2.3 Degrees of binding and non-binding commitments

…or: Drafting a Letter of Intent (LOI), MOU or Term Sheet

If the contracting parties are not prepared to enter into a binding agreement, they might nevertheless consider some kind of non-binding commitment. The possible reasons for this vary considerably. For example:

  • the anticipated transaction is too complex or too large to negotiate in one single step towards an agreement;
  • the parties are not yet aligned on the structure or nature of a transaction (e.g. cross-border tax effects remain to be optimised or the transferability of assets and rights must be determined);
  • a transaction, in whatever form, would be subject to conditions of such importance that it is not efficient pursuing the transaction in its entirety; however, discussions may have reached such stage that outlining some mutually acceptable principles and procedures is possible; or
  • an agreement is necessary and even entered into, but there are certain post-closing obligations, which can only be agreed upon if other factors are settled, if certain (internal or external) developments have taken place, if certain milestones have been achieved, if a prototype has been delivered and accepted, or if a basis of mutual trust has been established necessary for exploring further extensions to the agreement.

The first three examples may well be cases for a term sheet, letter of intent or memorandum of understanding. The fourth example is often found in (binding) joint venture agreements, joint development agreements, master services agreements and other (long-term) relational contracts: in those agreements, the wording of intent would appear as contractual guidelines, anticipated procedural steps marked by milestone deliverables for decision-making or in the form of (serious but non-binding) intentions and ‘agreements to agree’.

Drafting techniques. Many lawyers are overly cautious in drafting letters of intent or term sheets, repeating the non-binding nature in every provision, which makes the entire document difficult to read. Other than expressing that a term sheet or letter of intent is non-binding, there are a few techniques to create a functional non-binding document. In order to prevent that a letter of intent or term sheet is considered to be binding, it is recommended to:

(a)     be selective (as regards the provisions in which intentions are expressed instead of obligations) and accurate and consistent (as regards the wording used to express intentions or obligations);
(b)     include conditions precedent (CPs); and
(c)     state which specific matters are to be agreed in order to achieve an agreement.

Let’s explore the three recommendations. As regards selectivity and accuracy, a drafter should focus on the provisions that matter and reflect those in non-binding words. Of course, a non-binding LOI will talk about the parties intend to rather than the parties agree that. Also, an LOI may well refer to provisions that will be inserted or elaborated on in the definitive agreements: In the SPA, Party 1 shall undertake to… or The Licence Agreement shall contain the following provisions: … If a provision is irrelevant or ineffective, as long as the key provisions are non-binding, it is not necessary to stuff it with non-binding signals. Be careful, however, that a letter of intent does not contain many avoidable signals of being binding.

Given that generally, a contractual condition has a strong legal impact, providing that any agreement is ‘subject to approval‘ (e.g. by the shareholder or the board or board representative of a parent company) and ‘subject to contract‘ are effective means to establish the non-binding character of an LOI. Other conditions commonly included in a non-binding LOI include a reasonably satisfactory outcome of due diligence investigations and the involvement of a works council. The conditions in a letter of intent may relate to two or even three different objects, one being the letter of intent itself and the other the anticipated definitive agreement (and its completion). Accordingly, the LOI may state that a transaction is subject to due diligence, subject to contract and subject to obtaining finance; whilst the LOI may also state that the binding agreement (or completion of the obligations in the definitive agreement) will be subject to regulatory approvals and the payment of the purchase price.

Finally, the drafter of an LOI could list specific items that are pending agreement. Listing such matters is a clear indication that a final agreement has not been reached. The main ‘risk’ with listing such matters is that the other party who claims the LOI was binding simply accepts the proposals made although this should not be used as a reason not to list such items. Similarly, a drafter could include a timetable and a table allocating responsibility for drafting tasks (i.e. who is expected to prepare the first draft of an agreement).

It would of course not be very supportive to convey the non-binding nature of a letter of intent (or worse, a ‘heads of agreement’) by starting with words of (full) agreement. Accordingly, the body text could be preceded by:

NOW THEREFORE, the Parties intend to negotiate and to agree on the following subject matters:

Clause identifying binding provisions. In many letters of intent, a specific provision is included to establish that none of the provisions are binding, except for certain specific clauses. The purpose of such provision is obviously to satisfy those lawyers who fear that, as a consequence of the non-binding nature of the letter of intent or term sheet as a whole, the subjects that do matter at the preliminary stage would also be considered as non-binding. The clauses that would normally be identified are those on exclusivity (of negotiations), confidentiality and public announcements, applicable law, dispute resolution, liability for termination (if applicable) and that clause identifying those binding provisions itself.

Subsequent oral arrangements. Many letters of intent are never extended into a binding ‘definitive agreement’. On the one hand, the subsequent negotiations may end up in an impasse and do not lead to the anticipated transaction. On the other hand, operational managers might pursue the anticipated transaction with such a definitive agreement and issue binding purchase orders. Whilst in the former context no specific LOI or MOU-wording would be needed, in the latter case consider including a clause expressing that notwithstanding any subsequent acts of performance, references to general terms and conditions or any oral agreement between the parties, the provisions of the term sheet or letter of intent will prevail. See also paragraph 7.6(g) about discarding any term sheet or letter of intent in the definitive agreement.