Is Your Letter of Intent a Binding Contract?

October 01, 1999-By D. Kerry Crenshaw

The letter of intent, which is often called by various names such as "memorandum of understanding," "heads of terms," "terms sheet" or "agreement in principle," is the near-universal precursor of the modern business acquisition transaction. These letters, or outlines of proposed terms, almost invariably purport to be non-binding, yet virtually all of them contain terms intended to be binding. This paradox has resulted in some of the most hotly contested litigation in the history of business transactions, with one case resulting in the largest judgment ever recorded for a business dispute, a $10.53 billion award against Texaco, Inc. by Pennzoil ($7.53 billion in compensatory damages and $3 billion in punitive damages). Texaco, Inc. v. Pennzoil Co., 729 S.W.2d 768 (Tex. App. 1987, writ ref'd n.r.e.), cert. dismissed, 485 U.S. 994 (1988).

The letter in Texaco was styled a "Memorandum of Agreement" and exhibited many features typical of the letter of intent genre: (1) it purported to become binding only "after the execution and delivery of this agreement"; (2) a signature of one of the parties was missing; (3) it was expressly subject to board approval; (4) statements to the press described the transaction as "subject to execution of a definitive merger agreement"; and (5) the Memorandum styled itself as an "agreement in principle." Another significant factor in the case was that, other than some preliminary financial arrangements, there was no partial performance. The Texaco court held that while any of these factors might, independently, indicate that the parties did not intend to be bound to any agreement, "[t]here was sufficient evidence for the jury to conclude that the parties had reached an agreement on all essential terms of the transaction with only the mechanics and details left to be supplied by the parties' attorneys." Nor is the Texaco decision unique. There is ample authority in other jurisdictions to the effect that if a court perceives that the parties intended to be bound prior to the execution of the definitive agreement, it will give effect to that intent, even if certain issues have not been resolved. Moreover, the courts will sometimes supply commercially reasonable terms for these unresolved issues or impose a contractual duty to negotiate the resolution of these issues in good faith; and if one of the parties negotiates in bad faith, courts have imposed liability on that party. See cases cited at the ABA Model Letter of Intent, Ancillary Document No. 2 to the Model Stock Purchase Agreement (the "Model Letter"), pp 348-349.

In deciding whether or not a letter of intent is binding, courts generally examine five factors: (1) the language of the letter of intent; (2) the context of the negotiations (for example, in Texaco, where the letter of intent specifically stated that the transaction was subject to approval by the Getty Oil board of directors, even though Getty Oil's board did not approve the letter of intent itself, the court was influenced by the fact that the board indicated approval of a counteroffer price); (3) whether either or both parties have partially performed their obligations; (4) whether there are any issues left to negotiate, or whether any of these issues are of material importance to the transaction as a whole; and (5) whether the letter of intent describes a complex transaction which customarily involves definitive written agreements. See Model Letter, p. 348.

In Michigan, the leading case on letters of intent is Heritage Broadcasting Co. v. Wilson Communications, Inc., 170 Mich. App. 812, 428 N.W.2d 784 (Mich. Ct. App. 1988), which involved a letter of intent which purported to be "subject to the further condition...[of] a definitive agreement." Notwithstanding that the definitive agreement was never concluded, the Michigan Court of Appeals held that the letter could be characterized as a "contract to make a subsequent contract," and as such, "it may be just as valid as any other contract." The Heritage decision surprised many M & A practitioners, who had assumed that the use of "subject to the execution of definitive documentation" language in letters of intent was sufficient to avoid the letter of intent being characterized itself as a binding contract. While later Michigan reported cases have been inconsistent, and often inscrutable, in announcing their reasons for deciding letter of intent cases, there is no evidence of departure from the "binding contract" view of Heritage, and Heritage stands as a stern warning that letters of intent may be interpreted as binding contracts in Michigan.

Many Michigan lawyers advise their clients that letters of intent create a disadvantage for the client, since there is always some risk that no matter what disclaimers are included, courts may give binding effect to terms generally regarded by the parties as preliminary and subject to further discussion, or even worse, could supply missing terms which may not reflect the views of any of the parties. Nevertheless, letters of intent remain enduringly popular, and parties to these transactions are rarely restrained by such cautions. There are several reasons. First, there is often a need for buyers to obtain financing or secure the appropriation of capital for the transaction, and these exertions generally are not undertaken by buyers unless there is a moral certainty that the target company will not be taken by another bidder while this effort is underway; hence, the popularity of "no-shop" clauses in letters of intent, usually intended to be binding. Second, the conduct of due diligence activities and inspection of the seller's business by the buyer almost always places the seller at a negotiating disadvantage, even if the seller is not a direct competitor of the buyer, and sellers usually want to define the limits of this activity. Third, there is an element of cost in preparing definitive documentation for a transaction that may not be concluded, and the letter of intent is frequently viewed as a declaration that the intent to conclude a transactions is serious, and not just "tire kicking."

