While Letters of Intent (“LOI”) have long been understood to be unenforceable agreements that simply memorialize the parties’ intentions during contract negotiations, a burgeoning body of law in states across the country are providing such parties the means to enforce certain provisions of LOIs. As a result, parties who regularly sign LOIs should scrutinize the terms more carefully and be aware of the factors that courts consider when determining whether an LOI is an enforceable contract. Letters of Intent are traditionally documents that outline parties’ respective positions while negotiating a contract, whether it is for the sale of goods or the purchase of services.Often times, LOIs will contain a number of standard terms, including the items that are being purchased or sold, the approximate pricing, a timeline for further negotiations and/or product delivery, confidentiality, and an exclusivity provision limiting the ability to negotiate with others. Two provisions that often go unnoticed or, at most, garner limited attention, are terms that dictate the manner in which the parties will engage while continuing to negotiate toward a final contract and the choice of applicable law governing the LOI and any future agreement. With respect to the former, many LOIs state that the parties will continue to negotiate toward a purchase and sale agreement or final contract in “good faith” or through the “use of best efforts.”
Enforcing Letters of Intent as Contracts to Negotiate
Generally, LOIs are understood to be “agreements to agree” – unenforceable contracts that simply set the stage for a binding contract that requires additional and final negotiations to complete. But a growing number of state courts, as well as a recent opinion by the United States Court of Appeals for the First Circuit, are recognizing that within otherwise unenforceable LOIs, parties will be legally bound to comply with any covenant governing subsequent negotiations – even if the parties never ultimately execute a final contract. Often described as “contracts to negotiate,” these provisions of LOIs legally bind parties to engage in a certain standard of conduct while pursuing further negotiations. Even if the parties do not ultimately consummate a final contract, if one of them failed to satisfy any covenant in the LOI governing the manner in which those negotiations were to be conducted, they would be susceptible to a claim by the other party. So, for example, if one party agreed in the LOI to negotiate “in good faith” or “use best efforts” and thereafter unjustifiably failed or refused to comply with the promised standard, they likely would have exposed themselves to potential liability for violating the LOI’s provisions constituting a contract to negotiate.
In its recent decision, Butler v. Balolia, No. 13-1329, decided in late November 2013, the First Circuit carefully examined this area of the law and noted that “the trend line appears to be moving steadily in favor of recognizing a cause of action for breach of a contract to negotiate.” The First Circuit was specifically asked to predict under applicable Washington state law whether an LOI executed between the parties was enforceable as a contract to negotiate where the parties in the LOI agreed to “use their best efforts to negotiate and attempt to agree to terms for” a final purchase agreement. The parties had previously been negotiating the sale of certain intellectual property, but after signing the LOI, the prospective purchaser allegedly attempted to renegotiate the entire transaction, resulting in the collapse of the proposed transaction and the subsequent legal action whereby the seller (represented by Sheehan Phinney attorneys) claimed that such action breached the covenant to use best efforts to negotiate. The court of appeals ultimately concluded that this provision of the LOI was likely enforceable as a contract to negotiate and remanded the matter back to the trial court to proceed with discovery. While recognizing that the caselaw is mixed across the United States, the First Circuit cited cases applying California, Delaware, Illinois, New York, Oregon, Pennsylvania, Rhode Island, and West Virginia law – just by way of example – where courts have found it to be appropriate to enforce contracts to negotiate. The court also noted that legal commentators, as well as the United States Court of Appeals for the Ninth Circuit, have also found that the “modern trend” is for courts to enforce the provisions within an LOI that constitute a contract to negotiate.
Certainly, there are courts in other states that have not adopted this legal theory, such as Connecticut, Kentucky, Minnesota, Virginia, and Utah, and instead employ a more traditional view. Under such a perspective, these states have taken an “all or nothing” approach. They have held that a contract to negotiate in an LOI is not an independently enforceable obligation where there is no binding contract to consummate the underlying transaction.But in a number of these states, the courts have not had the opportunity to analyze the issue in recent years. Thus, it is uncertain if those states would continue to abide by their historical analysis or begin to apply the more modern approach of enforcing contracts to negotiate.
