction
A letter of intent is an interim document used in the course of negotiating the terms of a prospective commercial transaction. It serves a number of important functions, including:
- signifying a commitment to the proposed transaction by setting out agreed key terms
- officially declaring that the parties are currently in negotiations
- obligating the parties to maintain confidentiality
Although not intended to bind the parties to a proposed transaction, a letter of intent aims to bind them to negotiate, in good faith, a binding agreement of purchase and sale. The letter of intent can be said to serve as a “roadmap” of the essential terms of the proposed transaction so that the parties can proceed to negotiate and resolve outstanding issues and to settle on the more “standard” terms of the purchase and sale agreement. Furthermore, a letter of intent provides comfort and re assurance that the parties are serious about the proposed transaction and willing to commit the resources necessary to further investigate and negotiate the proposed transaction.
Where a transaction is not exceedingly complex, a letter of intent fulfills a slightly different role, that of avoiding misunderstandings, maintaining momentum for the transaction and creating a moral obligation, if not a legal one, to proceed. It can also allow a purchaser to bind a target before a competitor enters the bidding or to facilitate obtaining financing for the acquisition. Despite its potential benefits however, a poorly drafted letter of intent may impose obligations and liabilities which are unintended and unwanted. In certain circumstances, particular aspects of the letter of intent may be unexpectedly binding and enforceable. Specifying the correct set of responsibilities and objectives is essential. What is important for one commercial transaction can be quite different from the needs of another.
Where the Problems Arise
Letters of intent should not be taken lightly. In law, the parties either have a contract or they don’t. Business people and their lawyers, however, invariably seek to have the best of both worlds and attempt to create the legal equivalent of being “almost pregnant.” This arises from the paradox of the parties stating, in a single document, that they agree to something, while concurrently stating that they don’t.
A letter of intent generally lacks otherwise essential commercial terms that would be found in a definitive agreement of purchase and sale (such as representations and warranties, limitations on liability, waivers and indemnification). Yet, where a party prevails in its attempt to have the court declare a binding agreement, the parties have the worst possible contractual scenario to resolve: the parties have become bitter adversaries that are now obligated to negotiate minor details in a very contentious atmosphere. Attempting to avoid such a scenario is fraught with danger; since committing to too much detail in a letter of intent greatly increases the risk that a court may conclude that the document contains the essential terms necessary to complete the transaction and is accordingly, a binding contract.
To avoid the perils associated with a letter of intent being construed as binding, it is important to properly consider the following:
- the language of the letter of the intent
- the context of the negotiations
- whether the parties have partially performed their obligations
- whether essential terms remain to be negotiated
The letter of intent should be drafted to incorporate both non-binding and binding terms. Financial terms and related commercial variables are often intended to be non-binding and subject to change based upon due diligence investigations and further negotiations. Conversely, binding terms generally include confidentiality obligations, “no shop” or “standstill” arrangements and termination provisions. Problems arise when the parties do not effectively distinguish between the binding and non-binding terms.
Avoiding Unintended Consequences
The following general guidelines will help to avoid unintended consequences when entering into a letter of intent:
- clearly indicate that it is not a binding agreement of purchase and sale
- be brief, informal and use words of futurity
- use tentative or conditional language such as “preliminary” and “proposed transaction”, while avoiding the mandatory terms “shall”, “will” and “must” that suggest an agreement has been reached
- avoid making a letter of intent “subject to” best efforts or every reasonable effort commitments, as those words could be construed as creating a valid contract with a good faith duty to complete the transaction
- clearly state which terms are binding and which are non-binding
- specify a deadline at which negotiations will end if a definitive agreement is not reached
Depending upon the complexity of a proposed transaction, a number of issues can arise in negotiating a letter of intent. This article touches upon just a few of the matters to be aware of. The more complex the deal, the more careful one has to be. In those cases, it is prudent to involve experienced legal counsel to assist in the preparation of a letter of intent which accurately reflects the intentions of the parties.