The ABCs of an LOI

Posted on October 19, 2014

Understanding Letters of Intent in Business and Real Estate Transactions, and What Happens When Litigation Ensues

Contributing Authors: Timothy M. Zieziula, Richard A. Lanzillo and Jeremy T. Toman

Originally published in October 2014

This article has not been updated for current law since the date of its posting on the website. This article is not intended to provide any legal advice. Please seek advice of your professional council.

Any U.S. federal and state tax advice contained in this communication is not intended or written by the Knox Law Firm to be used, and cannot be used by you, for the purpose of: (i) avoiding penalties under the Internal Revenue Code that may be imposed upon you, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

What Are Letters of Intent?

Letters of intent (LOI) are one of the fundamental building blocks of many corporate transactions.

LOIs are used primarily to communicate parties’ agreement to the basic structure of a transaction and a mutual desire to continue negotiations.

Business Perspective

LOIs are used to memorialize preliminary agreements or understandings with respect to a future contract. In most instances, LOIs are not intended by the parties to be legally binding.

Legal Perspective

LOIs can be problematic. LOIs are based on contract principles, but are in most instances intended to be non-binding instruments, which can lead to uncertainty and possible litigation.

In Spite of This Uncertainty, Why Are LOIs Used?

Simplify Complex Negotiations

Transactions may be multifaceted and an LOI provides a means by which the parties may simplify and organize the terms of the proposed transaction. It forces the parties to agree to some of the more material aspects of the proposed transaction at the outset.

Economic Considerations

LOIs will allow the parties to fairly quickly determine if there is a “meeting of the minds” sufficient to justify moving forward with the proposed transaction. The non-binding nature of the LOI allows a transaction to move forward in advance of all of the issues being meted out by the parties as would be the case with the preparation and negotiation of formal articles of agreement.

Opportunity to Further Investigate the Transaction

LOIs give the parties time to perform preliminary due diligence to “kick the tires” with respect to the proposed transaction. It may allow the parties to investigate potential environmental concerns, as well as title and valuation issues.

What Types of Provisions Does a LOI Typically Include?

Terms and conditions associated with the proposed transaction:

Proposed purchase price
Material contingencies or conditions to be included in the proposed transaction

Terms and conditions associated with the LOI:

Term of the LOI
Identification of property or interest being conveyed
Confidentiality
Intentions of the Parties – binding and/or non-binding nature of the LOI
Right to perform due diligence inspections
Right to explore financing options
Obligation of the parties to negotiate in good faith
Exclusivity

How Do Courts Interpret LOIs in the Event of a Dispute?

More often than not, disputes over LOIs arise when one party is attempting to enforce the LOI against the other party. Courts have struggled to interpret LOIs.

Typical claims

1. Breach of Contract: Traditional contract principles provide the courts with some guidance in terms of discerning the intent of the parties. An LOI may be a binding contract if:

A mutual manifestation of the parties’ intent to be bound is present. Express statement by the parties; or Performance by the parties.
The LOI contains necessary terms to form a contract (i.e., consideration, etc.).

If the LOI is clear and unambiguous, the terms of the LOI will be controlling. However, when the terms of the LOI are ambiguous, then the courts must consider all evidence, including written and oral statements in order to ascertain whether or not a binding contract had been formed.

In determining whether an LOI creates a binding agreement, courts may consider several factors:

Whether a party expressly reserved the right to be bound only when a written agreement is signed;
Whether there was any partial performance by one party that the party disclaiming the contract accepted;
Whether all essential terms of the alleged contract had been agreed upon;
Whether there exists any open terms;
Whether the complexity or magnitude of the transaction was such that a formal, executed writing would normally be expected;
The behavior of the parties after the execution of the letter of intent.

2. Breach of the Duty to Negotiate in Good Faith: Even if an LOI does not constitute an enforceable contract, many courts now recognize a breach of the duty to negotiate in good faith. Although Pennsylvania courts have not considered whether a letter of intent gives rise to an obligation to negotiate in good faith, the Court of Appeals for the Third Circuit has concluded that under Pennsylvania law such a contract would arise where:

Both parties had manifested an intention to be bound by the agreement;
The terms of the agreement were sufficiently definite to be enforced; and
Consideration had been given.

This typically means that the parties to the LOI must not make unreasonable demands or request changes to the terms that are substantially different from the terms found in the LOI.

Damages

Specific Performance, or Money Damages (Expectation Damages; Reliance Damages; and Restitution Damages).

Case Studies

Case Study 1

Party A executed an LOI with Party B regarding a merger. The LOI stated that the parties’ obligations would become binding only after execution of a final merger agreement. The parties issued press releases describing the terms of the transaction, while stating that they had only executed an “agreement in principle.” Before the final merger agreement was signed, Party B began negotiations with Party C, and Party C ultimately made a higher bid than Party A. Party B approved the offer from Party C. Party A then sued Party C for tortuous interference of a contract, asserting that the LOI with Party B was in fact a binding contract.

Result:

Notwithstanding the fact that (1) the LOI included language that Parties A and B would not be bound by its terms until a final merger agreement was executed, (2) there was no partial performance by either Parties A or B under the LOI, and (3) the magnitude of the transaction (several billions of dollars) would expect a formal agreement, executed in writing before it could be finalized, a jury determined that Parties A and B entered into a binding agreement.

On appeal, the verdict was upheld as the court determined that there was sufficient evidence for a jury to conclude that a binding agreement had been formed.

Case Study 2

Landowner entered into negotiations with Developer to build a warehouse. Landowner and Developer enter into an LOI stating their intent “to enter into the transaction on substantially the… terms and conditions” contained in the LOI. The LOI further provided that that it was not a “comprehensive statement of [the parties’] rights, duties and obligations.” Landowner determined that it needed to downsize the project and Developer sued the Landowner for breach of contract.

Result:

The Court determined that the LOI was ambiguous as to whether the parties intended it to be binding and therefore the court needed to consider all of the surrounding circumstances of the proposed transaction and instructed the jury accordingly. The jury concluded that the LOI was binding and that the Developer was entitled to damages.

Contributing Authors: Timothy M. Zieziula, Richard A. Lanzillo and Jeremy T. Toman

Originally published in October 2014