Letters of intent

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.

“Sometimes a letter of intent actually can be a contract. It really depends on the binding nature of the letter of intent,” points out Marshall Horowitz, partner in Alschuler Grossman Stein & Kahan LLP’s Transactional Department.

Smart Business spoke with Horowitz about how letters of intent should be used, when they should be made binding, and what type of legal disputes can arise if not done properly.

What is the basic principle behind a letter of intent?

A letter of intent is a way for businesspeople to gauge a level of interest in a project or transaction without having to go through the whole process of entering into a long-form contractual agreement. It can be an effective and cost-efficient way to determine the level of interest that parties have in a transaction. It also has the benefit of being able to focus the parties’ expectations about a deal, set up the key terms, make sure the parties are on the same page, and identify potential road blocks.

How does a letter of intent differ from a contract?

The pragmatic distinction is that a letter of intent is usually more of an outline of a potential business deal. The parties lay out the basic principles behind a deal and highlight some of the main points, but don’t describe in writing all of the details. In a contract, you want your i’s dotted and your t’s crossed.

The other distinction is that contracts with definitive documentation would almost always be binding, whereas only certain provisions are usually intended to be binding in letters of intent.

What are some of the business functions of a letter of intent?

Often, the business function of a letter of intent is for the businesspeople to avoid some of the costs and expenses of negotiating long-form documents. Sometimes, you will put confidentiality provisions in a letter of intent.

Although I would recommend that there is a separate disclosure agreement — especially if there is sensitive technology that might be discussed. Also, you can lay out timelines, major objectives and make sure that people understand the due diligence process.

How should a business negotiate a letter of intent?

The sooner they can bring their lawyers in, the better. At the end of the day, lawyers can look at potential pitfalls in a letter of intent that businesspeople might or might not be thinking about. For example, breakup-fee clauses are often put into letters of intent. These can sometimes be very significant sums, so you want to make sure that type of provision is done right.

Should businesses make their letter of intent binding?

If the parties actually intend to be bound, then certainly they should make it binding. However, normally, businesses only want some of the provisions to be binding. They really look at a letter of intent as more of a document that lays out the basic interest in doing some sort of transaction or working together on a project, but they know that they really need to do the detailed negotiation later on.

For example, the acquirer of a business knows that it might need to do a lot of due diligence before it finalizes the price and finalizes whether it wants to do a deal, but it wants to indicate its interest in doing the deal. In that case, the acquirer would only want certain provisions of a letter of intent to be binding.

What are some of the common legal disputes that arise from letters of intent?

The most common legal dispute is whether or not a letter of intent is binding. There is a well-known case, the Texaco/Pennzoil case, where I believe a jury awarded $9 billion to one of the parties over a letter of intent that the other party thought was not binding.

A typical dispute that might arise is if a business is looking to get some financing. They enter into a letter of intent and think it should be binding, but the financier never thought it was binding. The party receiving the financing is relying on the agreement, and they go ahead and take certain actions, stating that they had a binding letter of intent. This points out the need to have a well-drafted letter of intent that makes very clear which provisions, if any, are binding and which provisions, if any, are not binding.

MARSHALL HOROWITZ is a partner in Alschuler Grossman Stein & Kahan LLP’s Transactional Department. Reach him at (310) 255-9019.