A “letter of intent” (LOI) is a unique and useful instrument in conducting business transactions. Used most commonly in proposed acquisitions, LOIs permit the parties to document their understanding of key deal points and express their expectations of what each party will and will not do. But an LOI can also be an inherently contradictory exercise, particularly regarding the all-important question of whether the LOI is a binding legal document. Parties to an LOI can find themselves on the wrong end of a lawsuit arising from a document they thought was unenforceable.

However, the risk of litigation can be significantly reduced through careful drafting. Paying attention to the wording of an LOI is critical both to establish the expectations of the parties and to avoid liability in the event the contemplated transaction is never consummated.

Binding vs. non-binding

The non-binding clauses of an LOI will often include information such as a proposed price for the transaction, the subject of the transaction (e.g. the assets to be acquired or product to be supplied), an approximate timeline and any expectations as to how negotiations may proceed. These sections ensure the parties have analogous impressions about the transaction as dialogue continues and due diligence begins. Generally, these portions of the agreement will be expressly labeled as non-binding to confirm that the parties intend them to establish a framework, not a binding commitment.

An LOI will also generally include binding provisions to protect both parties. To conduct due diligence, a buyer will often need sensitive financial and organizational information. Accordingly, most LOIs will contain a confidentiality provision. The disclosing party would want to ensure these confidentiality obligations are not only binding, but also survive if the negotiations break down. Additionally, LOIs often contain an exclusivity clause that precludes the selling party from soliciting or accepting offers from anyone else during a specified period. Exclusivity provisions should be expressly made binding to ensure the buyer doesn’t invest time and money in due diligence only to be ousted from the deal by someone else.

Covenant of good faith

While much litigation can be avoided by clearly documenting which provisions are binding and which are not, a less obvious risk comes from claims arising out of the implied covenant of good faith and fair dealing (the covenant). The covenant includes “an implied duty that contracting parties refrain from actions that will intentionally destroy or injure the other party’s right to receive the fruits of the contract.” It exists whenever a contract is entered into and is imposed on the parties so long as it remains consistent with the agreed upon, common purpose of the contract. A violation of the covenant amounts to a breach of contract and can result in the same legal liabilities as breaching express contractual terms.

Due to the unique nature of LOIs as having both binding and non-binding provisions, determining how to ensure against an alleged breach of the covenant can be complicated. For example, it would be logical to assume that if the parties’ document stated the buyer could unilaterally terminate negotiations for any reason, there could be no cause of action if the buyer exercised that right. However, at least one Utah Supreme Court case suggests otherwise, although not in the specific context of an LOI. In Resource Management v. Weston Ranch & Livestock, the Utah Supreme Court held that a contractual provision allowing a party to unilaterally terminate an agreement “was circumscribed by the requirement that it exercise it in good faith …”

Thus, a party to an LOI would be well-advised to avoid any arbitrary action that might injure the other side. But Utah law is also clear the covenant must be construed in a manner consistent with the agreed common purpose and justified expectations of the parties, and the covenant “cannot create rights and duties inconsistent with express contractual terms.”

This makes it all the more important to be clear in the document itself what the parties intend and understand about their obligations. Although the risk of litigation can never be eliminated, it can be mitigated by following a few simple recommendations:

Specificity is key: Unambiguously state which provisions are legally binding and which are not. Clearly express that the non-binding clauses are not intended to be enforceable against the parties.

Comply with the covenant: Assume the implied covenant of good faith and fair dealing will apply to the binding provisions of your LOI and may apply to the LOI as a whole. Avoid actions that appear arbitrary, and never suggest that you are doing something “just because.”

Actions matter: Courts can conclude the parties actually intended more binding effect than they expressed based on post-execution conduct. Don’t treat non-binding provisions as binding or threaten to sue for breaches of the non-binding provisions.

Consider separate documents: By placing binding provisions in a document separate from an expressly non-binding LOI, the risk of being held liable under the LOI will be reduced.

Consult an attorney: It may sound obvious, but consulting a competent attorney at the outset of a contemplated transaction is always the best way to ensure your interests are protected.

Evan S. Strassberg is a partner in the Salt Lake City office of Michael Best with more than 18 years of experience as a commercial litigator.

 

 

 

 

 

Elmon B. Tanielian is a third-year student at the Pepperdine University School of Law who will be joining Michael Best following her graduation in the spring of 2017.