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LETTERS OF INTENT:
AVOIDING THE UNINTENDED CONSEQUENCES
by Steven A. Elder and Andrew L. Dahm
Cox Smith Matthews Incorporated
It has become customary in M&A transactions, especially large transactions, for parties to
enter into “letters of intent” or “agreements in principle” early in the negotiation process. Letters
of intent are generally intended to provide some assurance that the parties are serious about
pursuing the transaction before committing the time and expense required to negotiate a
definitive agreement. These letters of intent are generally brief, laying out only the basic terms
of a proposed transaction. The beguiling simplicity of the letter of intent is the source of its
allure—and can be the source of unintended consequences and costly litigation.
A properly constructed letter of intent can also serve to focus the parties’ attention upon the
deal and facilitate future negotiations. All letters of intent set forth the basic business terms the
parties expect to see in a definitive agreement. At a minimum, a buyer and seller will usually
specify the assets or stock being purchased and the purchase price. Letters of intent often
include a target closing date to give momentum to the deal and encourage the parties to work
diligently toward completion. In most circumstances, the business terms described in a letter
of intent are not intended to be binding. Other terms, however, may be intended to bind the
buyer and seller. For instance, a letter of intent may also contain provisions requiring
confidentiality and limiting the seller’s ability to “shop the business” to other buyers, or
specifically providing that each party will bear their own expenses.
Even if a letter of intent is not legally binding, many businesspeople take the act of signing the
letter of intent very seriously, and are less likely to try to renegotiate basic terms described in
the letter of intent unless they can justify a modification (e.g., as a result of matters uncovered
in the due diligence process). Letters of intent are also an opportunity for the sophisticated
party to gain a negotiating advantage. Frequently, a party may be able to include terms in the
letter of intent as “deal” terms, which would be more difficult for any attorney to negotiate later
in the process (e.g., escrows, baskets, caps, limitations of liability, allocations of purchase
price, etc.). In contrast, unwary or unsophisticated parties are often surprised by the significant
issues they failed to consider or the significance of the issues they agreed to, and in some very
unfortunate situations, by the fact that a short letter of intent could be binding or create an
obligation to negotiate in good faith. For this reason, it is important to engage legal counsel
and other professionals at the letter of intent stage to structure the transaction and include
other key terms.
What happens when a deal falls apart, or one party tries to renegotiate the terms of the letter of
intent, and one of the parties desires to enforce the terms of the letter of intent? Therein lies
the danger of a poorly drafted letter of intent.
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Whether a letter of intent creates legally binding obligations and/or duties, and the nature of
those obligations, is determined by the contents of the particular letter of intent in question and,
if the letter of intent is unclear, the circumstances surrounding the proposed transaction. If the
parties have done a poor job of drafting the letter of intent, then a court might have to
determine which, if any, provisions of the letter of intent are binding or whether the parties have
created other duties (e.g., a duty to negotiate in good faith). To decide if a letter of intent is
binding or creates duties, a court will investigate the intent of the parties when they entered
into the agreement. This investigation is necessarily fact-specific, so the results of any
litigation involving the enforceability of letters of intent or duties of good faith in negotiations are
unpredictable. Because the outcome of litigation is uncertain, it is in both parties’ best interest
to draft the letter of intent carefully to avoid ambiguity.
Most letters of intent will recite that the letter is only “intended to summarize the principle
terms” of a proposed transaction and that the “letter does not contain all matters upon which
agreement must be reached.” By applying the traditional “all or nothing” rule, most jurisdictions
would hold that the letter of intent is unenforceable because, as the parties recite, the letter
omits material terms. If the letter omits material terms, then it is too vague to comprise a
binding contract between the parties, even if the letter of intent recites that the parties will
negotiate in good faith. To these courts, the lack of detail in the letter of intent indicates that
the parties did not intend to enter into a binding contract, but merely entered into an
unenforceable “agreement to agree.” Jurisdictions following the traditional rule are less likely
to enforce a letter of intent than those that follow the so-called “modern trend.”
Some jurisdictions (including Alaska, California, Oregon and Washington) have begun
interpreting letters of intent according to the modern trend. Modern trend jurisdictions will
enforce a letter of intent if it appears that the parties intended to be bound, even if the letter of
intent recites that it is not the definitive agreement between the parties. Modern trend courts
take the position that a letter of intent can be a binding contract to enter into another, final
contract. To decide if the parties should be bound by the letter of intent, a court would
undertake to identify the true intent of the parties when they entered into the letter of intent by
examining the totality of the circumstances surrounding the parties’ entry into the letter of
intent. In this context, a statement in a letter of intent that the parties will negotiate in good
faith becomes evidence that the parties intended to be legally bound by the terms of the letter
of intent.
