X

Thank you for sharing!

Your article was successfully shared with the contacts you provided.
Parties contemplating a transaction frequently use letters of intent, memoranda of understanding and other types of preliminary documents to outline the key terms before executing a definitive agreement. (For purposes of this article any such preliminary document, however titled, is referred to as an LOI.) The main function of an LOI is to provide the parties with assurance that the deal will proceed in the manner contemplated before they commit time and expense to further negotiation. The LOI typically sets forth the basic structure of the proposed transaction, serving as a framework for negotiation and drafting of the final agreement. In addition to protecting one party from the other’s “memory loss” regarding points agreed upon in principle, LOIs are often useful for other reasons. For a purchaser, execution of an LOI may be helpful or required to obtain financing for the acquisition. Antitrust review can also be accelerated, since any premerger notification filing required under the Hart-Scott-Rodino (HSR) Act can be made on the basis of an LOI without waiting for execution of the definitive agreement. There may be disadvantages to LOIs in some situations. Depending on the personalities involved, the process of negotiating an LOI can become an unnecessary sideshow, particularly in a transaction of modest dollar value, consuming time and energy that could better have been devoted to negotiating the final agreement. There also are deals in which early execution of an LOI can have the unfortunate effect of painting a purchaser into a corner prematurely on a key issue, before the completion of business and legal due diligence, leading to accusations of bad faith when the purchaser revises its position based on due diligence input. Because LOIs are often held by courts to be unenforceable “agreements to agree,” the parties may believe that the LOI they have signed is non-binding and that they are free to walk away from the transaction in the event that negotiations break down or the deal otherwise becomes undesirable. However, in certain circumstances LOIs can be held to be fully binding agreements obligating both parties to perform the underlying transaction. This article discusses interpretations of New York law regarding the extent to which parties can be bound by LOIs and offers drafting suggestions to assist parties seeking to avoid the pitfalls of being unwittingly bound. THE 2ND CIRCUIT’S VIEW Ordinarily when parties sign an LOI and plan to negotiate the transaction further before executing a definitive agreement, the LOI does not create a binding contract. [FOOTNOTE 1]However, the 2nd U.S. Circuit Court of Appeals has held that under New York law there are two types of preliminary agreements that can create binding obligations between parties. The first type of preliminary agreement is created when the parties agree on all issues that require negotiation, but nevertheless agree to memorialize their agreement later in a more formal contract. This type of preliminary agreement is preliminary only in form, and the subsequent formalization of the parties’ agreement, although desirable, is not necessary. In this situation, both parties are fully bound to perform their obligations under the preliminary agreement regardless of whether a formal agreement is ever drafted and executed. [FOOTNOTE 2] The second type of preliminary agreement is created when the parties agree on certain major terms, but leave the remaining terms of the proposed transaction to subsequent negotiations. This type of preliminary agreement is not fully binding and only obligates the parties to negotiate a final agreement in good faith within the scope of the terms set forth in the preliminary agreement. Parties to this second type of preliminary agreement have no right to demand performance of the transaction. A party to this type of preliminary agreement may abandon the transaction if the final contract is not agreed upon, provided that the party has made a good faith effort to negotiate and has not insisted on terms contrary to those of the preliminary agreement. [FOOTNOTE 3] In determining whether either the first or second type of preliminary agreement has been formed, the courts of the 2nd Circuit examine whether the parties to the preliminary agreement intended to be bound. In determining whether an LOI is a fully binding preliminary agreement of the first type, the courts of the 2nd Circuit look at the following factors to determine the parties’ intent: (1) the language of the agreement and whether there has been an express reservation of the right not to be bound in the absence of a later writing; (2) whether