Clients like letters of intent. Letters of intent can be developed easily and shipped out quickly to get a deal rolling. They can lay out basic terms of a deal in laymen’s language, and in just a few pages, so the parties can decide if they are generally on the same page. They can even be used to create certain obligations, say a no-shop provision, giving a buyer some comfort that it will not have the rug pulled out from under it before it can cut a deal.

Lawyers like letters of intent, too. Really. Like clients, we view them as useful tools, perfect for putting the basics parameters of a deal in front of both sides, and ensuring that there is some accord on the most important terms. They can also be used to entice important details from the parties: information concerning the property, the security, timing, due diligence, financial covenants, costs, etc., which the parties might otherwise not tend to focus on up front, but which are important foundations for the transaction and some of which can become major sticking points.

But lawyers also view letters of intent with a mixed eye. This is especially true of certain letters of intent that we have all received, faxed copies of poorly drafted, inconsistent or incomplete letters bearing, sadly, the signatures of both parties, executed before we had any chance to add our two cents. These letters can lead to difficult, sometimes contentious discussions as the parties later attempt to translate their own language.

Fortunately, letters of intent are by definition generally not intended to be binding upon the parties. They are simply an interim step in the negotiating process. As a result, the normal course, if there is not in fact a meeting of the minds, is that the deal unwinds and the parties go their separate ways, with little lost other than some time and effort.

What happens, though, if one or the other party is under the impression that the letter of intent was in fact “the deal,” and seeks to enforce this term sheet, following an acrimonious breakdown of negotiations? This can be an attorney’s nightmare, as the control over detail that we all seek in drafting voluminous closing documents may be lost to a judge or, even worse, a jury unschooled in commercial practice. To ensure that this does not occur, letters of intent drafted by careful attorneys are generally chock full of language stating that the letter “is not intended to be binding upon the parties,” that “neither party can rely upon this letter,” and that there will be no agreement “unless and until the parties sign a final and definitive agreement, at each parties’ sole discretion.”

Such language, and this understanding of the letter of intent, allows the parties to approach the negotiating table safe in the knowledge that much may be learned during the negotiations, and that there will be a give and take that may lead to modification of initial bargaining positions, but that neither party will find itself bound to an undesirable agreement based upon initial proposals. In short, the parties know that there will not be a deal until all terms are fully negotiated, and the negotiations are memorialized in a comprehensive and definitive agreement approved and signed by both parties.

At least, that is the way it is supposed to work. The recent 9th U.S. Circuit Court of Appeals case of First National Mortgage Company v. Federal Realty serves as a cautionary tale, illustrating that a lack of care by negotiating parties can render a letter of intent enforceable — even under a set of facts most attorneys would find surprising — and that this can be a costly mistake.

In that case, a bare-bones, one page, nine-paragraph document between two parties with a history of failed negotiations, together with a few ill-conceived statements, served as the basis for a damages award of nearly $16 million, predicated upon theories of anticipatory breach of both a lease and a purchase agreement.

According to the court, First National Mortgage Co. owned and controlled a property in San Jose, Calif. Federal Realty wanted to either purchase or ground lease the property as part of a much larger development scheme, and made numerous overtures to First National during the 1990s. During early 2000, negotiations became more serious, and the parties exchanged a number of letters regarding a proposed ground lease. Headings on these documents were revised over time from “Proposal” to “Counter Proposal” to, ultimately, “Final Proposal.”

The final proposal was one page long and provided for a rental of $100,000 per month, with 3 percent increases. It provided that First National would have an option to put the property to Federal at any time during the first 10 years of the lease, and that Federal would have a 10-year call. The purchase prices for both the put and the call were the same. The document provided that Federal Realty was to “‘prepare a legal agreement for First National’s review to finalize the agreement,’” the court wrote. Above the signature lines, the letter read, “‘The above terms are hereby accepted by the parties subject only to approval of the terms and conditions of a formal agreement,’” according to the opinion.

After the letter was signed, the parties pursued extensive negotiations but were unable to agree upon the terms of a final lease document. Included in those discussions were proposals regarding the lease term, which was not addressed in the letter of intent. At various times, Federal Realty proposed a 34-year term, and First National proposed 50 years.

Finally, it became apparent that the parties would not be able to reach an agreement. Federal Realty informed First National that the parties had no binding agreement, and First National filed an action for anticipatory breach.

The case was heard by a jury, which found that the parties intended to form a lease when they executed the letter of intent, and that First National was entitled to damages both for Federal’s breach of that lease as well as its repudiation of the First National put.

On appeal, Federal argued that the final proposal was not binding both because the letter expressly called for development of a “final agreement” and because a necessary element of the transaction — the lease term — was never specified. The district court found that the document was ambiguous respecting whether or not it was intended to be conditional, and that therefore the jury’s determination would not be overturned. As for the omission of term, the court held that the presence of the 10-year put and call provisions could be found by the jury to imply agreement on a 10-year term for the lease. The district court therefore upheld the jury’s awards, consisting of $10.6 million for breach of the lease and $5.2 million for breach of First National’s put.

