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Massachusetts Court Narrows Obligation to Negotiate in Good Faith Under Letter of Intent

January 1991

At one time or another, almost every business will enter into a “letter of intent,” a document intended to summarize the terms of a sale of assets, a license or of a number of other common contracts, before a binding agreement is negotiated and signed. However, many deals fall apart between the letter of intent and the final contract, and a recent Massachusetts Appeals Court decision for the first time establishes clear ground rules for actionable behavior in connection with a letter of intent.

The facts were as follows. In 1980 Federal-Mogul Corporation entered into a letter of intent to sell the assets of its Velumoid Division, located in Worcester, Massachusetts, to John Schwanbeck. In the letter of intent, Federal-Mogul included language which it must have thought protected it completely from any contractual obligation. Specifically, the letter of intent provided that “this letter is not intended to create, nor do you or we presently have any binding legal obligation whatever in any way relating to” the sale and purchase of the division. The letter of intent went on to provide that no further obligation would arise until a definitive agreement was reduced to writing and executed by Schwanbeck.

After several months of negotiations with Schwanbeck, Federal-Mogul sold its division to another bidder. During the negotiations, Federal-Mogul not only failed to disclose to Schwanbeck the fact that there was another interested party, but falsely assured him that there was not.

Schwanbeck sued, claiming breach of the agreement. Schwanbeck argued that the letter of intent was an enforceable contract since it provided that Federal-Mogul and Schwanbeck would “proceed in good faith in the negotiation of a binding definitive agreement.” Schwanbeck claimed that Federal-Mogul’s clandestine negotiations with another buyer violated the obligation to negotiate in good faith, and therefore Federal-Mogul was liable for breach of the agreement and for multiple damages and attorney’s fees under the Massachusetts “little FTC Act,” M.G.L.c. 93A.

After a 57 day trial in Massachusetts Superior Court in 1989, the trial judge sided with Schwanbeck and awarded him damages totaling $32.5 million. However, in a decision issued in late September of this year the Massachusetts Appeals Court reversed this judgment (although Federal-Mogul must still defend against a further appeal to the Massachusetts Supreme Judicial Court).

In its decision, the Appeals Court emphasized that the purpose of a letter of intent is not to bind the parties, but to establish a framework for negotiating an actual agreement. The court analogized business negotiations to a courtship, and noted that “there is commercial utility to allowing persons to hug before they marry.”

The court also addressed the language in the contract which obligated Federal-Mogul and Schwanbeck to “proceed in good faith” to reach a binding agreement. In the context of a letter of intent, the Court held that such language “means something less than unremitting efforts to get to ‘yes,’ with the players at all times playing their cards face up.” So long as the letter of intent has not been entered into for an ulterior purpose, a genuine motive “may be taken as established” if the party “takes some action, such as the exchange of drafts.”

TLB Comment: We read the Schwanbeck decision to imply that in the absence of express language requiring the parties to negotiate in good faith, there is no obligation of good faith negotiation whatsoever. The Schwanbeck decision should encourage business to make more use of letters of intent by eliminating fears that the document may be held to be a binding contract. If the Appeals Court’s decision is not itself reversed, a party to a letter of intent is free to walk away from a transaction with no fear of legal repercussions, particularly if it does not expressly assume an obligation of “good faith negotiation.” Even if there is an express obligation to negotiate in good faith, as a practical matter the burden it imposes on the parties is minimal.

To take advantage of the guidelines established in Schwanbeck , companies should be sure that letters of intent are identified as such, and contain an express and unqualified disclaimer of binding effect. Moreover, they should be aware that the identification of express duties and obligations — such as rights of first refusal, options, expense sharing arrangements and the like — may lead a court to disregard the disclaimer language and treat these items as contractually binding.

Postscript: The Appeals Court decision was affirmed by the Massachusetts Supreme Judicial Court.