A letter of intent is often used to confirm the mutual understanding of a prospective deal - in other words, the prelude to a full-blown agreement. All parties involved, however, should be aware that letters of intent have significant legal ramifications.
“A letter of intent is best understood as an intermediate step along the road to a fully documented agreement,” says Dick Jordan of White and Williams LLP. “However, if not carefully drafted, a letter of intent may be found by a court to be enforceable as a contract.”
Smart Business spoke to Jordan about the function of letters of intent, and some of the legal complications that can arise from them.
Are letters of intent binding?
A letter of intent can be entirely nonbinding, entirely binding, or have some provisions which are binding and others which are not, depending on the intention of the parties.
Difficulties arise when the parties don’t clearly understand whether some or all of the terms are binding or nonbinding. On the one hand, where the parties have agreed on the essential terms, an intention to later formalize the agreement by writing does not prevent the formation of a contract. When the letter of intent is ambiguous, a court has to determine where a particular document might fall on the spectrum between “nonbinding” and “clearly binding.”
The court’s determination may turn not only on the words the parties used to express their intention, but on what was both said and done by the parties. That is, the parties’ actions and conduct will be considered in determining whether a contract exists. The parties’ own interpretation will ordinarily be adopted by the court.
What business functions are served by a letter of intent?
Letters of intent are a common part of many business transactions.
For example, the prospective purchaser of a commercial property might want to tie up the property while it explores zoning, financing or obtaining an anchor tenant. An agreement to keep the property off the market might be a binding provision, whereas the buyer’s obligation to complete the transaction may be completely nonbinding. If a seller of real estate believes he has a particularly good deal, he may want a letter of intent for the comfort of knowing the property is in fact sold if a certain limited number of contingencies are met.
Letters of intent are often a part of business mergers or acquisitions. In such a case, the acquirer would favor a letter of intent before it goes to the time and expense of due diligence. The letter of intent would typically contain binding confidentiality provisions. On the seller’s side, it may provide a break-up fee if the transaction does not go forward, to compensate the seller for time, expenses and other lost opportunities.
On the buyer’s side, the letter may provide for an “exclusive dealing” period, to enable the buyer the exclusive right to close the transaction.
What are some common disputes that arise under letters of intent, and how do you counsel clients?
Because a letter of intent is often extensively negotiated, if there is not a lot of subsequent due diligence necessary, it is probably more economical in the long run and less fraught with possible disputes to go immediately to a full agreement.
On the other hand, the discipline involved in negotiating a letter of intent often forces the parties to get their arms around the essential terms of the agreement at an early stage of negotiation. It can help the parties determine whether the material terms are going to be acceptable before they spend a significant amount of time and expense in negotiating and preparing the entire agreement.
The most common problem relating to letters of intent concerns whether the language of the letter is mutually intended to be binding.
Where the letter of intent explicitly states that it is nonbinding, or specifically conditioned on some later event or third-party approval, a court will not find a contract.
Where the letter of intent leaves open further negotiation, a number of the cases have considered whether or not such a letter implies a duty to negotiate in good faith. A federal court sitting in Pennsylvania has predicted that the Pennsylvania courts would find such a duty, but to date no Pennsylvania court has so found.
As with all terms in a letter of intent, where a promise is unequivocal, it will be enforced. When it is vague, it is not likely to be enforced. If the open item is an essential term of the transaction, a contract is less likely to be found than where the open items are generally matters of routine boiler plate.
DICK JORDAN is chair of the Business Litigation Group at White and Williams LLP. Reach him at (215) 864-7106 or [email protected].