Letters of Intent:  A Word of Caution Under California Law

Alan S. Petlak
California Real Estate Journal
April 17, 2006

In this commercial real estate market, many deals are being consummated while others are falling through. When a deal falls through, it is not uncommon for one of the parties to attempt to enforce a letter of intent as the parties’ binding final agreement. This is especially true when the terms of the letter of intent are perceived as more favorable to one side than the other.

Drafting an LOI: Be Careful & Precise

A letter of intent, also known as an “LOI,” has been described by one court as a writing documenting the preliminary understanding of parties who intend in the future to enter into a contract. However, courts do not always look at the LOI as an agreement to later agree. Sometimes they enforce the LOI as the parties’ final contract. Therefore, to avoid being bound by the often-times incomplete or imprecise terms of the letter of intent, the parties should draft their LOIs carefully to make sure they are not intended to be a final agreement. Otherwise, the parties risk having a court construe their LOI to be a binding agreement requiring the parties to comply with what at least one party believed was just “proposed” terms. Overall, the intention of the parties in signing the LOI controls whether or not the LOI is binding. If the LOI is unambiguous concerning whether it is enforceable, California courts will look to the actual written words of the LOI to determine whether the parties intended the LOI to be a binding final agreement.

Keeping the LOI from Being an Enforceable Final Agreement

What can be done to limit the potential for a court finding that an LOI is, in fact, an enforceable contract? Labeling a document a “letter of intent” is not enough to preclude a court from finding that a document is an enforceable contract. In one case, a buyer of machinery signed a “letter of intent” in which the buyer agreed to pay ,000 in order to acquire (for resale) certain machinery, structures and supplies. After entering into the “letter of intent,” the seller told the buyer that the “deal was off.” Notwithstanding that the document was called a “letter of intent,” the court found that aside for one provision in the letter of intent which concerned the removal of a hoist, the letter of intent embodied all of the terms and understandings of the parties and was, therefore, fully enforceable.

Instead of just labeling a document a “letter of intent,” the LOI should state in clear and unambiguous terms that it is not an enforceable contract. Some examples of provisions which have been upheld by California courts include:

  • “There is no agreement until the parties enter into a formal written agreement;” or
  • “The validity of said proposed agreement is subject and conditioned upon the parties agreeing upon and reducing to writing all terms and conditions necessary and incidental to the validity of said proposed agreement.”

In the commercial leasing context, one California court held that a LOI did not constitute an enforceable lease contract where it stated that if “a lease upon the above terms and conditions has not been executed within 30 days from the date hereof, both parties reserve the right at any time hereof, but prior to the execution of such a lease, to terminate this offer.”

An LOI Requires Parties to Negotiate in Good Faith

However, even when the LOI contains the necessary cautionary language to avoid an enforceable agreement on the terms of the LOI, a party who, after signing an LOI, negotiates in bad faith may still be subject to a potential claim. In one case, the LOI provided, among other things, that the defendant, an ice-cream supplier, would agree, subject to a separate co-packaging agreement and negotiated price, to provide an ice cream maker with a three year co packaging agreement for the sale of ice cream. After the parties entered into the letter of intent, the parties continued negotiating the terms of the co packaging agreement. However, two months after the parties entered into the letter of intent, the ice cream supplier wrote the ice cream maker to end the negotiations over the co-packaging arrangement.

The ice cream maker sued, alleging breach of contract against the ice cream supplier for “unreasonably and wrongfully refusing to enter into any co-packaging agreement” with the ice cream maker. The California Court of Appeal held that while there was no cause of action for breach of the co-packaging contract, the parties had entered into a “contract to negotiate the terms of the agreement.” In other words, the court construed the LOI as requiring the parties to negotiate in good faith. Because the LOI properly reflected that it was not the final agreement, damages were limited to the ice cream maker’s reliance on the “agreement to agree” rather than the profits the ice cream maker hoped to have earned though the co-packing agreement and other ice cream sales.

Final Thoughts

California courts will look to the letter of intent taken as a whole to determine whether the parties intended the letter to be a binding final agreement. As a result, parties should clearly provide, in the LOI, whether or not it is intended to create a binding agreement. Parties still must be cautious because even where the parties do not intend to create a final agreement and the proper cautionary language is used in the letter of intent, under California law, a party may still be held to a duty to negotiate in good faith. Consequently, it is not enough to be careful in drafting final, execution documents. Care must be taken during the negotiation and drafting stages to make sure no contract is created or breached before the final documents are signed.

About the Author: Alan S. Petlak, Esq. specializes in real estate litigation and is Of Counsel at Pircher, Nichols & Meeks, a law firm that represents real estate clients nationwide through its offices in Los Angeles and Chicago.