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Letters of intent are they worth it?

Feature Articles

Cite as: (2004) 78(3) LIJ, p. 60

Whether a letter of intent is binding will depend on its terms, the circumstances of its creation and the subsequent actions of the parties.

By Robert Macey

Many organisations use a letter of intent, sometimes known as a memorandum of understanding (MOU), terms sheet or heads of agreement, to set out the basic terms of a proposed transaction. The very nature of letters of intent indicates an intention to contract in the future; however, problems can arise if it is unclear whether the document is or is not a final statement of the parties’ agreement. The approach of “just getting something down on paper” and letting lawyers fix things up later can be risky.

Legal treatment of letters of intent

The general presumption adopted by Australian courts is that letters of intent are usually not legally binding agreements. Documents or agreements that are said to be “subject to contract” will not generally be binding agreements.[1] However, the words used by the parties are not the sole consideration of the courts. The intention of the parties, evidenced by the surrounding circumstances, will also be a matter that a court will have regard to, and may have the effect of qualifying the general presumption.

For example, in Air Great Lakes Pty Ltd & Others v KS Easter (Holdings) Pty Ltd,[2] the New South Wales Court of Appeal stated:

“The intention to create a legally binding contract although a matter to be proved objectively may, nevertheless ... be proved by what the parties said and did as well as what they wrote”.

In that particular case, the parties entered into a document entitled “Terms of agreement”. The document was signed by all parties and contemplated the sale and purchase of light aircraft. The Court held that the “Terms of agreement” document was legally binding having regard to the statements and actions of the parties. These statements and actions were as follows:

  1. the urgent desire of the defendant to have the purchase settled quickly;
  2. the unavailability of the parties’ lawyers and the parties’ agreement to draft their own contract;
  3. the attempted use of a sale of business contract as a precedent document; and
  4. the defendant’s wish to have the contract as simple as possible.

In Electricity Corporation of New Zealand Ltd v Fletcher Challenge Energy Ltd,[3] decided in October 2001, the relevant MOU contained comments including “to be agreed” and “not agreed” against various paragraphs in the MOU itself. In the circumstances, the court found that the MOU was not a binding contract.

The legal position in other jurisdictions

The courts in the UK have also viewed letters of intent as generally not resulting in binding agreements. In British Steel Corp v Cleveland Bridge and Engineering Co Ltd,[4] a letter of intent between a principal and contractor proposing terms of supply was held not to give rise to a binding contract. The parties had continued to exchange correspondence and the terms of the bargain were never agreed. In this case, the contractor had actually completed the proposed work and was able to recover on a quantum meruit for the work performed. On the enforceability of letters of intent the court said:

“There can be no hard and fast answer to the question whether a letter of intent will give rise to a binding agreement; everything must depend on the circumstances of a particular case”.

Interestingly, however, the court stated it was possible that a binding contract could be created by a letter of intent in two ways: first, by the creation of an “executory” contract where each party assumes reciprocal obligations to each other; or second, by an “if” contract, where one party promises to do something if the other performs reciprocal obligations and that party does then perform them.

In the US, the courts have relied more on the factual scenario to support the finding of a binding letter of intent. In Apco Amusement Company Inc v Wilkins Family Restaurants,[5] the parties entered a letter of intent contemplating the building of an amusement centre. The letter was signed by both parties and the court found the letter constituted a binding contract, saying:

“The existence of a contract, the meeting of the minds, the intention to assume obligations, and the understanding are to be determined in the case of doubt not alone from the words used, but also the situation, acts and conduct of the parties, and the attendant circumstances”.

Lessons from the law

Whether a letter of intent constitutes a binding contract between the parties may be affected by the course of conduct of the parties. The courts are now more inclined to have regard to the surrounding circumstances of the deal and, in certain circumstances, consider letters of intent to create legally enforceable relationships rather than merely honourable engagements.

Those wishing to use letters of intent should include a clear statement as to whether the letter of intent is to be binding or not.