there has been partial performance of the contract; (3) whether all of the terms of the alleged contract have been agreed upon; and (4) whether the agreement at issue is the type of contract that is usually committed to writing. [FOOTNOTE 4]A similar test is applied to determine whether an LOI is the second type of preliminary agreement; this test includes an additional factor which permits the court to examine the context of the parties’ negotiations. [FOOTNOTE 5] Although no single factor is dispositive in determining the extent to which the parties intended to be bound, the most important factor in making such determination is the language of the preliminary agreement. [FOOTNOTE 6]In fact, in at least one case, the 2nd Circuit examined only the contractual language and did not go on to consider the other factors in finding a preliminary agreement of the second type to be non-binding. [FOOTNOTE 7]Since the text of an LOI receives more judicial scrutiny than the other factors, this article focuses next on the interpretation of this factor by the courts of the 2nd Circuit. INTERPRETATION OF LANGUAGE The clearest way for the parties to an LOI to indicate the extent to which they intend to be bound is to state specifically in the text of the LOI that it is either binding or non-binding. The courts of the 2nd Circuit have found the use of the words “binding agreement” in an LOI to be indicative of an intent to create a fully binding preliminary agreement of the first type. [FOOTNOTE 8]Merger clauses stating that a preliminary agreement “constitutes the entire agreement” between the parties have been found to indicate a similar intent to be bound. [FOOTNOTE 9] Conversely and not surprisingly, the clearest expression of the parties’ intent not to be bound is a specific statement in the LOI that the document is non-binding. [FOOTNOTE 10]Courts have accorded weight to the fact that a preliminary document refers to the necessity of further negotiations and conclusion of a formal agreement, [FOOTNOTE 11]states that the preliminary agreement will terminate at a specific date if the formal agreement is not concluded, [FOOTNOTE 12]reserves the right of the parties not to be bound until such formal agreement is entered into [FOOTNOTE 13]or otherwise uses language indicating that the parties intend to enter a formal agreement at a later time and are not entering into such an agreement by executing the LOI. [FOOTNOTE 14]Titling the document as an “agreement in principle” [FOOTNOTE 15]or stating that the document constitutes a “preliminary understanding” between the parties [FOOTNOTE 16]is also typically deemed to indicate the document’s non-binding nature. The courts of the 2nd Circuit have also recognized that the parties may choose to make certain provisions of a preliminary agreement binding and others non-binding. [FOOTNOTE 17]LOIs that include both binding and non-binding provisions should clearly indicate which provisions fall in which category to avoid ambiguity in the interpretation of the parties’ intent. Although the language of an LOI is the most important factor in determining the parties’ intent, drafters of LOIs should be cognizant that other factors of the 2nd Circuit’s analysis can override the plain language of the document in some instances. Whether material terms remain to be negotiated can be an important factor. For example, in NAP, Inc. v. FRAJAC, S.A., the 2nd Circuit held a letter to be a fully binding preliminary agreement of the first type (despite the fact that the letter stated it was non-binding until a formal agreement was executed) because no material terms remained to be resolved by the parties, there was no evidence that further negotiations were contemplated, and both parties had begun to perform extensively their obligations under the letter. [FOOTNOTE 18]Conversely, if an LOI fails to set forth any agreement on any material terms, courts will most likely find the LOI to be too fragmentary to be capable of sustaining any binding legal obligation and therefore hold it to be completely unenforceable. [FOOTNOTE 19] NEW YORK STATE COURTS The New York Court of Appeals has neither adopted the 2nd Circuit’s framework of analysis with regard to preliminary agreements [FOOTNOTE 20]nor has it officially recognized the second type of preliminary agreement that obligates parties to negotiate in good faith. Nevertheless, similar factors are examined by the New York state courts in evaluating whether LOIs are fully binding on the parties. In determining whether a fully binding contract exists, the court’s inquiry focuses on the parties’ intent to be bound, i.e., whether the parties have agreed on all the material terms in the LOI. [FOOTNOTE 21]If, however, material terms