Our article addresses the binding force of letters of intent, memoranda of understanding and term sheets, and pre-contractual liability from a comparative law perspective, explaining culpa in contrahendo, reliance loss, the English law approach and the UNIDROIT Principles.
In the sixth month of an acquisition negotiation, the buyer has incurred substantial advisory and due diligence costs, while the seller has stopped speaking to other suitors during this period. Four months earlier the parties signed a letter of intent; the document sets out the price, the structure and the timetable, but states at the end that it is not binding. When the negotiations are abruptly broken off, the question arises; does this document really produce no legal consequence at all, or may one of the parties be held liable for that sudden rupture? The answer to this question varies strikingly according to which legal order applies. In continental European legal systems, contract negotiations give rise to a relationship of trust between the parties founded on the rule of good faith, and the breach of that relationship may lead to liability in damages. Under English law the approach is fundamentally different; freedom of negotiation prevails and a duty to negotiate in good faith is as a rule not recognised. This article comprehensively examines letters of intent, memoranda of understanding and term sheets, their binding force, pre-contractual liability and the institution of culpa in contrahendo from a comparative law perspective.
1. The Types of Pre-Contractual Document
The pre-contractual documents used in commercial negotiations differ in function, even though their names are often used interchangeably. The letter of intent is a declaration of will setting out one party's intention to enter into a particular legal relationship, but carrying no intention to be bound; it is process-oriented and contains arrangements as to how the negotiations will proceed. The memorandum of understanding performs a different function; here the parties record the concrete results of earlier negotiations as a kind of interim result and jointly reduce to writing the point the negotiations have reached. Unlike the letter of intent, the memorandum of understanding contains fixed elements of content that have been agreed rather than dynamic elements relating to the process; in this respect it has the function of preparing the main contract and is concerned less with the process and more with the contract. The term sheet, used particularly in investment and financing transactions, summarises the commercial terms of the transaction in itemised form. The preliminary contract differs from all of these; it is a contract imposing on the parties an obligation to conclude the main contract in the future and is in this respect genuinely binding. Drawing these distinctions correctly is the first step in determining a document's legal consequences.
2. Content, Not the Title, Is Decisive
The most widespread misconception concerning pre-contractual documents is the belief that the legal consequence can be determined by looking at the document's heading. Yet the law looks not at the name of the document but at its content and at the parties' real intention. A document headed letter of intent may be characterised as a binding contract where its content contains the parties' definite undertakings and an intention to be bound has been manifested. Conversely, a text bearing the heading contract may be regarded as non-binding where there is no agreement on the essential points and the parties have expressly stated that they are not bound. Under Turkish law the basic elements of a letter of intent are that it is a unilateral declaration of will, that it manifests an intention to enter into a particular legal relationship and that it carries no intention to be bound. This third element is decisive; where an intention to be bound exists, the document ceases to be a letter of intent. In doctrine it has been debated whether a letter of intent may, according to its concrete content, carry the character of an offer, a preliminary contract or an option. For this reason, when preparing or assessing a document, one must look not at the heading but at the definiteness of the undertakings assumed and at the intention manifested in the document.
3. The Problem of Partial Binding Force
The great majority of pre-contractual documents in practice are not texts that are either wholly binding or wholly non-binding; they are of a mixed nature. A typical letter of intent states that it is non-binding as regards the commercial terms of the transaction, while genuinely binding the parties as regards certain of its provisions. The provisions intended to be binding are generally as follows; the confidentiality obligation, the exclusivity undertaking, on whom the costs will fall, the governing law and dispute resolution, and any advance payment or security arrangements. The clear separation of these two layers in the document is the most critical technical matter in practice. A well-prepared letter of intent specifies, by article number, which provisions are binding and which are not; a general and vague statement that the document is not binding is not sufficient, because that statement may appear to cover provisions such as confidentiality and exclusivity that are genuinely intended to be binding. The opposite error is for a party, in a document stated to be non-binding, to assume detailed and definite undertakings and to act as though a contract had in fact been concluded; in that case a conclusion of binding force may be reached notwithstanding the document.
