From Intent to Obligation: Enforceability of a Term Sheet

From Intent to Obligation: Enforceability of a Term Sheet

Term sheets are crucial in the deal making process and therefore, it is important that the parties draft the term sheet with the utmost caution analysing and foreseeing the risks

Introduction: Understanding the Role of Term Sheets in Business Transactions

A term sheet is often perceived as a preliminary document that establishes the foundation between the parties for future negotiations and is usually, although not always, understood to be an ‘agreement to agree.’ A well-drafted term sheet would expedite the process of finalisation of definitive documents, thereby minimizing the overall time and effort to be spent by the parties. It establishes the groundwork for the parties to reach a consensus on the crucial aspects of the definitive documents. Term sheets also provide flexibility to the parties during the negotiation phase where the parties can explore diverse options, make adjustments, and ultimately arrive at a solution that is beneficial to both parties and ultimately reflected as a final agreed understanding in the definitive documents to be entered into by parties for implementing the subject transaction.

Legally Binding Term Sheets: The Path to Enforceability

Term sheets or letter of intent were initially interpreted by the courts to be merely exploratory in nature and a pre-cursor to the definitive documents which would essentially be treated as enforceable documents. The position adopted by courts with respect to the term sheets on numerous occasions was that the term sheet indicated a party’s intention to enter into a contract at a later stage i.e., an agreement to agree. In the case of Dresser Rand S.A.v. BindalAgro Chem Limited¹, the court held, “letter of intent merely indicates a party’s intention to enter into a contract with the other party in future. A letter of intent is not intended to bind either party ultimately to enter into any contract.” Also, in the case of Rajasthan Co-operative Dairy Federation Ltd. V. Maha Laxmi Mingrate Marketing Service Pvt. Ltd² the Supreme Court held that the letter of intent is merely an intention to enter into a contract between the parties and there is no binding legal relationship between the appellant and respondent at this stage.

Intention of parties is an especially key factor for determination of the nature of contract under the Indian Contract Act, of 1872 (“ICA”). A closer look at S.13 of the ICA states that for a contract to be valid, it should be entered with free consent between the parties, S.14 of the ICA states that consent should be free from any kind of coercion, undue influence, fraud, misrepresentation or mistake, S.16 of the ICA notes that the parties must perform their obligations under the contract in good faith and their conduct shouldn’t be unconscionable or against the public property. ICA thus aims to ensure fairness in contractual relationships. The objective thus is to understand the true intentionof parties while they are entering into a contract. Contrary to the previous opinion, the courts also acknowledged that term sheets can indeed have a binding effect between the parties involved. The Supreme Court in the case of South Eastern Coalfields Ltd v. S. Kumar’s Associates AKM (JV)³ held that a letter of intent can be enforced if the intention of the parties is evident from the letter, but such intention must be clear and unambiguous. Similarly, in the case of Bhoruka Power Corporation Limited v. State of Haryana and Ors⁴, the court held that it is true that the letter of intent does not create any vested right but the fact that after the issuance of the letter of intent, the petitioner took various steps and spent considerable amount created a legitimate expectation that in the absence of any adverse factor, the contract would be awarded to the petitioner. Considering the aforesaid, the earlier position further evolved where under the parties would explicitly mention the provisions such as governing law and jurisdiction, exclusivity, and confidentiality, which would be binding in nature as opposed to the provisions which would not be binding and thus not enforceable between the parties.

The position on this has been further evolving and the binding nature of the term sheet is being determined by the adjudicating authorities not only from the explicit reading of provisions contained therein but also taking into consideration the conduct of parties upon execution of such document. In the case of Zostel Hospitality Pvt Ltd and Ors v. Oravel Stays Pvt Ltd⁵ (“Zostel Hospitality Case”), the binding nature of the term sheet was one of the focal points of discussion and some remarkably interesting observations arose from the said ruling.

