Letters of intent

Formal letters of intent are usually integral to the process of consummating a
business transaction — especially larger more complex transactions. Those
letters can be legally binding or nonbinding. Confuse the issue, and it can become a
costly proposition.

In order to avoid any missteps when
drafting a letter of intent, it is absolutely
necessary to consult with an attorney.

“The main reason to consult an attorney
is to create a well-drafted and well-thought-out letter of intent,” says Michael J.
Petersen, a partner with Shulman Hodges
& Bastian LLP. “A lawyer experienced in
transactional work can help a client avoid
pitfalls that will come back later when
enforceable agreements are negotiated. He
or she can provide you with a letter that is
either binding or nonbinding, depending
on which option is best for your company.”

Smart Business talked to Petersen about
the confusion that can exist in situations
that calls for a letter of intent.

What is a letter of intent?

Letters of intent are the first step toward
contracting between the parties involved in
a transaction. The classic definition of a letter of intent is a document that is supposed
to be nonbinding and that describes the
critical elements of a transaction. However, as deals have evolved into larger and
more complex structures, binding letters
of intent — which give a short summary of
key provisions of a deal — are now being
used. Letters of intent can have very substantial legal and financial implications.
They reflect commitment on both sides,
and the parties involved often will commence making corporate decisions based
on a letter of intent.

Part of what a letter of intent does is help
parties think through and agree on key
terms of the contemplated transaction. It
forces precision and forethought. Even if it
is a nonbinding letter, it will be used by
both sides as an agreement in the negotiation process if either side attempts to vary
from its terms.

A great deal of preliminary negotiation
goes into a letter of intent because key elements of a deal are included, such as pricing. Also, as transactions have become
more complex, it is almost a necessary
step to put key elements of the deal on
paper so that both parties can have the
same intention before a contract.

Specifics can vary from relatively little
detail to quite detailed. The more detailed a
letter of intent is, the more likely it is to be
ruled binding. In a typical transaction, the
letter of intent will tend to be three pages
to six pages in length and not overly
detailed. It will hit upon the key aspects of
the deal, like price, assets and closing time-lines. It might also include a binding confidentiality agreement.

A short letter of intent often becomes a
20-page to 60-page legal contract — or
even longer — when the final, legally
enforceable contract is drafted. Rarely will
you see a letter of intent spell out dispute
resolution, arbitration provisions, choice
of law and details of closing.

A well-drafted letter of intent also works
as a disclaimer. It usually begins and ends
with, ‘This is a nonbinding letter of intent.
Any final agreement is to be negotiated between the parties and will include additional significant terms.’ That helps establish the intent of the parties — but it’s not
necessarily a silver bullet.

Why be so careful about signing a letter of

It is possible for businesses to believe
that they are not bound by a letter that
actually is binding. If a dispute arises, the
courts examine the letter itself and the
behavior of the parties — including any
press releases or other communication —
to determine if the parties are legally
bound to the terms of the letter.

What kind of disputes can arise between the
two parties that have signed a letter of

Obviously, the biggest is whether it is
binding or nonbinding, which is only tested
if the deal falls apart. Not going forward
can end up being an extremely expensive
process for one of both of the parties

The largest trial verdict in this country’s
history was $10.6 billion. The issue was
whether a letter of intent was binding or
nonbinding. Pennzoil had entered into a
memorandum of agreement to acquire
Getty Oil. Texaco made overtures and ultimately purchased Getty for more money
than Pennzoil had offered in the memorandum. The Texas courts found that the
memorandum was, in fact, a binding agreement, and Texaco was liable to Pennzoil
for $10.6 billion.

The lesson is that you can have a poorly
drafted letter of intent that contains
enough detail that the court deems it a
binding contract. And the core moral is
that you need a lawyer to help you make it
either binding or nonbinding, depending
upon the approach you want to take.

MICHAEL J. PETERSEN is a partner with Shulman Hodges &
Bastian LLP. Reach him at [email protected] or (949) 340-3400.