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What You Need To Know About Drafting and Living with Letters of Intent
I. The Risk of an Unintended Binding Contract.
Blue, Inc. and Green, LLC, two sophisticated commercial parties, agree to begin negotiations for the formation of a joint venture. Blue and Green are both enthusiastic about the proposed venture and believe it would be a profitable endeavor. Green drafts a letter of intent and both parties sign it. The letter of intent lists the basic elements of the proposed venture. It also provides – in its opening paragraph – that the parties are not entering into a binding agreement and do not intend to be bound unless and until several other agreements – the deal documents – are fully negotiated and signed.
Blue and Green then begin to negotiate the specific terms of the proposed venture. During the following 18 months, they exchange numerous red-lined drafts of the deal agreements. Blue and Green also collaborate in planning and preparing for the venture: their executives work closely together on developing a business plan and often refer to one another as “partner” in email communications. Blue and Green form a jointly-owned LLC, which would eventually manage the proposed venture, although neither party contributes any capital to it. Blue, on behalf of this newly formed LLC, places a multi million order for several pieces of equipment that would be used in the venture’s business, although it is ultimately canceled. Blue also hires an architect and an interior decorator to design a facility that it would eventually lease to the joint venture and involves Green in the design process. The parties also design the signage for the new facility and even set a date for a groundbreaking ceremony to mark the beginning of the facility’s construction. After 18 months, Green and Blue have agreed on nearly all the terms of the venture agreements, although neither party has signed any of the agreements.
At that time, however, regulatory changes lead Blue to the conclusion that the proposed venture would be a losing proposition. Blue announces that it will not proceed with the venture. Green, dismayed, sues for breach of contract. Because neither party signed any of the (nearly finalized) venture agreements, Green claims that the parties are bound by a conduct-based oral agreement. Green seeks to recover over $20 million in alleged lost profits.
So, which prevails – the parties’ initial express agreement not to be bound until certain conditions are met, or their subsequent conduct, which arguably evidences mutual intent to be bound?
Unfortunately, this is not an unusual chain of events. The sheer number of cases across the country involving some version of this scenario reflects the inherent risks involved in drafting a letter of intent and, more significantly, living with one. A carelessly drafted letter of intent can be viewed by one party as a binding agreement while the other party believes it is merely a tentative framework for future negotiations. But, as the Green vs. Blue case demonstrates, even a well-drafted, expressly non-binding letter of intent may not be enough to save a party from the costs and uncertainty of litigation when the parties’ subsequent communications or conduct could be interpreted as intent to be immediately bound or, worse, as actual performance of an oral agreement.
In other words, it is not enough to draft the perfect letter of intent. In-house counsel and businesses should be aware of the possible consequences of subsequent communications (particularly written ones, including email) and other conduct that may later be construed as superseding or somehow waiving the earlier agreement not to be bound. In the real world of complex business transactions, where significant investment and collaboration are routinely required just to reach a deal, it is often impossible to avoid such communications or conduct. Bearing the risks in mind and following a few simple guidelines, however, will help to keep both parties’ expectations aligned and may save either party from the unintended consequence of a binding agreement or, at the very least, from costly litigation.
II. How Do Courts Deal With Letters Of Intent?
In Arizona, as in virtually every jurisdiction in this country, a contract (including a partnership) may be found based on parties’ oral communications or conduct if it is clear the parties intended to bind themselves, even where they also plan to formalize their agreement in writing and even if certain terms are still missing. Blue and Green did much more than negotiate the terms of the proposed venture. They engaged in collaborative preparatory work: They drafted a business plan, formed a joint entity, worked together to design the venture’s facility and even ordered equipment to be used in the venture’s ongoing business. Putting aside the letter of intent, Green would have a strong argument that the parties are bound by a conduct-based agreement and all that remained is the mere formality of executing the already agreed upon and deal documents.
The same “policy of the law [which] favors enforcement when it is clear that the parties intended themselves to be bound,” however, also mandates enforcing the parties’ intent not to be bound until certain conditions are met. Thus, courts give effect to non-binding letters of intent. As the Arizona Court of Appeals stated: “where there is an express nonbinding clause, we will honor it and not look to surrounding circumstances to imply an obligation at variance with the express clause.” Courts have long recognized that, even if the parties have agreed on all the terms of the proposed contract, they may also “agree that reduction to writing and formal execution of a contract will be necessary to create binding relations.” Indeed, the very purpose of a non-binding letter of intent is to “eliminate confusion about when a binding contract arises.”
