Letters of intent.
This statement definitely ranks as one of my all time favourite responses from a client. The response came after I explained to the client that a letter he had signed over lunch in New York created a binding agreement to sell his profitable family enterprise to a fledging public company, a consequence he had neither intended nor anticipated. Because the client had intended to do no more than advance an opportunity, he was understandably alarmed to learn that he had in fact signed for and legally bound not only himself, but also all other shareholders, with neither their knowledge nor authorization. Worse still, when the shareholders did hear about the agreement, many disapproved. Fortunately for the client, the deal collapsed when one fundamental point could not be resolved after weeks of negotiations. Litigation was avoided and the client learned a valuable lesson about letters of intent.
By no means rare, this client's experience illustrates the common and dangerous misconception that letters of intent are nothing more than an agreement to agree. Generally speaking, parties do intend their letters of intent to be a preliminary document that might transform into a purchase and sale agreement if and when the parties come to a final "meeting of the minds." The name itself implies casualness: letter suggests an absence of formality; intent suggests a desire or understanding with no obligation. However, despite the disarmingly simple name, the letter of intent frequently accomplishes far more in practical effect and prudent parties will guard against being misled by this seemingly informal terminology. The following article reviews the fundamental elements and use of letters of intent, and the pitfalls to avoid when using them in the purchase and sale of a business.
Letters of intent are a common element of many business transactions. Although no two letters are alike, they do share similar characteristics. Often incorrectly titled "statement of intention," "memorandum of understanding," and "heads of agreement," letters of intent can appear at many different stages of transactions and for a range of purposes. Most frequently, they arise somewhere in the middle of the process, after the "honeymoon" phase--where tantalizing synergies and dollars are discussed--and before the sometimes excruciating and detailed closing phase. Basically, the letter of intent surfaces at the point where the parties have given their transaction opportunity sufficient shape for one or both to want to see something in writing before advancing further. Used correctly, letters of intent are a potent transaction tool.
Letters of intent can benefit a transaction in a number of ways. Depending on the circumstances surrounding the potential deal, the letter of intent may:
* signal a willingness to proceed and expand initial negotiations,
* generate deal momentum by creating a positive attitude and spirit of cooperation,
* demonstrate or test the parties' commitment,
* identify transaction parties (including guarantors and third party right holders),
* serve as the basis for a detailed purchase and sale agreement and specifies transaction process,
* sharpen due diligence review and deficiencies, and
* help keep third parties (such as banks and other stakeholders) informed of the transaction's progress.
What is more, the process leading to a letter of intent can also benefit participants by providing them with a taste of things to come. The manner, tone and timing of preliminary negotiations, the advisors' level of participation and attention to detail, and the participants' reactions on the letters' circulation all can reveal the parties' sensitive issues, sophistication and decision-making hierarchy. Thus, careful attention to all participants' actions and reactions during this early stage is strongly advised.
In addition to the potential benefits, letters of intent also pose many risks, not the least of which are the legal risks discussed separately below. Specifically, letters of intent have been known to:
* reveal points of possible contention before one or both parties have become sufficiently wedded to the idea of advancing the deal,
* involve two rounds of costly negotiations, one for the letter of intent and a second for the purchase and sale agreement,
* place parties in the uncomfortable position of having to agree to certain deal points without knowing all elements of the transaction, and
* prematurely grant a period of exclusivity.
Again, actively participating in the process can reduce these risks. For instance, the party who drafts the letter of intent establishes control of the letter's format, timing, delivery and mix of binding and non-binding provisions. As such, the party who receives the letter of intent must be extremely vigilant when reviewing the letter. Every letter of intent must be read carefully and fully understood. Each letter should be regarded as a unique reflection of the specific circumstances of a particular transaction. Parties must avoid being lulled into complacency by another's assertion that the document is "just our usual form of letter."
Letters of intent typically cover what will be acquired, the price to be paid, the method and timing of payment, pre-closing conditions and consents, and collateral agreements (concerning, for example, non-competition, key employees and consulting arrangements). They may also include other significant provisions, such as access and information parameters for further due diligence, requirements to demonstrate financial ability to complete the deal, and purchaser exclusivity. Most parties have little or no trouble deciding which of these common provisions to include. On the other hand, agreeing on the language of the letter, coupled with the circumstances surrounding the transaction, may well raise several issues requiring careful consideration.
