Energy companies often use a letter of intent, memorandum of understanding, or heads of agreement (“LOIs”) to quickly establish a transaction’s principal terms. LOIs are a few pages long and may only capture the basics of price and quantity. In contrast, definitive agreements often span more than 100 pages. The process for agreeing to the other 95 pages takes place over many conference calls, face-to-face meetings, and exchanges of red-lined drafts. Parties are usually able to conclude the documents via negotiation – even if it takes many days or weeks. But what happens if progress halts, with the parties refusing to compromise on a handful of provisions?
- The Sword of Damocles. The most common approach involves creating a “long-stop” date by which the failure to reach agreement results in the LOI’s automatic termination, or, at least, the right of either party to terminate. The Roman orator Cicero described this kind of situation in his Sword of Damocles anecdote. The king’s courtier (Damocles) was complimenting the king on how great it was to be king. The king generously offered to switch places with him, and Damocles eagerly accepted, climbing upon the throne. The king then hung a sword above Damocles’ head, secured by a single thread, representing the danger and risk that went along with being king. Damocles begged to return to being a courtier. As Cicero explained, “there can be nothing happy for the person over whom some fear always looms.” A contract’s long-stop date is like a Sword of Damocles – the impending loss of the deal incentivizes a speedy resolution.
Looming termination may not always be enough. What if one party can use the LOI as a stalking horse, or otherwise “shop” the deal, seeking a better price elsewhere? A similar concern arises in a bidding scenario. The bidder needs certainty that its contractors will honor their pricing – even if other terms and conditions are not yet agreed. In such a case, the LOI may need to preclude termination using one or more of the following approaches:
- Compromise by Division. Certain terms and conditions are quantitative in nature. For example, project sponsors and contractors often argue about the duration of the warranty period. In such cases, parties can include in the LOI a clause along the following lines: “The parties’ positions on any numerical aspects of the terms shall be compromised by equally splitting the difference between the two numbers representing the parties’ last written positions (for example, if the parties’ positions were 2 years and 1 year, respectively, the final position adopted would be 18 months).”
- Rotational Selection. Contractual clauses are not always susceptible to compromise by division. Just as King Solomon could not actually “split the baby,” only one party can get its preferred contractual provision. For example, will the agreement be governed by the laws of the Angola or those of England? The LOI may determine such indivisible positions through a rotational selection, rather like picking teammates on the playground: “Any unresolved issues shall be determined by a rotational selection. The party winning a game of chance shall be the first to select one unresolved term, and thereafter, the parties shall alternate selections of one unresolved term each, with such selecting party’s [last proposed language] being adopted and incorporated into the Agreement (for example, if there were six unresolved terms, and Party #2 won the coin toss, Party #2’s language would be adopted for the 1st, 3rd, and 5th selections, and Party #1’s language would be adopted for the 2nd, 4th, and 6th selections).” Informally, negotiators often engage in a variation of this approach by proposing “trades.” For example, a party may propose to give the other Angola law in exchange for it agreeing to international arbitration.
- Trial by Game. In Game of Thrones, the character Tyrion Lannister’s innocence (or guilt) is determined by a battle, with the defendant and his accuser each selecting a combatant (the Red Viper versus the Mountain). One of my students at the University of Chicago came across a similar contractual clause last summer, which had been devised by technology tycoons. If they reached an impasse, the outcome would be settled by a game of Ms. Pac-Man, the 1981 videogame. Each company would select a competitor to play on its behalf, and the one with the highest score would prevail. You can imagine any number of variations on this approach, from flipping coins to tennis matches. Good luck, or a better player, could result in one party winning most (or all) of the open items.
Compromise by division, rotational selection, and trial by game are all attempts to address the same problem – a kind of moral hazard. Moral hazard generally describes a situation in which one party disproportionately bears risk. If a deal’s failure has similarly bad consequences for both parties, then automatic termination is usually sufficient. The parties also might dispense altogether with the intermediate step of the LOI and seek to proceed to the definitive agreement. Unfortunately, time and circumstances do not always allow for this luxury. The good news is that once the Ms. Pac-Man machine is rolled into the conference room, a spirit of compromise tends to emerge.
About the Gaille Energy Blog. The Gaille Energy Blog discusses issues in the field of energy law, with weekly posts at http://www.gaillelaw.com. Scott Gaille is a Lecturer in Law at the University of Chicago Law School, an Adjunct Professor in Management at Rice University’s Graduate School of Business, and the author of two books on energy law (Shale Energy Development and International Energy Development).