Courts especially recognize this freedom to avoid unintended oral agreements where – as in the Green vs. Blue case – sophisticated business parties engage in negotiations of complex business transactions. As the Seventh Circuit observed:
A complex business transaction … requires a significant expenditure of time, effort, research and finances simply to arrive at its terms. The books of the companies must be carefully reviewed, difficult judgments of valuation must be made, financing must be secured, new corporations may have to be formed, and various timing and risk allocation issues must be spelled out in detail in the purchase and sale contract, obviously incurring substantial legal fees. Depending upon the specifics of the deal, other professional services such as accounting and financing may have to be commissioned as well. Together, all these costs in executing a complex transaction may consume more than a trivial portion of the benefit the parties hope to realize.
Particularly in the case of such complex transactions, where expensive groundwork is often an inevitable reality, the parties’ express allocation of risk must be honored. As another court noted: “the magnitude and complexity of the deal as reflected in the numerous written drafts not only reinforce the parties’ stated intent not to be bound until written contracts were signed, but also reflect a practical business need to record all the parties’ commitments in definitive agreements.”
III. Green vs. Blue: Lessons Learned
In Blue’s and Green’s case, the answer should be clear: the only agreement Blue and Green have ever executed was a letter of intent in which they expressly stated neither party was bound by a contract unless and until both parties fully negotiated and signed several venture agreements. Nevertheless, Green filed a lawsuit alleging that – through its conduct during the 18 months following the execution of the letter of intent – Blue demonstrated its intent to be bound, thus impliedly waiving the letter of intent’s non-binding provision. Green lost. The court dismissed its lawsuit on summary judgment, correctly giving force to the express provisions of the letter of intent. There are, however, some important lessons to be learned.
First, and most obviously, a letter of intent containing an express non-binding provision and specifically stating the conditions precedent to a binding agreement (be it formal execution, approval by a board of directors or a third party) is absolutely necessary to avoid an unintended oral agreement. Without the non-binding language, Green would have probably prevailed in its lawsuit.
Second, even a well drafted non-binding letter of intent may not be enough if the people who negotiate the deal are unaware of the possible consequences of their conduct. In this case the court rejected the notion that Blue somehow waived the non-binding agreement, but would the court’s conclusion have been different under more ambiguous circumstances? Would an email from Blue’s senior executive exclaiming “its great to finally have a deal” after the last red-lined draft had been approved change the court’s conclusion that no triable issues existed? Would the fact that one or both parties had actually invested capital in the jointly formed entity change this conclusion? What about the fact that the custom-made, costly technical equipment needed for the venture’s operation has been manufactured, or delivered? The further the parties progress on the continuum that begins with a tentative agreement to explore a deal and ends with the actual performance of the venture’s business, the more difficult it would be to persuade a court that they did not intend to be bound.
Finally, Green filed a suit despite the clear judicial policy enforcing express non-binding provisions. Green is not unique. Again, the sheer number of similar cases across the country shows that plaintiffs often try (and every now and then succeed) in convincing courts to find an oral agreement notwithstanding an initial agreement not to be bound. If nothing more, these cases present a significant litigation risk and, as all litigators know, litigation is rarely a cost-effective way to resolve a dispute. In this case, although it prevailed on summary judgment and was granted a fee award, Blue had to invest both fiscal and human resources in litigation and bear the uncertainty entailed in litigation for well over a year. The cost and risk would have increased substantially had this dispute proceeded to a jury trial.
IV. Is There A Duty To Negotiate In Good Faith?
The letter of intent Blue and Green executed also contained the following short and seemingly innocuous provision: “The parties agree to negotiate in good faith.” In addition to its breach of contract claim, Green argued that Blue had breached this duty by backing off from the proposed venture after months of preparation and after the deal agreements have been virtually finalized. Green lost this argument as well, but it raises a few red flags. In retrospect, Blue would have been more prudent to leave this provision out of the letter of intent.
Every contract contains an implied covenant of good faith and fair dealing, but because this obligation assumes the existence of a binding contract, no such covenant is implied in a non-binding letter of intent. But negotiating parties who execute a letter of intent should not automatically assume they are free of good faith obligations. Although a mere “agreement to agree” is too indefinite to enforce, most jurisdictions, including Arizona, have recognized that an agreement to negotiate in good faith within a reasonably certain framework is enforceable.
