One of the documents we see often exchanged in contract negotiations is a Memorandum of Understanding (“MOU”) but what that document actually constitutes varies widely. Sometimes those are fully binding contracts which obligate the parties to fulfill the specified contractual terms. Other times, they are statements of an intention on the part of the parties to continue discussions along the lines specified in the document and do not bind any party to any particular agreement. Other times, they are documents that become binding if certain other events occur. Sometimes they are a vague combination of all three with the parties not fully understanding the differences. That’s when attorneys make a lot of money in the resultant dispute.
The real problem is that laypersons and, indeed, attorneys often use the term without fully defining it which can lead to dispute and even litigation later when the parties discover that what one thought was a binding agreement was considered an invitation to further discussions by the other parties.
How to both be alert to signs of that danger and how to avoid that danger is the subject of this article.
The Basic Problem:
Most agreements are entered into after negotiations. Those negotiations can take minutes or can take years and the negotiation is a process in which various terms are agreed upon while others are still a matter of further discussion or debate. During those negotiations it is common for outside parties to be involved with similar negotiations with one or both of the parties as to the same transaction. In short, those third parties are seeking their own deal with one of the parties and are “competitors” for the transaction.
For example, if I am selling my business to X and those negotiations proceed for months, Y can approach me or even Y and Z, and I may enter into negotiations with them as well since my negotiation with X may not bear fruit. This is neither unethical nor unusual and so long as I do not misrepresent the status of the multiple negotiations, it can be a powerful incentive for one of the parties to actually close the deal.
At some stage in the negotiations, one or more of the parties wish to move to the next stage: isolate the remaining terms to be worked out and, often, engage in fact finding (due diligence) or seek funding (to see if financing is available from banks or the like) and at that stage the parties often wish to memorialize their nascent understanding in a written MOU since reliance upon the deal happening becomes vital. Since due diligence can involve CPAs, attorneys and financial advisors, the expense can be substantial. It is common for due diligence to cost tens of thousands of dollars. Few parties want to spend that money without some binding understanding…though what is actually a binding commitment varies widely.
In the example above, note that the binding commitment of such an MOU would probably only be sufficient to allow due diligence or some other similar acts to occur. Typically, if bank financing is found to be available at acceptable terms or if no undisclosed liability or defect is discovered in due diligence, then the parties agree that the MOU will then either become a fully binding agreement or will be reduced to a fully binding contract within a specified period of time and that binding contract will adhere to the basic terms of the MOU. The MOU becomes a binding agreement to make a binding agreement with more details. A common additional term is that while the due diligence is being conducted, no offer from any outside party will be entertained. There is usually a time limit by which the due diligence must be completed, or the entire transaction is voided.
It is not uncommon for a fully drafted agreement with its exhibits to be dozens, even hundreds of pages long. Most MOUs are less than ten pages, sometimes a page or two or even an e mail. Thus, the lower cost of an MOU at the intermediate stages of a transaction makes good sense; it allows the due diligence and/or seeking financing without spending the significant legal and accounting bills that a full-fledged agreement would require.
The problem arises when the parties confuse an interim MOU with being the final agreement or object to some of the terms in the MOU being incorporated into the final agreement. Equally common, the short MOU, which always was to be enlarged into a far more complete agreement, is silent on important terms and the parties cannot agree upon them, with one claiming the MOU is binding and the other stating that without the other terms agreed upon, there is no binding agreement.
Thus, MOUs, which are meant to facilitate agreements and allow the parties to fully understand what the transaction entails, can become obstacles to the agreement if the parties do not create the MOU with care and clear understanding. Since in an effort to save money attorneys are often brought into the picture after the MOU has been signed, terms are often not in the MOU that are vital for a successful conclusion to the negotiation.
As an example: Acme Company is planning to sell to Baker Company and they entered into an handwritten MOU stating that Acme would not entertain other offers for thirty days while Baker performed due diligence and if Baker determined that the value stated in the Balance Sheet delivered to them already is within ten percent of that stated, they will buy for five million dollars, twenty percent down, five years to pay the rest, interest at seven percent. The parties wrote out that MOU themselves at dinner and signed it.
