A letter of intent (“LOI”) is often the first document in a proposed deal – a summary of a range of key terms or concepts for negotiation toward entering into a final, formal agreement. But what seems like a simple document can be much more than a mere list of possible terms to be discussed by the parties, and might just result in a final agreement in one side’s sole discretion.  In some cases, an LOI can be an enforceable agreement to negotiate in good faith toward a final agreement based, at least in part, on its stated terms.  Even those LOIs that specifically say they are non-binding may, in fact, be binding.  For instance, an LOI could be enforceable in its own right if all material terms of a final agreement are set out in the LOI and the parties’ conduct suggests they treated the LOI as a final agreement.  Rather than being a “safe haven” that can be terminated at will without liability, an LOI can present great risk and unintended consequences to the parties if not recognized and handled with care.  Missteps in documentation and/or subsequent conduct of the parties along the way could result in blown deals and damages.  Even an otherwise carefully and clearly drafted LOI may not be free from risk or unintended consequences.

An LOI typically contains two parts: those provisions called out specifically as enforceable, and those provisions called out specifically as non-enforceable.

The non-enforceable provisions generally include proposed deal terms: price, timing, deposit and other material items. While the LOI generally states that such terms themselves are neither enforceable nor a complete set of terms of the proposed deal, the typical LOI contemplates that the parties will use those terms as the basis for beginning negotiations. The expressly enforceable provisions generally are those designed to protect the proposed deal or the parties’ respective expectations that a good-faith effort will be made to reach a deal.  Exclusivity provides the parties with assurances that their anticipated deal won’t be scooped up or pre-empted by a competing offer by another party during the exclusivity period, and confidentiality provisions protect material, confidential information.

The typical LOI states which provisions are enforceable and which are not. But words alone may not be enough.  Once signed, the parties to an LOI almost always have a duty of good faith to act in a fair and commercially reasonable manner.  Sometimes, a good-faith provision is drafted into the LOI.  However, in most states, including California, Washington, Oregon and Alaska, a duty of good faith is implied in every contract.

Precise definitions of “good faith” vary by state, but generally good faith requires acting in a fair and commercially reasonable manner consistent with the reasonable expectations of the parties. This means that the parties cannot frustrate the deal by acting unreasonably or contrary to the terms of the LOI.  The purpose of an LOI often is to set parameters for further negotiation.  If a seller midway through negotiations purposely tries to make negotiations fail in favor of a better deal (particularly if there is an exclusivity clause), the seller would be risking a bad-faith claim if it attempted to blow up the deal by engaging in unreasonable negotiation tactics, e.g., tripling the asking price without reason, or arbitrarily asking for a 100% deposit on a “take it or leave it” basis.  The good-faith obligation ensures that the parties’ investments in time, money and effort will not be wiped out by an arbitrary change of heart or unreasonable delay not contemplated in the LOI terms.

If a party fails to act in good faith as contemplated by the LOI, it could be liable for reliance damages equal to the other party’s costs incurred in pursuing the LOI (reliance damages), and for breach of an exclusivity covenant. In fact, a few jurisdictions have suggested that expectancy damages for failure to negotiate in good faith may be awarded as if a final agreement were negotiated.  The extent and scope of damages vary by state.

Conduct is also key. Even if the stated deal terms are non-binding, partial performance of the stated terms (or other terms deemed agreed to by the parties) or acting in a manner that would lead third parties to believe an actual agreement existed may be enough to bind the parties to the LOI.  Even an express term in an LOI that no subsequent conduct of the parties short of executing a final written agreement will bind the parties can be overridden by the subsequent conduct of the parties.

LOIs have an important role in memorializing terms and creating clarity, focus and stability in negotiations, but they come with risk. Clear language and careful conduct are needed to protect buyer and seller.  Some factors to consider when drafting or reviewing LOIs include:

  • Make clear which terms are binding and non-binding
  • Expressly state that no joint venture or partnership is formed by the LOI
  • Clearly state conditions precedent to formation of a binding agreement, and that the listed terms do not constitute final terms or all material terms
  • Include express statement of reliance on disclaimers, waivers or non-binding nature of LOI
  • Don’t act as if the LOI is the final deal; use care in conduct of business during the LOI phase and in any communications to the public and third parties
  • Identify the period for negotiations and completion of transaction documents
  • Identify the parties’ respective termination rights and effect of termination