By: Mark G. Johnson and Ladd Hirsch

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In Edgar Allan Poe’s short story, the Purloined Letter, his fictional sleuth, C. Auguste Dupin, successfully located a stolen letter the thief had cleverly concealed by hiding it in plain sight.  In the legal world, letters of intent (LOIs) are used to form partnerships, raise funds, and add investors, among other things, but the common use and non-binding character of LOIs does not mean they are problem free.  This post takes a look at LOIs and focuses on issues that may be overlooked, but which can create significant legal problems in the use of LOIs.

Letters of intent are referred to by many different names, including memoranda of understanding, term sheets, agreement in principles.  Whatever it may be called, an LOI is simply a summary description of the essential terms of a business transaction.  In most cases, the parties intend that the LOI will be non-binding and will not establish an enforceable agreement between them except as to one or two provisions, such as confidentiality and exclusivity.  Due to the non-binding nature of LOIs, and the fact they “have no teeth,” business owners and investors may conclude there is no need for or value in retaining legal counsel to negotiate and draft LOIs.    This common sense assessment, however, actually reflects a risky business strategy.  Whether the proposed transaction involves the start up of a new company or the investment in an existing business, hiring an experienced business lawyer to assist is a wise, cost-effective decision.

Setting the Stage and Expectations of the Parties

An LOI serves as a critical tool that summarizes the material terms of the transaction the parties are considering.  Although LOIs are non-binding, when properly drafted, they serve as the foundation for the binding deal documents ultimately signed by the parties.  In short, the LOI serves as the road map, and it is critical for the LOI to identify and address all principal terms, both business and legal, so the parties are comfortable that they have truly reached an agreement before they incur the time and expense of drafting and negotiating the definitive deal documents.

Even when experienced, sophisticated businesspeople are negotiating the deal, they may unknowingly omit an essential legal term from the LOI.  This missing legal term that was never discussed, negotiated or agreed to may then crater the entire deal weeks or months down the road when it is finally brought up by one side or the other.  Just as often, the parties make reference to a legal term in the LOI, but they don’t fully address or discuss it in the absence of legal counsel, and once again this term later becomes the stumbling block that ends the deal.  Legal counsel therefore plays an important role in the LOI process by identifying, explaining and helping to precisely document the actual agreement on all of the material terms the parties reached in their negotiations.  Deal lawyers who negotiate and draft LOIs help to ensure that the parties fully understand all of key business and legal terms of their proposed transaction before they commit their time and resources to pursuing the deal in earnest, including conducting extensive due diligence and disrupting their lives and businesses.

After-the-Fact Input Can Create Serious Conflicts

To save legal fees, business owners and investors may negotiate and finalize the terms of the LOI themselves, and then send it to their counsel to approve before drafting the final deal documents.   This situation is analogous to locking the barn door after the cows have already fled to the pasture – it is too late to agree on all material terms in an LOI and then ask for input from counsel after the deal has been reached.

The LOI sent to counsel may include loosely drafted business terms; it may be missing key legal provisions and/or may present a business structure that is strongly against the client’s financial interest.  When the lawyer brings these problems to light and the client then seeks to make changes to the terms of the LOI, that can create an uncomfortable conflict.  The client is likely to be accused of re-trading the deal or worse, acting in bad faith or breaching some alleged informal promise or agreement.  Simply put, the best way to avoid this awkward situation and potential legal conflict is to retain counsel at the outset who can make sure that the LOI fully covers all material terms of the transaction and also fleshes out these terms in plain language.

When Does Non-Binding Become Enforceable

While LOIs are commonly understood as being non-binding, in litigation, the LOI will be considered on its own, specific terms. Once a lawsuit is filed, merely titling the document letter of intent will not control, because the trial court will closely scrutinize the precise terms of the document to determine whether it reflects an intent by the parties for the agreement and terms to be binding.   This is where legal counsel is particularly key, because even in an LOI that is not binding as to the transaction at issue, the parties may want the confidentiality and the exclusivity provisions of the LOI to be enforceable.  Making sure these are the only two provisions in the LOI that will be deemed to be binding requires careful drafting to avoid later disputes.

If the LOI does not expressly state in unambiguous terms that it is not binding, a court will not reach this conclusion as a matter of law, and a claim by a disgruntled party that the LOI was, in fact, binding will then be decided by a jury.  To avoid having the matter determined by a jury, the LOI should include a clear provision stating that: (i) the parties have made no binding agreement, and (ii) the parties are not legally bound to conclude any agreement with each other unless and until they each sign a definitive written agreement expressly stating that they are bound by the agreement.  Some LOIs will go even further and state that no agreement between the parties will be deemed to be binding/enforceable unless/until a written agreement has been presented to and approved by a vote of the boards of both parties.   This language is essential to head off any future legal claim that the LOI itself is enforceable.

Conclusion

LOIs play an important role in the business world helping parties reach agreements promptly and cost-effectively because they allow for the material terms of the transaction to be summarized without requiring a binding commitment by either side.  The purchase or sale of a business, the formation of a new company, securing capital for a new business or structuring the sale of a minority interest in a business are just a few examples in which LOIs are helpful to the parties in reaching a deal.  But the common use of LOIs and the fact that they are non-binding does not mean there is no risk in signing one, because LOIs quite often result in litigation when one of the parties backs out rather than concluding the proposed deal.

The LOI should be a summary of terms that moves the parties to the next stage.  If the LOI process drags on because the parties are including too much detail rather than merely a summary of key terms, they may want to forego an LOI entirely and simply move to drafting the final documents.  If the parties are committed to signing an LOI, however, in light of the frequency of litigation involving these documents, the following tips may be helpful to avoid errors in LOIs that would otherwise be hiding in plain sight.

  • Consider retaining experienced business/transactional counsel at the outset to assist in negotiating and drafting the terms of the LOI to ensure all necessary terms are included and expressed in a way that accurately documents the parties’ agreement.
  • Attempt to include all major business and legal terms in the LOI.
  • Expressly state that the LOI itself is non—binding and also that each party has the absolute right not to go forward in concluding a deal.
  • If any provisions of the LOI are intended to be binding, those should be stated clearly and placed in a separate, designated section of the LOI.
  • Specifically disclaim and confirm that neither party has any right to obtain specific performance from the other party of the LOI or any term in the LOI.
  • Recite that the parties are relying solely on their own independent investigation and analysis are not relying on any promises, consideration, agreements or statements by the other party that are not fully set forth in the LOI.