The Letter of Intent (or more commonly, the “LOI”) is very often the first document negotiated between the parties to a transaction such as the sale of a business. It is an opportunity for the parties to put the broad terms of the proposed transaction on paper, along with the conditions and steps to be followed in order to carry it to fruition.
The parties frequently stipulate in an LOI that it is non-binding with respect to the terms of the proposed transaction and that it merely contains an expression of their intention, with more formal and “complete” agreements to be subsequently negotiated. It is common for the business people involved in a transaction to draft the LOI themselves, the impression being that this document does not truly constitute the contract between the parties and that any ambiguity or inaccuracy will be susceptible to correction by the attorneys during their drafting of the final agreements.
Moreover, the formal contracts usually contain an entire agreement clause which specifically aims to ensure that any prior negotiations or agreements, the most important of which is often the LOI, are completely canceled and replaced by the formal contracts. The clear goal of including such a clause is to ensure the stability of the contractual relationship by eliminating, as much as possible, the uncertainty which might be created by resorting to elements extrinsic to the contract. This bulletin addresses the following questions: should it be taken for granted that the terms of the eventual formal contract will always prevail over the LOI and is it necessary to pay the same degree of attention to the drafting of the LOI as is paid to the drafting of the final contracts?
The Superior Court of Québec, under the pen of the Honorable Judge Paul Mayer, recently provided an example of a situation in which an LOI, which the parties had expressly stipulated as being non-binding, was given precedence over the clear and unequivocal terms of the formal contract, despite the inclusion in that contract of the usual Entire Agreement clause1.
The decision involved facts which are quite uncommon (let’s hope). Briefly, the case dealt with the sale of a recreational complex (a ski center and golf club) and the transaction called for a portion of the sale price to be payable several years after the closing, calculated according to a formula based on a multiple of the EBITDA (commonly called an “earn-out”). This formula was described in the LOI drafted internally by the purchaser and counter-signed by the vendor. The purchaser’s outside counsel, mandated to draft the final contract, substantially modified the earn-out formula in his draft, creating a situation prejudicial to her own client. The suit, for approximately $6,000,000, arose from the fact that the vendor subsequently insisted on the literal application of the terms of the final contract.
It is clear from the facts related in the decision that the vendor was aware of the error and was attempting, abusively, according to the judge, to take advantage of it. The Superior Court of Québec discarded the formula contained in the final contract and applied that contained in the LOI, holding, in substance, that there had been a manifest error in the drafting of the final contract and that the court had to seek out the common intention of the parties beyond the literal meaning of the words used in the contract, as prescribed by the Civil Code2. According to Judge Mayer, that common intention of the parties was to be found in the LOI.
The decision seems to reach an equitable result in light of the specific facts of the case. It would be inequitable and go against common sense to allow a party to insist on the strict application of a text which that party knows to be erroneous, particularly when the result of such a literal application would lead to a commercial absurdity, as was the situation in this case. Clearly, the error by the attorney in drafting the final contract was determinative. The judge qualified this error as an excusable error, mentioning that the attorneys and experienced business people reviewed the contract and did not uncover it3. Judge Mayer also invoked the duty to act in good faith and in a reasonable fashion4 to support his conclusions.
We can assume that this type of situation is rare. This decision nevertheless introduces a certain degree of uncertainty into the conclusion and interpretation of commercial contracts. It reminds us that a contracting party can always attempt to disregard the application of the clear terms of the final contract in order to return to the “common intention of the parties” which, according to him, is better expressed in the LOI. For this reason it is important to pay proper attention to the drafting of the LOI and not to presume that the LOI will necessarily be cancelled and replaced by the final agreement.
Moreover, once the main terms of the transaction are expressed in the LOI, as nonbinding as it may be, it is always difficult to modify these terms to add substantial elements afterwards, the logic being that if the proposed modification or addition were material, it should have been expressed at the LOI stage.
In conclusion, while the LOI has its raison d’être, namely, to reduce transaction costs by enabling the parties to verify the seriousness and chances of success of the proposed operation from the outset of negotiations, and while it is convenient to avoid unnecessarily burdening the process by introducing the type of detailed provisions which are generally contained in the final contracts, it is important to be careful to include, in a generic fashion, all the essential elements of the projected transaction. It is strongly recommended that the LOI be reviewed by an attorney prior to its execution.