This may come as a shock, but contract negotiations are rarely smooth and risk-free endeavors. There are a multitude of issues to consider, from terms of payment, to performance and damages provisions, to choice of law provisions and arbitration clauses, and many more potential issues. The list goes on and on. To make life easier, during particularly complex contract negotiations, parties oftentimes execute legal documents called letters of intent (“LOIs”). Used to memorialize the general terms of the business deal, LOIs provide the parties with somewhat of a safety blanket before fully documenting the transaction. LOIs are intended to give the parties assurance that the transaction is moving forward along specified parameters and that all parties intend to follow through on the deal according to those terms set forth in the LOI.
LOIs are regularly executed by commercial parties, but what is the legal effect of signing an LOI? Is it binding on the parties? As with most other legal questions, the answer is “yes, no or maybe,” depending upon the circumstances.
Courts have recognized that it is a common commercial practice for two negotiating parties to sign an LOI or a memorandum of understanding, signaling that they have come to a tentative agreement on the general outlines of a deal without having nailed down all of the details. Whether such a document reflects a binding agreement between the parties turns not on what the parties subjectively believed at the time, but on what they expressly manifested in their writing.
As some courts have noted, an “agreement to agree” is not enforceable. Such agreements are generally unenforceable because they don’t provide a basis for determining the existence of a breach or for giving an appropriate remedy. Furthermore, where the parties have agreed that an agreement to negotiate or an LOI, in its entirety, is not a binding legal agreement, courts have generally refused to enforce an individual provision of the LOI as a freestanding contractual promise. More specifically, courts have held that no contract exists where two parties consider the details of a proposed agreement, perhaps settling them one by one, with the understanding during this process that the agreement is to be embodied in a formal written document and that neither party is to be bound until each party executes the document. As one court stated: “The purpose and function of a preliminary letter of intent is not to bind the parties to their ultimate contractual objective. Instead, it is only to provide the initial framework from which the parties might later negotiate a final agreement, if the deal works out.”
While LOIs are generally not enforceable on their terms alone, the analysis does not end there. The terms of an LOI may impose upon the parties an obligation to negotiate in good faith. This obligation has generally been described as preventing one party from renouncing the deal, abandoning the negotiations, or insisting on conditions that do not conform to the preliminary agreement. For instance, a party might breach its obligation to negotiate in good faith by unreasonably insisting on a condition outside the scope of the parties’ preliminary agreement, especially where such insistence is a thinly disguised pretext for scotching the deal because of an unfavorable change in market conditions.
Importantly, the duty to negotiate in good faith does not equate to a duty to finalize the transaction. Courts have made it clear that an LOI is merely an agreement to negotiate, not a promise that those negotiations will be fruitful. Accordingly, a duty to negotiate in good faith does not encompass an automatic duty to approve the final deal. Stated differently, an LOI is no guarantee that a final definitive agreement will be concluded, even if the parties fulfill their good-faith obligations. The full extent of a party’s duty to negotiate in good faith can only be determined, however, from the terms of the letter of intent itself.