Signer Beware: A “Nonbinding” Letter of Intent or Preliminary Agreement May Be Binding
Parties often enter into a letter of intent, memorandum of understanding, or other preliminary agreement to memorialize the proposed terms of an anticipated commercial transaction, including a joint venture, affiliation, merger, asset acquisition, or equity acquisition. Preliminary agreements may be formal written agreements or may be purposely or inadvertently entered into by parties through the exchange of emails. These agreements help ensure that the parties are on the same page while they continue negotiations and due diligence. Given the early stage in which these types of agreements arise, parties generally desire to retain the ability to terminate and walk away from the transaction. Red flags raised during diligence, impasses in negotiations, or any number of other reasons can lead to such a decision. To reduce risk and facilitate walking away, parties may include language in the preliminary agreement stating that the document is nonbinding.
However, under state law, even a self-declared “nonbinding” preliminary agreement may be deemed binding and obligate the parties to consummate the transaction contemplated by the preliminary agreement. For example, courts in New York, Delaware, and other states classify preliminary agreements as either Type I or Type II. Type I agreements are those in which the parties have already agreed to all of the material terms (e.g., payment terms, etc.), so the courts disregard any “nonbinding” language. Even if a Type I document specifically states that it is nonbinding, the parties are obligated to consummate the transaction. In contrast, Type II agreements contain open terms requiring further negotiation by the parties and only obligate the parties to negotiate the transaction in good faith. Thus, with Type II documents, courts will typically enforce nonbinding language.
Courts in New York, Delaware, and other states will analyze the following factors, among others, to determine whether a preliminary agreement is binding or nonbinding.
• Whether the preliminary agreement includes an express reservation of the right not to be bound in the absence of a writing.
• Whether the preliminary agreement uses decidedly non-committal language suggesting at most a promise that the parties will work together.
• Whether there has been partial performance.
• Whether the parties have agreed to all of the material terms in the preliminary agreement.
• Whether the agreement at issue is the type of contract that is usually committed to writing.
If a party terminates a preliminary agreement and walks away from a transaction, the other party may be able to sue for damages. The type of damages that may be awarded depends on whether a preliminary agreement is nonbinding or binding. If the agreement is nonbinding, a party may be awarded only reliance damages, though some state courts may award expectation damages in certain situations. If the agreement is binding, the court may order specific performance of the transaction contemplated by the preliminary agreement. That is, the court may compel the party to go through with the deal.
Before entering into any type of preliminary agreement — even one with express nonbinding language — you or your client should at least:
• Be careful not to inadvertently enter into a preliminary agreement through the exchange of emails agreeing to terms of a preliminary agreement;
• Carefully weigh the risks of entering into a preliminary agreement, which risks include potentially being legally obligated to consummate the transaction contemplated thereby;
• Consider which obligations in the preliminary agreement you want to be legally enforceable and include language in the preliminary agreement to make that clear;
• Identify any open material terms and describe them as such in the preliminary agreement; and
• Consult with corporate counsel who understands the applicable state law with respect to whether a preliminary agreement is binding.