Commercial transactions can arise through a series of form offers, counteroffers and acceptances – sometimes culminating in a letter of intent (an “LOI”). Usually, the parties intend that formal contracts be drafted based on the LOI. Often, though, parties also conduct negotiations through telephone calls, emails and other correspondence. When negotiations end without a formal agreement, more often than not, the parties part ways. However, two other situations can arise. First, a party might assert that, although a contract for the deal did not arise, through their correspondence the parties entered into a binding contract to further negotiate in good faith. Second, a party may assert that, although a formal contract has not been signed, enough of the material terms have been agreed upon and, therefore, a formal contract does in fact exist.
Since the case of Copeland v. Baskin Robbins USA in 2002, California law has recognized that parties can enter into an enforceable separate “contract to negotiate” a contract.
If the parties negotiate in good faith to enter into a contract but fail to do so, then the “contract to negotiate” has been performed even though the parties ultimately failed to enter into that contract. However, if one of the parties fails to negotiate in good faith, then that party would be liable for the breach of the contract to negotiate.
The Copeland court distinguished between (i) negotiations to form or modify a contract where neither party has an obligation to continue to negotiate in good faith vs. (ii) the parties entering into a “contract to negotiate” because California’s implied covenant of good faith and fair dealing is attached. Generally speaking, parties to a negotiation do not without more have a duty to negotiate in good faith. Either party can break off negotiations for any reason. However, during the negotiations, the parties’ communications to one another can give rise to the separate “contract to negotiate”. This situation arises because of California’s implied covenant of good faith and fair dealing in contracts. While the scope of this law is well outside of this brief article, the implied covenant states in part that neither party to a contract will do anything to deprive the other party of the express benefits of that contract. The implied covenant cannot, however, force a party to do anything contrary to the express terms of the contract. Avoiding terms in an LOI such as, “upon signing this letter, the parties shall negotiate final lease documents”, would therefore be wise. A judge finding that your LOI is really a “contract to negotiate” will obviously place you in an unenviable negotiation position.
The second unwelcome scenario is a claim that the LOI and all the other communications contains all the essential elements of the deal and was agreed upon, even though you don’t have a formal written contract. For example, in order to have a binding lease, only six items need to be agreed upon: (1) the intent to create a landlord/tenant relationship, (2) the identification of the landlord and the tenant, (3) a sufficient description of the premises, (4) the rent, (5) the time and manner of payment, and (6) the term. If any writings have those elements, or a court can reasonably find them from the parties’ signed communications, you could have a binding lease even if you didn’t sign a formal one.
So, in the entire spectrum of “whether or not we have a contract even though we didn’t sign a formal contract”: on the left side you have negotiations that don’t ripen into any rights at all, in the middle you have negotiations that ripen in a “contract to negotiate” in good faith, and on the right side you have a binding contract based on LOI’s or other signed correspondence containing all the material terms of the contract. Therefore, assuming you do not wish to enter into a binding contract during your negotiations, it’s prudent to keep your actions in mind and carefully select language communicating your offers and counteroffers to be clear that you reserve your right to terminate those discussions at any time for any reason.