A Binding Agreement?
No matter which provisions the parties choose to include in the letter of intent, the parties must agree on the document's intended legal effect. Where the parties do not wish to be bound, the letter of intent must simply and clearly state this intention. Moreover, the clear expression of this intent must be consistent with other provisions and the parties' oral discussions and conduct. Words such as "understanding," "intention," "if," "subject to preparation and agreement of a formal contract," "proposals," "discussion points" and "subject to satisfactory completion of due diligence" are most likely to prevent unintended consequences.
Even after settling the letter, the parties should ensure that their conduct continues to be consistent with the terms of the bargain. In the event of litigation, a party's conduct could be seen as evidence of an intent to be bound. Indeed, courts have found one party's reliance on steps the other party took after signing the letter to evidence an intent to be bound.
In some cases, the parties' letter of intent is silent regarding whether the parties intend to be bound. G.H.L. Fridman summarizes the courts' general approach in the absence of clearly expressed language as follows:
While there appears to be no clear statement to such effect, it would seem that the approach favoured by the courts is that of the reasonable bystander, the hypothetical onlooker. The application of this objective standard of interpretation should yield an appropriate answer to the question of whether the parties have finally concluded an agreement by the requisite offer and acceptance, or are still in the process of negotiating the ultimate terms of the intended contract. (1)
Nowadays, most letters of intent include both binding and non-binding provisions. The binding elements generally concern confidentiality (subject to disclosures as required by law), public announcement, access for due diligence, expenses and exclusivity (subject to a "fiduciary out" where required). Parties should take care to clearly distinguish those that will bind from those that will not when including both binding and non-inding provisions in the letter.
Although by no means customary in commercial transactions, a deposit is used in some cases. When using deposits in conjunction with a letter of intent, parties must insure that the deposit is not a partial payment. In the absence of agreement, a vendor retains a true deposit if the transaction does not close because of the purchaser's conduct. To avoid this consequence, the letter should specify any forfeiture provisions and indicate that the deposit represents a genuine estimate of potential damages, and not a penalty.
A binding letter of intent may create an enforceable contract, and like any contract may raise serious repercussions for a party who fails to complete the terms. When brought before a court, the legal effect of a given letter of intent is a matter of interpretation to be determined on the facts and circumstances of the specific case. However, case law has revealed a few basic principles:
* Because the law presumes that commercial agreements are intended to create legal relations, the onus of proving that an arrangement was intended to create no legal relations apparently rests with the party asserting this position. (2)
* Although a document's title may indicate the parties' intention, the title alone is not determinative. (3)
* Where fundamental terms of the agreement remain to be agreed upon, the arrangement is not enforceable. (4)
* A letter of intent's reference to "customary" provisions indicates that the agreement is not binding, unless the parties manifest a clear understanding as to what the customary provisions are. (5)
Absent special circumstances (for example, a pre-existing relationship), opposing parties do not owe each other a duty of care in negotiating a letter of intent. In Martel Building Ltd. v. R. (6), the Supreme Court of Canada considered whether the tort of negligence extends to damages for pure economic loss arising from conduct in pre-contractual negotiations. In Martel, a landlord and the Department of Public Works ("DPW") were negotiating the renewal of a lease, when the DPW decided to tender the lease and award it to a competitor. Martel sued for damages and the trial court ruled that the DPW owed Martel a duty of care, which the DPW breached. Nevertheless, the trial court awarded no damages because the landlord had not established causation. On appeal, the Federal Court of Appeal approved the trial court's finding of negligence against the DPW, but ruled that damages the DPW caused could and should be assessed. (7) In overturning the Federal Court of Appeal's decision, the Supreme Court invoked the two-stage test established in the English case, Anns v. Merton London Borough Council. (8) Applying Anns, the Supreme Court asked:
(a) Did Martel and the DPW have a sufficiently close relationship so that, in the DPW's reasonable contemplation, carelessness on its part might cause damage to a party like Martel with whom it negotiated?
(b) Do any policy considerations serve to negate or restrict (1) the scope of the prima facie duty of care, (2) the class of persons to whom the duty is owed, or (3) the damages to which a breach of the duty may give rise?
