In M&A transactions involving privately-held targets, letters of intent ("LOI's") are often employed. For both buyers and sellers they provide some comfort that the parties are "on the same page". An LOI may also contain provisions that are important to the buyer, such as exclusivity and access to records, properties and personnel for due diligence.
In many cases, a buyer will want certain provisions of an LOI to be binding and the remainder to be non-binding. The seller may expect that the whole LOI will be binding, or may want it to be totally non-binding to keep its options open. How can a party to an LOI be sure it has achieved its objective? The United States Court of Appeals for the Second Circuit recently addressed these issues applying New York law in the case of Vacold LLC v. Cerami, 07-0050-CV (2008) (hereinafter "Cerami").
Cerami involved a suit under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, which prohibit material misstatements or omissions in connection with the purchase or sale of securities. Plaintiff Immunotherapy Inc ("Immuno") and defendant Cerami Consulting Corporation ("CCC") formed a 50/50 joint venture corporation, Applied Vaccine Technologies, Inc. ("AVT"), to conduct certain biotechnology research. Ultimately, CCC bought Immuno's shares in AVT. CCC financed the purchase by striking a deal with a subsidiary of Johnson & Johnson ("J&J") which imputed a far higher value to AVT than CCC paid Immuno. Immuno claimed that Section 10(b) and Rule 10b-5 required CCC to disclose its arrangement with J&J or refrain from buying Immuno's AVT shares. The district court found in favor of CCC and Immuno appealed.
The Second Circuit held that if Immuno was already contractually bound to sell its AVT shares at the time CCC made its deal with J&J, then CCC had no duty to disclose the J&J relationship. That set the stage for the Court to determine whether an April 9, 1999 letter agreement (the "April 9 Agreement") entered into between the parties legally bound Immuno to sell its AVT shares to CCC.
The Court discussed the status of "preliminary agreements" under New York law. "Preliminary agreements" are agreements that expressly call for the execution of additional, more formal agreements, which LOI's generally do. Some preliminary agreements, the Court noted, are so indefinite and leave so much to future negotiation that they are simply nonbinding and unenforceable. Other preliminary agreements, however, can be binding, at least in part.
The Court stated that these "binding" preliminary agreements fall into two categories: Type I preliminary agreements that are "fully binding" because the parties have agreed on all points that require negotiation; and type II preliminary agreements that are binding as to certain major terms, even though they leave others to future negotiation.
The Court outlined the tests for the two types of binding preliminary agreements. To determine if there is a type I preliminary agreement, courts look at the following factors:
- Whether there is an express reservation of right not to be bound in the absence of further agreement;
- Whether there has been partial performance;
- Whether all the terms of the alleged contract have been agreed upon; and
- Whether the agreement at issue is the type of contract that is usually committed to writing.
For a type II preliminary agreement, the courts examine:
- Whether the intent to be bound is revealed in the language of the agreement;
- The context of the negotiations;
- The existence of open terms;
- Partial performance; and
- The need to put the agreement into final form, as indicated by the customary form of such transactions.
Given the general and overlapping nature of these factors, it may be difficult to predict how a court will categorize a particular preliminary agreement.
In Cerami the Court analysed those factors it saw as relevant to the April 9 Agreement. Immuno argued that the April 9 Agreement did not bind it to sell its AVT stock because it read "it is presently contemplated. . . " While many M&A lawyers might be sympathetic to this argument, the Court rejected it finding that "contemplated" in this context meant "anticipate doing or performing", "plan on" and "intend" rather than "view mentally with continued thoughtfulness" or "muse or ponder about". The Court noted that many acquisition agreements use phrases such as "transactions contemplated by this Agreement."
The Court also noted that the April 9 Agreement was styled a "letter agreement" although earlier drafts had used the term "summary of discussions." The Court viewed this as evidence of the parties' intent to be bound.
In addressing the type II factor "context of the negotiations", the Court found that although there were contingencies, such as CCC's need to obtain financing, the April 9 Agreement addressed what would happen if those contingencies were not met. In the Court's mind this favored the finding of a type I (and therefore fully binding) preliminary agreement.
The Court then considered open terms, noting that they tend against the finding of a binding agreement. Immuno argued that there was plenty left to be negotiated, including a definitive stock purchase agreement and legal opinions. The Court noted that the April 9 Agreement referred to the stock purchase agreement as "standard" and that, incredibly, the record revealed no negotiations relating the stock purchase agreement between April 9 and the date it was signed, June 1. The Court found that the stock purchase agreement was mere "boiler-plate" that the parties foresaw no difficulty in negotiating. It held that the need to negotiate and execute the stock purchase agreement did not undercut the conclusion that the April 9 Agreement was a type I preliminary agreement that bound the parties with respect to the purchase and sale of Immuno's AVT shares.
Anyone who has negotiated an acquisition agreement might disagree with the Court's conclusion. Words such as "standard" and "customary" in an LOI do not necessarily augur a smooth negotiation of the definitive agreement, since the meaning of those terms will vary with the circumstances and the experience of those participating. Indeed, the dissent in Cerami notes that there is a strong presumption against finding a type I preliminary agreement when future preparation and execution of definitive contract documents is contemplated.
Tellingly, the dissent in Cerami states that there is nothing in the majority's opinion that adequately explains why the April 9 Agreement is better viewed as a type I rather than a type II preliminary agreement. That is the challenge Cerami presents for M&A participants. Given the general nature of the factors considered, it may be difficult to predict with confidence which provisions of an LOI a court might find to be binding.
A buyer, for example, may want the exclusivity ("no-shop") and due diligence/access provisions of an LOI to be binding. At the same time, it views the "economic terms," such as price and payment terms, as non-binding and subject to due diligence and definitive documentation. But what if buyer walks and seller attempts to enforce the LOI? Will the court honor buyer's intent or will a Cerami analysis yield a type I preliminary agreement?
The legal and factual backdrop of Cerami as a Section 10(b)/Rule 10b-5 case must be considered. The Court may have viewed Immuno as suffering "seller's remorse" and crafted a decision aimed at denying it relief. Nonetheless, Cerami should cause the M&A community to revisit its letter of intent practices.