As published in the Daily Journal of Commerce

In many commercial transactions involving the lease or sale of real property, the first document drafted by the parties to evidence the agreement terms is a letter of intent. Generally speaking, the letter of intent is simply an expression of the parties’ intent to proceed with formal documentation of the transaction and is not intended to be binding. So, why use an LOI?

Commercial real estate transactions are usually complex matters with many terms to negotiate. Parties use the LOI for two basic purposes.

The first is to document the seriousness of the parties’ intent to complete the transaction. By signing the LOI, each party is expressing good faith in going forward with negotiations needed to close the deal.

The second is to highlight the deal’s essential terms, such as price and closing date or lease rate and lease term. Other essential terms, such as representations and warranties, insurance requirements and closing terms, are saved for the final purchase agreement or lease agreement.

Careful drafting of the LOI is necessary if the parties intend the LOI to be nonbinding. If an LOI otherwise expresses all of the necessary elements of an enforceable contract – such as price, payment terms, a closing date and an adequate description of the property – but does not express the parties’ intent that the LOI not be binding pending the execution of a full purchase agreement, a court will enforce the LOI as the agreement between the parties.

This can have serious unintended consequences for one or both parties. For instance, in a purchase transaction, a financing contingency, environmental indemnities or other representations and warranties can be very important to the parties, but none are necessary to make an enforceable contract. Without a specific provision in the LOI stating it is not intended to be binding until the final agreement is signed by all the parties, these important provisions may be omitted from the agreement.

On the other hand, one of the parties may want certain provisions in the LOI to be binding, even though the obligation to close the deal depends on the execution of the purchase and sale agreement or lease. For instance, it is common for the purchaser or lessee to insist on a provision in the LOI that says the seller or landlord will not make other offers to sell or lease the property while the parties are negotiating a final agreement.

Another common provision the parties want to be binding is that each party will keep the terms of the transaction confidential pending negotiation of the final documents. Again, careful drafting of the document is necessary to include these binding provisions.

An example of a hybrid LOI, in which part of it is intended to be binding and part of it is not is discussed in the ruling issued by the Court of Appeals in the case of Lillian R. Logan v. D.W. Sivers Co. In that case, the parties specifically agreed that the LOI would not be binding, pending the negotiation of a formal purchase and sale agreement. The LOI did provide, however, that the seller would not market the property to other potential purchasers for 60 days while the parties worked on finalizing a formal agreement. Prior to the end of the 60-day period, the seller found a new purchaser for more money and ended up selling the property to the second purchaser.

Despite a provision stating that the LOI was not intended to be binding, the court ruled that the seller was in breach of the LOI provision of not “shopping the deal” for 60 days. Because the purchaser was involved in a Section 1031 exchange, which has very tight time frames for identifying and closing on the replacement property, the sale to the second purchaser caused the original purchaser to miss on the exchange and suffer more than a million dollars in tax obligation, which the court ruled the seller had to pay in damages.

Obviously, the result of the holding requires careful drafting of which provisions in an LOI, if any, are intended to be binding.

As with any commercial real estate matter, consult with a real estate professional and legal adviser before signing on the dotted line.