Letters of intent (LOIs) can be valuable, but they also present risks. Those risks arise in part because LOIs often are drafted in a manner that places them in a legal gray area. They usually are intended to be non-binding but might inadvertently contain binding language, or they are intended to contain both binding and non-binding provisions but fail to make the distinction clear.
Significant legal battles have been fought over LOIs and the deals supposedly created by them, so it pays to know the risks and to take steps to minimize them. One well-established way to avoid many of the risks of an LOI is to use an unsigned term sheet that is stated to contain basic terms, be non-binding, and only be a framework for further discussions. While an unsigned term sheet nonetheless can still become a contract, term sheets may be a useful but less risky way for the parties to keep the prospective deal moving forward.
Even though intended by one or both of the parties to be non-binding, the language of an LOI and/or the conduct of the parties surrounding execution of a LOI might lead a court to conclude that an LOI is binding in its entirety. The following factors are used by courts to determine whether an LOI is binding:
The LOI language – are there disclaimers of contract; are binding words such as “shall” or “will” used instead of aspirational words such as “would?”
Does the LOI contain contingencies or contemplated further action such as governmental approval or board approval?
Does the LOI contain all the necessary terms to form a binding contract?
What is the conduct of parties in connection with the LOI; did the parties say “we have a deal” and exchange souvenir pens, for example?
Has there been partial performance by one or both parties in reliance on the LOI?
Even though parties intend for the LOI to be non-binding, they often include an obligation to negotiate in good faith. This seemingly innocuous provision can have unintended consequences. The obligation to negotiate in good faith in a LOI has been found by courts to substantially limit the conduct of the parties. Parties under a good faith obligation might be prevented from: renouncing the deal, prematurely abandoning negotiations, insisting on terms inconsistent with the LOI, insisting on other than the customary documentation, or entering into discussions with a third-party.
To maintain the greatest flexibility and avoid the potential problems with an obligation to negotiate in good faith, the LOI could contain no agreement to negotiate in good faith or, better yet, a disclaimer of any obligation to negotiate in good faith. To most people, it does not seem like an undue burden to be required to negotiate in good faith, so inserting a disclaimer might be problematic from a deal-making perspective.
Rather than eliminating a good faith obligation, the parties might include one subject to a time limit. As such, if a definitive contract is not signed by a certain date, either party will be free to pursue alternatives with less risk of a claim that, by doing so, they breached an agreement (there remains the risk of a claim that a party did not negotiate in good faith during the agreed-upon time period).
Beyond an obligation to negotiate in good faith, other common LOI provisions that parties might want to make binding are: no shop/exclusivity, confidentiality, and reimbursement obligation for expenses incurred if no definitive agreement is reached. If binding provisions are used, the LOI should be carefully drafted to distinguish between those and the provisions intended to be non-binding.
It pays to be careful when signing any document. Because LOIs are commonly used and sometimes treated very loosely, they deserve particular care. A poorly-drafted LOI can disrupt expectations and plans if one party wants to insist that it is a contract and not merely a non-binding term sheet. A well-drafted and unsigned term sheet might be a good substitute for a full-blown LOI.
In any event, if in doubt, don’t sign the LOI until you are sure it truly is what you want it to be, whether that is binding or non-binding or the appropriate combination of both.