The Ties That (May) Bind: ensuring letters of intent do not impose binding obligations on parties

Non-binding letters of intent (“LOIs”), which sometime take the form of ‘indicative term sheets’ or ‘memorandums of understanding’, can be useful tools to start negotiations between parties in a commercial transaction. These documents, typically lay out the principal terms of a transaction and facilitate negotiations of a binding agreement between the parties.

LOIs are most useful when parties can set forth the main points of a proposed deal, such as the structure of the transaction or purchase price arrangements, without committing to a legally binding contract. However, recent Ontario jurisprudence confirms that, based on certain language of the LOI or the behaviour of the parties, LOIs may be interpreted as binding even where the parties explicitly intend for them not to be. As such, it is key to draft the LOI with purpose and be mindful of your actions during negotiations.

Risks and rewards of LOIs

There are several important advantages to using an LOI in the course of a transaction. Entering into an LOI signals to the parties – and in certain instances to the public – that the parties are serious about the potential deal, and it lays a foundation to further negotiation, thus creating deal momentum. An LOI also allows parties to set out their basic understanding of the key business terms they want to achieve before investing time and money into hiring a team of advisors and negotiating the full deal. The increasingly popular “Hybrid” LOIs, or LOIs that have both binding and non-binding terms, help the parties protect themselves during negotiations, such as through committing to confidentiality, exclusivity and non-solicitation terms.

Signing an LOI may also come with some hazards. Negotiating through an LOI may increase the costs and tensions of a transaction by requiring a separate round of negotiation. LOIs, which by their nature are shorter than definitive legal documents, can be internally incoherent and lend themselves to varied interpretations and expectations by the counterparties. An LOI may also create unintended disclosure obligations for reporting issuers by triggering material change and/or early warning reporting. The most critical risk of an LOI, however, is the possibility of a binding obligation being unintentionally imposed on the parties. In the private equity space, this can be of particular concern given the prevalence of investor or third party rights of first refusal that could be triggered by a party inadvertently creating binding obligations. The current case law on this issue is summarized below.

Recent developments in Ontario jurisprudence

As discussed in our recent Canadian M&A Perspectives blog post, Canadian common law courts have not formally recognized a general pre-contractual obligation to negotiate an agreement in good faith, however the Supreme Court has refrained from definitively indicating that such a duty might not be recognized in the future[1] and in certain provinces, such as Ontario, such a duty has been recognized in instances a “special relationship” exists between the parties. Our aforementioned blog post delineates a list of factors which may influence a court’s determination of whether a duty to negotiate in good faith exists on a case-by-case basis, including after an LOI has been signed.

Ontario courts have been more definitive in establishing when binding obligations may arise from a signed LOI. In Wallace v. Allen, the Ontario Court of Appeal held that an LOI must be read as a whole, with an eye to the presence of contractual language.[2] In the LOI in Wallace, the clause “this letter of intent must be reduced into a binding agreement of purchase and sale by the parties within the next 40 days” demonstrated a clear intention of the parties to be bound.[3] However, the Court of Appeal also held that general use of “the language of contract”, such as “it is agreed”, “upon acceptance” and “this agreement” created a binding implication even in the absence of language as unambiguous as the clause above.[4] The Court of Appeal also considered the behavior of the parties in making its finding. It held that the parties in Wallace behaved as though they were bound by the LOI – the seller announced his retirement upon the sale of the business, and referred to the buyer as the new owner.[5] The Ontario Superior Court recently extended this reasoning in Seelster Farms et al. v. Her Majesty the Queen and OLG, noting that contractual language may not be necessary provided that hallmarks of contractual intention – an offer, an acceptance at its inception and consideration – are present both within the wording of the LOI and the behaviour of the parties.[6] In Seelster, a contractual relationship was formed, which led the court to consider the LOI as an enforceable agreement.