4. The Basis of Pre-Contractual Liability under Turkish Law
Under Turkish law the stage of contract negotiations is not a legal vacuum. From the moment the parties begin negotiations a contract-like relationship of trust is established between them, and this relationship gives rise to certain obligations founded on the rule of good faith. Liability arising from the breach of these obligations is termed in doctrine and case law culpa in contrahendo and takes its basis from the article of the Turkish Civil Code regulating the rule of good faith. Under this institution, where during contract negotiations one of the parties or its auxiliaries engages in faulty conduct contrary to the relationship of trust established on the basis of good faith and causes the other party loss, it is liable for that loss. For liability to arise it is not necessary that the main contract have been concluded; indeed the most typical field of application of the institution is where the contract was never concluded at all. Whether or not a letter of intent or preliminary protocol has been prepared beforehand, since the relationship established during contract negotiations rests on good faith, the parties are obliged to conduct the negotiations honestly and to refrain from faulty conduct causing the other party loss.
5. The Content of Pre-Contractual Obligations
The obligations arising at the negotiation stage may be gathered under certain headings. The first is the duty of disclosure and information; the parties are obliged to disclose important matters capable of affecting the other party's decision to contract, in particular information the other party could not be expected to learn on its own. The second is the duty of confidentiality; commercial information learned during negotiations must be kept confidential and not used for other purposes. The third is the duty of care; the parties must show the necessary care not to harm the other party's assets or personality. The fourth is the duty of seriousness; continuing negotiations without any real intention to contract, putting the other party to expense, or prolonging discussions in order to keep it away from its competitors constitutes a breach of this duty. The common feature of these obligations is that they show that, notwithstanding that no contract has been concluded, the parties are not in a position of complete freedom towards one another. The right to withdraw from negotiations exists as a rule; but the exercise of that right cannot take place in a manner abusing the other party's justified reliance.
6. The Concept of Reliance Loss
The most distinctive aspect of pre-contractual liability is the scope of the loss to be compensated. What is compensated here is not the gain that would have been obtained had the contract been concluded, that is, the expectation loss; what is compensated is the reliance loss. Reliance loss denotes the expenses incurred on account of justified reliance that the contract would be concluded and wasted because that reliance was disappointed. Typically included in this scope are the following; travel and meeting expenses incurred for the negotiations, advisory fees paid for legal and financial review, technical report and valuation costs, preparatory expenditure required by the transaction and, in certain cases, the loss arising from a missed alternative opportunity. By contrast, the profit that would have been earned had the planned transaction gone ahead cannot be claimed; for there is no concluded contract and no breached performance obligation. This distinction determines the limits of pre-contractual liability and ensures that the institution does not eliminate freedom of contract. The parties cannot be compelled to contract; only the concrete losses caused by conduct disappointing justified reliance are made good.
7. The Approach under German and Swiss Law
The institution of culpa in contrahendo takes its origin from German legal doctrine and is deeply rooted in the continental European legal family. Under German law this liability was expressly regulated in the code with the reform of the law of obligations, and it was accepted that an obligational relationship arises upon the commencement of contract negotiations; the pre-contractual stage was thereby recognised as a statutory obligational relationship. German doctrine has further argued that reliance loss may fall within the scope of the tort provisions relating to intentional conduct contrary to morality. Under Swiss law the institution is founded, in parallel with Turkish law, on the rule of good faith and is assessed within the framework of liability for reliance. Since in Turkish-Swiss law the distinction between reliance and expectation loss essentially arises in contractual liability, it is accepted that loss arising from the disappointment of reliance that the contract would be validly concluded should be compensated within the framework of the provisions on contractual liability. This approach produces consequences approaching the contractual regime in dimensions such as proof, limitation and liability for the acts of auxiliaries.
