"Letters of intent" are often used by parties who are thinking about entering into a contract with another party, but who do not yet want to be bound by any particular provisions. There are several reasons why a business contemplating a deal may wish to draft only a letter of intent in the early stages of negotiation. The business may want to get some idea of the terms which it will negotiate later; to lay the groundwork for the manner in which a contract will be drafted; to establish a timeline for drafting final agreements; to establish confidentiality terms; to prohibit negotiation with other parties for a certain period of time; or just to find out if the other party is serious about pursuing a deal before both sides expend considerable time, effort, and money working out the details of the transaction. Whatever the reason may be, letters of intent are not used to create a binding contract. However, if care in drafting the letter of intent is not taken and the letter of intent becomes the subject of litigation, the party who prepared it may find a court determining it to be a binding contract or at least an agreement to negotiate in good faith.
Binding Contract
A letter of intent may be a binding contract if it contains: (1) the necessary terms to form a contract and (2) a mutual manifestation of the parties' intent to be bound. A real estate purchase agreement, for example, must contain such essential terms as the identity of the parties, a description of the property to be purchased, and, in most cases, the purchase price. If a letter of intent contains these material terms and is signed by the parties (contracts for the purchase of real property must be signed by a party to be enforceable against that party), a court may find the letter of intent to be a valid and enforceable contract even though it lacks details that one of the parties intended to include in the "final contract" that would come later.
In order to enforce a letter of intent as a contract, a court must find that the material terms of a contract are present in the letter of intent and determine that the parties intended to be bound by the terms of the letter of intent. Determination of the parties' intent can be difficult, but such intent needs to be shown to the court only by a "preponderance of the evidence." To make such a determination, a court must determine only that it is "more likely than not" that both parties intended to be bound. If the language of the letter of intent is clear and unambiguous, the court may focus solely on the language of the letter. On the other hand, if the language of the letter of intent is ambiguous, the court will look beyond the language of the letter of intent and consider other evidence.
In determining whether a letter of intent actually creates a binding agreement, the courts will consider several factors:
- The sophistication of the parties.
- The relationship of the parties.
- Whether all of the material terms of a contract are included. Courts are reluctant to supply terms to a contract when those terms are not found in the document itself.
- The type of documents typically used in similar transactions. If a particular transaction usually involves the use of many complex, sophisticated documents, a two- or three-page letter of intent which touches on a few of the basic terms may not contain enough information to be considered a binding agreement.
- Whether the letter of intent provides a remedy for nonperformance by the other party. The absence of a remedy provides weight to the argument that the letter of intent was not intended to be binding.
- The circumstances surrounding the preparation and execution of the letter of intent.
- The behavior of the parties after signing the letter of intent. If the parties continue to negotiate terms after the letter of intent is signed, that may prove that an agreement had not been reached.
Obligation to Negotiate in Good Faith
Even if the terms of the letter of intent do not form a binding contract, a court may hold that the letter obligates the parties to continue to negotiate the terms of the transaction in good faith. This typically means that the parties to the letter of intent must not make unreasonable demands or request changes to the terms that are substantially different from the terms found in the letter of intent. The court may determine that the sole purpose of such requests was to cause the other party to withdraw from the negotiation and that the requesting party is responsible for any losses suffered by the other party. Depending on the scope of the obligation to negotiate in good faith, each party also may be required to take affirmative steps to cooperate with the other party to reach an agreement. The exact manner by which the parties must negotiate the terms of the contract will be determined by the court from an examination of the letter of intent, as described above.
How to Avoid Turning a Letter of Intent into a Binding Contract
Considering the potential problems which may arise from drafting and executing a letter of intent, the best advice may be to avoid drafting the letter altogether and proceed directly to the preparation of a full-blown contract containing not only the material provisions such as price and quantity, but also all of the details desired. However, if you do feel the need to draft a letter of intent, the following are a few precautions you may take to avoid creating a binding agreement:
- State clearly and unambiguously at the beginning of the letter of intent that the letter is not a binding contract and should not be interpreted to be a binding contract. The letter should state, in a conspicuous manner, that it is not an offer to contract, that it cannot be accepted as a contract or a binding agreement of any kind, and that you do not intend to be bound by the terms contained in the letter of intent unless and until all parties execute a formal written contract. If you do not want to be obligated to negotiate in good faith, you should include an appropriate statement in this part of the letter of intent as well.
- Do not include all the material terms of the agreement in the letter of intent. Leave one or two out and identify them. The letter of intent should state clearly that you contemplate further negotiation of the terms and the execution of a more complete agreement.
- Throughout the letter of intent, use language to suggest that neither party intends to be bound, that the terms contained therein are preliminary and not final, and that any binding agreement or obligation will be created only by new and additional documentation. There is no need to be subtle when making the point that neither party intends to be bound by the terms of the letter.
- Do not sign the letter of intent. If the type of agreement contemplated is subject to a statute of frauds, a party that does not sign the agreement cannot be charged with the obligations contained in the agreement.
- Once the letter of intent is prepared and signed, do not take any action that may suggest you are performing obligations pursuant to an agreement.
Conclusion
Letters of intent often fail to serve their intended purpose and can cause problems that neither party anticipates. Before drafting or agreeing to sign a letter of intent, consider whether the letter of intent is beneficial to the transaction or whether you may accomplish your goals through some other method. If you do decide to draft a letter of intent, consider taking the steps outlined above in order to avoid the unintended consequences of becoming legally bound to perform a contract you did not think you were making.
© 2010, Ward and Smith, P.A.
For further information regarding the issues described above, please contact Justin M. Lewis.
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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.
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