Letters of Intent: Actions May Speak Louder Than Words

March 15, 2012

Actions often speak louder than words.  That was the case in City of Santa Cruz v. MacGregor (1960) 178 Cal.App.2d 45.  In MacGregor, the court considered whether an informal, preliminary agreement formed a binding contract based upon the parties’ subsequent actions.  The Gibsons entered into a preliminary agreement with Silvanes stating that they would construct a building for Silvanes’ tire business.  The preliminary agreement clearly stated that the parties would enter into a five year lease upon completion of the building.  The Gibsons completed the building and Silvanes moved in.  However, the parties never executed a formal lease agreement.  The city exercised its eminent domain powers and condemned the property after Silvanes had taken possession of the property.  The court held that the preliminary agreement between the Gibsons and Silvanes and the conduct of the parties was sufficient to find that Silvanes had a valid, binding lease and that Silvanes could share in the compensation for the condemnation of the property.  The MacGregor case illustrates an inherent risk associated with using a letter of intent: namely, that a court will interpret a letter of intent as a binding agreement despite one party’s assertion that no binding agreement was formed or intended. 

A letter of intent (“LOI”) can generally be defined as a writing between parties to a potential transaction setting forth the important terms of the transaction, generally with the idea that a more formal and detailed contract will be entered into by the parties at a later date.  The LOI is usually intended to be non-binding and unenforceable (although the parties may desire that certain provisions in the LOI, such as confidentiality provisions or exclusive negotiation provisions, be enforceable).   LOIs are generally intended to be little more than negotiation tools, allowing the parties to reach consensus on key issues before spending the time and money associated with drafting a formal contract.  However, as noted above, the usefulness of an LOI as a negotiation tool is tempered by the risk that a court will find the LOI to create enforceable obligations due to vague drafting or the subsequent conduct of the parties.

In making a determination as to whether or not to enforce an LOI, courts will examine the intent of the parties.  This will be a fact-specific analysis based upon the given circumstances.  Some of the factors that a court will consider include the following: (i) the conduct of the parties, both at the time of execution and after execution (for example, after signing the LOI, did one or both parties issue press releases, make public filings, prepare for performance or actually commence performance?); (ii) whether a formal contract to be entered into by the parties at a later date is explicitly contemplated by the LOI; (iii) the specificity of the deal terms in the LOI (the more specific the terms, the more likely a court is to find that the LOI was intended to be a binding agreement); (iv) whether the LOI contemplates additional approvals being obtained by one or both parties prior to entering into a formal contract; and (v) the complexity and size of the transaction (the larger and more complex the transaction, the less likely a court is to find that the LOI was intended to be a binding agreement).

The parties may reduce the risk that a court will interpret an LOI as an enforceable agreement by adding explicit language that the parties do not intend to be bound by the LOI and that partial performance by either party does not create a binding contract.  One party (typically the seller or the landlord in a real estate transaction) may also choose not to execute the LOI.  The parties could also consider adding a liquidated damages clause that would limit any potential damages to a nominal sum in the event that a court did interpret the LOI as a binding agreement. 

There is no clear, bright-line standard that can be gleaned from the relevant case law as to when a court will interpret an LOI as an enforceable agreement between the parties.  Therefore, the parties to an LOI should state their intent regarding enforceability as clearly as possible in the LOI and then act in conformance with their stated intent.

Even if an LOI does not create a binding agreement between the parties, it may obligate the parties to negotiate with one another in good faith.  I will discuss that issue in my next article.

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