The Letter of Intent – Legal Issues
The letter of intent is a critical document that is written up at the beginning of a potential real estate transaction between either a prospective buyer and seller or a prospective tenant and landlord. The LOI contains preliminary understandings between both parties about major points of interest and concerns that will need to be reconciled over an agreed period of time to reach the final PSA or lease agreement.
The purpose of this post is to discuss the overarching legal implications surrounding LOIs and some steps to take to protect oneself while drafting one up. This post is not going to go into specifics on how to draft clauses found within these documents. If you are unfamiliar or interested in seeing some examples of LOIs, you can Google ‘sample real estate letters of intent’ or something similar and there will plenty that show up in the search for you to examine.
Important Note: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for legal advice. You should consult your own legal council before engaging in any potential transaction.
The Three Types of LOIs
The letter of intent can be legally interpreted in three ways: (1) a non-binding term sheet, (2) a binding agreement to negotiate
in good faith, or (3) a binding contract that solidifies a future transaction.
The negotiating parties must be extremely cautious when finalizing the details of the LOI so that the document created is what they intend it to be. There have been dozens of lawsuits surrounding letters of intent due to ambiguity, misunderstandings, and miscommunications, among other issues between the negotiating parties. When lawsuits do occur, the goal of the courts is to ultimately decide the intent behind the LOI. How courts decide on these cases will be discussed later in this post.
Wording Is Everything
Creating a Non-Binding LOI
It is very important to understand that a carelessly worded LOI meant to be non-binding could unintentionally become a legally binding contract. To create a non-binding LOI, it is critical to be consistent in wording and as clear as possible within the document about the intention for it to be non-binding. Below are a few suggestions to help effectively create and maintain a non-binding LOI:
- First and foremost, create a disclaimer at the beginning of the document stating something along the lines of the following:
This document, and the contents herein, does not constitute an agreement of sale, and shall only be used to keep track of discussion points that may one day lead to a future agreement of sale. Neither party is bound to nor obligated by this document. This paragraph supersedes all others contained within this document.
- Avoid using words such as “contract” or “agreement” to refer to the LOI. Use “term sheet” or “proposal” instead.
- When referring to the potential deal in the LOI, always precede it with words like “potential” or “proposed”.
- Add an additional clause at the end of the document reiterating that it is a non-binding letter.
- Add a clause that says the proposed purchase (or lease) is subject to the approval of either the party’s attorney or board of directors. With this clause, it can be relatively easy to have your attorney or board review and not approve it. However, it must actually be submitted and disapproved by the stated approving party.
- Always act in a way that is consistent with the wording in the agreement. No matter how clear the disclaimer is in articulating the LOI is non-binding, if one does not act in accordance, his or her actions can be used as evidence in court and in many cases, the actions will overrule the LOI. For example, let’s say there was a promise made outside of the LOI and one party relied on the promise and acted upon it to its detriment. Later, the other party backed out of the negotiations, claiming that the LOI was non-binding. The doctrine of promissory estoppel can be invoked to award damages to the impacted party.
- Avoid signing the document. The Statute of Frauds requires that contracts dealing with sale of real property or leases over one year are not legally binding without the signature of both parties. However, if you don’t follow the advice on the previous bullet point, you may still run into problems.
Creating an LOI to Negotiate in Good Faith
In many real estate transactions, a letter of intent is designed to legally bind the parties to negotiate in good faith. Good faith, as defined in The People’s Law Dictionary, means an honest intent to act without taking an unfair advantage over another person or to fulfill a promise to act, even when some legal technicality is not fulfilled. The LOI, if done properly, can legally protect one party from the other party that may negotiate in bad faith. Bad faith, as defined in The People’s Law Dictionary, means an intentional dishonest act by not fulfilling legal or contractual obligations, misleading another, entering into an agreement without the intention or means to fulfill it, or violating basic standards of honesty in dealing with others. Some examples of violating an LOI with a duty to negotiate in good faith are (1) abandoning the negotiations, (2) insisting on new and previously not agreed upon conditions in order to make it unrealistic for the other party to continue with the negotiation process, and (3) calling off the negotiation prematurely.
An LOI intended to be used to negotiate in good faith is meant to be non-binding with regards to the final commitment to a purchase and sale (or a lease agreement), but legally binding with regards to the due diligence and negotiation process. It allows both parties to have a sense of security before the potential final agreement is reached or not.
An oversimplified example of what may happen after the signing of an LOI to negotiate in good faith
Typically, once the LOI is executed, the seller will take the property off the market for a period of time so the potential buyer can have exclusive access to investigate. In exchange, the buyer will make a deposit and has to conduct due diligence during that period. If potential buyer is unsatisfied, he or she gets the deposit back and the property goes back on the market. If the due diligence period expires and the potential buyer cannot close on the property, the seller will keep the deposit as liquidated damages. If the buyer agrees to purchase, the deposit goes toward the purchase price of the property and the PSA is created.
The LOI essentially lays out a legally binding road map for the negotiation to proceed before a final agreement must be made. Here are some general guidelines that can help to create a solid LOI to negotiate in good faith:
- Follow the middle five bullet points from the ‘Creating a Non-Binding LOI’ section above. With regards to bullet point four – the additional non-binding clause, you should additionally state which sections of the LOI are meant to be binding.
- Include the words “… to Negotiate in Good Faith” in the title of the document
- The first clause of the document should be something along the lines of the following:
This document, and the contents herein, does not constitute an agreement of sale, nor does it obligate the parties to do anything more than negotiate in good faith. This clause supersedes all other clauses in this document.
This document is not a PSA and creates no binding obligation for either buyer or seller other than to negotiate in good faith.
Common Discussion Points Worked Out in LOIs
Towards a Purchase and Sale
- Property – address, parcel number(s), square footage
- Length of due diligence period
- Required materials that seller must provide to potential buyer for due diligence period
- Financing Contingencies
- Deposit – Go-hard date
- Deposit increase
- Broker fees
- Escrow details upon execution of the PSA
- Who pays what costs
- Who pays sales commissions
Towards a Lease Agreement
- Property: location, square footage, address
- Lease commencement date
- Term length
- Rent terms
- Reimbursable expenses
- Security deposit
- Tenant Improvements
- Rent abatements
To The Courthouse:
When Negotiations Go Bad and the Parties Go to Court
As mentioned earlier in this post, there have been dozens of court cases surrounding LOIs. When there is a trial that involves a dispute over an LOI, it is the sole purpose of the court to determine the intent of the parties. However, there is not a unanimous consensus among the courts as to how to go about doing this. There are two approaches, the objective approach and the subjective approach, and each jurisdiction goes about these cases using one or the other.
The Subjective Approach:
With the subjective approach, the case is decided based on a matter of fact. In other words, which party can better prove and support their claims of the intent behind the negotiations. It is the job of a judge or jury to determine the intent of the parties based on what is written in the LOI plus additional evidence introduced in the case. Additional evidence can be oral agreements, emails, etc. The subjective approach is favored when LOIs are a bit ambiguous and there is significant external circumstances outside of the LOI that may be critical to consider.
The Objective Approach:
The objective approach is used when the LOI is unambiguous. The intention of the parties can be clearly determined, usually within the four corners of the document. An objective case is decided on as a matter of law, not a matter of fact.
In objective cases, the Parole Evidence Rule can be used as an effective tool to prevent the other party from introducing additional evidence to the trial. The parole evidence rule, as defined by the Legal Information Institute at Cornell University, is a rule that governs the extent to which parties to a case may introduce into court evidence of a prior or contemporaneous agreement in order to modify, explain, or supplement the contract at issue. The rule states that where the parties to a contract intended for their written agreement to be the full and final expression of their bargain (i.e., the writing is an integration), other written or oral agreements that were made prior to or simultaneous with the writing are inadmissible for the purpose of changing the terms of the original agreement.
However, throughout my research for this post, I have found many exceptions that nullify the parole evidence rule, especially if a judge determines that the LOI was not the full and final expression of the bargain. Evidence of these exceptions are found here, here, and here.
When creating a letter of intent, it is usually in both parties best interest to be as articulate and clear as possible about your intentions. LOIs, when done correctly, are excellent tools to guide the negotiation process to the point of signing a PSA (or lease) or to the point of walking away from a deal without any legal repercussions. Done incorrectly, and it could result in lengthy and potentially costly court battles.
About the Author: Michael Belasco has over eight years of real estate and construction experience. He currently works for a global real estate investment, development, and asset management firm in San Francisco managing large scale development projects in the city. Michael has both an MBA and Master in Real Estate with a concentration in Real Estate Finance from Cornell University.