When negotiating a complex business transaction, how often do you find yourself asking, “What does the term sheet say?” And of those times, how frequently is the answer the opposite of what was intended? Too often a client will execute a letter of intent (LOI) to quickly commence a formal negotiation process without accounting for all of its ramifications or repercussions.
Despite a client’s eagerness to reach a formal, comprehensive agreement, his or her lawyer should be involved as early as possible in the negotiation of an LOI. There are several traps that can be avoided. Examples are inadvertently creating binding terms, like an obligation to negotiate in good faith, or omitting certain terms that should be binding upon the other party, like exclusivity or confidentiality provisions. Moreover, counsel should caution clients that courts may have differing opinions about whether an LOI is enforceable, and point out ways to limit its enforceability. Even if an LOI is not binding, it is often difficult to back off a deal point included in an LOI in subsequent documentation negotiation, further underscoring the importance of counsel review upfront.
A nightmare scenario for any lawyer would be to create a binding agreement when the expectation is to merely set forth preliminary terms in a document without formalizing a contract. Indeed, Pennzoil v. Texaco, a case that reached the US Supreme Court in 1987, teaches us that, contrary to expectations, a five-page memorandum can be sufficient to establish a binding agreement for a multibillion-dollar deal. In that case, Pennzoil Co. and Getty Oil entered into a preliminary “memorandum of agreement” where Pennzoil was to buy certain shares of Getty Oil at a specified price. After the memorandum was executed, Getty Oil subsequently agreed to sell the shares at a higher price to a separate party, Texaco Inc. Lawsuits were subsequently filed in Delaware and Texas, and a jury in Texas ultimately found that the memorandum, and subsequent actions by Getty Oil, indicated that a binding agreement had been reached between Getty Oil and Pennzoil. The jury found that Texaco wrongfully interfered with that agreement, awarding damages against Texaco to the tune of $10.53 billion.
While not many cases will have damages as high as the Pennzoil case, it is important to understand the role LOIs play and how they can be used as a tool in a commercial transaction. This article provides guidance on how a party can set the stage for a successful negotiation and avoid traps that could result in litigation if a deal goes awry.
Most negotiations will commence with at least some sort of document identifying the fundamental business terms. Often a broker or business person will prepare it, and one or more of the parties may not have a lawyer review it. In many instances those reviewing or preparing the document without advice of counsel will overlook adverse legal consequences for future negotiations.
In all circumstances, the business terms set forth in the LOI should reflect accurately the intentions of the parties. Clients and their lawyers should review the LOI to make sure it includes the fundamental business terms of the transaction and confirm that any future negotiations will be based on the essential terms contained in the four corners of the document. Minimizing the risk of misunderstanding is not only critical to the ongoing negotiation, but will also save costs since the parties and their counsel will not become involved in protracted and expensive negotiations about terms established in the LOI.
Counsel should also make it clear which terms are binding on the parties, and which terms are subject to a definitive written agreement between the parties. Explicit disclaimers are useful in this instance to demonstrate an objective intent to be bound or not be bound. Actions taken after the execution of the LOI, however, should be consistent with the terms of the LOI as courts have found that actions taken after execution of an LOI can be sufficient to establish implied intent. For instance, a client should not provide access to a property or disclose diligence materials if the LOI expressly states that access to the property and to the materials will only be granted upon execution of a definitive agreement.
While the general rule is to make LOIs nonbinding subject to the negotiation of comprehensive deal documentation so that each element of a deal can be properly fleshed out, a party may wish to make certain terms of an LOI binding for strategic reasons. For example, a prospective buyer of a highly sought-after property may be anxious to tie up the property quickly, and it may be in that buyer’s interest to attempt to make those terms of the LOI binding. Thus, it is critical to know a client’s motivation and the overall deal dynamics so an informed, strategic decision can be made at the LOI stage.
Letters of intent may include a requirement that the parties are to negotiate a future instrument in good faith. Despite a general disclaimer that an LOI is nonbinding, courts have found a duty to negotiate in good faith when the parties agreed in writing to negotiate under such standard or otherwise included an objective set of guidelines for negotiation of final documents. The controlling factor is the intent of the parties. Such an obligation has sometimes been inferred from other language in the LOI or from the conduct of the parties. If negotiations subsequently fail and a party did not negotiate in good faith, that party could be subject to a cause of action based on the “nonbinding” LOI. If a party does not want to be held to a standard of negotiating in good faith, then the LOI should not include a “good faith” provision. It should include a fixed expiration date and should state that either party has the right to decide in its sole discretion whether to enter into a final agreement. If intended, it should also contain express language clearly stating that the party is free to negotiate with third persons.
One way to potentially avoid an obligation to further negotiate and to end all negotiations is to include a broad termination provision in the LOI. Such provision could include that either party has the right to terminate negotiations at any time, or could state that the LOI shall terminate upon the earlier of an outside date or the date the parties enter into a more definitive agreement. Otherwise one could argue that without a termination provision, the LOI could last indefinitely. A termination provision should be binding and should allow a party to exit negotiations without recourse.
Similar to a party’s obligation to negotiate in good faith, exclusivity provisions are also often negotiated at the LOI stage and can be binding upon the parties. If one of the parties, such as an owner or borrower, desires to negotiate with other buyers or lenders, then an LOI should expressly disclaim exclusivity. Indeed, an owner, as a landlord or seller, should be cautious to include an exclusivity provision if there is an ongoing advertising or marketing campaign of the asset in question. Conversely, if the buyer is going to incur costs negotiating a final agreement, it may want an exclusivity provision, or request a break-up fee or a right of first refusal. To avoid any litigation, each side should make its intent clear from the beginning.
Confidentiality provisions should also be considered when preparing an LOI. If a party desires to keep any negotiations and the terms discussed during those negotiations confidential, then the LOI should expressly state that the terms are confidential, and such provisions should be binding upon the parties. Without explicit provisions, either party could be free to disclose the terms to other third parties, which could jeopardize or affect future negotiations or other deals. One should be careful to include, among other things, what is confidential, how long it will be confidential, and how such information may be used.
Letters of intent are routinely prepared in commercial real estate transactions as they are a useful tool in commencing a more formal negotiation. While certainly not required, clients should make an effort to have counsel review the LOI before it is signed. This not only ensures that the lawyer is aware of the potential transaction, but also allows the lawyer to provide insight as to what terms may be binding on the client once the LOI is executed and to make sure that it accurately reflects the intentions of the client.