A letter of intent (“LOI”), a framework document that features flexibility and concision, is frequently used by prospective foreign investors in China to note down the intentions of the parties involved for further cooperation. While it’s natural to confuse an LOI and a contract, they are not the same. As lawyers in China, we would like to explain some of the following key differences.
I. An LOI is not necessarily a contract.
1. Different legal natures.
According to our legal practices in China, the LOI can be classified into three categories: negotiation document, final contract and preliminary contract and their legal natures are as follows:
2. Different legal effects and responsibilities.
Violation of LOIs in different legal natures can bring about different legal consequences:
- Violation of an LOI found to be a negotiation document will cause no legal consequences;
- In case of violation of an LOI found to be a final contract, the violator shall bear the liabilities for breach of contract in accordance with the relevant provisions of the Civil Code of PRC;
- In case of violation of an LOI found to be a preliminary contract, the violator shall bear the liabilities for contracting negligence or for damages.
Therefore, the legal nature of the LOI has a major impact on the performance and liabilities in relation to the business practices.
II. An LOI shall be deemed a contract when it has the essential clauses of a contract.
1. If an LOI constitutes a negotiation document, it is not a contract.
Usually before the conclusion of a contract, the parties involved will have rounds of negotiations, during which they may preliminarily agree on some major issues of the cooperation and record such issues in a negotiation document, which is more like a meeting minutes and is not a contract.
A typical negotiation document includes the names of the parties and the major issues negotiated, but the intention is not specific enough, leaving the subject matter and quantity undetermined, or the parties agree that such negotiation document is not binding and a formal contract will be concluded in the future, thus excluding the legal effects that may arise from a formal contract.
2. If an LOI constitutes a final contract, it is a contract.
The final contract here is what we usually understand as a contract. A final contract has the main content and essential clauses provided for by law and is legally binding. To be more specific, a final contract includes the essential clauses, such as the parties, subject matter, quantity, method of transaction, etc. and such main content is clearly prescribed. In addition, the parties may explicitly or implicitly agree to be bound by such contract and there should be no clauses in the contract to exclude the legal effects thereof.
A case is cited here for your reference.
Company A and Company B concluded an Acquisition Framework Agreement for the share transfer and had some disputes, which were then brought to the court. The court held that although it is stated in the Acquisition Framework Agreement that this agreement is just an LOI for the acquisition and all the matters unspecified shall be subject to the share transfer agreement concluded by the parties, from the content of the Acquisition Framework Agreement it can be seen that the main content and essential clauses of a contract are included and specified, including the parties (Company A and Company B), the subject matter and quantity, the method of the transaction (listed transaction in a designated property rights trading institution) and price of the transaction (not less than the asset evaluation price determined at the time of entering the market).
With specific provisions about the parties, subject matter, quantity, method of transaction, etc., such Acquisition Framework Agreement has the essential clauses of a contract. Although the price is not specified, it can be determined by the method agreed by the parties. Therefore, this Acquisition Framework Agreement shall be a final contract and legally binding on the parties.
3. If an LOI constitutes a preliminary contract, it is a contract.
A preliminary contract refers to a contract providing for that the parties shall enter into a contract within a certain period. According to Article 495 of the Civil Code, a letter of subscription, letter of order, and letter of reservation, and the like, in which the parties agree to conclude a contract within a certain period of time in the future, constitutes a preliminary contract. Where one of the parties fails to perform the obligation to conclude a contract agreed in the preliminary contract, the other party may request such party to bear the liability for breach of the preliminary contract.
The purpose of a preliminary contract is to arrange for the conclusion of the final contract. Breach of a preliminary contract will cause legal liabilities stipulated in the preliminary contract and will not directly affect the final contract. Once the final contract is concluded, the preliminary contract terminates automatically.
To conclude, the content of an LOI determines its legal nature, which then leads to different legal consequences. To promote the consummation of the business transaction in China, we would like to provide the following suggestions from the perspective of Chinese lawyers experienced in foreign investment:
- In the initial stage of negotiations, it is advised to use negotiation documents by specifying in the letter of intent that such letter is not legally binding on the parties and avoiding mentioning any particular date for the conclusion of the final contract.
- After several rounds of negotiations, if the parties want to nail down some conditions that are mutually agreed but still have doubts about some other terms, it is advised to specify the date for the conclusion of the final contract in the letter of intent and meanwhile stipulate that the final contract shall be concluded based on the conditions nailed down. To enable the addition of new terms and conditions, the parties may stipulate that the final contract shall prevail, thus further confirming the legal nature of the letter of intent as a preliminary contract.
- Where the terms and conditions of the contract have been negotiated and agreed, there is no need for the parties to use the letter of intent. In this case, it is advised to name the document as “XX contract” to avoid ambiguity and specify in the contract the main content, such as the subject matter, consideration, payment method, etc.
- It should also be noted that the procedural clauses such as the clauses of confidentiality and dispute resolution shall be binding on the parties no matter whether the letter of intent is considered a negotiation document or a preliminary contract.
If you have any legal questions regarding Letter of Intent, please feel free to contact us via firstname.lastname@example.org.