12.3 Preliminary Understanding 409The signing of a letter of intent typically ends the preliminary discussions as to
the structure of the deal, the price or pricing method, the form of consideration,
and other key terms. The negotiation process then shifts to the preparation of de-
finitive contract documentation. At the same time, the acquirer will conduct due
diligence, and the parties will prepare for taking the necessary corporate action
and seeking the necessary regulatory approvals.^8
A letter of intent creates a sense of moral obligation and provides a framework
and context for further negotiations and due diligence.^9
Whether it is legally binding and enforceable depends very much on its actual
wording (not its heading). In practice, most letters of intent specifically state that
they do not create a binding obligation. In the US, such a clause is called the Tex-
aco clause.^10
In 1984, Pennzoil, Co. intended to acquire Getty Oil Company. In January 1984, a “Memo-
randum of Agreement” was drafted between Pennzoil and various Getty entities to reflect
the terms that had been reached in conversations between their representatives. However,
the board of Getty Oil accepted an offer made by Texaco. Pennzoil demanded that the
Getty entities honour their agreement with Pennzoil and sued Texaco for damages and pu-
nitive damages for Texaco’s tortuous interference. Pennzoil’s claim for damages and puni-
tive damages prevailed. Before Texaco, Inc. v. Pennzoil Co.,^11 it was believed that such an
agreement-in-principle was not a final, binding agreement, but rather, a commitment that
the deal would proceed on the announced terms if residual issues were satisfactorily re-
solved. Since Texaco, Inc. v. Pennzoil Co., it is standard practice to include a disclaimer of
intent to be bound in every pre-closing document.
In the absence of such a clause, legal risk is increased for a party that does not yet
want to be bound. If the letter of intent contains the necessary terms of the transac-
tion, the probability that the court will regard the letter of intent as a binding sales
contract will be increased. This may be the case when the only things missing are
a due diligence examination, regulatory approvals, and other formalities (see sec-
tion 12.5).
In the US case of United Acquisitions Corp. v Banque Paribas,^12 the court adopted a four-
factor test for determining whether a letter of intent is binding: (1) Does the document con-
tain an express statement of intent to be bound only by a written agreement? (2) Has one
party partially performed and has the other party accepted that performance? (3) Are there
issues remaining to be negotiated? (4) Does the agreement involve complex issues in which
definitive written contracts are the norm?^13
(^8) See Bainbridge SM, Mergers and Acquisitions. Foundation Press, New York (2003)
pp 173–175.
(^9) Ibid, pp 174–175.
(^10) See Johnston JS, Communication and Courtship: Cheap Talk Economics and the Law of
Contract Formation, Virg L R 85 (1999) pp 459–460.
(^11) Texaco, Inc. v. Pennzoil Co., 729 S.W.2d 768 (Tex. App. 1987).
(^12) United Acquisitions Corp. v. Banque Paribas, 631 F.Supp. 797 (S.D.N.Y.1985).
(^13) Bainbridge SM, op cit, pp 174–175.