Can a Letter of Intent be an Enforceable Contract in California?

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.

Mutual Consent

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.

Conclusion

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:

  1.  Non-Binding Language.  Explicitly state in the letter of intent that it is non-binding on the parties and that no party shall be bound in any way until a final contract has been agreed to, executed and delivered by each party.  Avoid language that imposes some sort of standard on the conduct of such negotiations, such as “good faith” or “best efforts”, which could be interpreted as creating a binding obligation.
  2. Termination Language.  In addition to confirming that the LOI is non-binding, the parties should explicitly state their right to terminate negotiations for any reason, or no reason, at any time prior to consummation of the contemplated final agreement in each parties’ sole discretion.
  3. Future Contract Language. Require that a more formal and comprehensive contract be executed in the future.
  4. Avoid Language Implying a Legal Standard of Conduct.  Language must clearly deny the existence of a duty to negotiate in good faith.  Inclusion of language in a letter of intent contemplating negotiation of future documents, especially if that language imposes some sort of standard on the conduct of such negotiations such as “best efforts” or “good faith,” could be interpreted as creating binding obligation to negotiate in good faith.  Violating this duty (if created) can result in reliance damages to the aggrieved party.

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:

  1.  Avoid Stating the Deal Has Been Finalized.  All parties involved in the deal should also avoid taking any actions that could imply that they intend to be bound by the LOI or believe that a binding contract exists, such as making public announcements that a deal has been reached.
  2. Consistently Confirm the LOI is not Binding.  The negotiating parties should consistently confirm that in accordance with the terms of the LOI, the parties will not be bound to the transaction until a definitive written agreement is executed by the parties.
  3. Avoid Treating the LOI as a Binding Agreement.  Avoid using terms such as “breach” to describe a party’s inaction or failure to respond within a period for contemplated action, which can be used as evidence there was a binding, final 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 evelyn@ibvadvisorygroup.com 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.