Letters of Intent: The Good, The Bad and The Ugly
Call it what you will: a letter of intent, an agreement to lease, an agreement in principal. Business people, including real estate professionals, often times seek to move toward a final and executed formal contract by tying up the parties, narrowing the issues and, sometimes, entering into binding agreements that summarize most, if not all, of the terms of the deal. Generally called a letter of intent or “LOI,” these documents are usually not written by lawyers. The drafters of these documents, sometimes the principals of the proposed transaction and sometimes their brokers, can create future problems for themselves if and when the transactions fall through. As one federal Chicago court explained:
It is a common commercial practice for two negotiating parties to sign a letter of intent or an agreement in principal, signaling that they have come to a tentative agreement on the general outlines of a deal without having nailed down all of the details. Not infrequently, the negotiations that follow the execution of this document break down, prompting the disappointed party to sue on the theory that the preliminary document is binding (Ocean Atlantic Development Corp. v. Aurora Christian Schools, Inc.).
How do the courts decide whether these LOIs are enforceable? While courts across the country interpret LOIs in different ways, there are some trends that are generally consistent. For example, as that Ocean Atlantic court held, “whether in fact the writing reflects a binding agreement between the parties . . . turns not on what the parties subjectively believed, but on what they expressly manifested in their writing.” For example, does the LOI state that there will be no binding contract unless and until the parties sign a formal written contract? As one California court held, simply stating that the parties intend to “reduce the informal writing to a more formal one . . . does not negate the existence of the prior contract.” Instead, to avoid the LOI being held to be binding, it should state that the parties do not intend to have a binding contract until a formal written contract is executed (Harris v Rudin, Richman & Appel).
For example, in one case, an LOI provided that it did not create any legally binding obligation to complete a stock purchase, and that any obligations would arise only upon the signing of a formal purchase agreement (J.B. Enterprises Int’l, LLC v Sid and Marty Krofft Pictures, Corp.). In another case, the LOI provided that “it is understood that this is not a binding agreement and that the obligations and rights of the parties shall be set forth in the definitive agreement executed by the parties (Feldman v Allegheny Int’l, Inc.). Generally, these types of straight forward disclaimers preclude the eventual determination that the LOI constitutes an enforceable contract.
On the other hand, LOIs can be held enforceable if the express language allows for such an interpretation. For example, in one California case involving an LOI with respect to the sale of a mill, there was no disclaimer, and there was, according to the court, a description of all of the terms and understandings of the parties; therefore, the court found there was an enforceable contract (Dulien Steel Products, Inc. v. A.J. Industries, Inc.). To be safe, the parties should include a disclaimer if they want to avoid enforcement of the LOI. However, the absence of a disclaimer does not always lead to a court’s finding of an enforceable agreement. For example, one court held that “a letter of intent or a similar preliminary writing that reflects a tentative agreement contingent upon the successful completion of negotiations that are ongoing, does not amount to a contract that binds the parties (Ocean Atlantic Development Corp. v Aurora Christian Schools, Inc.). In another example, a Nebraska court looked to see if there had been subsequent draft documents “as a sign that the parties did not intend to be bound by an earlier document (Diesel Power Equipment, Inc. v ADDCO, Inc.)
Many times, the parties want at least a portion of the LOI to be enforceable, even if there is no final, overall agreement. As one court held, “the parties are entitled to shape the letter of intent as they please to fit their need (Feldman v. Allegheny Int’l, Inc.). Therefore, while the parties may agree that there is no enforceable purchase and sale agreement or lease agreement until they have executed a formal, written agreement, they can still use the LOI to enforce certain rights and duties that flow from their negotiation process.
- Confidentiality/Non-Disclosure. Regardless of whether the ultimate transaction is consummated, the parties can include a binding requirement in the LOI that confidential information provided by the parties is not to be disclosed to third parties and is to be utilized only for the purpose of evaluating the pending deal. These provisions may also require that if the transaction is not consummated, the confidential materials (and all copies) must be returned to the party who provided the information.
- Non-Circumvention. Again, one of the parties may require that regardless of whether a transaction is completed, the other party cannot compete with the first party on the project and certainly cannot use the confidential material provided by the party for any other purpose.
- Exclusive Negotiation. To promote focus, the parties can include a provision which requires that with respect to the particular project, they can only negotiate among themselves for a period of time. Once the deadline has lapsed, then the parties can be free to negotiate with others, unless, of course, there is a non-circumvention provision in the LOI.
Expiration of LOIs
Once the LOI has expired, there is no further obligation on the parties to attempt to come to an agreement. In California, courts have held that the implied covenant of good faith and fair dealing requires that parties must negotiate in good faith and that if they do not, then the party who did not do so may be responsible for some types of damages. A deadline for completing negotiations puts an end to any potential claim by a party that the other is not acting in good faith. It also provides support for the argument that once that deadline passes, there can be no enforceable agreement reached in the absence of a formal agreement reached by the parties.
Post-LOI Conduct May Create Rights and Duties
Finally, even with the proper disclaimers and the objective intent that the parties, at the time the LOI was signed, did not want to create a binding agreement, post-signing conduct must be kept consistent with that intent. In one California case, for example, the court held that an LOI created an enforceable sublease because, in part, the prospective subtenant entered into possession with the consent of the sublessor. If the parties had not intended to create a sublease, why would the prospective subtenant be allowed to take possession? The court found that such conduct demonstrated that the parties intended to enter into a binding agreement (Calif. Food Service Corp. v Great Amer. Ins. Co.). In a case decided under Iowa law, the court held that a jilted seller could potentially recover based upon an LOI “by showing substantial expenditures in reasonable reliance on oral assurances by [the buyer] that the deal would be consummated (Budget Marketing, Inc. v Centronics Corp.). As the court explained, if the assurances had been made, “they could reasonably be taken to supersede the disclaimer provisions of the letter of intent . . . .”
While LOIs are useful to bring the parties together toward an eventual agreement, the parties must be careful in drafting them if they want to avoid having a court later hold that instead of a precursor to an agreement, the LOI became an enforceable agreement. Care should be taken by having counsel review the terms before the LOI is signed. It is much easier to make changes before the LOI is signed than after the parties are heading toward a dispute.
About the Author: Jeffrey N. Brown is a litigation partner specializing in complex real estate litigation at Pircher, Nichols & Meeks, a law firm that represents real estate clients nationwide through its offices in Los Angeles and Chicago.