are left open for future negotiation, an LOI will not be enforceable as a fully binding contract on the parties. [FOOTNOTE 22]Like the 2nd Circuit, the New York state courts regard the language of the LOI as the most important factor in determining intent, because when the parties’ intent to be bound is unambiguously manifested in the document, such manifestation is controlling. [FOOTNOTE 23] One important difference exists between the analysis employed by the New York state courts and the analysis employed by the courts of the 2nd Circuit. In a New York state court, if the parties to an agreement do not intend the agreement to be binding until the agreement is reduced to writing and signed by both of them, the parties will not be bound until it is written out and executed. [FOOTNOTE 24]In contrast, under the 2nd Circuit’s analysis, a reservation contained in a preliminary document that the document will not be binding until formalized can be outweighed by other analytical factors. [FOOTNOTE 25] SUGGESTED LOI PROVISIONS The following discussion assumes that the parties to a proposed transaction wish to create a preliminary agreement of the second type (under the 2nd Circuit analysis), i.e., the terms of the proposed transaction outlined in the LOI are not binding on the parties, but the parties are obligated to negotiate the transaction in good faith and within the terms set forth in the LOI. In drafting such an LOI, the parties should set forth the principal terms of the proposed transaction in a manner that provides a basic framework for further negotiation. The idea is to supply a road map for subsequent discussions, but not to bind the parties to perform the obligations described in the road map. To help ensure that the parties are not bound to perform the general terms of the proposed transaction, the LOI should specifically state that such terms are not binding and that the parties intend to draft and execute a definitive agreement. A statement that the LOI does not contain all the material or essential terms of the transaction and that certain open terms will need to be negotiated should provide further protection against the LOI being found to be a fully binding agreement. The parties to an LOI may also wish to consider including certain binding provisions in the LOI. Any such provisions should be expressly described as binding and clearly distinguished from the non-binding general terms describing the proposed transaction. A list of possible binding provisions might include: � A binding obligation to negotiate in good faith.Although this obligation may be implied by operation of law, from a deal-psychology standpoint it may be useful for the parties to confirm that they will negotiate the formal agreement in good faith. � A binding choice of law and/or choice of forum provision.The laws of different states can vary significantly regarding which factors make an LOI a fully binding contract. Selecting New York law and, if possible, the courts of the 2nd Circuit should help to ensure that the parties’ intent is interpreted in a predictable manner and that the provisions included to make aspects of the LOI either non-binding or binding will accomplish their purpose. � A binding termination date.Stating that an LOI will terminate if the parties are unable to execute a definitive agreement by a certain date should make it difficult for a court to find that the LOI constitutes the final agreement of the parties. If such a provision is included, the parties should consider which if any provisions of the LOI should be identified as surviving the termination of the LOI. � A binding provision regarding the expenses of negotiation.It may be useful to make it clear that each party is responsible for its own advisers’ costs if such costs could potentially be significant. In the event that negotiations break down and a formal agreement is never concluded, such a provision should prevent one party from attempting to recover these costs from the other. � A binding provision regarding confidential information.If the parties have not already executed a separate confidentiality agreement, the inclusion of such a provision should ensure that any confidential information exchanged between the parties during the negotiation process will remain confidential if the proposed transaction is not concluded. � A binding provision regarding exclusivity.If the seller has undertaken to refrain from conducting negotiations with other potential purchasers for a specified period of time, this undertaking should be made a binding agreement in the LOI. Brian McGunigle is a partner with Coudert Brothers, and Per Chilstrom is a corporate associate at the firm. ::::FOOTNOTES:::: FN1 See Adjustrite Systems, Inc. v. GAB