Drafting considerations

Parties drafting an LOI should do so with clarity and a sense of purpose – it is key to identify at the outset which terms are intended to be binding, and which are not. The following tips will be helpful if the intention is to draft a non-binding LOI:

• Avoid any contractual language, such as “it is agreed”, “upon acceptance”, “this agreement” or “the parties shall/will”.
• Clearly state the conditions under which parties intends to be bound, for example by stating that a binding intent will only be crystalized in a definitive agreement and the entering into of a definitive agreement is contingent on the Recipient’s satisfaction of its due diligence review, external factors and the Recipients sole discretion.
• Include a “non-binding” provision that expressly covers which terms are and are not intended to be binding on the parties. For example, an LOI may state that, other than the confidentiality and exclusivity clauses, all other sections are not binding on the parties and any such provisions will only be binding when incorporated in an executed definitive agreement.
• Consider dealing with any non-generic binding provisions in a separate agreement or exempting them from the LOI, such as an exclusivity letter agreement or confidentiality agreement for example.

Making sure to “practice what you preach”

The language of the LOI, however well-drafted, is not alone sufficient to prevent binding obligations from arising. In the aftermath of Wallace and Seelster Farms, the intention of the parties to enter a binding agreement is to be determined on the entirety of the evidence. Where the parties intend for the LOI to not be binding, they must act as such. Behaviour that implies that the deal is going to happen and that negotiations are a mere formality may influence the courts to read in contractual obligations between the parties of a non-binding LOI. Any inter-related agreements will also be considered in this determination, meaning other contractual relations between the parties must not differ from the intention stated in the LOI.[7]

Post-script: Extra caution in the Province of Québec

Parties contemplating an LOI governed by Québec law should be mindful that the Civil Code of Québec provides a statutory duty of good faith which requires the parties to conduct themselves in good faith both at the time the obligation arises and at the time it is performed (as opposed to only when the obligation is performed, which is the current law in Ontario, for example).[8] In its recent August 2020 decision in Beauregard v. Boulanger, the Quebec Superior Court reiterated that an LOI is an agreement akin to a preliminary contract, and thus imposes that the parties conduct themselves in good faith.[9] That said, the obligation to act in of good faith at the pre-contractual stage does not prevent either of the parties from putting an end to negotiations that have failed or that have been carried out in bad faith by the other party. While the court ultimately found that the defendants could withdraw from the LOI, the court in an obiter explained that a party who breaks off negotiation in breach of its duty to act in good faith could expose itself to the damages suffered by its counterparty between the signing of the LOI and the breakdown of the discussions (for example, damages could include the fees and expenses of advisors incurred in that period and travel expenses). The obligation of good faith in preliminary contractual relations is particular to the Civil Code of Quebec. It has yet to be determined whether the Supreme Court of Canada decision in Bhasin v. Hrynew, [10] which recognized as a general organizing principle of common law good faith in contractual performance, extends to preliminary contractual relations.

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[1]Martel Building Ltd. v Canada, 2000 SCC 60 at para. 73.

[2]Wallace v. Allen, 2009 ONCA 36.

[3]Wallace v. Allen, 2009 ONCA 36, at para 27.

[4]Wallace v. Allen, 2009 ONCA 36, at paras 29-31.

[5]Wallace v. Allen, 2009 ONCA 36, at para 34.

[6]Seelster Farms et al. v. Her Majesty the Queen and OLG, 2020 ONSC 4013, at para 175-178.

[7]Seelster Farms et al. v. Her Majesty the Queen and OLG, 2020 ONSC 4013, at para 177.

[8] Civil Code of Québec, section 1375.

[9]Beauregard c. Boulanger, 2020 QCCS 2090.

[10]Bhasin v. Hrynew, 2014 SCC 71.

Source: https://www.mccarthy.ca/en/insights/blogs/canadian-ma-perspectives/ties-may-bind-ensuring-letters-intent-do-not-impose-binding-obligations-parties