Letters of intent, or LOIs, serve an important purpose in corporate deals and M&A, and their use is widespread. Equally widespread is litigation concerning their enforceability. Unless commercial parties are careful, they may find themselves embroiled in litigation even though they never intended for their preliminary agreement — whether in the form of an LOI or a term sheet — to be enforceable. LOIs that are vague, ambiguous or imprecise present a ripe opportunity for a jilted party to create litigation mischief. To protect against claims for damages based upon an LOI following termination of negotiations, parties are advised to carefully and expressly differentiate between the provisions of the LOI that are binding and those that are not, and choose a governing law that will respect the nonbinding aspects of the LOI.
As courts have long recognized, LOIs are “a customary device used within the financial community, and it is clear that the financial community does not regard such a document as a binding agreement, but rather, an expression of tentative intentions of the parties.” Parties are bound by an LOI only when they so intend, and only when they view a later written contract as merely a formality. “‘If parties intend to be bound by their preliminary agreement and view the later written contract as merely a memorialization of their agreement, they are bound by the preliminary agreement.’ Otherwise, the parties are not bound by the letter of intent.”
Noting that “[a] primary concern for courts in such disputes” concerning the enforceability of preliminary agreements “is to avoid trapping parties in surprise contractual obligations that they never intended,” one seminal decision in this field described the governing principles this way:
It is fundamental to contract law that mere participation in negotiations and discussions does not create binding obligation, even if agreement is reached on all disputed terms. . . . Nor is this principle altered by the fact that negotiating parties may have entered into letters of intent or preliminary agreements if those were made with the understanding that neither side would be bound until final agreement was reached.
A typical LOI might recite many if not most material terms, including a price term, financing and other conditions. Or the LOI might leave some material terms to be negotiated. An LOI will likewise often recite a provision disclaiming any legal obligations. For example: “This LOI is an expression of intent only. This LOI does not constitute an offer to buy or sell and shall not be binding…. Except as expressly set forth here, no legally binding agreement shall arise between the parties unless and until a definitive agreement shall have been executed by Buyer and Seller in their sole discretion.”
Often, however, parties will carve out, as binding, provisions concerning confidentiality and/or exclusivity — to provide some protection to a prospective buyer before it invests time and resources in a potential acquisition. The LOI may also contain a provision requiring the parties to negotiate in good faith. The parties are free to denominate that provision binding or nonbinding. Or, the LOI may be silent as to whether that provision is binding.
Choice of law and forum issues
LOI litigation is an area in which choice of law and choice of forum make a significant difference.
If one wishes to maximize the chances of avoiding liability for breach of an LOI, then the LOI should provide for application of New York law and a New York forum. New York courts generally have extensive experience with LOIs, and the leading cases in the area have been decided by New York courts, both federal and state.
New York courts routinely dismiss on the pleadings breach of contract claims when the parties have executed a preliminary agreement specifically stating that the LOI is not binding or that conditions the parties’ obligations on definitive documentation. And New York courts generally do not permit parties to recast legally defective LOI breach of contract claims as claims for promissory estoppel or unjust enrichment.
New York courts likewise do not allow parties to substitute legally defective LOI contract claims as claims for breach of a supposed good faith duty to negotiate. And unlike other jurisdictions, New York courts do not recognize a duty of good faith and fair dealing separate from obligations explicitly recited in a binding contract. In other words, an LOI plaintiff who cannot sustain a breach of contract claim will not be able to sustain a claim for breach of the duty of good faith and fair dealing; so-called duty of good faith and fair dealing cannot be used to imply terms or require parties to negotiate, unless the LOI contains an explicit binding provision so stating.
Damages are another area in which New York law makes a big difference. As a general matter, the only damages recoverable for breach of a provision of an LOI specifically denominated as binding — for example, binding exclusivity or confidentiality provisions — are reliance or out-of-pocket damages. Expectation or benefit-of-the-bargain damages are not recoverable.
In Goodstein Construction Corp. v. City of New York, 80 N.Y.2d 366 (1992), a real estate developer sought benefit-of-the-bargain damages after New York City had terminated the parties’ letter agreements concerning the development of urban renewal sites. The letter agreements provided that the developer had the exclusive right to negotiate to develop the land, but the agreements stated that any binding obligation on the city’s part was contingent on the fulfillment of various legal requirements, and that the city had the right to terminate negotiations at any time. Id. at 369. After the city discontinued negotiations, the plaintiff sued for breach of the letter agreements, premised on the city’s alleged discussions with a third party and other purportedly bad faith conduct in connection with the negotiations. The developer sought, in addition to out-of-pocket reliance damages, the lost profits that supposedly would have been realized had the proposed development gone forward with the city.
The New York Court of Appeals held that “both the law and logic” precluded recovery of lost profits for alleged breach of the exclusivity provisions of the agreements. Id. at 373. The parties’ relationship in Goodstein was governed not by a final contract of sale, but rather by preliminary agreements to negotiate a final contract exclusively with the plaintiff. Id. at 372. The court held that with respect to the availability of benefit-of-the-bargain damages, “the distinction is crucial.” Id. The developer’s claim for lost profits was “based upon the City’s anticipated performance of the obligations it would have undertaken assuming that the negotiations had progressed to agreement. . . .” Id. at 373. Under the letter agreements, however, “[t]he City was neither bound to agree to [a final contract] nor to continue the negotiating process.” Id. Therefore, “[t]o allow the profits that plaintiff might have made under the prospective [final contract] as the damages for breach of the exclusive negotiating agreements would be basing damages not on the exclusive negotiating agreements but on the prospective terms of a nonexistent contract which the City was fully at liberty to reject.” Id. That “would, in effect, be transforming an agreement to negotiate for a contract into the contract itself.” Id.
By contrast, other jurisdictions, including for example Delaware, may allow for recovery of expectation damages for breach of a preliminary LOI under certain circumstances.
Letters of intent perform the useful function of mapping out a framework for discussion among parties to a potential acquisition transaction. By setting out the basic terms and structure of a contemplated deal, the LOI provides assurance of a reasonable prospect that the parties will achieve a meeting of the minds, and that the resources to be expended in negotiation will lead to a definitive agreement. The parties must be alert to the possibility, however, that their counterparty, disappointed with the failure to reach agreement, may use the LOI as a basis for litigation and seek to extract reliance or even benefit-of-the-bargain damages. A carefully crafted LOI, and an appropriate choice of governing law, should mitigate this risk.