The due diligence did come out within ten percent but also discovered a claim from a customer that could exceed insurance coverage for products liability though Acme’s counsel and insurance counsel insisted the odds of success of that claim were small so it should not alter the balance sheet. Baker’s lawyer stated nothing is certain in a law court and claimed a discount of 20% of value was warranted. Acme was outraged and said that the terms of the MOU had been met and five million dollars is owed. The ultimate legal question was whether the balance sheet should include the contingent liability and for how much. The answer to that would determine if the MOU required the purchase. Litigation ensued since the MOU did not have terms in it as to contingent claims as any full sales agreement would have. The MOU did allow the due diligence but did not adequately describe and define what the balance sheet must specify. The MOU, itself, became the problem and the cause of litigation.
Put simply, a badly done MOU not only can cause problems, but can destroy the entire transaction. What was meant to facilitate the transaction actually killed it.
Mark Twain once wrote, “I’m sorry I wrote you such a long letter. I didn’t have time to write a shorter one.” Therein lies a powerful truth. It takes more skill and care to draft a short effective writing than a long one.
It is vital for the parties to understand what the MOU is to accomplish and what it is not to accomplish. Is it merely a document indicating further interest in the transaction and that is all? Is it a document that becomes binding if certain other events (due diligence, etc.) occur? If the latter, are the later events carefully defined? If new events occur, will they void the MOU or will they be resolved by some process, such as a CPA deciding if financial date is critical?
In short, is it a binding mini contract or is it a “feel good” expression of interest?
Often the problem is the atmosphere around the creation of an MOU. Business dinners, social outings, informal conferences are dangerous locales to create an MOU.
Often the problem is the person creating the MOU. A vice president of sales may sign an MOU which the operations director finds not only confusing, but detrimental.
Above all, drafting a full agreement which avoids future conflicts is not an easy task. There is a reason why business contracts are often dozens of pages long and attorneys are able to charge high hourly fees: a good contract is a document requiring skill, experience, and, perhaps above all, experience of what leads to litigation.
Thus, ideally the MOU is prepared by experienced legal counsel who will know the most basic issues to address:
- If this a binding agreement?
- What terms still need to be negotiated and if you cannot come to conclusion on them, what happens?
- What still needs to happen to make this the final agreement? Will a binding agreement replace this one or is this binding if X or Y happens?
- If the final agreement cannot be agreed upon, what happens?
- Can third parties continue negotiating with a competing deal with one of the instant parties?
- What is the time limit on the MOU?
- What is a fast and inexpensive method to resolve disputes should they arise, such as arbitration?
- Is this confidential?
- What information has to be exchanged? If exchanged, how kept confidential and what remedies if leaked?
- What proof of ability to pay is to be rendered? When?
Our article on contracts and on ambiguity in contracts explains in far more detail the pitfalls facing parties in creating the MOU and contracts. One client never created MOUs…he felt that one either has a contract or one does not: if one has a contract, that is the final deal and he wanted all the terms in it. If it is merely “an invitation to dance,” as he put it, then the MOU only gives a false sense of security.
However, an equally experienced client always demanded an MOU after a deal he had worked on for three months and spent tens of thousands in CPA fees examining disappeared when a competitor; snatched up the company he was going to buy. He told the writer that he had merely educated the seller into what to ask for from his competitor. A restriction on entertaining third-party offers was part of every MOU he created, and he always wanted an MOU.
And one client used MOUs to find out about possible competitors before he entered a new territory. He would laugh and say the seller would give him more information about his business and customers than he would get in any other way and since his MOUs always gave him a way to walk away from a deal, it was free information. Note that the seller had no way to claim breach unless the MOU was properly constructed to be binding.
But note that an experienced attorney once told the writer that MOUs poorly drafted put his son through college. He wrote, “They think they are saving time and money by writing up a deal on a napkin. No, they are simply deciding to make lawyers rich…”
MOUs serve a purpose but only if carefully constructed. One has a choice: educate yourself as to what key terms must be in the MOU or hire an attorney to do so. Avoid “jumping” at deals and scribbling a document on the spur of the moment that may cause you far more problems later.
Think before you write…or hire someone who has thought it out…