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Letters of Intent – Key Aspects and Dangers

Parties frequently sign an “agreement in principle,” “term sheet,” “memorandum of understanding” or “letter of intent” (LOI) which are synonymous terms for a summary of points forming a basis for continued negotiation of a business acquisition, merger or other business transfer or a commercial transaction, joint venture or other business arrangement.

I. Letter of Intent Benefits

A. Start regulatory review periods (e.g., Hart Scott Rodino pre-merger antitrust notification filings).

B. Cost-Effective “Go – No Go” Decision. LOIs are relatively inexpensive means for confirming major deal terms before incurring the substantial expenses of due diligence and purchase and financing documentation.

II. Letter of Intent Risks

The LOI may be construed as a binding purchase and sale agreement if it is improperly drafted or if it is improperly characterized in subsequent announcements or other actions of the parties.

A. Vague Tests for Binding LOI. The legal standard in determining if the parties intended to reach an agreement is an objective test – would a “reasonable person” believe that an agreement had been reached based on all of the evidence? The subjective intent of the parties (their actual understandings) is not determinative and, in any event, their understandings would be conflicting in a dispute. Since reasonable persons may reach different conclusions, this imprecise standard leads to unpredictable outcomes and litigation.

  1. An enforceable agreement requires agreement on essential terms. T.O. Stanley Boot Co. v. Bank of El Paso, 847 S.W.2d 218, 221 (Tex. 1992).
  2. Parties may agree on some of the contractual terms, understanding them to be an agreement, and leave other contract terms to be made later. It is only when an essential term is left open for future negotiation that there is nothing more than an unenforceable agreement to agree. A party cannot accept an offer to form a contract unless its terms are reasonably certain. Oakrock Exploration Co. v. Killam, 87 S.W.3d 685, 690 (Tex. App.–San Antonio 2002, pet. denied) (citing T.O. Stanley Boot Co., Id at 221).
  3. Texas courts will construe several separate instruments relating to the same matter together, even if executed at different times, to determine if their cumulative effect constitutes a binding agreement. Board of Ins. Comm’rs v. Great Southern Life Ins. Co., 239 S.W.2d 803 (Tex. 1951).

TIP – Rather than forcing a court to determine the “intent” of the parties who are now making contradictory claims, the LOI should clearly and plainly state its nonbinding or binding effect. Simply stating that a document is a “letter of intent” or “agreement in principle” is insufficient. While most parties subjectively intend an LOI to be a preliminary road map for further negotiations, occasionally a seller wants the LOI to be a binding purchase agreement to fix the purchase price, avoid seller representations and warranties, and eliminate the buyer’s opportunity for due diligence. Sometimes the buyer, as in the Texaco v. Pennzoil case discussed below, wants the LOI construed as a binding agreement. In that case, the buyer (Pennzoil) wanted its LOI to acquire Getty Oil characterized as a binding agreement in order to sue Texaco for tortious interference with contract. Some commentators believe that Pennzoil fared better from the litigation than if it had successfully purchased Getty Oil.

B. Binding LOI without Subsequent Purchase Agreement.

In Texaco, Inc. v. Pennzoil Co., 729 S.W.2d 768 (Tex. App. 1987), writ of error refused 748 S.W.2d 631 (Tex. 1988), cert. dismissed, 485 U.S. 994, Pennzoil won a $10.5 billion judgment against Texaco for tortious interference with Pennzoil’s “handshake” agreement to acquire a controlling interest in Getty Oil for $5.3 billion. Although the judgment was later settled for $3 billion cash, Texaco was forced to file for bankruptcy. A definitive merger agreement for this multi-billion dollar transaction was never signed or even negotiated. However, the court found that a merger agreement had been reached based on a 5-page Memorandum of Agreement and a Getty Oil press release that it had reached an “agreement in principle” with Pennzoil. Other evidence of an agreement included a provision in the subsequent agreement between Texaco and Getty Oil where Getty affirmatively disclaimed making representations regarding the “Pennzoil Agreement” and Texaco indemnified the Getty Oil trustees for any claims arising out of the Pennzoil Agreement. In addition, the Getty-Pennzoil press release announcing the “agreement in principle” included multiple statements worded as covenants or agreements such as: (i) Getty shareholders will receive; (ii) Pennzoil will contribute; (iii) the parties will…. These statements were used to determine that Getty and Pennzoil had reached a “binding agreement” notwithstanding the reference in the press release that the agreement in principle was subject to execution of a definitive merger agreement and stockholder approval.

