Letters of intent (also known as heads of terms or memoranda of understanding) are commonly used in commercial transactions. They are a means by which parties to commercial negotiations document the progress of those negotiations pending completion of the final contract. A recent case in the High Court has highlighted the fact that letters of intent may be fully binding.

Advantages

Letters of intent can be a useful commercial tool. They enable the parties to flush out what the significant issues are and provide written confirmation of the main terms agreed in principle so far. This helps to avoid any misunderstandings about what has actually been agreed and provides a useful ‘road map’ and timetable for the direction of future negotiations. A letter of intent can be used as a basis for instructing professional advisers and as a framework for the final contract.

Furthermore, although the letter of intent may or may not be legally binding, it is at least firm evidence that the parties do intend to enter into the final contract and so creates a strong moral commitment to the commercial relationship.

Disadvantages

The parties may begin work on the agreed project once the letter of intent has been signed. There is a risk that their focus will be on progressing the project rather than on the potentially difficult contractual issues which have yet to be agreed. The parties may become diverted and the negotiations leading up to completion of the final contract can lose momentum. If the parties don’t go on to negotiate the details, there is a risk that key issues in the final contract will be unclear and ‘fudged’ or that the final contract will never be signed.

The fact that the parties have entered into a letter of intent can also subsequently limit the room that the parties’ advisers have for negotiation of the final contract.

Legally Binding?

Parties are often unclear about the legal effect of letters of intent, in particular whether they are legally binding. In fact, letters of intent can be legally binding. Whether any particular letter of intent is legally binding will depend on all the circumstances of the transaction, including the conduct of the parties themselves.

This was illustrated in the recent case of RTS Flexible Systems v Molkerei Alois Muller GmbH [2008]. In this case, the High Court held that a letter of intent entered into by RTS and Muller, which contained no express indication of whether its terms were intended to be binding, did amount to a legally binding contract between the parties. The court found that the comprehensive terms included and the language used meant that the letter of intent was sufficiently certain and complete to be given contractual force.

Commercial Implications

To ensure that a letter of intent has the legal effect that you intend and to maximise its commercial benefits you should ensure that it is carefully drafted (preferably by legal advisers). The following are some of the practical points that should be considered when drafting a letter of intent: 

  • Letters of intent are intended to be merely an outline of the main terms agreed so far with the final contract putting the ‘flesh on the bones’. State the agreed principles only and defer the detail to the final contract; 
  • To avoid the legal uncertainty that existed in the RTS case and to ensure that a binding contract is not entered into inadvertently, it should be made clear in the letter of intent whether the terms are intended to be legally binding. Include a clause that stipulates whether none, some or all of the terms are to be legally binding. It may be sufficient to limit these to the governing law and confidentiality terms. In corporate finance transactions, the exclusivity or lock out provisions may be binding. In other cases, it may be appropriate to specify that all terms are binding, including limits of liability. Much will depend on the circumstances of the particular transaction. Use of the words ‘subject to contract’ is probably insufficient for this purpose. Although, arguably, they suggest that none of the terms are intended to be legally binding it is probably preferable to say this more clearly by actually using the words ‘not intended to be legally binding’; 
  • There is no magic in the names ‘letter of intent’, ‘heads of terms’ or ‘memoranda of understanding’. They are just different names for the same thing and it is still necessary to indicate whether none, some or all of the terms are intended to be legally binding; 
  • Warranties should be expressly non-binding terms or, preferably, deferred to the final contract altogether; 
  • State expressly the intended duration of the terms in the letter of intent. Otherwise, if the final contract is never signed, there is risk of the courts finding that the relationship is governed by the letter of intent in lieu of the final contract. This could have potentially severe financial and commercial consequences for one or both of the parties; 
  • Include an obligation to negotiate the final contract in good faith. Although agreements to agree are not binding, an obligation to negotiate in good faith where an agreement is not subject to contract can be binding and the parties will be required to negotiate in good faith. This can help to focus the parties’ minds on achieving completion of the final contract; 
  • The governing law provision should be appropriate and take account of the implications of local law if the activities of the parties are in other jurisdictions. In some jurisdictions, letters of intent can lead to an obligation to act in good faith and may be more difficult to move away from; 
  • Consider the interaction of the letter with the final contract and the use of entire agreement clauses. Should the letter of intent supersede all previous correspondence and negotiations or should the parties remain liable for any statements made prior to the letter of intent? Also, should the final contract supersede the letter of intent? 
  • Arrange for the letter of intent to be signed by all parties.