Letters of intent in corporate negotiations: using hostage exchanges and legal uncertainty to promote compliance.

AuthorHolten, J. Andrew

INTRODUCTION I. LOIS FROM BUSINESS AND LEGAL PERSPECTIVES A. LOIs from a Business Perspective B. LOIs from a Legal Perspective 1. Lawyers' Perceptions of LOIs 2. LOIs and Traditional Contract Doctrine 3. Courts Have Struggled to Interpret LOIs II. THEORETICAL JUSTIFICATIONS FOR THE USE OF LOIS DESPITE THEIR LEGAL UNCERTAINTY A. Reputational Consequences of Noncompliance B. Strength of Moral Obligations C. Simplifying Complex Negotiations D. Securities Laws and Financing III. COMPARISON WITH OTHER NONBINDING AGREEMENTS IV. LOIS AS A FORM OF HOSTAGE EXCHANGE A. The Hostage Theory B. LOIs as a Form of Hostage Exchange CONCLUSION INTRODUCTION

Letters of intent (LOIs) are fundamental building blocks of many corporate transactions. Although their form and terms vary, LOIs are used predominantly to communicate parties' agreement to the basic structure of a deal and a mutual desire to continue negotiating. (1) They are commonly called "agreements to agree" or, somewhat oxymoronically, "nonbinding agreements." (2) In almost every respect, these agreements are contracts--except they aren't supposed to be. They state that the parties agree, while also stating that the parties don't agree yet. Under a traditional legal analysis, these agreements pose a problem: either there is an enforceable contract or there isn't one. It's no wonder that LOIs have been described as the contractual equivalent of being "almost pregnant." (3)

Nevertheless, business professionals value these almost-binding agreements. When two companies sign an LOI, the parties often view it as a reason to celebrate. An LOI is considered a major milestone in the lifecycle of many transactions. (4)

Lawyers, however, are less enthusiastic. One prominent corporate lawyer went so far as to describe LOIs as "an invention of the devil [that] should be avoided at all costs." (5) Case law provides numerous examples of the potential legal pitfalls of using LOIs. In Texaco, Inc. v. Pennzoil, Co., one of the most prominent cases involving LOIs, the court held a supposed LOI to be a binding contract, which ultimately cost Texaco $8.5 billion. (6) Although such a large recovery is rare, the legal conclusion is not. Courts frequently find LOIs to be binding contracts, (7) but just as often find similar LOIs to be unenforceable. (8) In the words of the late E. Allan Farnsworth, "It would be difficult to find a less predictable area of contract law." (9)

If parties cannot predict the legal effect of LOIs, why are they used so frequently? Many explanations have been proposed, yet none adequately addresses the element of legal unpredictability that inheres in LOIs. In fact, the leading explanations do not identify a meaningful relationship between LOIs and contract law. This Comment identifies how legal unpredictability affects the operation of LOIs as a negotiating tool and ultimately concludes that LOIs manipulate legal unpredictability to the parties' mutual advantage. Specifically, this Comment argues that signing an LOI facilitates an economic hostage exchange that aligns counterparties' incentives, decreases both parties' abilities to act strategically, and makes completion of the transaction more likely.

Part I provides an overview of how LOIs are viewed from business and legal perspectives, highlighting the difficulty that courts have encountered when interpreting LOIs within the framework of traditional contract doctrine. Part II considers the most common justifications for why LOIs are used despite their legal uncertainty and explains why these justifications are incomplete. Part III compares LOIs with other forms of nonbinding agreements, noting the differences between each and concluding that the unique attributes of LOIs call for a unique explanation of how they operate. Part IV presents the principal thesis that LOIs are useful precisely because of their legal uncertainty. To further this thesis, it demonstrates how parties executing LOIs strategically manipulate uncertainty in the American legal system to create a form of economic hostage exchange. Finally, Part IV provides an overview of the hostage-exchange theory and applies it to LOIs.