TIP – References to an “agreement” and obligatory statements should be avoided in subsequent emails, press releases, announcements or other descriptions of the LOI.

C. Binding LOI in Addition to Binding Purchase Agreement.

In Kelly v. Rio Grande Computerland Group, 128 S.W.3d 759 (Tex. Civ. App. – El Paso 2004, no writ) the selling shareholders entered into a “Letter of Intent” providing favorable employment terms for the largest shareholder to serve as President after the closing. However, the purchase agreement omitted these and several other provisions. When the largest shareholder was not retained as the President or even as an employee, he sued the purchaser for breaching the “agreement” contained in the LOI. The purchase agreement contained the following general merger clause:

“Entire Agreement. This Agreement merges all previous negotiations between the parties hereto and constitutes the entire agreement and understanding between the parties with respect to the subject matter of this Agreement. No alterations, modifications or change of this Agreement shall be valid except by a like instrument in writing and signed by each party to this Agreement.”

TIP – A subsequent purchase agreement should specifically list superseded LOIs, agreements and writings in addition to containing a general merger clause.

III. Binding and Nonbinding Provisions. Most LOIs contain binding and nonbinding provisions. Typically, the “transaction” terms are expressly stated to be nonbinding and the “deal protection” provisions are expressly stated to be binding. As a partially binding agreement, these types of LOIs present challenges in clearly stating the intent of the parties.

A. Structuring for Clear Intent.

  • Include an introductory paragraph stating that (1) the provisions listed in “Part A” are not binding agreements unless and until the parties sign definitive agreements regarding and that (2) the provisions in “Part B” are binding on execution of the LOI.
  • List Binding and Nonbinding Provisions under Separate Headings in the LOI such as: “Part A – Nonbinding Provisions” and “Part B – Binding Provisions”
  • Under each heading, restate the intention (the following provisions of this Part [A/B] [are/are not] binding on the parties)
  • List the types of closing conditions typical for the type of transaction in the nonbinding provisions of Part A. Invariably, the buyer will want a “due diligence” closing condition (although the standard of satisfaction with the due diligence results may vary).
  • Reiterate at the end of the LOI which provisions (e.g., those in Part A) are not intended by the parties to be binding and which provisions (e.g., only the provisions in Part B) are intended to be binding.

B. Nonbinding Provisions. Although nonbinding, these provisions are the most important from business and cost control perspectives. These provisions vary based on the type of transaction but typically state:

  • The nature of the transaction – stock or asset purchase, merger, etc.
  • Price and type of consideration
  • Seller financing – terms of promissory notes and/or earn-out
  • Purchase price adjustments based on working capital, cash equivalent, or inventory levels at closing.
  • Buyer’s pricing formula subject to due diligence confirmation of seller statements
  • Post-closing employment and consulting arrangements
  • Post-closing noncompetition and nonsolicitation terms
  • Post-closing purchase price holdback/escrow
  • Closing conditions
  • Due diligence and applicable standard for buyer’s satisfaction
  • Approval requirements
  • Interim conduct of business (may be binding or nonbinding)
  • Interim compensation of employees
  • Applicable financing condition(s)

C. Binding Provisions. Binding provisions may include:

  • A “reasonable or best efforts” obligation to negotiate
  • No-shop/exclusive dealing clauses
  • Interim conduct of business (may be binding or nonbinding)
  • Confidentiality agreement of buyer
  • Governing law
  • Dispute resolution
  • Responsibility for expenses
  • Expiration/deadline for returning fully executed counterpart

IV. Sample Provisions

A. EBITDA Definition for Earn-out (Nonbinding). Transaction provisions defining critical terms may reduce future disputes when drafting the definitive agreement. For example:

