Is a Memorandum of Understanding (“MOU”) or a Letter of Intent (“LOI”) Legally Binding in the U.S. and China?

LOI MOU USA China

By Brian J. Donovan
ChinAmerica Legal Advisors, PLLC

Difference Between MOUs and LOIs

An MOU and an LOI are each fundamentally an “agreement to agree.” Both define the intent of the parties. The main difference between an MOU and an LOI is the number of the signatories. In an MOU, more than two parties may be involved but for an LOI only two parties are involved. MOUs imply that all the parties involved have to be signatories, while an LOI needs only the party which proposes the agreement to be a signatory.
 
Like an MOU, an LOI is a document which describes an intention to take some action. From the business perspective, it is defined as an agreement between two parties before the agreement is finalized. It is basically a compilation of key points of an agreement between the two parties who intend to conduct a business transaction.
 
An MOU or an LOI is executed for the purpose of declaring that the various parties involved are negotiating a contract. Each is something that the parties fall back on if the negotiation between the parties is terminated in bad faith. In sum, each is the agreement signed prior to the final agreement.
 

Common Law vs. Civil Law

Most nations today follow one of two major legal traditions: common law or civil law.
 
In common law, prior judicial decisions (“Precedent”) are used to decide cases at hand.
 
Under civil law, legislative decisions (codified statutes and codes) rule the land.
 
The common law tradition emerged in England during the Middle Ages and was applied within British colonies across continents. The civil law tradition developed in continental Europe at the same time and was applied in the colonies of European imperial powers such as Spain and Portugal.
 
Common Law is now the basis of legal systems in UK and former British colonies including U.S. and Canada.
 
Civil Law is now the basis of legal systems in Continental Europe, including Eastern Europe and former Soviet Union, China, Japan, most of Africa and Latin America, Louisiana and Quebec. Divided into French (Napoleonic) and German Codes.
 
Under common law, contracts are not based on statutes and codes. Each contract can be drafted more easily to fit the transaction instead of a statute or code. As a result, U.S. lawyers are involved in extensive legal analysis of an international business transaction and the negotiation process. The fact that there’s a greater risk of litigation in common law countries might have something to do with this extensive involvement by legal counsel.
 
Under civil law, lawyers are limited by statutes and codes. Contracts need to qualify for one of the many standards set by statutes or codes. The lawyer’s role is merely to demonstrate that the statutory rules should or should not apply. As a result, Chinese lawyers are not generally involved in extensive legal analysis of an international business transaction and the negotiation process but are often only engaged to address contract disputes after the fact.
 
In the civil-law tradition, contracts are shorter than their common-law counterparts and attempt to address fewer contingencies. That’s presumably because civil-law codes address issues that in common-law systems are routinely covered in contracts.
 

The U.S. Perspective

Generally, under U.S. law (common law), no party is exposed to any liability during the negotiation period; liability arises only after the parties have executed a formal, written contract. Under this rule, if the written document clearly states that it is non-binding, no liability arises.
 
An MOU or LOI is frequently used by buyers and sellers to memorialize their agreement on the material terms of a transaction such as price, closing date, financing, due diligence and other important deal points. The MOU or LOI can provide a measure of comfort that the parameters of a workable deal are in place and the parties can safely proceed to contract drafting and, possibly, the due diligence stage of the transaction. Details, boilerplate and remaining issues excluded from the MOU or LOI are typically addressed during the contract drafting stage by the parties and their attorneys. Though an MOU or LOI is almost universally intended to be non-binding, it frequently contains binding provisions governing confidentiality and marketing or negotiating exclusivity. The hybrid binding and non-binding nature of an MOU or LOI begs the question: when is a non-binding MOU or LOI binding?
 
Let’s take a look at LOI case law. A typical LOI contains a broad disclaimer that the parties will not be bound by its terms unless and until a separate binding agreement has been negotiated and executed by the parties. However, despite the presence of broad disclaimers, some courts have held that an LOI can evidence a “meeting of the minds” on the terms of an enforceable contract sufficient to award damages for breach. This is true even when one of the parties possessed the subjective belief that it never intended to be bound by the LOI. The rationale for this conclusion results from the court’s use of an objective test in lieu of a subjective test in determining the existence of a binding contract: the interpretation of an offer or acceptance is not what the party making it thought it meant or intended it to mean, but what a reasonable person in the position of the parties would have thought it meant.
 
In determining whether an LOI is binding upon the parties, Florida courts will generally consider several factors to determine whether “a meeting of the minds” occurred, including: (1) the type of contract at issue; (2) the number of terms agreed upon relative to all of the terms to be included; (3) the number of details to be ironed out; (4) the relationship between the parties; and (5) the degree of formality attending similar contracts as compared to the LOI. Midtown Realty, Inc. v. Hussain, 712 So. 2d 1249, 1252 (Fla. Dist. Ct. App. 1998). Below are two illustrative cases.
 
