Mergers and acquisitions (“M&A”) are often documented in 3 stages, the first of which is the letter of intent (“LOI”) stage, the second of which is the definitive documentation stage, and the third of which is the completion stage. In this article, one of a multi-part series on business acquisitions, we examine the role and limitations of a letter of intent. In other articles, we look at a range of issues including due diligence (“M&A due diligence”) and representations and warranties (“M&A reps and warranties”), financial assistance for the purchase of shares, and purchase and sale agreements. Readers who may be contemplating an M&A transaction may contact our M&A lawyers for more specific information tailored to their individual circumstances.
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In any M&A transaction, the initial step is for the purchaser to identify a suitable business (“M&A target”) to buy and for the seller to identify a suitable purchaser for the business they wish to sell. M&A bankers specialize in assisting prospective buyers and sellers to find each other.
Once this initial step has been completed, the purchaser and the seller will normally wish to commence discussions with a view to reaching an agreement in principle. In this regard, it is common for the purchaser and seller to sign a letter of intent (“LOI”), memorandum of understanding (“MOU”) or other heads of terms to summarize the key commercial terms of the business acquisition.
Role of M&A Letter of Intent
A letter of intent typically represents the first of three documentation stages in an M&A transaction, the second being the formal purchase and sale agreement (i.e. definitive deal documentation) and the third being the completion documentation.
A letter of intent provides a framework for taking the transaction forward, providing the context for the buyer to conduct due diligence on the target and setting the framework for the purchase and sale agreement to follow. It is usually expressed to be non-binding as to commercial terms but binding as to procedural terms.
By making a letter of intent non-binding as to commercial terms, the purchaser has ample room (i) to withdraw from the transaction should further information in relation to the target undermine the commercial case for the transaction, and (ii) to tailor the purchase and sale agreement to the specific information disclosed in relation to the target during due diligence.
Because a letter of intent typically does not bind the purchaser to proceed with a transaction, it differs from the purchase and sale agreement which, in contrast, is invariably binding but, often times, is subject to the conditions precedent (“CPs”) (i.e. pre-conditions) to closing. If conditions precedent are not satisfied, then the sale and purchase agreement may give the purchaser or the seller, as the case may be, the option to terminate the agreement.
It follows from the above that a letter of intent does not transfer actual ownership of the target. Such a transfer takes place at closing, which will normally involve the delivery of title documentation as well as payment of the purchase price. Closing may also require the delivery of a number of collateral documents. These may include, in some cases, evidence of regulatory clearances, shareholder approvals and third party consents (e.g. waiver of pre-emption rights) to evidence the satisfaction of conditions precedent, board resolutions authorizing the transactions and other matters contemplated by the purchase and sale agreement.
As noted above, aside from the commercial terms, a letter of intent will normally be expressed to be binding as to procedural terms which help facilitate pre-transaction dealings. An M&A lawyer can help determine what provisions should be binding and what provisions should be non-binding, to ensure that binding provisions are, in fact, binding and to define the scope of these binding obligations. As with any agreement, binding provisions require careful consideration and drafting.
An exclusivity period gives the purchaser time to obtain further information about the M&A target through due diligence and to negotiate terms of the definitive M&A documentation, whether in the form of a share purchase agreement (“SPA”), asset purchase agreement (“APA”) or otherwise, without fear that the costs of so doing will be wasted by the seller selling the target company to a third party.
In this vein, sometimes a letter of intent will provide that the seller and purchaser will negotiate the definitive M&A documentation in good faith. Under Hong Kong law, however, agreements to negotiate in good faith are generally unenforceable. As a result, a letter of intent may provide that the seller agrees not to negotiate with any person other than the purchaser for a specified period of time. Such a provision can lock in the seller in an enforceable manner.
Confidentiality obligations (also known as non-disclosure agreements or NDAs) protect information released by the seller or the target to the purchaser in the course of the transaction (e.g. during due diligence) from being used or disclosed by the purchaser. In the case of business acquisitions involving public companies, confidentiality obligations limit the risk of the creation of a false market.
Restrictive covenants protect the seller and the target from the purchaser abusing sensitive information released to it on the basis that the transaction will proceed. They complement confidentiality obligations and may include, for example, restrictions on poaching key employees or customers of the target, details of which may have been disclosed during due diligence.
A letter of intent may require the purchaser to pay a deposit. The payment of the deposit normally requires binding provisions to govern how the deposit will be applied. If the business acquisition does not proceed, the purchaser will want the seller to refund the deposit but the seller may wish to keep the deposit, particularly if he feels that the purchaser has reneged on the commercial terms agreed in the letter of intent.
Non-Binding Commercial Framework
The non-binding provisions of a letter of intent are, in many ways, no less important than the binding provisions. They require careful consideration even though they are non-binding.
Whilst the non-binding nature of such provisions clearly provides considerable latitude for the parties to settle on the final language, a letter of intent sets a framework for the formal definitive binding documentation which normally follows and the parties may find it more difficult to back away from or vary commitments given in a letter of intent, even if those commitments are non-binding.
Identifying Key Commercial Terms
As the letter of intent sets the framework, it is important to ensure that key commercial terms are present and that key commercial terms properly reflect the needs of the purchaser or seller, as the case may be.
For example, in some M&A transactions, it will be important for the seller to perform certain obligations, such as providing critical representations and warranties. However, the seller may be a shell company against whom such obligations are, for all practical purposes, unenforceable following completion given the absence of any assets to stand behind them. A skilled M&A lawyer can identify this problem for a purchaser at the stage of preparing the letter of intent and provide for an appropriate mechanism, whether through a holdback of purchase monies, a guarantee from a party related to the seller or otherwise, to address this problem. If such commercial terms are not addressed at the letter of intent stage, a seller may baulk at the purchaser’s proposal to address it at a later stage when the parties negotiate the formal sale and purchase agreement, as such a proposal may be regarded as inconsistent with the framework set out in the letter of intent.
Legal Consequences of Non-Binding Provisions
Beyond setting a framework, an M&A letter of intent may have legal consequences even if expressed to be non-binding. For example, it may be produced as evidence in legal proceedings, including, for example, in tax proceedings to determine the commercial substance of a transaction in the context of the application of anti-avoidance provisions. Equally, for example, if the target is a listed company, the letter of intent, including the non-binding terms, may form the basis for a public announcement as to the terms of the proposed business acquisition.
Level of Detail
It is important for the purchaser and the seller to remember that the non-binding provisions of a letter of intent are intended only to provide a framework for future discussions. A common problem that arises is that discussions in relation to the letter of intent become too involved and too detailed, bogging down the transaction at this preliminary stage. Often, it is desirable instead to complete the letter of intent with a focus on key commercial terms only so that the deal momentum can continue.