Like Blue and Green, therefore, parties can create a binding promise to negotiate in good faith even in an otherwise non-binding letter of intent. A duty to negotiate in good faith can also be implied, however, where the letter of intent (or term sheet) is construed to be a binding contract itself. This is another good reason to include clear non-binding language in the letter of intent. In an oft-cited case, a New York District Court found that the parties to a letter of intent bound themselves to a framework of basic, yet incomplete terms. The court found that each party was under an implied duty to negotiate the remaining terms and was not free to withdraw from the deal for reasons outside the agreed-upon framework. In another case, the Third Circuit found an implied duty to negotiate in good faith where the letter of intent contained a property owner’s “unequivocal promise” to “withdraw [the property] from the rental market, and only negotiate the … leasing transaction to completion.” The Circuit court remanded the case for trial to determine whether the defendant breached its duty to negotiate in good faith by terminating the negotiations.
To negate the argument that your client acted in bad faith by withdrawing from negotiations late in the game (and the accompanying argument that it was equitably estopped from withdrawing), the letter of intent must contain non-binding language. Courts do not imply a duty to negotiate where a letter of intent is expressly non-binding. And, even if the parties did include a “duty to negotiate in good faith” clause in their non-binding letter of intent, courts have widely recognized that an agreement to negotiate is not a promise to close the deal.
Importantly, damages for breach of an agreement to negotiate are limited to plaintiff’s out-of-pocket costs and, where applicable, opportunity costs in conducting the negotiations (reliance damages). Unlike a breach of contract claim, this claim will not afford the plaintiff it lost profits. Nevertheless, the volume of litigation over agreements to negotiate in good faith demonstrates that such provisions can open the door to additional arguments and increase litigation risk. Businesses who wish to maintain the greatest amount of flexibility in negotiations should carefully consider whether an agreement to negotiate in good faith is beneficial.
V. Some Practical Suggestions
In the real world, businesspeople who are trying to close a deal cannot and should not be expected to insert legal qualifiers (like “this is subject to our non-binding letter of intent”) when communicating with the other party and, as the Seventh Circuit recognized, complex transactions typically entail lengthy negotiations, significant costs and collaborative effort. Still, educating the people who work on the deal and following some basic guidelines would considerably mitigate the risks or unintended oral agreements and litigation.
- Have a Letter of Intent. A letter of intent or term sheet with an express non-binding provision is necessary. It should clearly state what conditions must be met for the parties to be bound (e.g., formal execution of certain agreements; approval by board of directors).
- Do not call the Letter of Intent “Agreement.” This initial document should be entitled “Letter of Intent “ or “Term Sheet.” It should not be entitled or referred to as an “agreement” or “contract.”
- Make it clear who has the authority to revise the letter of intent: The letter of intent should specifically state who – within each party – has the exclusive authority to revise, amend or waive the letter of intent’s provisions. If, for example, board action is required to amend the letter of intent, a careless “we have a deal” email from an enthusiastic executive will not be enough to support the argument that the defendant considered itself bound.
- Drafts should be labeled “draft.” All agreement drafts should be labeled “Draft” or, even better, “Draft – subject to [date] Letter of Intent.”
- Consider if you need a “Duty to Negotiate in Good Faith” provision. Avoid agreements to negotiate in good faith unless necessary. Also avoid language suggesting that your client is obligated to negotiate the deal to completion.
- Educate, educate, educate. Most importantly, in-house or outside counsel should educate their business clients on the risk of unintended oral agreements. Again, the point is not to chill business negotiations or to curb the preparatory collaborative work necessary for the deal to close. Rather, well informed businesspeople, will make better choices. They will refrain from making possible damaging statements in conversation or emails (like “don’t worry about that letter of intent” or “we have a deal, partner!”) that may be later used to argue that the defendant no longer stood by its initial intent not to be bound. When appropriate, an executive may also use language like “subject to our letter of intent” or “subject to the execution of the deal documents” in communicating with the other party.
- Everything is discoverable. Clients should also be reminded that all (non-privileged) internal documents and communications will be disclosed in litigation. They should take care to avoid from making damaging statements not only in communicating with the other party, but also in internal communications.
Non-Binding Nature; Binding Provisions. This Letter of Intent, together with the Term Sheet, is solely for the purpose of summarizing the current intentions of the Parties with respect to the potential transaction contemplated under this Letter of Intent and the Term Sheet as reflected in discussions to date, and it is expressly understood that (a) this Letter of Intent is not intended to, and does not, constitute an agreement to enter into the Operating Agreement, and (b) the Parties hereto will have no rights or obligations of any kind whatsoever relating to the transaction contemplated under this Letter of Intent unless and until the Operating Agreement is executed and delivered, and then only to the extent set out therein.
