Last week this blog had a posting, Don’t Sign the Term Sheet, in which we discussed some dangers of signing term sheets, even if they are stated to be non-binding.
We called the document a term sheet, although we could have used any number of alternative names that are often used interchangeably with term sheet, including:
- heads of terms
- heads of agreement
- memorandum of understanding
- letter of intent
Which term is used seems to depend largely on commercial practice in a particular country or industry. We are not aware of any legal distinction between these terms. Under English law, the document’s title is far less important than whether the parties intend the document to be legally binding, which should be stated in the document itself. As we discussed last week, parties usually prefer the document to be non-binding, although sometimes a hybrid solution is agreed, under which certain terms are binding (typically, an exclusive negotiation obligation and a confidentiality obligation) and the rest are stated to be non-binding.
This week we focus on a different issue, which is whether these preliminary documents (let’s call them letters of intent, for the sake of variety) should ever be stated to be legally binding in their entirety. Where this is done, parties usually intend the terms of the letter of intent to create a short term contract whose terms will apply until a more detailed agreement is signed.
For clarity, we are not referring here to option agreements or other preliminary agreements that may trigger or lead on to a substantive agreement. Rather we are talking about the situation where the parties start a full contractual relationship on the basis of a short written agreement, but in the expectation that they will negotiate more detailed “legal” terms at a later date.
A couple of examples may illustrate the point:
Example 1. The CEO of an IT company that is listed on a stock exchange is concerned about a recent slump in the company’s share price. The company has recently negotiated a letter of intent with a prospective joint venture partner, which sets out the main terms of the proposed JV. The CEO believes that the JV will be viewed favourably by the share market, and that news of it will halt the decline in the company’s share price, or even increase the share price. The company would be required by the rules of the stock exchange on which it is listed to announce the JV as a material contract. However, it is a rule of the relevant stock exchange that only binding agreements can be announced; non-binding letters of intent may not be announced.
The letter of intent is fairly detailed (12 pages) and the CEO instructs the company’s General Counsel to convert it into a binding agreement. The CEO suggests that this can be done simply by changing the clause that says the document is non-binding by deleting the word “non”. After all, the CEO says, we’ve negotiated all the important terms; the rest is merely legal boilerplate. The CEO is confident that the detailed legal terms can be negotiated at a later date.
Example 2. Two companies have agreed the key terms on which one of them (the service provider) will provide product development and testing services to the other party (the product owner) in respect of the latter’s next “flagship” product. The product is potentially very important to the product owner and any delay in bringing it to market will result in lost revenues, not least because the product is protected by patents that have a finite duration. The parties do not wish to wait until a detailed agreement is negotiated and signed before starting work, so they agree a three-page, binding letter of intent that enables work to start and to be paid for, whilst they negotiate a detailed agreement.
Ultimately, the Board of Directors (or, by delegation, the CEO or other senior management) must decide which contract terms are in the company’s best interests, weighing up any legal advice against other relevant factors. In the first example, though, our experience suggests that a binding letter of intent would often be a bad idea. One on notable occasion in which this situation arose, the share price continued to slide, and the news made no difference. However, signing a binding letter of intent, or preliminary agreement as it was later called, caused significant problems. Usually, parties work to a deadline in negotiations and whittle down the differences between them as the deadline approaches.
In this case, once the letter of intent was signed, one of the parties referred the draft (full) agreement to their relevant departments for comment. Each department came back with their shopping list of preferred terms. The resulting draft agreement took several major steps backwards in the negotiations. In the absence of time pressure to reach an agreement, negotiations made little progress for over a year, until eventually someone new came into the other party’s legal department and decided to stick closely to the principles of the terms agreed in the letter of intent. The resulting agreement was pretty close to the letter of intent “plus some legal boilerplate” but it was a painful process to get there.
The second example above is probably more often seen than the first. For instance, we have seen binding letters of intent used in the pharmaceutical sector when one party performs R&D work for another party. This practice has become sufficiently widespread that it may be difficult to say “no” to it sometimes. In such situations, our main priorities are to make sure that the letter of intent includes terms that:
- clearly describe the work to be done, including stating any standards or specifications to be met
- clearly state the price or rate for the work done
- limit the amount of money that may be spent under the letter of intent and the duration of such work (so that is not open-ended as to amount or time; 60 or 90 days may be a suitable maximum period)
- state who owns any intellectual property arising from the work
- include liability provisions
- state which law and jurisdiction govern the letter of intent
Part of the role of contract terms is to manage risk and, particularly in the case of long-term contracts such as JVs, IP licences and R&D agreements, to address contingencies – the “what if…” clauses. Detailed contract terms are usually considered necessary to address these matters. It is not always obvious to this lawyer why short-term commercial priorities make a binding letter of intent an acceptable alternative. Where they are used, they should carry a large health warning.