May 3, 2007

If you've been in the real estate business long enough, odds are you've found yourself in the following situation: You've signed a letter of intent (LOI) to buy or sell a property, which contains some combination of the basic deal terms (property description, price, due diligence period, closing date, earnest money, etc.) and contemplates the negotiation of a detailed, definitive purchase agreement. Then, before the agreement is actually signed, you decide not to pursue the deal—because you've changed your mind, market conditions have shifted or the negotiations have reached an impasse. If the other party still wants to proceed, can they force you to go through with the deal?

The answer depends on the language in the LOI. In almost all cases, this preliminary document is not intended to be a binding agreement for the purchase and sale of the property; its purpose is to memorialize the terms that the parties have agreed to in principle and provide a framework for continuing negotiations. Although brokers and other real estate professionals often rush to execute an LOI, care should be taken. If the document is not drafted properly, you could be forced to follow through with a deal that no longer complements your business objectives.

When Can an LOI Become a Binding Agreement?

In some instances, an LOI can be enforced as a purchase agreement, compelling you to either close the transaction or compensate the other party for not doing so. The enforceability of an LOI depends on a court's determination of the parties' intent, which is evaluated by considering the following factors:

Qualifying Language. If the LOI contains language that indicates it is not binding or that its obligations are conditional on the signing of a formal agreement, it is less likely to be enforced as a binding agreement. Keep in mind, however, that a "qualifying" clause alone will not necessarily render an LOI non-binding if the document as a whole indicates that both sides intended it to be a definitive agreement.

Timing of Key Events and Obligations. The probability that an LOI will be enforced as a binding purchase agreement decreases when critical steps in the deal are triggered by the signing of a formal contract, rather than the LOI itself. For example, if the document provides that an earnest money deposit is not necessary and the due diligence period does not begin until after the final contract is signed, it is less likely that the LOI will be sufficient to force the sale.

Inclusion of Material Terms. If an LOI omits critical terms customarily found in a purchase agreement (taking the size of the transaction into account), this is an indication that the parties have contemplated a more definitive agreement. For instance, in one $4 million deal, the LOI did not contain a specified closing date; any representations or warranties by the seller or the buyer; or provisions regarding title insurance, responsibility for taxes or notice to the other party. In part because of these omissions, the court deciding the issue found that the LOI was insufficient to enforce consummation of the deal.

If, after evaluating these factors, the court decides it is still unclear whether the parties intended the LOI to be binding as a purchase agreement, other considerations may come into play. These include whether the type of agreement involved is usually the subject of a more formal document; the level of detail in the LOI; the amount of money involved; whether the negotiations indicate that a formal written document was contemplated; the point at which the negotiation process is abandoned and the reasons for doing so; the extent of assurances by one party that the deal will close; and the other party's reliance on the assurance that the anticipated transaction will be completed.

Obligation to Negotiate in Good Faith

Even if an LOI is not enforceable as an agreement to consummate a deal, the document may include language that compels the parties to continue negotiations in good faith. Whether an LOI imposes such a duty depends on a court's assessment of intent. For example, in one recent case, an LOI stated that it was "intended to set forth the terms upon which [the parties]...intend to negotiate and consummate an Agreement of Sale..." Based on that language, the document was found to impose a duty to negotiate in good faith, even though it also contained a disclaimer that the LOI was "subject to [the parties] concluding an Agreement of Sale which shall be acceptable to the Boards of Directors of [the parties'] respective corporations, whose discretion shall in no way be limited by this letter...."

An obligation to negotiate in good faith generally means that the parties cannot walk away from the deal, abandon negotiations or insist on conditions that are obviously contrary to the LOI. Beyond that, the scope of the requirement is determined by the actual language of the LOI. For example, if the document provides only a price term and specifies that the seller will negotiate exclusively with the buyer, then as long as those terms are met, the seller may be able to reject the deal on other grounds (e.g., timing of due diligence, splitting of transaction costs, etc.). On the other hand, if the LOI contains detailed terms that specify a 90-day due diligence period, the seller cannot request a 30-day alternative and then break off negotiations simply because the buyer will not agree to the shorter time period.

How Can I Protect Myself?

The best way to avoid becoming unwittingly committed to a transaction is to involve your attorney early in the process, ideally before signing an LOI. That way, your legal team can help prepare a document that does what an LOI is intended to do—outline the terms the parties have agreed to and provide a framework for further negotiations—while preserving the option not to pursue the deal if you so choose.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.