This letter constitutes an outline of the basic terms upon which Seller would consider selling the Property to Purchaser, but it is not intended to be, and is not, a binding contract. The parties do not intend to be bound by this letter of intent, nor do they intend to have any obligations to the other, including, without limitation, a duty of good faith, until both parties sign and deliver a formal written Purchase and Sale Agreement and Escrow Instructions (the “Purchase Agreement”). This letter does not obligate either party to continue to negotiate and/or to proceed to the completion of the Purchase Agreement, it being understood that, unless and until the Purchase Agreement is signed and delivered by both parties, either party may withdraw from negotiations at any time and for any reason. Therefore, any cost incurred or actions taken by either of the parties in the absence of such an executed and delivered Purchase Agreement will be at such party’s sole risk and cost. No member, manager, agent, partner or representative of Seller has the authority to enter into oral agreements on behalf of Seller. Neither party may reasonably rely on any statement or promise inconsistent with this paragraph.
1 See, e.g., Tabler v. Indus. Comm. of Arizona, 202 Ariz. 518, 47 P.3d 1156 (Az. App. 2002); AROK Const. Co. v. Indian Const. Services, 174 Ariz. 291, 848 P.2d 870 (Az. App. 1993).
2 Johnson Int’l, Inc. v. City of Phoenix, 192 Ariz. 466 (Az. App. 1998).
3 Id., 192 Ariz. at 473. See also Lininger v. Sonenblick, 23 Ariz. App. 266, 268, 532 P.2d 538, 540 (App. 1975) (citation omitted) (“Where it is clearly understood that the terms of a proposed contract, though tentatively agreed on, shall be reduced to writing and signed before it shall be considered as complete and binding on the parties, there is no final contract until that is done.”)
4 Feldman v. Allegheny Int’l, Inc., 850 F.2d 1217, 1222 (7th Cir. 1988).
5 Feldman, 850 F.2d at 1219. i, 751 F.2d 69, 74 (2nd Cir. 1984) (“The point of these rules is to give parties the power to contract as they please, so that they may, if they like, bind themselves orally, or by informal letters, or they may maintain ‘complete immunity from all obligation’ until a written agreement is executed.”)
6 Feldman, 850 F.2d at 1221.
7 Reprosystem, B.V. v. SCM Corp., 727 F.2d 257, 262-63 (2nd Cir. 1984). See also Phoenix Mut. Life Ins. Co. v. Shady Grove Plaza Ltd. Partnership, 734 F. Supp. 1181, 1188 (D. Md. 1990) (“The large amounts involved and the complexity of [the] transaction highlight the practical business need to have the parties’ legal obligations recorded in formal documents”); Kona Hawaiian Associates v. Pacific Group, 680 F. Supp. 1438, 1454 (D. Haw. 1988) (noting that business entities ordinarily do not enter into multi-million dollar transactions in the absence of a comprehensive writing).
8 Johnson, 192 Ariz. at 473-74.
9 See e.g., Schade v. Diethrich, 158 Ariz. 1, 9, 760 P.2d 1050, 1058 (Ariz. 1988).
9 Johnson, 192 Ariz. at 473; Rennick v. O.P.T.I.O.N Care, Inc., 77 F.3d 309 (9th Cir. 1996).
11 Teachers Ins. and Annuity Ass'n of America v. Tribune Co., 670 F. Supp. 491 (S.D.N.Y. 1987).
13 Channel Home Centers v. Grossman, 795 F.2d 291 (3rd Cir. 1986).
14 Id. at 300.
15 Johnson, 192 Ariz. at 473.
16 See, e.g., A/S Apothekernes Laboratorium for Specialpraeparater v. I.M.C. Chemical Group, 873 F.2d 155, 159 (7th Cir. 1989) (citations omitted) (The letter of intent, however, ‘was merely an agreement to negotiate, not a promise that those negotiations would be fruitful.’ …. A duty to negotiate in good faith does not encompass an automatic duty to approve the final deal. A letter of intent is no guarantee that the final contract will be concluded, even if the parties fulfill their good faith obligations.”)
17 See, e.g., Copeland v. Baskin Robbins U.S.A., 117 Cal.Rptr.2d 875, 885 (Cal. App. 2002).