Curiously, even though letters of intent almost universally favor buyers, sellers are often as insistent as buyers on entering into a letter of intent. One reason for this insistence may be that sellers see the intended transaction as so economically or strategically attractive that nailing down the price is perceived to be in the seller's interest, even if there is later slippage following a due diligence investigation. Moreover, from a tactical standpoint, the seller is often at the apogee of negotiating leverage at this preliminary stage; alternative terms of sale are not yet excluded by a lock-up, and the seller can insist on limitation of terms typically favorable to the buyer, such as holdback or escrow of a portion of the purchase price, the scope of representations and warranties, and terms such as survival of indemnification.

Returning to the paradox that the letter of intent is typically viewed both as a binding and a non-binding expression of the transaction terms, experience in the courts and in M & A practice indicates that a high percentage of letters of intent contain terms explicitly stated to be binding. These "binding" terms tend to deal not with the "deal points" but with regulation of the negotiation process, and typically include such items as "no-shop" clauses, breakup or topping fees, confidentiality and nondisclosure obligations, public announcements, payment of expenses and termination. In transactions between direct competitors, these are often the most fiercely negotiated terms, since failure to consummate the transaction could leave the seller substantially injured or the buyer unjustly enriched.

Two modes of bifurcating these inherently conflicting objectives have emerged in recent years. Some practitioners argue for placing binding and non-binding terms in completely separate documents, so that the letter of intent would deal only with a description of the proposed transaction, the purchase price, key ancillary agreements and important conditions; while a separate binding "lockup agreement" would cover the terms of the negotiating process and the consequences of termination. Alternatively, the American Bar Association Negotiated Acquisitions Committee which prepared the Model Stock Purchase Agreement has addressed this dichotomy by proposing the Model Letter. The Committee's proposal formally divides the letter of intent into two clearly separate parts, one intended to contain non-binding terms subject to a definitive written agreement, and another part containing covenants intended to be legally enforceable agreements of buyer and seller. To date, there are few reported cases to guide practitioners on how courts will view either of these approaches, although dicta in scattered lower court decisions indicates a tendency of trial courts not to regard as enforceable the portions of bifurcated letters expressly stated to be nonbinding.

In the absence of authority to support bifurcation as a sole defense to enforceability of a letter of intent as a binding contract, there are nevertheless precautions which can be taken in drafting such letters which should increase the chances that they will not be misconstrued. One of the simplest of these is to eschew the use of mandatory terms such as "shall," "will" and "must," substituting where possible more tentative or conditional terms such as "would," "proposed transaction," "summary of issues," "being considered by" and terms of like usage. An explicit statement as to which essential terms have not been definitively agreed should also assist in bringing the letter within the ambit of the key holding of Heritage, as would the avoidance of the use of "subject to," which implies a binding obligation subject a condition subsequent. Beyond the drafting of the document, however, courts have tended to examine the conduct of the parties post-letter. This is a more difficult area for lawyers to regulate, and about all that can be done on this count is to advise the client to take care not to act as if the letter were binding-probably one of the least likely-to-be-heeded cautions you will ever issue. Oral statements such as "Looks like we have a deal!" or handshakes can be considered evidence of an intention to be bound contractually. See cases cited at Model Letter, p. 349. In the final analysis, however, limiting the length of letters of intent may be the best defense to an assertion that a binding contract has been concluded. A short letter not only adds to the argument that major points remain to be discussed, but frequently a short letter keeps the negotiation process from bogging down and losing momentum at an early stage by burdening the process with too many difficult issues.

Notwithstanding the desirability of keeping letters of intent short, both from legal and business perspectives, parties differ in their negotiating strategies, and a substantial number of buyers (or their counsel) believe that the letter of intent stage is the ideal time to wrap up 90% or more of the "lawyer's issues" in the definitive documentation before the seller's lawyer ever sees the document. Sadly, this tactic is often effective. Most draft letters of intent either have been prepared by a lawyer for the buyer or have been cribbed from a draft prepared by a lawyer, while many sellers are lulled by the non-binding recitations in letters of intent into thinking that the terms can always be changed, and that it is too early a stage to involve their counsel. These are the negotiations that are usually over almost before they begin. To find an illustration of the terms that many lawyers find convenient to include in letters of intent, one need look no further than the Model Letter, which, after pages of admonishment in the Preliminary Note to keep the letter short, runs for no less than 17 pages (with commentary and annotations).

In summary, letters of intent continue to be controversial, but often encountered, fixtures in the M & A landscape, and a working knowledge of the issues and enforceability of these instruments is a useful tool for the Michigan lawyer.

D. Kerry Crenshaw is a member of Clark Hill PLC and Chairman of its Business Practice Group. He is located in the firm's Detroit office, where his practice is concentrated on international and domestic business transactions, principally in the areas of mergers and acquisitions, joint ventures, securities and intellectual property. He can be reached at (313) 965-8266 or at kcrenshaw@clarkhill.com. The author gratefully acknowledges the assistance of Michelle L. Mack of the University of Notre Dame Law School in the preparation of this article.