Letters of Intent: Binding or Non-Binding
When should you call your attorney in regards to an LOI? Here are questions to consider.
business sale – whether it’s a piece of real estate or a whole business – begins as an idea while financial and strategic information is gathered. It then starts to form into a mutual interest where the owner wants to sell for a price the other party thinks they might pay. This often results in a letter of intent or LOI.
The LOI is intended to set out the principal terms of the proposed transaction and define what needs to be investigated and confirmed to consummate the deal. Usually an LOI comes after some preliminary investigation by the buyer. An LOI that precedes any investigation will usually be too vague to be of much use. That is, unless the buyer is already engaged in the same business and is familiar with just what it needs to complete the transaction.
So what do buyers and sellers need to consider in deciding to use an LOI?
First Question: Are the parties in a hurry?
The time spent drafting an LOI could be better spent just drafting the purchase agreement, which must follow. An LOI and a purchase agreement are distinctly different animals, so there are definitely additional costs in the two-step process. Yet in complex transactions, much time can be wasted if the parties didn’t identify their main concerns in an LOI.
Second Question: Is the LOI to be binding, non-binding or partially binding? Seventh Circuit Judge Frank Easterbrook described the recurrent problems posed by LOI’s:
We have a pattern common in commercial life. Two firms reach concord on the general terms of their transaction. They sign a document, captioned ‘agreement in principle’ or ‘letter of intent,’ memorializing these terms but anticipating further negotiations and decisions – an appraisal of the assets, the clearing of a title, the list is endless. One of these terms proves divisive and the deal collapses. The party that perceives itself the loser then claims that the preliminary document has legal force independent of the definitive contract. Empro Mfg. Co., Inc. v. Ball-Co. Mfg., Inc., 870 F.2d 423, 424(7th Cir. 1989).
More often than not, the LOI states it is a non-binding agreement, but then somewhere inside the ropes it states that certain sections are binding. For example, LOI’s often have a ‘no-shop’ clause, meaning that the seller can’t continue to negotiate with another buyer while the LOI is in effect. The no-shop clause is always designated as binding, even if the introduction to the LOI states the LOI is non-binding.
To minimize the risk of a non-binding agreement being enforced, there should be a clear statement that the parties do not intend to be bound until they execute and deliver a definitive agreement, or that the parties do not intend to be bound by the LOI. This by itself is not necessarily enough, but nevertheless, it’s important.
Third Question: How can an LOI that claims to be binding be enforced when it requires preparation of a definitive agreement and contains other conditional provisions?
Many things need to be agreed on to come to a definitive agreement, yet most sale issues are recognized as often handled in a customary way. For example, where silent taxes are usually prorated, the governing law is usually the state where the business or asset is located. Each party pays its own counsel; cash on hand is never part of the sale.
These and many other issues can be dealt with by language that recognizes custom and practice. For example the clause below:
The definitive agreement will contain the representations, warranties, covenants, and conditions, and other terms and provisions that are customary for transactions of this nature and are commercially reasonable between similarly situated parties. If the parties do not enter into a complete, definitive agreement, they agree that any provisions necessary to construe and enforce this agreement will reflect such commercially reasonable and customary provisions.
The foregoing sample clause is not the remedy for everything. In an LOI that is intended to be binding, both buyer and seller will want to state the representations and warranties being given or excluded.
A binding LOI will likely have a clause requiring the parties to negotiate (the definitive agreement) in good faith. Perhaps surprisingly, Indiana (and some other states) hold that (with few exceptions); there is no implied duty of good faith in negotiating or performing a contract. Unless it is ambiguous, it is to be performed as written. This dooms a party that gets cold feet and issues tactics to avoid completing the transaction.
The best example of this concept is a lease that can only be assigned with the landlord’s consent. Cases asking the court to rule that the landlord must exercise this right “reasonably” will fail. Unless the lease provides a reasonableness test, the landlord can refuse consent for any or no reason since there is no duty to act in good faith. However, as noted, such a duty can be created in an LOI or any contract by stating so.
Fourth Question: Can a non-binding LOI be enforced?
Strictly construing the question – as written – the answer is no. However, the question assumes the answer that the agreement is non-binding. Better stated – can an agreement that states it is non-binding be enforced? That answer is “sometimes.” Where the agreement contains the essential terms of a contract (price and identification of the asset to be transferred and other conditions that must be met to bind the parties), some courts have decided there was an agreement struck despite including language stating the LOI was non-binding.
For example, the actions of the parties can indicate they felt an LOI was binding where one party makes a demand based on the LOI terms and the other party cedes a previously held opposition and so on. Most legal writers feel a jury rather than a judge is much more likely to find an LOI that states it is non-binding, is binding, because to laymen, an LOI has all the appearances of an enforceable contract.
Some writers have suggested that if an LOI is intended to be non-binding, why sign it? Other writers suggest not titling a document as a Letter of Intent, but calling it a Term Sheet or a Memorandum of Understanding.
In Conclusion: Binding LOI’s can be non-binding if they fail to set forth the material elements of a deal or a means by which a missing element can be determined. In other words, the LOI is just a contract and if missing an essential term, it isn’t a contract.
An LOI that states it is non-binding can be binding under a variety of circumstances if it contains the essential elements of a contract. For example, where the parties act as if it is binding, or where one party makes a claim the other party is bound to follow some of it or it requires the parties to act in good faith and one party refuses to negotiate in good faith.
An LOI can be an integral part of an acquisition transaction, but its language, despite a statement that it is non-binding, is important. An LOI guides the parties toward finalizing their deal because it represents their expectation, frames the way the price can be adjusted or determined and it sets completion deadlines.
It may be enforceable, despite declaring it is not. Or enforceability may fail, despite a declaration it is binding when an essential element is missing. A buyer or seller who enters into an LOI planning to later have his counsel work only on the definitive agreement may find they have made a serious error when the definitive agreement isn’t ever completed.
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