Great care should be taken given this increasing trend of both state and federal courts to enforce LOIs that contain provisions governing the conduct of parties as they continue to negotiate toward a final contract. As a result, parties should take into account certain considerations when drafting and executing LOIs in any transaction.
First and foremost, parties must assess whether it is to their advantage to put in place some safeguard governing the conduct of the parties as they negotiate a final contract. For example, a party lacking leverage during the course of a negotiation may be more inclined to include in the LOI a covenant to negotiate in good faith or require use of best efforts. Such a provision will help to ensure that the counter-party is contractually bound to participate in a substantial and meaningful way in the negotiations rather than unilaterally or unjustifiably disengage from discussions.
The same holds true for a party that will be required to invest substantial resources during any negotiation, possibly to perform complicated or burdensome due diligence. An enforceable contract to negotiate can provide a certain measure of protection for the amount of time, effort, and expense that may be incurred during the course of the negotiation after entering into an LOI. It could also dampen the likelihood that a counter-party may take advantage of the other party’s substantial expenditures to engage in last-minute renegotiations.
In contrast, some entities may not want to be hindered by the obligations that a contract to negotiate places on the parties. Moreover, if a party is found to have violated a contract to negotiate – even if no final contract was ever executed and the transaction was abandoned – that party risks being subject to what are known as “expectation” damages. In other words, a party that violates a contract to negotiate could be forced to pay damages in an amount equal to the full and complete value of what the LOI contemplated the contract would be worth. This was the calculus employed by the Washington state courts, for example, which adopted the reasoning of Judge Posner from the United States Court of Appeals for the Seventh Circuit, and which described this assessment of damages as the “trend of authority.” See Columbia Park Golf Course, Inc. v. City of Kennewick, 160 Wash. App. 66, 85-86 (2011). As a result, each party must carefully and strategically assess its own needs and bargaining position in determining whether it is advantageous to include an enforceable contract to negotiate provision in any LOI.As a result, each party must carefully and strategically assess its own needs and bargaining position in determining whether it is advantageous to include an enforceable contract to negotiate provision in any LOI.
If a party does not want to be bound by any aspect of an LOI, including a term governing the conduct of future negotiations, explicit language should be included in the LOI that makes this intention clear. In particular, a party that does not want an LOI to be interpreted or enforced as a contract to negotiate should, at a minimum, include a provision that expressly disclaims any intention by any party to be bound by any term in the LOI or any future action referenced in the LOI. Moreover, the LOI can also include a provision that specifically reserves both parties’ right to negotiate or renegotiate any term of the proposed transaction, including those set forth in the LOI and those not yet described.
Finally, as previously discussed, not every jurisdiction has adopted the concept that a contract to negotiate, as set forth in an LOI, is independently enforceable. In addition, a number of states have not addressed this issue recently or at all. Such states may be inclined to follow the growing trend of enforcing a contract to negotiate, especially in light of the specific states that have recognized the independent validity of such claims (i.e. California, Delaware, Illinois, and New York). Therefore, parties should analyze any choice of law provision in an LOI as carefully as any other term. At a minimum, prior to signing any LOI, parties should confer with counsel to evaluate the potential enforceability of the LOI’s provisions and the consequences of engaging in certain conduct while continuing to negotiate towards a final contract.
Letters of Intent have traditionally been an effective tool in memorializing and outlining a proposed agreement between two parties at a critical stage of negotiations, while not binding either party to any future commitment. But based on the modern and growing trend in various jurisdictions across the country, parties should now perform an additional calculus before entering into an LOI. They should carefully evaluate their own position vis-a-vis the counter-party and determine whether it is to their advantage to bind the parties to a standard of conduct as they continue to negotiate their proposed transaction. Failure to do so could either expose an unwitting party to potential liability if a transaction fails to come to fruition, or forfeit a party’s opportunity to build in a certain measure of protection against future gamesmanship as the parties proceed with negotiations.