Letters of intent: are they contracts or not?

NOTE: The following article is from the collection of articles in our Automobile Dealership Buy/Sell Newsletters. The newsletter deals with the complex area of buying and selling automobile dealerships. Some of the material may not be up to date because of changes in the law from the date shown at the end of the article. This article is not to be taken as legal, accounting, tax, or other advice. You should consult your own professionals for such advice and for any updating of the information provided. 

Not long ago, a dealer sent me what he called a “letter of intent” to sell his dealership. In a couple of pages the document spelled out the general terms to sell and the dealer asked me to prepare a buy-sell contract.

You can imagine the dealer’s surprise when I told him he didn’t have a letter of intent at all, but rather a binding contract. When this happens and the buyer insists on the terms set forth in the letter of intent, the selling dealer can be put in a tough spot, making further negotiations much more difficult and leading to animosity and perhaps litigation between the parties.

Sometimes a letter of intent is called a “Gentleman’s Agreement.” What this means however is unclear because letters of intent are often considered nonbinding and not an agreement at all. Justice Vaisy has sardonically stated in a reported court case: “A gentleman’s agreement is an agreement which is not an agreement, made between two persons neither of whom is a gentleman, whereby each expects the other to be strictly bound without himself being bound at all.”

There are a number of reasons why people use letters of intent. Sometimes the parties simply want to state the general terms they have agreed upon to memorialize their understandings and also to use the document as a starting point for future negotiations. In other cases the parties use the letter of intent as the document for their attorneys to use in drafting the formal buy-sell agreement. Sometimes the parties believe that they can take the letter of intent to the factory to start the buyer approval process. However, the factory personnel will normally tell them that the factory will not start any approval process until a formal, signed buy-sell agreement has been presented. There are also times when a buyer will want a letter of intent to show potential investors to help in obtaining an investment commitment.

A letter of intent should clearly set forth the intentions of the parties concerning whether it is to be binding or not. This is the most important element of a letter of intent. A letter of intent can be binding concerning some matters and nonbinding as to everything else. For example, a buyer of a dealership will often have the seller agree in the letter of intent that, pending the signing of the buy-sell agreement, the dealer will not negotiate a sale of the dealership to anyone else, at least for a certain number of days. The dealer may also want to bind the buyer to confidentiality regarding the terms of the letter of intent and regarding the information, financial or otherwise, that has been given to the buyer.

Here is a clause which can be used to clearly state the intentions of the parties:

“This is intended to constitute a letter of intent only. Except as the provisions stated in paragraphs -, -, and – (which are intended to be binding and legally enforceable), there is no legally binding and enforceable contract between the parties pertaining to the subject matter of this letter of intent, and statements of intent or understandings in this letter of intent shall not be deemed to constitute any offer, acceptance, or legally binding agreement and do not create any rights or obligations for or on the part of any party to this letter of intent.”

Using a clause such as this can avoid many problems.

There should be no language in a letter of intent obligating the parties to bargain or negotiate in good faith. The parties should not agree to make every reasonable effort to agree. These types of clauses in the letter of intent have led some courts to enforce the agreement when, for example, the seller pulls out because he has found a better deal. And, in order to avoid a party’s claims that he took some actions or incurred expenses in reliance on the letter of intent, the letter should make it clear that no party is relying on the letter in taking any action or incurring any expenses.

The problems that can be caused by letters of intent are quite real. Getty Oil apparently thought that its preliminary agreement for a merger with Pennzoil was nonbinding, it continued to look for higher bids and three days later entered into a merger with Texaco. Pennzoil’s agreement had stated that the parties had reached an “agreement in principle,” but that the agreement was “subject to execution of a definitive merger agreement, approval by the stockholders of Getty Oil and completion of various government filing and waiting period requirements.” Pennzoil sued Texaco on the theory of tortious interference with its contract. The jury returned a $10.5 billion verdict for Pennzoil, which was reduced by $1 billion by the court. “Misunderstandings” can be very expensive.

Because of the problems in interpreting letters of intent, their use is not recommended unless there is a very good reason to do so. Courts in this country are all over the ballpark in interpreting them, so it is better not to take the chance that a letter of intent be interpreted against you and contrary to what you intended. The first draft of an automobile dealership buy-sell agreement usually can be prepared fairly quickly, with negotiations proceeding from there. However, if you are determined to start your buy-sell with a letter of intent, then be sure to have the document reviewed by your legal counsel before, not after, it is signed.

This article was written in 2002.