The facts of the case are as follows:

A term sheet (“Term Sheet”) was executed between certain claimants(“Claimants”) and the Respondent for the purpose of acquisition of assets of Claimant No. 1 and Claimant No. 2 including intellectual property rights, software, key employees etc. by the Respondent. It was the Claimants’ case that they acted upon the Term Sheet, fulfilled all the obligations stipulated therein and transferred their business to the Respondent. The Respondent refuted the Claimants’ case and inter alia submitted that the Term Sheet was merely exploratory, non-binding in nature and stood terminated and therefore the Claimants were not entitled for any relief. One of the issues framed by the arbitral tribunal (“Tribunal”) was whether the Term Sheet was non-binding as stated therein or whether it was a binding, valid and enforceable agreement in terms of the acts of the parties as alleged by the Claimants. The Claimants inter alia argued that: (i) notwithstanding the use of the term ‘non-binding’ in the recital, every aspect of the Term Sheet was intended to be binding. (ii) the parties had by conduct, waived the non-binding nature of the Term Sheet and the contract must be interpreted in accordance with language employed therein coupled with the intent of parties, which intent wasinter alia reflected from the ‘conduct of parties.’(iii) Furthermore, it was argued that contemporaneous correspondence could be read to deduce the intent and consensus ad idem between the parties and that signature of parties to a written contract is not a pre-condition for the existence of contractual relations as a contract can equally be accepted by conduct. The Respondent inter alia argued that (i) the Term Sheet does not constitute as a binding agreement for the proposed transaction. The preamble of the Term Sheet clearly stated the common intention of the parties was ‘not’ to create any binding obligation under the Term Sheet and the signatories clearly specified that they will only create binding contractual obligations upon execution of definitive documents. (ii) Term Sheet was an agreement to enter into an agreement and is not recognised in law and definitive documents were never agreed upon or executed or signed.

The Tribunal considering the issues and arguments made by the parties inter alia held that: (i) reading the Term Sheet as a whole was imperative to understanding the true intention of the parties. It was observed that Term Sheet specified several conditions to be fulfilled by the Claimants such as completion of the due diligence process, obtaining approvals, withdrawal of pending cases, transfer of assets to respondent etc. and the closing of the transaction was a natural and only consequence of compliance of the said conditions. The Term Sheet thus was not a mere exploratory document. (ii) it was only pursuant to the Term Sheet that the Respondent could conduct the due diligence and become privy to sensitive commercial information with respect to the Claimants. Therefore, the Term Sheet could not be held to be a non-binding document. (iii) Even if it was assumed that at the time of execution of the Term Sheet, the parties had intended that the Term Sheet be non-binding and exploratory, by conduct, parties waived the non-binding preamble of the Term Sheet and created a binding and enforceable contract.

Risks Associated with Term Sheets and Their Impact on the Deal-Making Process

One of the foremost risks associated with the term sheet is the interpretation of the binding nature of the term sheet, more so when both parties have different understanding in respect of the said matter. Considering the observations in the Zostel Hospitality Case, it becomes imperative that appropriate language is used while drafting documents in the nature of term sheets / letters of intent, so as to accurately reflect the intent of the parties. Furthermore, it also becomes crucial to regulate the conduct of parties post execution of such documents, to ensure that the parties do not end up waiving the non-binding nature of such documents by implication. Consequently, implementation of the condition precedent during the negotiation phase by the parties and before execution of the definitive documents, should be proceeded with caution. The parties should also keep in mind the safeguards to be followed while exchanging correspondence between themselves during the negotiation phase, as the courts will strongly take the same into consideration in attributing the intent and reflecting on the conduct of the parties. Moreover, when parties start negotiating with each other and formalise such negotiation and understanding into a term sheet, proper safeguards should be in place when disclosing sensitive / confidential information as this was also one of factors which was considered in the Zostel Hospitality Case.

Conclusion

Term sheets are crucial in the deal making process and therefore, it is important that the parties draft the term sheet with the utmost caution analysing and foreseeing the risks. Even though the term sheets / letters of intent in usual parlance are treated as a pre-cursor to the definitive documents, the observations and the ruling in Zostel Hospitality Case make it imperative to realise that the conclusions in this regard may not be so straightforward and it is crucial to lay emphasis on various aspects and employ safeguards so that parties do not end up with unintended consequences while executing such documents.

Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature.