Letter of intent

• January 30, 2023
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• Business, Company
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A letter of intent, also known as a heads of agreement, is often used by parties before entering into a formal contract. While such a letter can be a useful tool to maintain momentum during a commercial transaction, the document itself has been the centre of many disputes over the years.

We give an overview on why parties may wish to use a letter of intent, and the downsides that could lead to business losses and commercial disappointment.

What is it?

A letter of intent is a signed document with two or more parties that shows a commitment to achieve a particular outcome – usually in a commercial setting. A common example is when two or more parties are forming a joint venture or one party is procuring services from another.

The document may contain terms that have been agreed upon to date. It may include, for example, the subject of the transaction (a joint venture, merger, etc), key dates, pricing and details around what remains to be determined.

Purpose

Setting out the terms that have already been agreed can allow the transaction to proceed with confidence to more costly stages such as engaging specialist legal or taxation advice. It can also help tie together many different points of a negotiation process and give clarity to the parties as to what still remains to be resolved.

What could go wrong?

The primary issue with a letter of intent is enforceability. A letter often requires some goods or services to be procured while the contract is not yet finalised. If the letter is found to be unenforceable, this could lead to significant losses. For example, in a 2020 case (Electrix Limited v The Fletcher Construction Company Limited NO 3 [2020] NZHC 2348), the High Court determined that the letters of intent exchanged between the companies did not constitute a binding contract. In this matter, Electrix had provided services of up to the value of $28 million, despite the various letters of intent exchanged between the parties capping the work at approximately $14 million. The High Court found in favour of Electrix and determined that because there was no binding contract, Electrix was entitled to recover its reasonable costs of services rendered.

The accepted legal position is that letters of intent can be both enforceable or unenforceable; the content of the agreement, as well as the conduct of all the parties to the document, will be relevant in deciding if a letter of intent is enforceable.

This means that if a party is relying on the spirit of a letter of intent and the transaction is cancelled or it is  unenforceable, the result could mean a significant over-investment and loss for that party. It could also mean that after not following through on a letter of intent, a disappointed party could challenge the right to cancel or one party could seek to limit their losses, which can result in costly litigation.

If you really want a letter

A letter of intent should always be reviewed by your lawyer before it is signed. It is particularly important to ensure all parties receive legal advice on the enforceability of the document before it’s signed.

At a minimum, a letter of intent should state whether the letter is intended to be binding, if only parts of it are binding, and what happens if the parties decide not to proceed.

If all parties involved are seeking a non-binding and unenforceable document that ties together all the threads of a negotiation purely for reference or record keeping, a letter of intent may be a great option. In these circumstances, the letter of intent must be abundantly clear that it is not designed or intended to create a legal obligation between the parties.

Is a letter of intent worth the risk?

Considering the risks outlined above, it may be reasonable to ask why non-binding letters of intent are even used?

A non-binding letter of intent can be a useful way to document negotiated and agreed points in complex business transactions with multiple parties or stages. It can also be used as a good faith gesture from each party that the documented terms have been agreed and will not be renegotiated. A good faith gesture allows the necessary legal or taxation advice to be given with certainty while leaving the parties with the flexibility to back out if necessary or desirable.

If you want to secure services or a form of commitment that is available in a letter of intent while a formal contract is being prepared, tread carefully. If there is sufficient information to reach a formal contract, finalising a contract will provide the best protection and certainty to both parties.

If you are entering into a complex legal transaction and are considering using a letter of intent, please contact us before you sign it.