In this article, let’s understand the concepts of three types of pre-contractual instruments – Term Sheet, Memorandum of Understanding and Letter of Intent and learn how to draft them.
Pre-contractual instruments are as vital as the main contracts because they herald the beginning of a long and fruitful business association. Imagine you are meeting up a person to do business, discuss the key terms and then want to record them so that you are clear about the mutual understanding and can prepare the main contract basis the same. But the document that is drawn up is vague, unclear and totally meaningless. What will happen to that business deal? No prizes for guessing that it will end even before it started.
Usually you, as a lawyer will not a part of the initial discussion. Your client or business team will come to you, give you a brief outline of the main terms and then want you to draft a perfect Term Sheet or Memorandum of Understanding or Letter of Intent.
What can you do to churn an error-free, useful, to-the-point document at this stage?
What are these three different types of instruments and when to use which one?
What are the key points you should know as a lawyer so that the business deal does not go kaput just because you made an inadvertent error?
Let’s read on.
Understand the concepts
Taking a detour from the practical tone of this website, let’s get into theory for a moment for our understanding and know when the three types of pre-contractual instruments are used.
Term Sheet is a document which sets forth the fundamental commercial and technical understanding of a deal, usually pertaining to buying and selling of a business, funding of a start-up or formation of a joint venture. Look at it as sort of a summary of a complex transaction for the understanding of all the stakeholders, especially legal counsel who then go on to draft the definitive agreements of share purchase or joint venture basis the agreed upon term sheet. It is usually produced by one party for signing by the other party. A Term Sheet usually looks very plain, containing bullet points of the main and critical commercial and important points. It is also alternatively and interchangeably called as Heads of Agreement.
Memorandum of Understanding or MoU is an instrument which can function as a standalone document or act as a pre-contractual instrument between two parties. At times, the business relation between two parties are not so rigorous as to necessitate a full-fledged contract. An example can be a garment company agreeing to provide its surplus old-season inventory to an NGO to be distributed to the poor or a Government agency arranging with partners to further a social cause. There are few or no legal obligations between the parties and so, it might not make sense to prepare a contract with all the legal clauses. An MoU can work perfectly well in this scenario.
A Memorandum of Understanding can also precede a detailed definitive agreement in the case of a large or complex transaction. It usually takes the look and feel of an agreement, but is written in a much more simple and informal language. It is more detailed than a Term Sheet and may contain the normal boilerplate clauses.
Letter of Intent or LOI is a document which communicates to a bidder that their offer has been accepted. The ‘intent’ aspect of the letter basically tells the bidder that there is an intention to award and execute the contract with them. Some times, there is a long lead time to do certain activities to kick start the project eg. procure materials, mobilise manpower at the site, obtain certain special licenses etc, which entails expenses for the contractor. A Letter of Intent will give them the confidence to go ahead and start the work and also protect the expenses incurred in doing so.
Binding or Non-binding?
To be honest, this entire article can be encapsulated in this one point, ‘cos this is the most important question to ask with respect to Term Sheet, Memorandum of Understand and Letter of Intent. Should my Term Sheet, MoU or LOI be legally binding or not?
Let us ask ourselves the consequences of each.
What happens if you need to get out of the proposed transaction for any reason? You may realise you don’t have the funds, or discover that your partner is a fraudster or just don’t feel it any more. Ok, I am trivializing it a bit but you get the point. If your pre-contractual instrument is binding on you, then you have no way out. The other party can sue you to have the document enforced.
On the other hand, suppose your MoU or Term Sheet is non-binding. It will give both parties a written confirmation of the upfront key points of the proposed transaction, show commitment towards the same yet give the comfort of it being non-binding on both parties should the need arise to walk out of it. That’s why a Term Sheet, Memorandum of Understanding or a Letter of Intent is always followed by definitive, legally enforceable agreements.
It is a well settled legal position under Indian laws that an agreement to ‘enter into an agreement‘ is neither enforceable nor does it confer any rights upon the parties. So keep this principle in mind when you are preparing a Term Sheet, Memorandum of Understanding or a Letter of Intent.
Some time, we may need the documents to be partially binding. eg. a Memorandum of Understanding may record exchange of confidential information while exploring the deal or require the parties to be exclusively dealing with each other. In that scenario, it’s best practice to keep the MoU non-binding and execute a binding Non disclosure and Confidentiality agreement containing the exclusivity clause. Or one may consider inserting a clause like –
This MoU is being executed in order to put down in writing the understanding of the Parties on the basis of which discussions will be held to finalise the proposal and is non-binding in nature save for the provisions as set out under the heading “Exclusivity” and “Confidentiality”. It does not create any other legal rights and obligations between the Parties for consummation of the transaction.
