Takeover blog #2: the letter of intent

As a member of the Legal Persons & Contracts team, I am heavily involved in assisting in share transactions, both on the side of buyer(s) and seller(s). An acquisition process generally looks as follows:

• Orientation and introduction phase
• Signing confidentiality agreement ('Non Disclosure Agreement','NDA' or 'Confidentiality Agreement').
• Information Exchange
• Valuation and agreement on key points transaction
• Signing letter of intent ("Letter of Intent,""LOI," "Memorandum of understanding," "Heads of agreement" or "Term Sheet")
• Book examination ("Due Diligence Examination" or "DD").
• Signing purchase agreement ('Share Purchase Agreement' or 'SPA').
• Passage of deed of delivery ('Closing').

In a series of blogs over the next few weeks, I will focus on a lawyer's role in this process, highlighting the most important transaction documents. I pay attention to the place of the relevant transaction documents in the acquisition process, pointing out the main concerns and pitfalls.

A few weeks ago, I covered the non-disclosure agreement. Today I'll cover the letter of intent agreement. What is its added value? Surely the parties can simply record the (outline) agreement reached directly in a purchase agreement? They can (and in practice do), but the importance of the letter of intent should not be underestimated. Not only does it set out the contours of the deal (think: key clauses such as price and intended delivery date), the letter of intent is also a great instrument for streamlining the negotiation process leading up to the purchase agreement. Especially in acquisitions of size, with many parties involved and long lead times, this is desirable.

In this blog, I reflect on the most common issues in a letter of intent, highlighting some of the pitfalls.

1. Legal commitment to a deal

A question I get asked a lot is whether a letter of intent is "binding. The legal background to the question is whether entering into a letter of intent already creates a legally enforceable agreement pursuant to which shares must be transferred. This cannot be answered in general terms, as it is a question of interpretation of the agreement of intent in question. The title/name of the relevant document is relevant here, but - although this is often incorrectly stated - certainly not decisive. It mainly depends on what agreements were made, how these agreements were formulated and what intention the parties had in mind. A well-drafted preamble should make this clear.

And does the escape work if parties simply write down, "This letter of intent is not binding"? Not always. First, because this is only one of the factors by which the parties' intent is determined. Second, because mandatory law cannot be "written away. In other words, mandatory law applies in full regardless of what the parties write down. Provisions on reasonableness and fairness (an example of which is cited below), for example, cannot be set aside.

It is also important to explicitly state which provisions in the letter of intent are binding. Consider: a confidentiality clause (if not included in a separate confidentiality agreement), exclusivity and the dispute clause.

2. Reservations for a deal

This brings me to a second important aspect, namely contractual reservations. In English contracts one sometimes sees terms such as 'subject to (...)'. The purpose of contractual reservations is to ensure that, if a certain act or event occurs or fails to occur, the purchase agreement is not concluded. These are often already included in the letter of intent. Two common examples are:

• the financing proviso. Its content speaks for itself, although more than once it is taken lightly. It is important to clearly define the cases in which a buyer may invoke such a reservation. From the seller's point of view, it is usually advisable to stipulate that the buyer, in order to successfully invoke the financing reservation, must submit proof of two applications for financing in accordance with market conditions at banks that are recognized and reputable in the trade, on which he has received no response;
• the outcome of the due diligence. It is regularly included as a reservation that the outcome of the due diligence must be to the satisfaction of the buyer before a purchase agreement is concluded. In order not to depend entirely on the buyer's discretion, it may be advisable to link a quantification to this reservation. For example, by stating that the reservation in question only applies if it follows from the due diligence investigation that the purchase price should be reduced by EUR 100,000.00.

Incidentally, a reservation does not always constitute an escape for either party. For example, under Dutch law it is not automatically tenable for one of the parties to stipulate in the agreement of intent that the deal will only be concluded after approval by its board (also formulated as 'subject to board approval'). Such reservations have repeatedly gone down in court with reference to the doctrine of the potestative condition, which in short means that a party cannot make a legally valid reservation if it is made conditional on its own will. In addition, reliance on a reservation may be unacceptable by the standards of reasonableness and fairness. There are also known rulings in which it has been ruled that an agreement has been reached between contracting parties in case the parties formulated the reservation as a formality or formal requirement. This risk is more likely to be present when the negotiation phase has been completed and the parties have reached agreement on the key points of the acquisition.

3. Exclusivity

A third, common clause in a letter of intent is the exclusivity clause. With this, the parties intend to agree on a period in which they will negotiate with each other on an exclusive basis about the realization of the deal. A buyer will usually demand exclusivity, to prevent the seller from flirting with other potential buyers, with all the associated risks. At the same time, the seller will want to have his hands free if the negotiations do not lead anywhere, so sellers will usually want to limit the exclusivity period in time. Thus, there is a strong commercial component in (the scope of) the exclusivity clause. For a buyer, an exclusivity clause effectively eliminates (potential) competition for a certain period of time. Thereby he runs no risk of the price being driven up by third party bids. On the other hand, a seller runs the risk of being "stuck" with a buyer for a period of time, while he can get a better price elsewhere.

4. Break fee

Generally, both buyer and seller benefit from reaching a deal. However, experience shows that the intended deal, for example after completion of the due diligence, has become less attractive to either party than initially thought. In case the negotiations do not result in a purchase agreement or in case the seller enters into negotiations with third parties in violation of the exclusivity clause (see above), the other party wants to fix a certain compensation ('break fee' or 'termination fee'). Broadly speaking, there are two flavors of break fees, namely the break fee for only the costs incurred or (additionally) a penalty, which serves as an incentive to continue negotiations.