  1. LOIS FROM BUSINESS AND LEGAL PERSPECTIVES

    A. LOIs from a Business Perspective

    Business professionals use LOIs in a wide variety of settings. Most commonly, LOIs are used in "transactions involving the sale of goods and services, financing transactions, and real estate transactions." (10) They are also common in M&A transactions. (11) Regardless of the business transaction they are used in, all LOIs reflect the parties' preliminary agreements or understandings with respect to a future contract. Therefore, they are by definition precontractual rather than contractual. (12) As such, they are not intended to be fully binding. (13) This is true even when, as is often the case, an LOI contains certain terms that the parties intend to be binding; when it resembles a lengthy, complex contract in every respect; and when both parties sign it. (14)

    Although the use of LOIs is widespread, there is no consensus among business professionals as to why they are useful. Rather, corporate executives give a multitude of nonspecific justifications for their use. (15) For example, an LOI has been said to serve as "a mere gesture showing interest in the possibility of a transaction" or it may be "an orderly collection of the necessary contractual terms ready to be binding, but missing the key ingredient--the intent to be bound." (16) Others believe LOIs "set[] the binding ground rules of a negotiation," or, more generally, "provide some context to the interest of the parties" in a vague, nonbinding fashion. (17)

    Business professionals value vagueness as a positive attribute of LOIs, and ambiguity (18) is often intended. (19) It has been suggested that LOIs' ambiguity helps negotiating parties avoid "direct confrontation and deadlock," and that parties often "present nonbinding terms ambiguously with the expectation that the ambiguity will be resolved when the terms become binding." (20)

    While LOIs are characterized by a lack of clarity, one point is clear: LOIs do something--whether easily identified or not--to move parties closer to a final agreement. The frequency of their use and the sophistication of the parties that use them provide the best evidence of this conclusion. (21)

    B. LOIs from a Legal Perspective

    1. Lawyers' Perceptions of LOIs

      Lawyers generally dislike LOIs. LOIs' contractual form coupled with their intentionally nonbinding quality place them in an "unclear gray zone" of contract law. (22) While business professionals might view this coupling as a positive characteristic, contract lawyers view the coupling as inherently contradictory. Further, lawyers tend to equate ambiguity and uncertainty with poor lawyering because these characteristics invite litigation (23) as well as strategic behavior from counterparties. (24) The ultimate legal effects of LOIs have been described as possibly "ruinous." (25) If litigated, courts often ignore the business context in which LOIs were executed and analyze them "as typical contracts, focusing on the sufficiency of their terms and on the parties' 'intent.'" (26) Courts must use traditional contract doctrine to determine the intent of the parties manifested in an LOI. This creates anxiety for lawyers and challenges for courts because LOIs do not fit neatly within the bounds of standard contract law. (27)

    2. LOIs and Traditional Contract Doctrine

      When confronted with a dispute over an ambiguous LOI, traditional contract doctrine provides courts with the basic ground rules for discerning the intent of the parties. That doctrine, however, contains little practical guidance for completing the task. In an attempt to accommodate the realities of modern commerce, shifts in contract doctrine during the twentieth century urged courts to find a binding contract--even when a writing lacked the standard formalities or important terms often included in contracts--if the court concluded from the objective manifestations of the parties that they intended to form a binding contract. (28) To further this goal, factfinders have been given a variety of gap-filling tools to assist them if they find a binding contract that lacks certain essential terms. (29) While this development has proven beneficial in many contexts, it has also increased the chance that a court will find a binding contract when the parties did not intend one. This risk is compounded in the case of LOIs, where terms intended to be binding are often placed side-by-side with terms not intended to bind the parties. The relevant provisions of the Restatement (Second) of Contracts (Restatement) and the Uniform Commercial Code (UCC) illustrate the problem.

      Sections 33 and 34 of the Restatement are most relevant to a factfinder confronted with an ambiguous LOI. Section 33(3), entitled "Certainty," cautions that "[t]he fact that one or more terms of a proposed bargain are left open or uncertain may show that a manifestation of intention is not intended to be understood as an offer or as an acceptance." (30) The first official comment to that same provision, however, recognizes that "the actions of the parties may show conclusively that they have intended to conclude a binding agreement, even though one or more terms are missing or are left to be agreed upon." (31) In such an instance, the court is called upon "to attach a sufficiently definite meaning to the bargain. " (32) Similarly, the official comment to section 34 of the Restatement states that "[a] bargain may be concluded which leaves a choice of terms to be made by one party or the other." (33) Assuming a state's law mirrors the Restatement, how should a factfinder determine whether an LOI is binding or not when it lacks essential terms?

      Further complicating matters are the Restatement's "Rules in Aid of Interpretation" in section 202, which instruct that a writing must be...

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