Unintended Consequences of Preliminary Agreements

Roger J. Brothers

When does a preliminary agreement become an enforceable contract?  When does a “final proposal” become a binding agreement?  How can parties be sure that memoranda of understanding exchanged during negotiations will not create enforceable, contractual obligations? In First National Mortgage Company v. Federal Realty Investment Trust, 631 F.3d 1058, (9th Cir. 2011) (“First National”), the Ninth Circuit Court of Appeals provided guidance, if not a blueprint, as to how to avoid having a preliminary agreement unwittingly become a binding contract.  First National demonstrates the importance of including specific language in preliminary agreements and letters of intent that establishes their non-binding nature.

Ericka L. Ackeret

First National involved the enforceability of a written agreement between a developer and a property owner.  Federal Realty is a real estate investment trust that had plans to develop Santana Row, a mixed-use project in San Jose.  As part of its development efforts, Federal Realty entered into negotiations with First National to acquire the property at issue in the case (the “Property”).  The negotiations occurred over multiple years, and in 2000, the parties exchanged several proposals regarding the terms of a ground lease, including a “Counter Proposal,” a “Revised Proposal,” and finally a “Final Proposal,” signed by both parties.

The Final Proposal is set forth in a single page, nine (9) paragraph, document, which

Dominic V. Signorotti

includes the rent amount, a “put” option in favor of First National, a “call” option in favor of Federal Realty, provisions regarding reimbursement and moving expenses, and a deadline by which the agreement must be accepted.  The Final Proposal concludes with the statement that, “The above terms are hereby accepted by the parties subject only to the approval of the terms and conditions of a formal agreement.”

Following the exchange of the Final Proposal, the parties engaged in extensive, but ultimately unsuccessful, negotiations towards a formal agreement.  During these negotiations, First National gave notice to vacate to its current tenant at the Property, and requested that Federal Realty reimburse it for any loss of rent.  Federal Realty rejected this request, on the ground that no binding agreement was yet in place between the parties.  Shortly thereafter, the negotiations fell apart and were terminated.

First National sued, alleging that Federal Realty committed an anticipatory breach of the Final Proposal.  The district court, and eventually the court of appeal (the “Court”), agreed with First National, and held that the Final Proposal did, in fact, constitute a binding and enforceable agreement, and on those grounds awarded the sum of $15.9 million in damages to First National for lost rent over the term of the lease, and the loss of its “put” option.

At trial and during appeal, Federal Realty argued that the Final Proposal was conditional, and unenforceable to the extent that it was subject to the approval of a “formal agreement.”  The Court disagreed, and explained that an agreement is not rendered unenforceable merely because it is subject to the approval of a formal contract.  Rather, the intent of the parties is the primary concern when determining whether an agreement is intended to be final or conditional.

The Court focused its attention on the specific and deliberate language of the Final Proposal, and noted that the parties’ negotiations progressed from a “Counter Proposal,” to a “Revised Proposal, and ultimately to a “Final Proposal.”  This, in the eyes of the Court, implied an intent to make the Final Proposal binding.  In addition, the Final Proposal expressly provided that its terms “are hereby accepted by the parties subject only to approval of the terms and conditions of a formal agreement.”  Based on this language, the Court concluded that “it cannot be said, as a matter of law, that the Final Proposal was not meant to be binding.”  In doing so, the Court distinguished specifically the Final Proposal from a case in which the document at issue was titled “letter of intent,” and which contained the express provision that “this letter of intent is of no binding effect.”  (See, Rennick v. O.P.T.I.O.N. Care, Inc. 77 F.3d 309 (9th Cir. 1996).)  The Court observed further that the Final Proposal did not include a non-binding clause, which Federal Realty had included in its earlier drafts.  Finally, the Court held that substantial evidence was presented at trial to support the jury’s finding that both parties intended the Final Proposal to be an enforceable agreement.

First National should also be considered with respect to debtors in bankruptcy.  Once a bankruptcy is filed, the Trustee may elect to assume any unexpired executory contract, thereby preserving the remaining benefits of the contract.  When does a party have an “executory contract” with a debtor in bankruptcy?  The Bankruptcy Code furnishes no express definition of “executory contract.”  (See, 11 U.S.C. §365(a).)  However, the legislative history to §365(a) indicates that Congress intended the term to mean a contract “on which performance is due to some extent on both sides.”  (See, N.L.R.B. v. Bildisco & Bildisco, 465 U.S. 513 (1984).)  However, as a result of the recent ruling in First National, one must be aware that a preliminary agreement, which does not contain non-binding language, may be deemed to constitute an “executory contract,” and may therefore be assumed by a Trustee in bankruptcy.  An executory contract may be sold and assigned by the Trustee to a third party, even though the contract has a provision which otherwise prohibits assignment.  The non-debtor party to such a contract, or preliminary agreement, may find itself in the often risky position of having to continue to do business with a bankruptcy estate or a third party with whom such party might not otherwise choose to do business.

What lessons should be taken away from First National?  The first is that whenever preliminary documents are exchanged during negotiations, great care should be taken to title the documents “Preliminary” or “Non-binding.”  One should avoid the use of the word “Final”, unless and until the document is, in fact, intended to be “final”, and thus enforceable.  In addition, non-binding clauses should be included in all preliminary agreements.  Such a clause may read: “This agreement is not intended to be a final binding agreement or contract and is of no binding effect.  This agreement constitutes only a preliminary statement of the parties’ intention with respect to the transactions contemplated in this agreement.”

While individuals and entities should be mindful of the wording of their preliminary agreements, they should not disregard the usefulness of letters of intent or preliminary proposals altogether, notwithstanding the First National case.  These preliminary exchanges serve a valuable purpose in many negotiations.  In order to ensure that preliminary understandings are not taken to be final expressions with unintended consequences, it is essential that counsel include in such agreements express language that the agreements are preliminary and non-binding.

Roger J. Brothers is the managing partner of Buchman Provine Brothers Smith LLP who practices in the areas in Business Law, Real Estate Law and related litigation.
Ericka L. Ackeret is an associate in the law firm of Buchman Provine Brothers Smith LLP who practices in the areas in Business Law, Real Estate Law and related litigation.
Dominic Signorotti is an associate in the law firm of Buchman Provine Brothers Smith LLP who practices in the areas in Business Law, Real Estate Law and related litigation.