To decide if a letter of intent is binding, these courts look for language indicating the contingent
nature of the parties’ obligations. If the parties contemplated that the deal might fall through, or
that the deal terms may change, it is much harder for a court to bind the parties to the terms of
a letter of intent. Choice of wording can be important to these courts when determining
whether the parties intended to be bound. Even something as simple as use of the phrase
“proposed transaction” versus “transaction” provides evidence that the parties have not agreed
to be bound by the terms contained in the letter of intent. If the parties use words like “will” or
“shall” rather than “would,” a court may also find a binding obligation. The more detailed the
letter of intent, the more likely a court is to construe the letter as binding because it looks more
like a definitive agreement. The context of the negotiations in which the parties enter the letter
of intent can also impact its enforceability; for instance, if the parties have behaved as if the
obligations of the letter were binding, a modern trend court is more likely to find it so.
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Courts in certain jurisdictions are also more likely to conclude that the letter of intent was
intended to, or does in fact, create an obligation to negotiate in good faith. These courts look
for whether the language in the letter of intent indicates that the parties intended to create, or
contemplated, a duty to negotiate in good faith. Some courts also look at the surrounding
circumstances to determine whether such a duty was created. Including language such as
“the parties will proceed diligently to close the transaction by…” could result in a court
inferring that the parties intended to create an obligation to negotiate in good faith. The
uncertainty surrounding whether a duty to negotiate in good faith exists, and what the duty
entails, can be unsettling for a party, especially one considering proposing new material
terms or attempting to walk away from a deal. Similarly, a seller approached by another
buyer with a better offer will struggle with its exposure if it chooses to pursue another
transaction.
Before entering a letter of intent, both parties should identify and be aware of which
provisions they intend to be legally binding and whether they want to be bound by a duty to
negotiate in good faith. As a practical matter, some provisions of a letter of intent are
intended to be binding and some are not. The binding sections should be specifically
identified as such, and the rest should be specifically identified as non-binding. Numbering
paragraphs can be very helpful in this respect, even if it does imbue the letter of intent with a
more formal appearance. If no provisions of a letter of intent are intended to be binding, this
should be explicitly stated. If the parties desire to make some provisions binding, they
should consider including binding provisions in separately executed binding agreements,
rather than in the letter of intent. This can work particularly well for confidentiality and nondisclosure obligations, both of which are easily encapsulated in stand-alone agreements.
The parties should include, but not rely upon, a statement that the letter of intent does not
contain all material terms necessary for the parties to form a contract. The parties should
state that they contemplate entering into a material definitive agreement that will contain all
of the essential terms of the parties’ agreement, and that the letter of intent is not the
definitive agreement. Brevity is often a virtue when drafting letters of intent. The more
detailed the letter of intent, the more the letter begins to look like a complete, and therefore
binding, agreement. Leaving certain key terms out of the letter of intent will make it harder
for a court to find that the letter of intent constitutes a complete contract between the parties.
To avoid being faced with a duty to negotiate a contract, or the uncertainty as to whether
such duty exists, it is advisable to expressly include in the letter of intent a statement
disclaiming the duty to negotiate in good faith. Some parties will even go so far as to
expressly provide in the letter of intent that any party may propose different terms from those
in the letter of intent or unilaterally terminate all negotiations at any time. While this may
detract from the purpose of the letter of intent - which is to provide assurances of a
fundamental understanding of the key business terms - it is important to avoid the dangers of
unintentionally creating a duty to use good faith to complete a transaction.
If the parties contemplate that the transaction might never be completed, this should be
explicitly spelled out in a letter of intent. A court reviewing the letter of intent is less likely to
enforce the letter of intent if the parties contemplated situations in which the deal might fall
through. If entry into a definitive agreement is contingent upon, for instance, the satisfactory
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completion of the buyer’s due diligence, the letter of intent should include a provision allowing
the buyer to terminate negotiations based upon the results of its diligence. Attention to detail
while drafting is important. Generally, words like “buyer,” “seller,” “transaction,” “shall” and
“will” are to be avoided in favor of “proposed buyer,” “proposed seller,” “proposed transaction”
and “would.”
If a letter of intent contains any binding obligations, it should either identify a specific date upon
which the parties’ obligations to one another terminate or grant both parties the right to
terminate the agreement at any time. A “drop-dead date” is particularly important because
both parties should know when they may safely cease negotiations.
Letters of intent have much to recommend them, but they can be dangerous to the uninformed
and the careless. No letter of intent should be signed unless both of its parties have, in
consultation with their attorneys, carefully thought through which of the terms recited in the
letter of intent should be binding and which should not.
Steven E. Elder is the leader of the Business Transactions Department of Cox Smith Matthews
Incorporated, focusing on M&A transactions. Andrew L. Dahm is an associate in the Corporate
& Securities Practice Group.
This article is for informational purposes only and is not intended as basis for decisions in specific situations. This information is
not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Copyright © 2008 USLAW NETWORK,
Inc. All rights reserved.