“EBITDA” shall mean the earnings of Newco before deductions for interest, taxes, depreciation and amortization determined on a consistent basis with [GAAP consistently applied of/the federal income tax filings made by] the [Seller] prior to the purchase and sale (i) increased by the sum of (i) any [bonus] amounts paid or accrued to be paid to [Selling Owner/Key Employee of Newco] or other members of Newco’s senior management and (ii) any amounts paid or accrued to be paid to [Acquirer], any member of Newco’s board, any direct or indirect portfolio company of [Acquirer], or any direct or indirect affiliate of a Newco board member (each an “Acquirer Affiliate” and collectively “Acquirer Affiliates”), and (ii) after adjustment of the purchase and sales prices of any goods or services Newco sells to or purchases from any Acquirer Affiliate to reflect the amounts that Newco would have realized or paid if dealing with an independent party in an arm’s-length commercial transaction. EBITDA will be determined by [Seller/Acquirer] promptly after the close of each full year after the closing. If [Acquirer/Seller] objects within 30 days of receipt to the calculations, an independent CPA will make a final determination of the amount.

B. Post-Closing Operations (Nonbinding). These transaction provisions relating to Earn-outs must be carefully tailored to each transaction to address financial, accounting and operational issues (to be discussed in a future post relating to Earn-outs).

C.  Equity Protective Provisions (Nonbinding). If the purchase consists of only a controlling interest in the Seller or the Seller retains any equity ownership in the post-closing business, the LOI should summarize the equity protective provisions to be included in the definitive purchase agreement.

D. Confidentiality (Binding). Incorporating a separate Confidentiality Agreement by reference maintains the brevity of the LOI while permitting sufficient length in a separate document to address the issues described in posts on this website discussing “Confidentiality Agreement Traps.”

E. Due Diligence Procedures (Binding). “Subject to executing a confidentiality agreement satisfactory to Seller, the Seller shall permit Acquirer and its employees, consultants and representatives who require such information in order to analyze, investigate and possibly facilitate the proposed transaction (collectively “Personnel”) to have reasonable access to information regarding the Seller and its business; provided, however, until the Seller decides that the closing is assured, Seller may elect to withhold competitively sensitive information (including without limitation customer names, quantity of work and other business matters) and may elect to provide disclosures using symbols, code names and descriptive information in lieu of actual information. Acquirer shall use best efforts to not interfere in any material respect with the operations of the Seller’s business. Acquirer and all of its Personnel must observe the following procedures regarding access to the physical premises of the Seller unless otherwise approved in writing by the Seller:

  • The timing and duration of visits to any premises of the Seller shall be mutually agreed in advance.
  • Representatives of the Acquirer agree to converse only with such employees of the Seller as Seller approves in writing.
  • Acquirer shall send no more than three people at a time to visit any premises of the Seller.
  • Due diligence shall be conducted at the premises of the Seller only in [Seller/Owner’s] presence.”

F. Expiration Clause (Binding). An expiration clause should be included in each LOI since (i) an offer [consisting of the Binding Terms] remains open until it is either accepted or notice of withdrawal of the offer is given, (ii) a tight deadline may inhibit the ability of the other party to “shop the deal,” and (iii) in contrast to a written notice of withdrawal of the offer, an automatic expiration provides a non-confrontational means of terminating the offer without jeopardizing future negotiations.

G. Exclusive Dealing/No Shop Clause (Binding). This clause prevents Seller from seeking, negotiating or agreeing to other offers for a time period sufficient to provide Acquirer a reasonable amount of time to negotiate a definitive agreement.

H. Option Consideration (Binding). Under Texas law, generally a purchaser cannot enforce a “contract” in which it has no obligations. Adding a clause containing purchaser’s promise to pay Seller $100 on demand provides “legal consideration” to make the binding portions of the LOI enforceable when signed by Seller.

This blog does not establish an attorney-client relationship and does not constitute legal advice. Legal outcomes are based on the particular facts of a situation and the application of the law to those facts.  Anyone with issues described in this blog should hire an attorney for legal advice based on the relevant facts. The firm has no obligation to maintain the confidentiality of any information received by email or comments.

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