Letters of intent Featured

7:00pm EDT November 25, 2007

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 intent?

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 intent?

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 involved.

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 mpetersen@shbllp.com or (949) 340-3400.