Letters of intent or memoranda of understanding are frequently used in private equity transactions to evidence the preliminary understanding of a potential transaction before the parties commit significant time and resources to the transaction. Often such documents are prepared and negotiated by deal professionals based on the precedent from the last deal or another similar deal with limited or no review by outside counsel. A recent case suggests that this approach is not without risks and that careful drafting of letters of intent and memoranda of understanding is important.By Michael Szlamkowicz and Alex Radetsky
Associates in the Private Equity Practice at Weil Gotshal & Manges LLPIn the case of Vacold LLC v. Cerami, a decision by the United States Court of Appeals, second Circuit, held that some preliminary agreements, such as letters of intent or memoranda of understanding, may bind the parties and require them to complete the contemplated transaction even if the parties are unable to reach agreement on definitive documents for the transaction. The court considered the language of the agreement, the context of the negotiations between the parties, and the existence of open terms in determining whether the preliminary agreement in question was binding on the parties. The court concluded that a preliminary agreement that clearly manifests the intention of the parties to be bound will obligate the parties to fully proceed with the transaction.

The court presented several factors that, if present, could result in a preliminary agreement binding the parties to complete the transaction, including:

• The failure to draft an expressed reservation of the right not to be bound in the absence of a definitive written agreement;
• the partial performance of the agreement;
• the parties reaching agreement on all of the material terms of the transaction; and
• the transaction is the type that is usually committed to a more formal and definitive agreement.

As a result, when drafting a letter of intent, memorandum of understanding or other similar preliminary agreement it is imperative for private equity sponsors to always consider that such an agreement may bind them to more than they may have intended if they are not vigilant when negotiating and drafting the documentation.

The following are tips for private equity sponsors to consider when preparing letters of intent, memoranda of understanding or other similar documents in order to mitigate the risk that they will become bound to complete a transaction when it was not the sponsor’s intention to do so:

• Use unambiguous language for the title of the document. Use a title for the preliminary agreement containing words such as proposal, letter of intent or memorandum of understanding. A document entitled “letter agreement” may be interpreted as manifesting the intent of the parties to be bound. However, one should not rely alone on the title of a document to manifest the intent of the parties not to be bound by such an agreement.
• Include a conspicuous disclaimer that the document is not intended to be binding. In order to strongly indicate the intention of the parties not be bound by a preliminary agreement, a conspicuous disclaimer within the document should indicate that the understandings contained therein are for discussion purposes only and do not constitute a binding agreement (except, of course, with respect to certain provisions, which the parties may intend to be binding, such as exclusivity and confidentiality) but merely express a summary of current discussions with respect to the transaction, and that any terms discussed in the document shall only become binding upon the negotiation and execution of definitive agreements.
• Indicate terms that remain open. Including a list or a discussion of terms that remain open strongly indicates that the parties do not intend for the preliminary agreement to be definitive or binding and that a definitive agreement is necessary in order to bind the parties to complete the transaction. It is recommended that parties include clear and unambiguous language that specifies that the parties do not intend to be bound until a.) the private equity sponsor completes the due diligence process to its satisfaction, b.) the investment committee of the private equity sponsor approves, in its sole discretion, any potential transaction and c.) the parties enter into a definitive written agreement to complete the transaction.

Letters of intent, memoranda of understanding and similar preliminary documents are important components of private equity deals. However, sponsors need to be aware of the risks that such preliminary documents may be deemed binding. There is also a risk in some jurisdictions that a court may impose a good faith duty of negotiation on the parties and require them to work together to negotiate definitive agreements for a transaction. By following the practice tips identified above and having counsel carefully review all preliminary documents, private equity sponsors can lay out the intent of the parties while still avoiding the unintended.

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