8. Freedom of Negotiation under English Law
The approach of English law in this field differs fundamentally from continental European law and constitutes one of the most striking divergences in comparative law. English law does not recognise the notion of a duty of good faith at the stage of contract formation. The classic authority for this approach is the House of Lords decision in Walford v Miles. In that case it was held that an agreement to negotiate in good faith is unenforceable because it lacks the necessary certainty. The reasoning behind the decision is exceedingly clear; a court cannot be expected to determine whether, subjectively, a proper reason existed for the termination of negotiations. It was further stated in the decision that a duty to negotiate in good faith is inherently incompatible with the adversarial position of the parties in a negotiation; in a negotiation each party is entitled to pursue its own interest so long as it avoids making misrepresentations. On the same line, earlier authority had accepted that an agreement to agree is likewise unenforceable. This approach reflects the priority English law gives to commercial certainty and to party autonomy.
9. Lock-Out Agreements and the Limit of English Law
English law's closed attitude towards a duty to negotiate is not absolute and carries an exception of great practical importance. In the same decision it was accepted that a lock-out agreement, by which one party undertakes for a specified period not to negotiate with others, may constitute an enforceable contract. The distinction arises from this; an undertaking not to negotiate with others is a negative and measurable obligation, and a court can objectively establish whether it has been breached. By contrast, an undertaking to negotiate in good faith is a positive and unmeasurable obligation. However, this exception too has a firm condition; the lock-out agreement must be limited to a specified period. An exclusivity undertaking with no period stated was likewise held unenforceable for uncertainty. This distinction produces a directly practical consequence for lawyers working on transactions governed by English law; a party wishing to protect the negotiation process must rely not on a good faith clause but on an exclusivity undertaking with a firm period and on express sanctions attached to it.
10. The Subject to Contract Qualification
The established technique used in English law practice to prevent pre-contractual documents from becoming binding is the insertion into the document of the subject to contract qualification. This qualification expresses that the correspondence and understandings between the parties are not legally binding until a final signed contract is concluded. The strength of this qualification derives from the formal and foreseeable approach of English law; where it is used in due form, no binding force arises even though the parties have advanced in their negotiations. Under continental European law, by contrast, the effect of a similar qualification is not absolute; even where the document states that it is non-binding, the parties' actual conduct and the stage the negotiations have reached may give rise to liability within the framework of the rule of good faith. This difference produces an exceedingly important consequence in international transactions; the same text produces different results depending on the applicable law. The presence of a subject to contract qualification in a negotiation governed by Turkish law does not of itself displace liability arising from the breach of the duty of seriousness. For this reason, determining the applicable law in pre-contractual documents is not a technical detail but a strategic choice.
11. The UNIDROIT Principles and the International Standard
In the field of international commercial contracts, a middle way reconciling the two traditions is found in the UNIDROIT Principles of International Commercial Contracts. Although not a binding international agreement, these principles are a soft law instrument that may be incorporated into the contract by the parties and to which recourse is frequently had, particularly in arbitral proceedings. The principles expressly recognise freedom of negotiation; the parties are free to negotiate and are not liable for failure to reach agreement. However, this freedom has a limit; a party who negotiates in bad faith or breaks off negotiations in bad faith is liable for the loss caused to the other party. The principles further set out, as a typical manifestation of bad faith, entering into or continuing negotiations while having no real intention of reaching agreement with the other party. Alongside this, a separate duty of confidentiality is regulated, to the effect that information given in confidence during negotiations must not be disclosed or improperly used for the party's own purposes. This structure offers a balanced middle point between the good faith approach of continental European law and the emphasis on freedom in English law.
