The Most Likely Obligation Parties To A Letter Of Intent Will Incur Is …

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Way back in July of 2012, we Ruminated about the enforceability of a letter of intent (LOI). Last month, we revisited the subject at a presentation to the International Council of Shopping Center’s Law Conference in Phoenix. There, five possibilities were explored, one of which was that an LOI imposed an obligation on the parties to negotiate in good faith even if the terms of the LOI weren’t otherwise binding on the parties. Today, we’re going to expand on that “good faith obligation to negotiate” concept because that is the most likely decision a court would reach. To see the entire 2012 blog posting and read about the other four possible outcomes, click: HERE.

There are more than a few court decisions with the outcome that entering into an LOI imposes the duty to negotiate in good faith. They don’t require that the parties ever reach an agreement, only that they really try to do so. Last month (October 27, 2015 to be more precise), a Delaware Superior Court decision was published and it dealt with just this point. The facts were complicated, but not complex. The decision didn’t go to the merits of the case, leaving the parties to fight over the facts, but it did explain this aspect of the law pretty well. For those whose appetite has been whetted (archaically speaking) and want to see the court’s decision, click: HERE.

The story goes like this. A developer wanted to build a data center, one that would have its own power plant. For the project to be financially successful, it needed to ground lease a decent amount of land (turning out to be 43 acres) and it needed to sell its excess power and its unneeded steam. After an extensive search, it located a suitable piece of land at or adjacent to a university. It negotiated with a municipal utility to take the excess electricity the power plant would generate. The university was lined up to purchase the steam.

So, to put this all together, it needed a ground lease and negotiated one with the land’s owner. Almost certainly, the land owner was an alter ego of the University. That may have been important for the outcome of some of the other claims in the lawsuit, but not for today’s outcome.

The developer wasn’t going to sign the lease unless it wrapped up the steam and electricity deals or, at a minimum, felt pretty sure those pieces of the puzzle would drop in place. A final, execution copy of the electricity agreement with the municipal utility was prepared but the rest of this story will explain why it never got signed. Nonetheless, the developer was pretty comfortable once the electricity purchase agreement had been finalized. Of course, at that point in time it didn’t know what would follow.

Now, we are at the point of describing the debacle over the steam sale to the university. The developer was prepared to sign the lease even though the electricity sale agreement had not yet been signed. All it needed was comfort that the university would buy the steam. So, when the university issued a “Letter of Interest,” the developer signed the lease the very same day. [According to the court’s record, the developer said: “the University’s promise to purchase steam from the Project was an important factor in the University’s winning bid.”]

The Letter of Interest [we’ll call it the LOI], described by the court as being the same as a Letter of Intent for these purposes, was signed by the University’s Director of Real Estate. It “articulate[d] the University’s ‘support for the [] Project located on the [] Campus [and expressed] interest in seeing it developed to provide an option to purchase steam.’ Further, the LOI “expresse[d] a ‘willing[ness] to enter into [an] agreement [to purchase steam] upon” the completion of financing and the ground breaking for construction.

The Lease with the university’s alter ego landowner-landlord called for evaluation of the opportunity for the developer to “provide steam capacity to the University.”

The university and the developer negotiated the steam LOI for eight months resulting in the preparation of a “term sheet” that went beyond the “Letter of Interest.” It covered: “(1) ‘Capacity Payment,’ (2) ‘Contract Consumption Volume,’ (3) ‘Consumption Payment,’ (4) ‘Consumption Rate,’ and (5) ‘Payment Terms.’”

So, at this point things were looking pretty good for the project. The lease had been signed; an executable agreement between the developer and the municipality was “in hand”; and a reasonably detail “term sheet” had been reached between the developer and the university.

That’s when the wheels fell off the train, and the project got derailed.

A few months after the term sheet had been prepared, the university decided not to negotiate the actual steam sale agreement. Four or five months later, the landowner’s president “denied that the University intended to purchase steam.” Then, the university and its alter ego landowning entity attempted to terminate the project before any steam sales agreement had been signed.

