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Letters of Intent in Corporate Negotiations: Using Hostage Exchanges and Legal Uncertainty to Promote Compliance

Letters of intent (LOIs) are fundamental building blocks of many corporate transactions. Although their form and terms vary, LOIs are used predominantly to communicate parties’ agreement to the basic structure of a deal and a mutual desire to continue negotiating. They are commonly called “agreements to agree” or, somewhat oxymoronically, “nonbinding agreements.” In almost every respect, these agreements are contracts— except they aren’t supposed to be. They state that the parties agree, while also stating that the parties don’t agree yet. Under a traditional legal analysis, these agreements pose a problem: either there is an enforceable contract or there isn’t one. It’s no wonder that LOIs have been described as the contractual equivalent of being “almost pregnant.”

Nevertheless, business professionals value these almost-binding agreements. When two companies sign an LOI, the parties often view it as a reason to celebrate. An LOI is considered a major milestone in the lifecycle of many transactions.

Lawyers, however, are less enthusiastic. One prominent corporate lawyer went so far as to describe LOIs as “an invention of the devil [that] should be avoided at all costs.” Case law provides numerous examples of the potential legal pitfalls of using LOIs. In Texaco, Inc. v. Pennzoil, Co., one of the most prominent cases involving LOIs, the court held a supposed LOI to be a binding contract, which ultimately cost Texaco $8.5 billion. Although such a large recovery is rare, the legal conclusion is not. Courts frequently find LOIs to be binding contracts, but just as often find similar LOIs to be unenforceable. In the words of the late E. Allan Farnsworth, “It would be difficult to find a less predictable area of contract law.”

If parties cannot predict the legal effect of LOIs, why are they used so frequently? Many explanations have been proposed, yet none adequately addresses the element of legal unpredictability that inheres in LOIs. In fact, the leading explanations do not identify a meaningful relationship between LOIs and contract law. This Comment identifies how legal unpredictability affects the operation of LOIs as a negotiating tool and ultimately concludes that LOIs manipulate legal unpredictability to the parties’ mutual advantage. Specifically, this Comment argues that signing an LOI facilitates an economic hostage exchange that aligns counterparties’ incentives, decreases both parties’ abilities to act strategically, and makes completion of the transaction more likely.