12. The Effect of the Choice of Law in International Transactions
The comparative picture produces directly practical consequences for the preparation of pre-contractual documents in an international transaction. The same letter of intent produces different results when governed by English law and when governed by Turkish law. Under English law, a party breaking off negotiations after a document expressly stated to be non-binding is as a rule not liable; freedom of negotiation prevails. Under Turkish law the same conduct may give rise to liability for reliance loss where it has abused the other party's justified reliance and breached the duty of seriousness. This difference makes it essential that the governing law provision in pre-contractual documents be regulated separately and deliberately. A nuance requiring attention is that the legal nature of pre-contractual liability is debated in private international law as well; whether this liability is to be regarded as contractual or tortious affects the determination of the applicable law. The most practical way of preventing this uncertainty is to insert into the letter of intent both a governing law provision and a dispute resolution provision, and to state expressly that these provisions are binding.
13. The Elements of a Good Letter of Intent
The conclusions emerging from the comparative picture show how a good letter of intent should be structured. The first element is the clear separation, by article number, of the binding and non-binding provisions. The second element is the regulation of the confidentiality obligation as binding, together with its scope, duration and exceptions. The third element is the tying of the exclusivity undertaking to a firm period; this is mandatory for enforceability under English law and provides certainty in every legal order. The fourth element is the determination of on whom the costs will fall; where the rule that each party bears its own costs is not written in, a dispute over reliance loss may arise later. The fifth element is the determination of the document's termination conditions and duration; a letter of intent with no time limit creates uncertainty. The sixth element is the express statement that the parties may withdraw from the negotiations at any time and without giving reasons; although this qualification does not wholly displace liability under continental European law, it is decisive in the assessment of whether reliance was justified. The seventh element is the regulation of the governing law and dispute resolution provisions as binding.
14. Mistakes Frequently Made in Practice
Certain mistakes are frequently repeated in pre-contractual documents. The first is relying on the document's heading and assuming that, because it is called a letter of intent, it will produce no consequence; whereas content is decisive. The second is contenting oneself with a general and vague statement that the document is not binding, and thereby leaving provisions such as confidentiality and exclusivity, which genuinely ought to be binding, within the scope of that statement. The third is leaving the exclusivity undertaking without a time limit; this leads to unenforceability under English law and to an argument over proportionality in other systems. The fourth is the complete failure to determine the governing law in the document; this gap may, as the comparative picture shows, fundamentally change the outcome. The fifth is for a party, in a document stated to be non-binding, in fact to assume definite undertakings and to set the other party in motion. The sixth is to have in fact reached agreement with another suitor while continuing the negotiations; in both legal traditions this conduct gives rise to liability, either as a breach of the duty of seriousness or as a plain breach of the exclusivity undertaking.
15. Conclusion and Practical Recommendations
Pre-contractual documents are texts signed in haste on the assumption that they are not legally binding, yet capable of giving rise to serious liability. The basic considerations in this field may be summarised as follows. The legal consequence of a document is determined not by its heading but by its content and by the parties' real intention. Pre-contractual documents are as a rule of a mixed nature; the binding and non-binding provisions must be clearly separated by article number. Under Turkish law the negotiation stage gives rise to a relationship of trust founded on the rule of good faith, and the breach of that relationship leads to liability for reliance loss; what is compensated is not the profit that would have been earned had the contract been concluded, but the expenses wasted. Under English law freedom of negotiation prevails and an agreement to negotiate in good faith is held unenforceable; by contrast, lock-out agreements with a firm period are enforceable. The UNIDROIT Principles offer a balanced middle way between these two traditions and attach liability to bad faith negotiation. Since the applicable law fundamentally changes the outcome in international transactions, it must be regulated separately and as binding in the letter of intent. Finally, the right to withdraw from negotiations must be preserved, but must not be exercised in a manner abusing the other party's justified reliance.
Pre-contractual documents are closely connected with the other fields of commercial transactions and contract law. Our article on legal due diligence and the share purchase agreement in mergers and acquisitions, which addresses the place of the letter of intent in the transaction process, and our analysis of choice of law and jurisdiction agreements in international commercial contracts, which examines the determination of the applicable law, address the matters connected with pre-contractual liability.
For advisory services on the preparation of letters of intent and memoranda of understanding, the management of contract negotiations, pre-contractual liability disputes and the structuring of international transactions, you may contact us at info@guzeloglu.legal.