RICHMOND, Va. (3/16/11) – In a decision that is expected to have a significant impact on commercial real estate transactions, the Ninth Circuit Court of Appeals of California has upheld a district court's decision that a signed document, titled "Final Proposal," is an enforceable ground lease agreement with a put and call option to purchase—even though the document clearly indicated that a future legal document was intended to finalize the pending agreement between the parties, and no lease term was set forth in the document.

"It is a decision that has serious implications for commercial real estate deal making," says attorney Ann Lisa Braun, a partner in the Richmond, Va., office of LeClairRyan. The case, First National Mortgage Company v. Federal Realty Investment Trust, involved real property in San Jose, Calif. that Federal Realty wanted to buy in order to develop a mixed-use project. Negotiations continued for several years and a number of proposals were exchanged over that period.

Instrumental to the court's decision was that the initial proposals for the transaction included Federal Realty's standard non-binding clause, "language that one would see in a non-binding letter of intent," Braun notes.

The non-binding clause was eventually omitted from the Final Proposal, however. "Apparently, management of Federal Realty wasn't happy after learning that the draft proposals were not enforceable," she says. "Therefore, the non-binding clause was removed to ensure that neither party could alter any of the major points of the agreement."

Once the Final Proposal was signed, however, the two parties could not come to terms on a final agreement. As negotiations continued, First National gave its existing tenant at the property a notice to vacate and asked Federal Realty to reimburse them for the lost rental income. When the real estate market subsequently collapsed, the proposed agreement did as well, and First National sued Federal Realty for breach of the Final Proposal.

"While the Court of Appeals acknowledged that an 'agreement to agree' isn't a binding contract, it concluded that the parties' intention primarily determines whether a document is a final agreement or an unenforceable agreement to make an agreement," explains Braun. "After examining evidence to determine the parties' intent, the court concluded that an enforceable agreement had been created, upholding the lower court's award of $15.9 million in damages to First National for loss of both rent and its put option under the Final Proposal.”

"At issue here for the commercial real estate industry,” she continues, “is the binding effect given to what was essentially a preliminary document lacking many of the elements usually found in final contracts.” In a joint amici curiae supporting Federal Realty, several major industry trade associations argued that a ruling in favor of First National would discourage parties from entering into preliminary documents that the real estate industry finds useful in negotiating such transactions.

"For the real estate industry, the message from this decision is that one must now take additional precautions to ensure that preliminary documents, at the letter-of-intent stage of a negotiation, remain just that—preliminary," Braun concludes. "At the same time, one should never remove non-binding language without being fully prepared to live with the consequences of creating an enforceable binding agreement."