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The law of unintended consequences

This article was first published in Leasing Life in December 2016 (Vol. 22, No. 279). Reproduced with the kind permission of Leasing Life.

Parties to a potential transaction often record the understanding of the principal commercial terms in a letter of intent, but pre-deal documents can give rise – in some cases, perhaps inadvertently – to legally binding obligations, writes Adam Longney, partner at REN Legal.

It is common for the parties to a potential transaction to record their understanding of the principal commercial terms of that transaction in a letter of intent (or equivalent) before proceeding to document the transaction in a full suite of negotiated documents.

The purpose of this is generally to give the parties some comfort that they have reached a mutual understanding of the key commercial terms, and to provide a framework and process for working towards fully documenting and closing the deal.

For this reason, it is not uncommon for the parties to assume that pre-deal documents are non-binding statements of intent, and that they will only be bound to the deal when they enter into the full suite of negotiated documents.

However, the High Court case of Novus Aviation Ltd v Alubaf Arab International Bank BSC(c) [2016] EWHC 1575 (Comm) highlights the fact that such pre-deal documents can give rise – in some cases, perhaps inadvertently – to legally binding obligations. The case also gives some useful guidance to businesses when considering the nature and extent of their potential obligations under pre-deal documents.

Novus Aviation Ltd (Novus), an international aircraft leasing and financing company, entered into discussions with Alubaf Arab International Bank (Alubaf) regarding the potential financing of the purchase of Airbus aircraft to be leased to an airline.

In early May 2013, Novus and Alubaf exchanged emails regarding the terms of a commitment letter which was to set out the basis on which Alubaf would provide some of the funding for the aircraft’s purchase. On 9 May 2013, Alubaf sent an email to Novus attaching a scanned copy of the agreed commitment letter which had been printed on Alubaf’s letterhead and signed by Alubaf’s Head of Treasury and Investments.

Under the terms of the commitment letter, Alubaf’s agreement to provide funding was conditional upon, among other things, “satisfactory review and completion of documentation for the purchase, lease and financing”. The letter also contained an English governing law clause and a submission to the non-exclusive jurisdiction of the courts of England.

Although Novus did not return a countersigned copy of the commitment letter to Alubaf, throughout May 2013 various steps were taken to progress the transaction referred to in the commitment letter, including the incorporation of special purpose companies (SPCs) and the preparation of draft transaction documents.

In June 2013, Alubaf notified Novus that Alubaf’s board of directors had rejected the deal due to concerns about its accounting treatment in Alubaf’s accounts. Novus requested that Alubaf honour its funding obligations in the commitment letter, but Alubaf declined to do so. Novus then sued Alubaf on the basis that the commitment letter constituted a legally binding contract and Alubaf’s refusal to honour its obligations amounted to a repudiatory breach of contract.

Alubaf argued that the commitment letter did not constitute a legally binding contract because:

  • It was not intended to be legally binding;
  • The conditionality attached to Alubaf’s agreement to provide funding meant that it lacked sufficient certainty to be binding;
  • Alubaf’s signatory did not have the authority to bind Alubaf; and
  • The commitment letter had not been countersigned, and therefore had not been accepted, by Novus.

The judge rejected all of these arguments and found that the commitment letter did constitute a legally binding contract. The reasons given by the judge provide useful guidance for businesses when considering the nature and extent of their obligations under such pre-deal documents.

Do you intend to be legally bound?

The judge found that it was plain from the terms of the commitment letter that it was intended to be legally binding. He stated that this was evident by the use of the “language of obligation” throughout (the use of the words “shall” and “covenants” were highlighted as examples), and by the inclusion of a governing law and jurisdiction clause.

The judge also acknowledged that it is possible to create a document where certain provisions will be legally binding and others not. However, he added that if that is the intention of the parties, then the document should contain an express and clear distinction between those provisions that are intended to be legally binding and those that are not.

Therefore, if it is intended that a pre-deal document should only be a statement of intention and not be legally binding, that document should expressly state that it is not intended to be legally binding. Equally, if the intention of the parties is that some provisions of the document are to be legally binding and others not, this needs to be clearly set out in the document.

The judge found that while Alubaf’s obligation to provide funding was subject to certain conditions, including “satisfactory review and completion of documentation”, Alubaf’s ability to reject the documentation as unsatisfactory was not unqualified. This right was in the nature of a contractual discretion which, in the absence of very clear language to the contrary, must be exercised in good faith for the purpose for which it is conferred, and must not be exercised arbitrarily, capriciously or unreasonably.

Consequently, if a party to a pre-deal document wishes to have a general right to walk away from the proposed transaction – for example, for commercial or other reasons – it would be prudent to include an express provision to this effect in the document. Relying on a general qualification that, for example, the documentation must be satisfactory may not offer the flexibility desired.

The judge found that, as a matter of fact, Alubaf’s signatory had actual authority to bind Alubaf. However, the judge also noted that even if Alubaf’s signatory did not have actual authority, given his role, conduct and other factors, Novus was entitled to rely on his apparent authority to bind Alubaf.

Businesses should therefore ensure that their employees and officers are fully conversant with, and follow, any document signing protocols and are made aware of any limitations on their authority to bind the business. Any such limitations should also be made clear to the business’s counterparties.

Although the provisions of the commitment letter required Novus to signal its acceptance of the letter’s terms, the commitment letter did not stipulate that the only way Novus could do this was by countersigning the letter. The judge found that Novus’s conduct – including correspondence with Alubaf, establishing the SPCs and instructing lawyers to prepare the draft transaction documentation – was sufficient to communicate its acceptance of the commitment letter to Alubaf.

Parties to a pre-deal document therefore need to be aware of the risk of inadvertently accepting its terms by conduct. To mitigate this risk, the parties could consider stipulating in the document that the only permitted method of acceptance is signature / countersignature and that any waiver of this requirement can only be made in writing.