Federal appealed to the circuit court, seeking to overturn the jury’s findings as incorrect as a matter of law. The court declined to do so, drawing some surprising conclusions, and arguably lending support to those who religiously strive to include waivers of jury trial in all their business contracts.

The circuit court first considered whether the letter of intent was intended by the parties to form an agreement, or was merely intended to establish the basis for further discussions. The court relied heavily upon the language in the letter that stated “the above terms are hereby accepted by the parties” and was not compelled to a different conclusion by the subsequent “subject only to approval of the terms and conditions of a formal agreement.” It seems possible that the word “only” undermined this carveout to the point of immateriality, since the court ultimately found that the letter was not in fact “subject to” any such formal agreement.

The court noted that the parties had changed the title of the letter over various iterations, ultimately to the very final-sounding “Final Proposal.” Although not dispositive, this title was viewed by the court as indicative of the parties’ intent. And finally, the court noted that Federal had deleted from the last draft its standard language respecting the non-binding nature of the document. This revision was reportedly demanded by Federal’s principal to ensure that the enumerated terms were not later subject to renegotiation, but obviously the impact of the change went much further than this.

The court acknowledged that non-binding preliminary agreements play an important role in real estate transactions, as asserted by Federal and various amici curiae. However, the court posited the existence of a countervailing consideration that is bound to make most real estate practitioners uncomfortable: “We do note, however, that at times it is equally important for the parties to be certain that their interim agreements in the midst of protracted negotiations can be enforced.” In the view of the court (and it is unclear to what extent the jury joined in this reasoning), the parties had a true contract when they signed the “Final Proposal” and merely a separate agreement to replace this writing with a second “formal” agreement.

The court also upheld another aspect of the jury’s decision that may trouble many. As a real estate contract, the lease (if any), was subject to the statute of frauds, which requires the existence of written contract containing the essential contract provisions with reasonable certainty. The omission of the term for a lease is clearly fatal. However, in this case, the court relied upon indirect indicia in order to establish the lease term.

Based upon the existence of the 10-year put and the 10-year call, the jury had apparently concluded that the parties intended for the lease run 10 years. This determination was upheld by the court despite the fact that the two parties themselves had traded proposals calling for lease terms of 34 and 50 years respectively, following execution of the final proposal.

Not even the parol evidence rule could save Federal, as the court determined that extrinsic evidence was not being used to supply the missing 10-year term but rather was being used to interpret the “special meaning” of the put and call combination to the parties.

From the pleadings, it appears that Federal hired an attorney to negotiate the lease only after the final proposal had been signed. If so, it is not entirely surprising that Federal got whipsawed. Presumably operating in the general expectation that it was not entirely bound until it signed a “real lease,” Federal nonetheless wanted to nail down certain economic terms of great significance, primarily the rent and the call, in order to avoid having these renegotiated by First National at a later point. This “cake and eat it too” approach ultimately left Federal exposed to the judgment that came to pass.

Clearly, based upon the months of subsequent negotiations upon a wide variety of terms (one draft reportedly revised 69 points proposed by the other party), including the actual term of the lease, the parties were not yet of one mind except upon the most basic of terms. It is true that the market also shifted during these negotiations, making the lease generally less attractive to Federal, but that does not change the fact — the lawyer’s nightmare — that one party was, in the end, dragged into a deal that it did not want because of an ill-conceived letter of intent.

Avoiding the Nightmare

Letters of intent have their place if properly crafted and if the parties understand that they have limited reach and purpose. Federal, unfortunately, was sunk by ambiguity in its document, and by its own ambiguous goals. Certain steps can be taken to ensure that your client is not similarly exposed.

A letter of intent that is intended to be non-binding should: (i) state that the drafter is prepared to commence negotiations respecting an agreement and that the letter is intended to set forth a basis upon which the drafter is prepared to proceed; (ii) clearly state that it is neither a contract, nor an agreement to enter into a contract; (iii) indicate that it is not intended to address all terms that will be incorporated into the agreement; (iv) make clear that either party has the right to terminate negotiations at its discretion; (iv) state that it creates no legally binding obligations between the parties (except, perhaps, no-shop, confidentiality, and cost allocation and similar provisions regarding the negotiations); and (v) specify a time frame, during which an agreement must be signed or the letter will expire. The letter should not be denominated “memorandum of understanding,” “memorandum of intent” or “agreement in principal.” The parties should avoid taking actions that indicate that an agreement has been reached, such as issue press reports or general announcements to employees or third parties.

If the client wants a binding letter of intent, suggest a full-blown agreement of sale or lease, instead of a term sheet. The parties need to go there anyway, and it’s better to do so without a sword hanging over your head. •

Martin J. Doyle is a partner and  Bruce P. Bowen is special counsel in Saul Ewing‘s real estate department in the Philadelphia office. Both are experienced in all aspects of real estate financing, sales and leasing. Doyle received his J.D., cum laude, from the University of Pennsylvania Law School. Bowen received his J.D., magna cum laude, from Temple University’s James E. Beasley School of Law.