In Med-Star Cent., Inc. v. Psychiatric Hospitals of Hernando Cnty., Inc., 639 So. 2d 636 (Fla. Dist. Ct. App. 1994), Med-Star and Psychiatric Hospitals signed a document titled “Transport Proposal” which (1) identified the parties and listed the liabilities that both parties “shall” have under the agreement; (2) provided that there was an “independent contract relationship between the parties;” (3) provided that the agreement would bind the parties for a minimum of 12 months; and (4) established rates for transportation and a payment schedule for services. Id. Med-Star sued Psychiatric Hospitals alleging it had used another company to transport its patients. Psychiatric Hospitals defended on the basis that the proposal was not an enforceable contract, but only a proposal as the title indicated. The court of appeals reversed the trial court’s holding in favor of Psychiatric Hospitals and held that an issue of fact existed as to whether the proposal created a binding contract. Psychiatric Hospitals’ contention that it did not intend to enter into a binding contract was irrelevant. “The test of the true interpretation of an offer or acceptance is not what the party making it thought it meant or intended it to mean, but what a reasonable person in the position of the parties would have thought it meant.” Id.
 
In Midtown Realty, Inc. v. Hussain, 712 So. 2d 1249 (Fla. Dist. Ct. App. 1998), the court held that a letter of intent is not considered a binding contract when the parties are continuing to negotiate essential terms of the agreement. In that case, Midtown Realty entered into a listing agreement with Mr. Hussain (“Seller”) for the sale of a gas station. Mr. Fiori (“Purchaser”) signed a two-page LOI that stated it was a “proposal” for the purchase of the gas station and contained: (1) a proposed purchase price; (2) plan for financing; (3) proposed inspection period; (4) proposed closing date, and (5) a statement that if the terms of the LOI were acceptable to the Seller, the Purchaser would present a more detailed and formal Purchase and Sale Agreement (“PSA”). A few weeks after executing the LOI, the Purchaser presented a more detailed and formal PSA. When the parties could not agree on its terms, the Seller withdrew the property from the market and the Purchaser filed suit alleging that the LOI represented a binding agreement. The court disagreed, stating that “[i]t is well established … that a meeting of the minds of the parties on all essential elements is a prerequisite to the existence of an enforceable contract, and where it appears that the parties are continuing to negotiate as to essential terms of an agreement, there can be no meeting of the minds.” Id. The court examined the language of the LOI and the surrounding circumstances in coming to this conclusion and noted that, among other things, the parties repeatedly called the LOI a “proposal,” indicating it was not an offer but rather an initial statement for consideration. Furthermore, the LOI stated that after execution, Purchaser would present to Seller a “more detailed and formal Purchase Agreement.” The court concluded that the Purchaser, like the Seller, believed that until the PSA was executed, there would be no binding contract and the LOI was a non-binding agreement.
 
So, when is an LOI truly non-binding? While even a well-drafted LOI cannot provide absolute certainty, there are several steps parties can take to avoid being bound by the terms of an LOI. They include:

  • Include a clear and unequivocal statement that the LOI is non-binding upon the parties;
  • Follow the Midtown decision and characterize the LOI as an initial statement for consideration only and that further material terms will be negotiated as part of a subsequent detailed and formal agreement;
  • Reserve the right to terminate negotiations at any time in your sole discretion;
  • If the LOI contains a binding exclusive or confidentiality provision, comply with its terms completely. A failure to do so may provide grounds for a reliance claim;
  • Do not include a covenant to negotiate in good faith; in fact, consider an express disclaimer of the obligation. Though this issue is less problematic in Florida than in some other states, it’s a good idea to expressly disclaim any obligation to negotiate in good faith in the text of the LOI;
  • Do not characterize the LOI as a binding or final agreement in communications with the other side; insisting that the LOI contains material terms binding on the other side or represents the final agreement can prove costly in subsequent litigation.

The Chinese Perspective

Under Chinese law (civil law), the rule in China is exactly the opposite from U.S. law.
 
The Contract Law of the PRC has formally adopted the German law principle of liability for negligence in contracting (缔约过失责任). Contrary to the classic common law view of the United States, under this principle, parties to a contract owe one another a duty of good faith.
 
In a case where negotiations have commenced but no contract is concluded, the party that caused the failure to contract can be liable to the other party for damages. The damages in this situation are not contract damages, but rather damages for compensation for loss resulting from the reasonable reliance of the damaged party on the conduct of the other.
 
