In commercial real estate transactions, a letter of intent (an “LOI") establishes the framework to negotiate a formal agreement. As the quasi-deal before the “real" deal, an LOI can be important in determining the positioning and disposition of the parties, as well as the structure of a proposed transaction.
While the parties to an LOI do not typically wish to create a legally binding document, it is not uncommon for one of the parties to attempt to enforce the LOI as the parties’ binding final agreement.
California courts may find an LOI to be enforceable where there is mutual consent of the parties as well as the inclusion of essential terms. This article looks at these two important considerations as well how to minimize the risks in drafting a non-binding LOI.
Under California law, in order for a binding contract to exist, there must be mutual consent between the parties to enter into a contract, which is freely given and communicated by each to the other. The test for whether such consent exists does not depend on the subjective belief of the parties, but rather on the words and conduct of the parties. If there is sufficient outward evidence to allow a third party to reasonably infer that that parties intended to enter into a contract, then a court can hold an LOI to be enforceable. Thus, a court may determine in its reasonable judgment that the words of an LOI evidence mutual consent between the parties to form a contract, even if the parties subjectively had no such intent.
To avoid this result, parties must include in their LOIs statements that the LOI is intended to be non-binding and requirements that a more formal and comprehensive contracts must be executed in the future. When drafted clearly and precisely, such provisions can prove effective at preventing enforcement as a contract. However, if it is not absolutely explicit from the face of the document that the parties have no intent to be bound, it is possible for courts to interpret around such protective language or find cause in the actions of the parties to look past it.
Inclusion of Essential Terms
Secondly, in order for an LOI to be enforceable, there must be sufficient essential terms to allow the court to determine what the purported contract means and the legal obligations of the parties. Thus, if an LOI leaves out essential terms to a future agreement or is otherwise uncertain as to the intention of the parties with respect to those essential terms, then the LOI will be held unenforceable.
Note, however, that when presented with an LOI that is ambiguous or apparently lacking in essential terms on its face, California courts are not hesitant to look beyond the four corners of the LOI to find clarification and support for enforcing it. Moreover, with respect to non-essential terms, there is a willingness by the courts to take it upon themselves to impose terms on the parties based on the court’s own determination of what is reasonable or customary.
As California contract law leans in favor of enforcing agreements to the greatest extent possible and, a court will look beyond the parties’ written words and take into consideration other factors such as the parties’ conduct surrounding the execution of the subject letter, any terms that may be implied by the language of the subject letter, and the general custom applicable to transactions of the type contemplated in the subject letter.
Because of this, parties seeking to form a non-binding LOI cannot rely alone on a document’s conditional sounding title, such as “Letter of Intent" or “Proposal," or include general statements that they intend to later execute more formal contracts.
To minimize the risk of a court deeming an LOI as a final, binding agreement, negotiating parties should make sure to include in their LOIs:
In addition to language in the LOI, negotiating parties should make sure their conduct is not consistent with that of having a final, binding agreement:
A well-drafted LOI is an important first step in most real estate transactions, as it can put into place an essential framework for the transaction. Parties should exercise caution and not hesitate to seek the advice of legal counsel in finalizing an LOI.
For more information on drafting LOIs, please contact Evelyn Ginossi at [email protected] or 310.746.3837.
This article is provided by IBV Advisory Group Inc. for general educational purposes only. The information should not be relied on as legal advice, nor does it serve to create an attorney-client relationship. For legal advice on a specific matter, consult an attorney.