Business Services, Inc., 145 F.3d 543, 548 (2d Cir. 1998). FN2 See id. FN3 See id. FN4 See id.at 549. FN5 See Arcadian Phosphates, Inc. v. Arcadian Corp., 884 F.2d 69, 72 (2d Cir. 1989) (listing the following factors: (1) the language of the agreement; (2) the context of the negotiations; (3) the existence of open terms; (4) partial performance; and (5) the necessity of putting the agreement in final form, as indicated by the customary forms of such transactions). FN6 See id.; Adjustrite, 145 F.3d at 549. FN7 See Arcadian, 884 F.2d at 72 (finding that references to the possibility that negotiations might fail and a reference to a future binding agreement require no further examination of the other factors of the test). FN8 See Scholastic Inc. v. Harris, 80 F.Supp.2d 139, 147 (S.D.N.Y. 1999) (quoting contractual language stating that a preliminary agreement was to remain a “complete and mutually binding agreement” in the event negotiations failed). FN9 See id. FN10 See, e.g., Lieberman v. Good Stuff Corp., 94 Civ. 5601 (LAP), 1995 U.S. Dist. LEXIS 14868, at *9 (S.D.N.Y. Oct. 3, 1995) (noting the fact that a letter of intent states that it does not “create rights or obligations on the parties”). FN1 See Arcadian, 884 F.2d at 72. FN12 See Prudential Ins. Co. of America v. Hilton Hotels Corp., 95 Civ. 5575 (KMW), 1996 U.S. Dist. LEXIS 8499, at *20 (S.D.N.Y. June 17, 1996). FN13 See Missigman v. USI Northeast, Inc., 99 Civ. 4763 (CM), 2001 U.S. Dist. LEXIS 1536, at **32 (S.D.N.Y. Feb. 7, 2001). FN14 See Gordensky v. Mitsubishi Pulp Sales Inc., 92 F.Supp.2d 249, 255 (S.D.N.Y. 2000) (quoting “is prepared to enter into a commercial agreement” and “it is our intent to enter into a contract” as language indicative of an intent not to be bound). FN15 See Ward v. Pricecellular Corp., No. 90 Civ. 5214, 1991 U.S. Dist. LEXIS 5000, at *19 (S.D.N.Y. Apr. 16, 1991). FN16 See Lieberman v. Good Stuff Corp., 94 Civ. 5601 (LAP), 1995 U.S. Dist. LEXIS 14868, at *9 (S.D.N.Y. Oct. 3, 1995). FN17 See Space Imaging Europe, Ltd. v. Space Imaging L.P., 38 F.Supp.2d 326, 335-6 (S.D.N.Y. 1999). FN18 See NAP, Inc. v. FRAJAC, S.A., 96-7677, 1996 U.S. App. LEXIS 24944, at *6 (2d Cir. Sept. 20,1996) (unpublished opinion). FN19 See, e.g., Imtrac Indus. v. Glassexport Co., 90 Civ. 6058 (LBS), 1996 U.S. Dist. LEXIS 1022, at * 27 (S.D.N.Y. Feb. 1, 1996) (finding an agreement unenforceable because it lays out no major contractual terms). FN20 See Goodstein Constr. Corp. v. City of New York, 590 N.Y.S.2d 425, 429 (N.Y. 1992) (citing the lower court’s quotation of Arcadian Phosphates, Inc. v. Arcadian Corp.in evaluating an alleged breach of a specified obligation to negotiate in good faith in a preliminary agreement, but not employing the 2nd Circuit’s analysis). FN21 See Henri Associates v. Saxony Carpet Co., 671 NYS2d 46, 49 (N.Y. App. Div. 1998). FN22 See Yan’s Video v. Hong Kong T.V. Video Programs, Inc., 520 NYS2d 143, 145 (N.Y. App. Div. 1987). FN23 See Keis Distributors Inc. v. Northern Distrib. Co., 641 NYS2d 417, 419 (N.Y. App. Div. 1996). FN24 See Scheck v. Francis, 311 NYS2d 841, 843 (N.Y. 1970). FN25 See NAP, Inc. v. FRAJAC, S.A., 96-7677, 1996 U.S. App. LEXIS 24944, at *6 (2d Cir. Sept. 20,1996) (unpublished opinion).

This content has been archived. It is available exclusively through our partner LexisNexis®.

To view this content, please continue to Lexis Advance®.

Not a Lexis Advance® Subscriber? Subscribe Now

Why am I seeing this?

LexisNexis® is now the exclusive third party online distributor of the broad collection of current and archived versions of ALM's legal news publications. LexisNexis® customers will be able to access and use ALM's content by subscribing to the LexisNexis® services via Lexis Advance®. This includes content from the National Law Journal®, The American Lawyer®, Law Technology News®, The New York Law Journal® and Corporate Counsel®, as well as ALM's other newspapers, directories, legal treatises, published and unpublished court opinions, and other sources of legal information.

ALM's content plays a significant role in your work and research, and now through this alliance LexisNexis® will bring you access to an even more comprehensive collection of legal content.

For questions call 1-877-256-2472 or contact us at [email protected]

 
 

ALM Legal Publication Newsletters

Sign Up Today and Never Miss Another Story.

As part of your digital membership, you can sign up for an unlimited number of a wide range of complimentary newsletters. Visit your My Account page to make your selections. Get the timely legal news and critical analysis you cannot afford to miss. Tailored just for you. In your inbox. Every day.

Copyright © 2020 ALM Media Properties, LLC. All Rights Reserved.