Regarding the first prong of the test, the Supreme Court ruled that the proximity between Martel and the DPW, based on a pre-existing landlord and tenant relationship and certain tender discussions, were sufficiently close. According to the Court, it was foreseeable that one negotiating party's carelessness might cause the other party economic loss. However, the Supreme Court determined that Martel failed to meet the second prong of the test for five policy reasons:
1. The goal of many commercial negotiations is to realize a financial gain at the other party's expense.
2. Socially and economically useful conduct could be deterred by depriving a party of an advantageous bargaining position; labelling as negligent a party's failure to disclose its bottom line, motives or final position would defeat the essence of negotiation and hobble the marketplace.
3. Tort law could become after-the-fact insurance against failures to act with due diligence or to hedge the risks of failed negotiations by pursuing alternative strategies or opportunities.
4. Courts would assume a substantial and unnecessary regulatory function--that of scrutinizing the minutia of pre-contractual conduct--when other causes of action already provide alternative remedies.
5. Needless litigation should be discouraged.
The Court concluded that imposing a duty of care on the conduct of negotiations would have a negative impact on the commercial marketplace that outweighs any need for such a duty.
After Martel, the Ontario Court of Appeal in 978011 Ontario Ltd. v. Cornell Engineering Co. (9) confirmed that the law imposes no duty to negotiate in good faith. In Cornell, the Court unanimously decided that, absent a special relationship, parties have no duty to act in good faith in pre-contract bargaining. The Court observed:
Generally, parties negotiating a contract expect that each will act entirely in the party's own interests. Absent a special relationship, the common law in Canada has yet to recognize that in the negotiation of a contract, there is a duty to have regard to the other person's interests, namely, to act in good faith.
Accordingly, absent a special relationship, parties in Canada apparently can neither successfully sue, nor be sued, on the sole basis of a pre-contractual duty to negotiate in good faith. Parties alleging "bad faith" in pre-contractual negotiations may instead rely on other causes of action, such as fraudulent misrepresentation, negligent misrepresentation or quantum meruit (each of which are outside the scope of this article).
Ten Tips for Avoiding Pitfalls
To avoid unexpected consequences in negotiations and direct attention to the most important aspects of letters, of intent, the following ten tips to avoid common pitfalls should be kept in mind:
1. Include an express provision that the letter is not intended to be binding and may or may not form the basis of a future agreement.
2. Insure consistency of your intentions, the letter, and your post-signing conduct.
3. Avoid using "agreement," "legally bound," "binding obligation," "agreed terms," or "proceeding in good faith," unless you mean them and will adhere to their legal effect.
4. Use words like "proposed," "consider," "review," and "discuss."
5. Pay particular attention to binding provisions--exclusivity, confidentiality and the provisions pertaining to public or other announcements; (as vendor, an announcement may increase pressure to complete the transaction).
6. When proposing the letter, make it subject to a "sunset date"; so that if it is not returned signed by the other party by the specified date, it will not be unexpectedly accepted later.
7. If you are in a special relationship, take extra care in negotiations.
8. Remember who you are and to whom you are accountable; do not bind other shareholders or the company in the absence of proper authority.
9. Keep the letter simple, but not casual.
10. Do not let the title of the document disarm you.
(1) G.H.L. Fridman, Q.C., The Law of Contract in Canada, 2d ed. (Toronto: Carswell, 1986) at 59.
(2) R. v. CAE Industries Ltd. and CAE Aircraft Ltd.,  1. F.C. 129 (C.A.)
(3) Angus Leitch & Associates Limited v. Legrand Industries Limited (1983), 31 Alta L.R. (2d) 158 (Alta. C.A.).
(4) Angus Leitch & Associates Limited v. Legrand Industries Limited, supra note 3.
(5) Cedar Group Inc. v. Stelco Inc., , O.J. No. 3998, affirmed , O.J. No. 3974 (Ont.C.A.).
(6) Martel Building Ltd. v. R, (2000), 193 D.L.R. (4th) 1 (S.C.C.).
(7) Martel Building Lid v. R,. (1998), 163 D.L.R. (4th) 504 (F.C.A.).
(8) Anns v. Merton London Borough Council (1978) A.C. 728 (H.L.).
(9) 978011 Ontario Ltd. v. Cornell Engineering Co, 53 O.R. (3d) 783 (Ont. C.A.).
David Dunlop is a partner in McMillan Binch LLP, specializing in mergers and acquisitions.