FEATURE ARTICLE, MAY 2011

“FINAL PROPOSAL” IS ENFORCED AS A BINDING AGREEMENT
Court case that awards $16 million in damages serves as warning to companies involved in real estate negotiations.
By A.L. Braun

In a decision with important implications for the real estate industry, the Ninth Circuit Court of Appeals recently upheld a district court’s finding that a signed document titled “Final Proposal” is an enforceable ground lease agreement with a put and a call option to purchase, even though the document clearly contemplated a comprehensive legal agreement “to finalize the agreement;” did not set forth the duration of the lease term; and stated, “[t]he above terms are hereby accepted by the parties subject only to approval of the terms and conditions of a formal agreement.”

And you thought you weren’t bound to a lease until both sides signed a lease agreement!

The case, First National Mortgage Company v. Federal Realty Investment Trust, was decided on February 1, 2011. First National is a mortgage company that leased property in San Jose, California; Federal Realty is a publicly traded REIT, which, starting in the late 1990s, wanted to buy the property to develop a mixed-use project. Negotiations continued over the course of several years, during which several proposals were exchanged.

Crucial to the court was the fact that titles for the various proposals changed from a “Counter Proposal,” to a “Revised Proposal,” and eventually to a “Final Proposal.” The latter, the subject of the court’s decision, is a simple one-page, nine-paragraph document signed by authorized representatives of both sides. It provides for ground lease rent of $100,000 per month with 3 percent annual bumps; a 10-year “put” option for First National at a 9 percent capitalization rate; a “call” option for Federal Realty at the end of 10 years at a 9 percent cap rate; an option for First National to lease up to 5,000 square feet of office space at $4 per square foot per month; reimbursement to First National of $75,000 to buy out the current tenant; payment of First National’s moving expenses by Federal Realty, not to exceed $25,000; and indicates an effective date for vacating the premises.

The document also indicates that Federal Realty will “prepare a legal agreement for First National’s review to finalize the agreement” and provides that “the above terms are hereby accepted by the parties subject only to approval of the terms and conditions of a formal agreement.”

Instrumental in the court’s decision is that the initial proposals included Federal Realty’s standard non-binding clause — presumably language one would see in a typical non-binding letter of intent — but in the Final Proposal, the non-binding clause was intentionally omitted. There was testimony that the president/CEO of Federal was not happy when he learned that the proposal drafts were not enforceable, so he removed the non-binding clause to ensure that, “there was no way either party…could change any of the major points in the agreement.”

After the Final Proposal was signed, the parties were unable to reach agreement on terms for the formal agreement. But while negotiations were ongoing, First National gave its tenant a notice to vacate, then asked Federal Realty to reimburse it for the resulting loss in rent. The real estate market subsequently collapsed, the parties could not reach an agreement, and First National sued Federal for damages as a result of the buyer’s anticipatory breach of the Final Proposal.

The court acknowledged that an “agreement to agree” is not a binding contract, but went on to say that the intention of the parties primarily determines whether a writing is a final agreement or an unenforceable agreement to make an agreement. The court examined extrinsic evidence to determine the parties’ intent, found that an enforceable agreement was created, and upheld the lower court’s award of $15.9 million in damages to First National for lost rent and loss of its put option under the Final Proposal. In its ruling, the court noted the importance for parties in the midst of protracted negotiations to be able to rely on the enforceability of interim agreements.

The court also rejected Federal Realty’s argument that the Final Proposal is not enforceable because it was missing an essential provision in any lease agreement — the duration of the lease term. They concluded that a 10-year lease term was implied, even though during the negotiations for a final lease agreement, Federal suggested a term of 34 years and First National called for 50 years.

Considering the importance of this decision, the International Council of Shopping Centers, National Association of Real Estate Investment Trusts, Building Owners and Managers Association International, National Multi Housing Council, National Apartment Association, Real Estate Roundtable, and American Hotel and Lodging Association filed a joint brief of Amici Curiae supporting Federal Realty.

The associations' concerns are certainly valid. Indeed, their brief argued that by giving binding effect to a preliminary document lacking many elements commonly found in final contracts in the real estate industry, the court will discourage parties from entering into preliminary documents that the industry finds useful in negotiating transactions. The brief also contended that such action will create “unexpected and unintended obligations in an industry where the near universal practice requires that final and binding transactions be documented by detailed and comprehensive agreements that unmistakably evidence the intent of the parties to be bound.”

In the wake of this ruling, real estate companies — especially those doing deals in the Ninth Circuit — are advised to take additional precautions to ensure that preliminary documents at the letter of intent stage remain just that: preliminary expressions of an intent to agree. In the final analysis, one should never remove non-binding language without being prepared to live with the consequences of effectively creating an enforceable binding agreement.

A.L. Braun is a Richmond, Virginia-based partner in LeClairRyan and co-chair of the national law firm's Commercial Leasing practice.

©2010 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.