Letters of Intent

Manage the Risks to Maximize the Potential of These Documents.

To avoid wasting time and money pursuing deals that eventually do not close, many buyers and sellers memorialize the most significant agreed-upon deal points in a letter of intent (LOI) before they start incurring major legal and other transaction expenses. However, many clients are unaware of the risk involved in using LOIs. Brokers should identify that risk to their clients, and if they accept it, suggest ways to minimize unfavorable results.

Binding, Nonbinding, or Partially Binding?
Many courts, especially in California, tend to disregard the seemingly clear intent of parties reflected in executed LOIs and permit parol (word of mouth) evidence that contradicts an LOI.

The parol evidence rule prohibits the introduction of evidence at a trial that contradicts the terms of a written contract. However, the parol evidence rule does not prohibit the introduction of evidence of oral agreements that are not inconsistent with the contract where the contract either is incomplete or silent on the subject.

The Ninth Circuit Court summed up the risk that the parol evidence rule presents in Trident Center v. Connecticut General Life Insurance Company (9th Cir. 1988) 847 F. 2d 564, as follows:

The contract documents are lengthy and detailed; they squarely address the precise issue that is a subject of this dispute; to all who read English, they appear to resolve the issue fully and conclusively. Plaintiff nevertheless argues here...that it is entitled to introduce extrinsic evidence that the contract means something other than what it says. This case therefore presents the question whether parties in California can ever draft a contract that is proof to parol evidence. Somewhat surprisingly, the answer is no.

In light of such rulings, clients should be advised that courts may disregard even carefully drafted LOIs. Brokers should suggest using LOIs only if clients are prepared to risk that the documents may be treated as binding against them, but not the other parties.

Of course, despite disclaimers to the contrary, LOIs may be treated as binding contracts, depending on a court's determination of what the parties intended. Courts infer intent from the following:

  • conduct of parties;
  • the LOI language;
  • context of negotiations (parol evidence may be introduced that oral promises were made and relied upon); and
  • custom.

The four elements of an enforceable contract are:

  • the parties legally are capable of entering into a contract;
  • the parties reached a mutual agreement;
  • the subject of their agreement is not illegal; and
  • each party receives consideration.

A contract that contains all these elements creates a contract binding the party to do—or not to do—a certain thing.

Ordinarily, a promise to buy or sell property would not create a legal duty on the part of the person making a promise (promisor) due to the absence of consideration (what was bargained for). Because consideration is not given until the deal closes, a promise to buy or sell property by itself is not enforceable. However, a promise is binding even without consideration if three factors are satisfied:

  • the promise is one that the promisor reasonably should have expected would cause the party to whom the promise was made (promisee) to take action or refrain from taking some action of a definite and substantial nature;
  • the promise does not in fact induce the promisee into taking or refraining from taking such action; and
  • injustice can be avoided only by enforcement of the promise.

Thus, a promisor may be liable for damages under the equitable doctrine of promissory estoppel if the promisee can prove that

  • the promissor made a clear, unambiguous oral promise during negotiations;
  • the promisee relied upon the promise;
  • the promisee's reliance was both reasonable and foreseeable; and
  • the promisee actually was injured as a result of relying on the promise.

Even if an LOI is not binding to buy or sell property, it may be treated as binding to negotiate in good faith, in which case, both parties would be prohibited from renouncing the deal, abandoning negotiations, or insisting on terms inconsistent with those contained in the LOI.

An LOI also may bind parties to issues that remain pertinent even if a purchase/sale agreement is not signed, including confidentiality; negotiation exclusivity; and who pays for legal fees, brokers' commissions, and other expenses if the deal does not close.

On occasion, courts will treat LOIs as nonbinding outlines of issues to be addressed in negotiating agreements. This may occur if the LOI is drafted clearly to avoid being treated as a purchase/sale contract, an agreement to negotiate in good faith, or an agreement regarding relevant issues if a sale does not close. In addition, the parties cannot have made oral promises or taken any other actions contrary to the LOI.

How Detailed Should the LOI Be?
LOIs usually follow one of two models: detailed or "bare-bones."

A client who has the most leverage when the LOI is being drafted may want to capitalize on that position of strength, creating a comprehensive, detailed LOI to avoid future discussions about settled issues. Since most lawyers respect the fact that issues specifically addressed in a detailed LOI are not subject to renegotiation, a detailed LOI limits the issues that will be negotiated by the parties' attorneys. Thus, even if the market shifts and the other party gains more leverage before the contract is signed, your client retains the upper hand in those issues specifically covered in the LOI.

A detailed LOI also separates the business issues from legal issues. Parties must think through the deal carefully and resolve most business issues before their attorneys spend a lot of time posturing, negotiating, and drafting the legal issues. A well-thought-out LOI also serves as a useful roadmap to follow in drafting the purchase/sale agreement.

Of course, a detailed LOI carries greater risk; it is more likely to be treated as a binding contract than a short bare-bones LOI that covers few issues in sparse detail. As mentioned earlier, a court may disregard even well-drafted disclaimers by allowing parol evidence that contradicts the LOI. But because courts look not just at the LOI, but to the facts and circumstances surrounding the negotiations and the parties' subsequent actions, clients should be cautioned against making any promises or taking any other actions that are inconsistent with the LOI.

Clients who have the least leverage early in negotiations may prefer a bare-bones LOI. Then, if the leverage shifts during later negotiations, the client will not be restricted and may strike a more advantageous deal. Parties also can put together a bare-bones LOI quickly and keep the deal moving forward toward closing.

In addition, some people think a bare-bones LOI can increase the stakes: a short, undetailed LOI requires more legal work to be invested during the actual negotiations. The other party may spend so much time and money on negotiating that it cannot afford not to do the deal.

