Letters of Intent May be Binding

May 1, 2004
Greenberg Glusker Client Alert

Most real estate transactions begin with a letter of intent (“an LOI”) which outlines the parties' general understanding of a proposed transaction. The parties to an LOI do not typically wish to create a legally binding document, but intend only to establish the framework to negotiate their formal agreement. For that reason, most LOIs expressly state that they do not create legally binding agreements, but simply set forth the basis for future negotiations.

Real estate principals and brokers may be surprised to learn that the language described above may impose an enforceable obligation to negotiate in good faith to conclude a transaction consistent with the terms of the LOI. However, in Copeland v. Baskin Robins, U.S.A (96 Cal.App.4th, 1251 (2002)), a California court reached exactly that conclusion.

California courts have consistently held that agreements to agree are not enforceable because one party may refuse to agree to something to which the other party might. However, the Copeland court distinguished an unenforceable agreement to agree from an enforceable agreement to negotiate because the later does not create any obligation to agree in the future. Rather, the parties are simply agreeing to negotiate in good faith to reach agreement along specified terms. If the parties ultimately fail to reach agreement despite using good faith efforts to do so, then the agreement to negotiate is considered performed, and the parties have no further obligation to negotiate. A breach of an agreement to negotiate only occurs if the failure to reach agreement results from a party's failure to negotiate in good faith.

The Copeland court held that the damages for a party's breach of an agreement to negotiate are measured by the injury which the injured party suffers in relying upon the other party's agreement to negotiate in good faith. These "reliance" damages could include out-of-pocket costs incurred in conducting the negotiations, such as attorneys' fees and other third party costs. The Copeland court did not decide whether an injured party can recover lost opportunity costs, but it did not foreclose that possibility either. As a result, an injured party might also recover damages for any opportunity which it loses in reliance upon another party's agreement to negotiate in good faith. For example, a tenant might turn down a lease renewal offer from an existing landlord while it negotiates with a different landlord for new space. If the new landlord breaches an obligation to negotiate, that landlord could become liable for the increased rental later demanded by the tenant's original landlord. The Copeland court did rule that an injured party cannot recover lost expectations (profits) because there is no way of knowing whether the parties would ultimately reach an agreement, let alone what the terms of such an agreement might have been.

Given the Copeland ruling, parties involved in LOI negotiations should seriously consider whether they want to create a binding obligation to negotiate in good faith. For example, a tenant seeking to lease unique premises may want to create such an obligation in order to reduce the risk a landlord will engage in simultaneous negotiations with other parties. In contrast, a tenant with "vanilla" space needs may wish to avoid such an obligation so it can shop multiple locations at the same time.

A party wishing to create a binding obligation to negotiate may most likely do so by including language in its LOI which is similar to that described in the first paragraph of this article. However, a party that wants to avoid such an obligation should include very clear language to that effect in its LOI. Such a provision might state that "[n]othing contained in this letter creates a binding obligation on the parties, and no binding agreement will exist unless the parties sign a final and definitive agreement. Until that time, either party may cease negotiations at any time for any reason, or for no reason at all. Each party shall engage in negotiations at its sole cost and expense."

The use of LOIs in real estate transactions raises many issues of importance, and it is usually in a party's interest to consult with an attorney before signing one. For example, consulting with an attorney might prevent a party from unknowingly obligating itself to pursue negotiations in good faith.

This subject matter in this article is not limited to real estate transactions, as LOIs are used in mergers and acquisitions, distribution agreements and several other corporate transactions.

Ken can be reached at [email protected]or 310.201.7462.