Why did the university “choke” and try to abandon the project? Shortly after the term sheet had been finalized for the steam sale, a group of local citizens formed Newark Residents Against the Power Plant (NRAPP). Eventually this group had about 100 members. NRAPP opposed the project, insisting “that all newly installed power generation capacity must be exclusively wind or solar powered.” It alleged zoning violations. It attacked the sale of electricity to the municipal utility. It held protests outside of classrooms and at football games.

Interfering with football games may have been the last straw. Despite documents to the contrary, the university went so far as to tell the public and send a letter denying that it ever promised to buy steam from the project. To add insult to injury, the university allowed the contractor doing work on an adjacent parcel to dump construction waste of the very land that its alter ego had leased to the developer. This interfered with any construction the developer was to have done. The injury wasn’t yet insulted enough, so the landowner-landlord declared that the developer was in breach of the lease in that the developer-tenant had not met the agreed-upon project milestones.

A fine kettle of fish. [“It is customary for the gentlemen who live near the Tweed to entertain their neighbours and friends with a Fete Champetre, which they call giving ‘a kettle of fish’. Tents or marquees are pitched near the flowery banks of the river… a fire is kindled, and live salmon thrown into boiling kettles.”

Now, with the story told, here’s what was enforceable about the LOI. The developer sued the university, alleging that the university breached an obligation to negotiate the “Steam Sale Agreement” in good faith. Under Delaware law (and pretty much elsewhere as well), “the intention of the parties controls the creation of a good-faith duty to negotiate under a letter of intent.” Courts will “look at the parties’ outward and objective manifestations of assent, as opposed to their undisclosed and subjective intentions, in determining the intent of the parties.”

Here, the LOI “reiterate[d] [the university’s] support for the [] Project and express[ed] interest.” Further, the LOI expressed a “willing[ness] to enter into [an] agreement” to purchase steam upon finalization of [project’s] financing and the commencement of construction.” It concluded with the following promise: “We will work with you to complete due diligence, pricing mechanisms and documentation over the coming weeks and months.”

The term sheet included “fundamental terms negotiated by the parties relating to the Steam Sale Agreement including: (1) capacity payment, (2) contract consumption value, (3) consumption payment, (4) consumption rate, and (5) payment terms.” The lease with the university’s alter ego land owning landlord provided: “Tenant and Landlord agree to evaluate the opportunity for the Tenant to provide steam capacity to the University and to evaluate the requirements for installation of steam interconnection lines between the power plant and the University’s existing steam plant. Both the Tenant and the Landlord agree to pursue this option as the project design proceeds.”

So, as the court saw it, “based on the express contractual language of the Steam LOI, the Steam Term Sheet, and the Lease, it is reasonably conceivable that the parties intended to create a mutual obligation to negotiate the Steam Sale Agreement in good faith.”

That’s as much as the court could say because all this particular court needed to decide was whether parties to an LOI have a good faith obligation to negotiate a final agreement. And it said that there was such an obligation if it could be shown that, to an objective observer, that it looked like the parties intended to negotiate an agreement based on the LOI. Whether the developer could prove sufficient facts to show that the university breached that duty was left to later proceedings.

This is not a zebra among horses. In practice, it is very rare that a court will treat an LOI as if it were an agreed-upon contract. In contrast, the (admittedly few) disputes over LOIs that do get to court very often result in the same result described above. Parties to an LOI should expect that, even if signing an LOI will not bind them to the terms of the LOI, they will have “signed onto” an obligation to negotiate the intended agreement in good faith. They may not be obligated to reach such a final agreement, but they are expected to try.

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  1. Elliot L Warm says:

    The thought occurred to me that perhaps an LOI could express some concept about what it means to negotiate in good faith, given that such an obligation apparently exists whether or not one mentions it. I am thinking along the lines of a statement that a party does not need to continue negotiations if any event shall occur that would adversely affect the economics of the transaction. (On the other hand, I am aware that a party having such circumstances would hardly be lacking in good faith by backing out.)

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