This doctrine is embodied in Article 42 of the PRC Contract Law, which reads as follows:
 
Where in the course of concluding a contract, a party engages in any of the following conduct, and thereby causes loss to the other party, that party shall be liable in the event of a claim for damages:

  • negotiating in bad faith under the pretext of concluding a contract;
  • intentionally concealing a material fact or supplying false information relating to the conclusion of the contract;
  • any other conduct which violates the principle of good faith.

What is bad faith? The standard example is a U.S. party signing an MOU or LOI with a Chinese party and then negotiating with two parties at the same time without informing the two parties and using the MOU or LOI to keep one party from taking the initiative on a venture. And then sign a deal with the other party, cutting the first party out of the deal. This sort of strategy is not rare in common law countries, particularly in the mining/minerals and other natural resources businesses. Under the common law, the party cut out under this scenario usually has no claim. Under civil law, the party that has been cut out has a claim under the bad faith doctrine.
 
Very few U.S. (common law) lawyers are even aware of this issue or they say that the Chinese are “wrong.” However, China is a civil law country. It makes no sense to say the Chinese are just wrong. In fact, to the extent that the matter is subject to Chinese law, the Chinese are “right” by definition.
 
Extreme care must be taken to make clear the terms of negotiation and the commitments being made by the negotiating parties. An abrupt termination of negotiations with no warning and no explanation is very dangerous under this principle. However, even more dangerous is the failure to conclude a deal when the terms have been memorialized in a detailed MOU or LOI.
 
The magnitude of potential damage is far greater than most U.S. companies imagine. In the case of a typical commercial MOU or LOI, compensation can be demanded for the following:

  • Direct damages: These include costs incurred in preparing for the business venture, including the costs of drafting (attorney’s fees), research and development, and travel. These also include costs for time spent negotiating and the costs spent in preparing and delivering product samples.
  • Indirect damages: These include costs arising from abandoning negotiations with a third party for a similar transaction, lost profits from the other needing to pursue the project independently, or from needing to pursue other funding or related business opportunities.

The vast majority of U.S. companies believe that they have no risk by entering into an MOU or LOI with a Chinese company for the following two reasons.

  • First, the MOU or LOI clearly states that it is not binding and that no liability will arise for either party.
  • Second, the MOU or LOI clearly states that interpretation of the MOU or LOI is subject to U.S. law.

These arguments do not work. The good faith requirement of Article 42 is not a principle parties need to create by written contract; it is a statutory requirement that applies to all parties who negotiate contracts in China. It is an obligation that exists entirely separate from the agreement of the parties. More important, the requirement of good faith applies to the conduct of the parties, not to what they say in a written document. For this reason, a court will examine the underlying conduct of the parties to determine whether liability arises.
 
Thus, self-serving statements of a party that no liability will arise will be ignored. Even worse, such statements could be seen as a part of the plan to deceive the Chinese party about the U.S. company’s bad faith intent to cause harm. Reference to U.S. law will also be ignored, because liability arises under compulsory statutory law, not the consensual agreement of the parties.
 
In sum, there is no way to escape the application of the defect in contracting principle for any party who negotiates in China. This is particularly true when applied to a foreign company that has caused damaged to a Chinese entity. Since the basic principle is the opposite of what most U.S. companies think is the rule, extreme caution is therefore required.
 
Just about the only time an MOU or LOI should be used is when the parties need to set out specific steps that will be taken to complete due diligence for a specific transaction. In this case, such a document should be treated not as an MOU or LOI, but rather as a due diligence contract. The U.S. party should understand that it will be held liable if it does not perform strictly as required in the contract.
 
Once negotiations have begun in China, the rule of good faith applies. If no contract is ultimately concluded, then the risk of Article 42 damages is always there. For this reason, if no contract is concluded after negotiations have begun, the foreign side should carefully document the reasons and should provide those reasons in writing to the Chinese side.
 

Conclusion

There is a major gap between the U.S. and Chinese legal systems. It is not culture, it is the legal system itself.
 
Both the U.S. and Chinese sides are behaving in a manner completely consistent with their own legal system. But in the end, both sides look to the other as though they are acting in bad faith, when in fact both sides are doing nothing more than trying to reach a deal as best they know how.
 
Neither side has a bad intent. The Chinese side just puts a lot more stock in the MOU or LOI than the U.S. side. The U.S. side will sign the MOU or LOI thinking it is nothing more than “an agreement to agree” and planning to turn it over to their attorneys to draft the final agreement. U.S. companies should almost never enter into an MOU or LOI containing any detailed deal provisions with a Chinese company. All parties to any international business transaction should retain competent, local legal counsel.
 
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
 
Copyright © 2017, ChinAmerica Legal Advisors, PLLC. All Rights Reserved.


 

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