Similarly, a Letter of Intent may be made binding to the extent of the expenses incurred by the contractor in legitimate actions taken under the LOI in the event of a termination.
Always use suitable language to make it amply clear that the instruments are non-binding in nature. Something like this will be helpful –
In the event that the transaction contemplated in this Term Sheet/MoU/LoI does not fructify, neither Party shall have any claim against the other in respect of any costs, compensation, damages of any nature whatsoever.
Always execute the definitive agreement before undertaking any major work or expense. Many times, the Courts will go into the nature of the document, conduct of parties and intended effect of the document to determine whether it is binding or non-binding.
You can read this article for judgments on the topic of binding nature of pre-contractual instruments.
Don’t make them ‘forever and ever’
It goes without saying that a Term Sheet, Memorandum of Understanding or a Letter of Intent should have an expiry date, whether or not the definitive agreements have been signed. Never leave these pre-contractual instruments open-ended and vague in respect to its validity period.
A time-bound instrument also conveys its non-binding nature. Usually a clause is inserted which states that –
The Parties shall, within 90 (Ninety) days of the execution of this Term Sheet/MoU/LoI or within such period as may be agreed between the Parties, execute the definitive agreement as contemplated in herein upon completion of the required due diligence to the satisfaction of XYZ.
This Term Sheet/MoU shall be valid for a period of ninety (90) days from date of signing or until terminated by either Party by giving a notice in writing to the other Party of its intent or until the definitive agreement is executed between the Parties, whichever is earlier.
If you want certain pre-conditions to be satisfied before any binding obligation arises (for example, if financing is to be obtained), set forth the pre-condition upfront and state that it must occur for any binding obligation to arise.
You might also want to condition the proposal upon the approval of third-party such as a board, investment committee, financing institution etc. In that case include clear terms stating that the contemplated transaction is subject to the said approval. This will give you, the dealmaker, to take a foot back if the approving third party does not wish to go ahead.
If the transaction is subject to completion of due diligence (which it always is), include provisions setting forth how the completion of due diligence is to be effected, as well as what happens if a party is dissatisfied after due diligence eg. the instrument could be terminated in the sole discretion of the dissatisfied party.
In the case of a LOI, you can make it valid only until the definitive agreement is executed to safeguard the legitimate expenses incurred by the contractor.
Clauses to include (and exclude)
Now that we have a fairly good idea of what are Term Sheet, Memorandum of Understanding and Letter of Intent, let’s spend some time to understand what to include and what to exclude from each of such documents.
A Term Sheet should be fairly exhaustive as to the key commercial terms since that forms the backbone of the transaction. No one likes to be surprised with a new commercial angle at the time of negotiation of the definitive agreement.
Here is a great article on every aspect of a Term Sheet for your reading pleasure.
A Memorandum of Understanding, on the other hand, is a more detailed document which contains:
- Background and purpose of the MoU
- Identification of the parties
- Representations and warranties
- Key commercial terms
- Key duties and obligations under the proposed definitive agreement
- Proposed timelines for completing due diligence and execution of definitive agreements
- Validity period
- Non-binding nature
Letter of Intent, as the name suggests, is prepared in the form of a letter addressed to the successful bidder containing the following points –
- the intention to award the contract
- the contract value
- the time period of the contract
- conditions like submission of various bank guarantees
- requirement to mobilise manpower at site and procure long-lead items
- the fact that it is valid only until the agreement is executed
One should not add Dispute Resolution and Jurisdiction clauses to a Term Sheet/Memorandum of Understanding / Letter of Intent since these clauses impart a flavour of binding-ness to the document. I have always found it a better idea to put all binding clauses e.g. confidentiality and exclusivity along with Disputes Resolution in a separate Confidentiality and Non Disclosure Agreement (in case of MOU) or the main agreement (in case of LOI). However, if you need to have all clauses in one instrument (especially in case of Term Sheet), make it amply clear which are the binding terms.
Keep it simple, sweetheart.
If you have spent enough time around my website, by now you would have understood my key principle in legal drafting –
Simple takes the prize.
So whenever you are drafting a Term Sheet, Memorandum of Understanding or a Letter of Intent, less is more. Do not include too many legal clauses just to show you are worth the money being paid to you. Your endeavour should be to check whether all relevant terms that have been negotiated are being included and that the document remains non-binding.
At this stage, most of the content contribution will be made by the Finance guys, so let them have their day. Your time will come at the stage of preparing the lengthy and complex documents post closing of the deal.
In case you are not convinced that you need to learn how to draft a Term Sheet/ Memorandum of Understanding/ Letter of Intent (‘cos there are templates galore in the world wide web), read my post on Why You Should Learn How to Draft Contracts.
If you have enjoyed reading this article, share it with your friends.