Any subsequent conduct or representations should be consistent with this intention. Remember, however, that if a party begins performing under it, it may be considered to be legally binding.

Why use a letter of intent?
There are no strict guidelines for when to use a letter of intent for a particular transaction. The commercial drivers relevant in determining in each case whether a letter of intent is entered might include that:

(a)

the parties feel “bound” to a greater degree by a signed piece of paper;

(b)

the longer the parties wait to record their oral understandings in writing, the greater is the risk of misunderstandings arising;

(c)

if the terms of the proposed transaction are relatively complicated, a letter of intent will serve to assure each party of some “meeting of the minds”;

(d)

the letter might convince a third party – for example a bank, or even an internal party within the organisation – in order to get business case “sign off” and confirmation that the transaction contemplated is viable for the business; and

(e)

it may serve as an aide memoire and a brief for the draftsperson who will ultimately draft the formal contract.

Do I need one and what are the pitfalls?
Transactions involving “low value” amounts may dictate that the parties move directly to drafting a final contract rather than expend time, money and resources in negotiating a detailed letter of intent. Also, where only a short length of time is anticipated between the signing of the letter of intent and the formal contract it may be preferable to move directly to the final contract.

The conduct of the parties in the pre-contract period, particularly if the letter of intent and surrounding conduct suggests to the other party that it can rely on the eventual creation of a formal contract, may give rise to potential remedies under the law of estoppel – for example, where work is performed as a result of that reliance.

Reviewing letters of intent
Letters of intent may vary in style and content. The following, however, should be borne in mind when reviewing a letter of intent:

(a)

is there a general statement of the transaction being contemplated?;

(b)

is there a description of the services or products proposed to be sold or acquired?;

(c)

is there a description of the consideration or a formula for arriving at the consideration?;

(d)

are there any conditions precedent? Is there a timeframe for the reaching of the final contract?;

(e)

are there clear statements regarding the parties’ intention to be bound?; and

(f)

are there any statements that might create an expectation or encourage a reliance?

Suggested structure of a letter of intent
The terms of a letter of intent contemplating an IT contract, for example, might be arranged under seven broad headings:

  1. the intention of the parties in entering the letter of intent – be explicit;
  2. the services to be provided;
  3. any special arrangements, e.g. obligations of confidentiality, escrow arrangements, a deadline for the execution of a definitive contract;
  4. a statement of any conditions precedent, for example a buyer’s due diligence, important disclaimers, the non-binding nature of the letter;
  5. how service fees or payments, including any ongoing maintenance fees and payments, are calculated;
  6. the protection of intellectual property and use of any developed intellectual property; and
  7. termination and consequences of termination.

Conclusion

It pays to think twice before deciding on the next step following an oral agreement or “handshake”. Consider whether you want to sign a letter of intent that is binding. Remember that the court, having regard to surrounding circumstances, can still decide that a letter of intent is binding even though one party did not so intend.

If you do not wish to be bound, then make this clear.

It might be prudent to ask: Is a letter of intent appropriate for my particular transaction? Alternatively, is proceeding directly with the drafting of a definitive contract a more practical course?

If you decide that a letter of intent is appropriate in the circumstances, preserve some “wiggle room”. Ensure that the letter contains a clear statement that the parties do not intend to be bound, and make sure that any subsequent conduct is consistent with this intent. State that no reliance should be placed on the terms of the letter of intent. Outline the basic terms to be covered, without too much specificity or detail – leave open some substantive issues for the impending final negotiations. Consider adding a modest liquidated damages provision – it could serve as a basis for limiting potential liability under the letter of intent.


ROBERT MACEY, a consultant with Ebsworth & Ebsworth, is a former senior associate of Blake Dawson Waldron where he practised primarily in the areas of information technology and telecommunications.


[1] Masters v Cameron (1954) 91 CLR 353.

[2] [1985] 2 NSWLR 309.

[3] [2001] NZCA 289 (10 October 2001).

[4] [1984] 1 All ER 504.

[5] (1981) 673 SW 2d 523.

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