Letters of Intent (LOIs)[1] are the building blocks of corporate and commercial transactions and, except for a few specified, typically legal terms, they are predominantly non-binding.
But does “non-binding” still mean non-binding in relation to good faith? Specifically, does non-binding still mean that the duty of good faith doesn’t begin to apply until after the parties have signed the definitive agreement contemplated by the LOI, or can the duty of good faith apply to the parties’ negotiations that lead up to the definitive agreement contemplated by the LOI?
The general rule in commercial dealings is that the duty of good faith only applies to the performance of a contract, not to the negotiations leading up to it. That said, two recent rulings from Ontario and Saskatchewan cast doubt on this point. They suggest that, where an LOI contains at least some binding terms, the negotiation of the definitive agreement under the LOI can be subject to the duty of good faith. This in turn raises the question of whether it may be prudent for negotiating parties to add additional text to their LOIs to limit this possibility.
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The Role Played by LOIs in Dealmaking
LOIs set out the key tentative terms of a prospective deal.[2] They establish a framework for the broader, binding contract the parties hope will follow their negotiations and, depending on the type of transaction, further due diligence by one or both parties.
The bulk of an LOI’s terms are typically expressly stated to be non-binding. Binding terms are often limited to key legal terms such as confidentiality, governing law and, possibly, exclusivity. The rest of the LOI’s terms, i.e., those speaking to the basic commercial relationship or transaction the parties aim to agree on, are expressly non-binding.
Why LOIs are Typically Non-Binding
Commercial parties typically prefer that most of the terms of an LOI be non-binding for multiple reasons. They know that the “devil is in the details” and that, as they work through the deal’s open points, unexpected issues will likely arise. They know that the bargaining power among them can shift, sometimes significantly (e.g., if the buyer in an M&A transaction discovers problematic issues during its due diligence of the target). The parties also seek to maintain their freedom to bargain hard. Many commercial transactions are fundamentally adversarial, and both sides are looking to win as many concessions from the other party as possible as their negotiation strategies evolve.
The General Rule: Negotiations Don’t Attract Duties of Good Faith
The organizing principle of good faith in contract was established by the Supreme Court of Canada in 2014 in Bhasin.[3] However, Bhasin only imposed a duty of good faith on the performance of contracts, not on their negotiation. Other courts have since highlighted this distinction.[4] Bhasin also made clear that the principle of good faith must be applied consistently with the “fundamental… freedom of contracting parties to pursue their individual self-interest.”[5] That said, there have been certain instances in which Canadian courts have been prepared to recognize that duties of good faith can apply to negotiations under an existing contract, e.g., negotiations to renew a lease.[6]
Two Recent Rulings that Cast Doubt on the General Rule
Two recent cases from Ontario and Saskatchewan raise a simple but important question: are things starting to change? Specifically, the rulings raise uncertainty as to whether good faith obligations may arise in negotiations conducted under an otherwise non-binding LOI containing certain binding terms.
The Ontario dispute[7] arose from an LOI for the purchase of a dentistry practice after the buyer walked away from the deal. The seller alleged the buyer had breached a duty to negotiate in good faith. The LOI expressly stated it was “not contractual in nature or binding (except as specifically set out herein)”. This was followed by a mix of binding and non-binding clauses. Curiously, the court didn’t set out the full terms of the LOI or explain which terms were binding and which weren’t. Similarly, the court didn’t directly address whether or not a duty of good faith applied; the court simply analyzed the parties’ negotiations as though a duty of good faith applied, eventually holding that it had not been breached by the buyer.
A similarly curious ruling has since been made in Saskatchewan.[8] The parties signed an LOI for the purchase of a poultry business. The LOI expressly stated that, other than its confidentiality and no shop clauses, nothing in the LOI would “create any obligation or liability of any nature” for either party and that, until an asset purchase agreement (APA) was executed, neither party would be under “any obligation” with respect to the transaction. Although the court stated that “there has been no recognition in Canadian law of a duty of good faith in pre‑contractual negotiations”, the court nonetheless held that “the parties here had an obligation, in the context of the LOI, to negotiate in good faith the terms of the APA that was contemplated by the LOI.” The court thus appeared to hold the LOI to effectively be a binding agreement to agree that attracted a duty to negotiate the APA in good faith, albeit that the court also found that the parties did in fact fulfill that duty for the LOI in question.
Practical Takeaways: How Negotiating Parties Can Protect Themselves
How much weight should be put on these two rulings is debatable. Neither court clearly explained its reasoning nor definitively held that an LOI partly comprised of binding terms will impose a duty to negotiate in good faith. That said, there are several ways commercial parties can protect themselves.
- Be explicit and carefully consider which clauses in the LOI are binding and which aren’t. Don’t simply begin by stating that the LOI is non-binding and then follow this with a mixture of commercial terms and legal clauses. Consider separating any binding terms into a discrete, unambiguously binding section of the LOI.Provide, at a minimum, a governing law clause and, if the parties are from different jurisdictions, an attornment or dispute resolution clause. Stipulate that neither party will be bound by any other right or obligation until the execution of a definitive agreement, if any.
- In light of the two rulings discussed above, it may be prudent to go further and expressly state that the inclusion of certain binding clauses in the LOI does not create any duties of good faith in relation to the non-binding terms included in the LOI or under the LOI as a whole. Similarly, consider stating why this is the case, e.g., because the LOI only reflects the tentative terms of a prospective contract that’s expected to include numerous additional terms, not all of which are reasonably foreseeable at the time of the LOI and which may turn on the parties’ further negotiations and/or due diligence. Consider specifying that neither party has any obligation to negotiate or produce materials for due diligence review. Also consider clarifying that, to the extent that further negotiations do occur, either party can walk away from the negotiations at any time and without any obligation or liability to the other party (except such obligations expressly set out in the binding provisions).
- Be careful not to act in any manner which could objectively indicate that a binding agreement has been reached prior to the definitive contract. Once again, cautionary examples from the M&A context are illustrative. In one case, the Ontario Court of Appeal held that the parties were bound by an LOI for the sale of a business partly because the seller began introducing the buyer to the company’s employees and customers as the new owner.[9] In another, the British Columbia Court of Appeal held an LOI for the sale of a business to be binding partly because the buyer was allowed to immediately assume control of the company, including its banking arrangements and business records.[10]