Drafting the LOI
Even the briefest LOIs should be reviewed carefully to ensure that they are consistent with clients' objectives, contain no internal inconsistencies or ambiguities, and no information is missing.

A client wanting a binding LOI should include all the promises made to the client, the consideration given by the client for those promises, and the fact that the client has relied upon those promises to his or her detriment. A binding LOI should address all issues in as much detail as possible, leaving no open terms to be documented in a separate purchase/sale contract.

A nonbinding LOI should be as brief as possible, expressly stating that it is only intended to serve as an outline to assist the negotiating parties, no promises have been made or relied upon, and neither party has the right to infer even an agreement to negotiate in good faith or exclusively with each other.

Subject to Approval. If a purchase/sale agreement is subject to the approval of a party's board of directors or management committee, include that in the LOI; however, if such a condition is relied upon, then the agreement actually must be submitted for such approval and the board must act in good faith to consider it.

One company involved in acquiring numerous retail sites throughout California gave its agent clearance to proceed on deals that met certain economic criteria. However, all deals were subject to the board of directors' approval of the property location. The fact that the location of the property being purchased/sold was described in the LOIs signed by the authorized agent might lead a court to conclude that the buyer had waived any right to object to the location of the property. To avoid this, the company required its agent to include an express provision in each LOI stating that the property location still had to be analyzed demographically and remained subject to the approval of the company's board.

If an LOI is intended to be binding only on certain issues, it should clearly state the provisions intended to be binding and expressly state that the remainder of the LOI is merely an outline to assist the negotiating parties. It should further state that any ultimate agreement for a purchase/sale remains subject to the parties' mutual agreement.

Although LOIs can speed transactions, they carry the risk that courts may misinterpret or disregard them. To minimize the risk, advise clients to have their lawyers review LOIs before execution.

Susan Fowler McNally, JD

Susan Fowler McNally, JD, is a partner in the law firm of Gilchrist & Rutter in Santa Monica, California. You can reach her at (310) 393-4000.The discussion of legal issues in this article is for informational purposes only. Results may vary depending on state laws and particular facts.Issues to Cover in an LOIAll parties, including lenders if construction financing is an issue, should be identified clearly. The property that is the subject of the LOI should be identified in as much detail as possible. The closing date should be included and the parties should determine what will happen if the closing does not occur by that date. If an LOI is intended to be binding or partially binding, the LOI should address available remedies in the event of a breach of the LOI. For example, the LOI may specifically provide for liquidated damages, recovery of out-of-pocket costs, recovery of lost profits, or injunctive relief. If some provisions of the LOI are binding, state whether they will continue indefinitely or expire if a contract is not signed by a specified date. Sample DisclaimersThe more carefully worded the disclaimer, the stronger the argument that the parties\' intent is reflected in the LOI. No disclaimer can ever really protect your client; however, the following sample disclaimers illustrate the various intents of different LOIs.Nonbinding LOIThis LOI reflects our understanding, at the present time, of certain preliminary discussions we have had concerning the purchase/sale of the property and is intended to be an outline to assist us in preparing a definitive purchase/sale agreement. This LOI does not obligate us to negotiate with each other (in good faith or otherwise) and/or to proceed to completion of a signed purchase/sale agreement. This LOI is not intended to contractually bind either of us in any way, nor shall we be legally bound until an agreement, in form and content satisfactory to each of us and our respective counsel and our respective boards of directors (in their sole discretion) is fully executed by us. Neither party shall be entitled to rely upon this LOI nor any promises (whether oral or written) that may have been made or that may be made in the future, in connection with the negotiations pertaining to the purchase/sale of the property, except as may be contained in a fully executed purchase/sale agreement. Seller shall be entitled to negotiate with other prospective buyers and buyer shall be entitled to negotiate with other prospective sellers pending the full execution of a purchase/sale agreement.Binding LOIWithin ________ days after the execution of this LOI, the parties shall execute a purchase/sale agreement in the form of the agreement attached hereto as Exhibit A. [Exhibit A should be a form of agreement with the blanks filled in.]An Agreement to Negotiate in Good FaithPlease confirm that you are willing to proceed in good faith to negotiate a mutually acceptable purchase/sale agreement by executing a copy of this LOI where indicated below and returning it to the undersigned. Execution of this LOI shall not obligate either party to accept any particular terms, but will preclude both parties from insisting on any terms that are inconsistent with those terms described in this LOI. It is expressly agreed that the form and content of the purchase/sale agreement must be mutually acceptable to both parties and their respective counsel and that if a mutually acceptable purchase/sale agreement is not agreed to and executed by both parties on or before ________, neither party shall have any further obligation to continue negotiating with the other.Optional ProvisionsTo induce buyer to proceed to negotiate with seller to purchase the property, seller agrees to withdraw the property from the market and seller will not entertain offers to purchase the property nor negotiate with any other party to sell the property [(during the pendency of this negotiation) or (until ________)].If either party hereto fails and/or refuses to negotiate in good faith, the other party may terminate this LOI and recover from the other party [(liquidated damages in the sum of $________) or (its out-of-pocket costs incurred in the course of negotiation, including, without limitation, attorneys\' fees, consultants\' fees, architectural and engineering fees, and all related costs)]. If any legal action is brought to recover such [(liquidated damages) or (out-of-pocket costs)], the prevailing party in such action shall be entitled to recover its reasonable attorneys\' fees and costs.[Note that if you include a liquidated damages provision, the text should be bold, in all capital letters, in at least 10 point type and the provision must be signed separately or initialed by both parties to the contract. You may prefer to consider providing for other types of possibilities, including injunctive relief (such as to prevent the seller from negotiating with and selling to a third party), or special damages (such as lost profits or loss of bargain).]