Canada: Negotiating The Deal: Letters Of Intent vs. Agreements Of Purchase And Sale

Our clients deserve exemplary service that is both cost-effective and time-efficient. Accordingly, when negotiating commercial real estate deals, a question arises as to whether our client's aforementioned interests are best served by initiating the transaction through a letter of intent (an "LOI") or proceeding directly to drafting an Agreement of Purchase and Sale (an "APS").

On the one hand, an LOI prolongs the negotiation process as it requires the creation of a preliminary document that will eventually be replaced by a more comprehensive and definitive APS anyway, and such LOI preparation requires billable hours. On the other hand, especially when there are complex business and legal issues at play that are not easily resolvable, the process of drafting a short LOI can force the parties to confront the fact they will be unable to reach a "meeting of the minds" before time and money is spent on creating a lengthier APS.

How, then, can we determine the best route by which to proceed? The following analysis seeks to answer that question, explain the general nature of LOI's, and discuss the typical factors that courts interpret to determine whether an LOI is binding or non-binding on the parties.

What is an LOI, and What Types of Provisions does it Typically Incorporate?

This preliminary document goes by many names. While it has been variously described as a memorandum of understanding, a term sheet, or heads of agreement, it shall be referred to as an LOI for the purposes of this analysis. Ultimately, by setting out the key terms of a deal, an LOI signifies a willingness of the parties to commit to a proposed transaction, and it documents in writing that negotiations are officially underway.

An LOI can also take many forms. For example, it can be binding, non-binding, or it can take the shape of a hybrid. Oftentimes, LOI's conform to this latter structure through incorporating both binding and non-binding elements depending on what types of provisions are being included.

At the pre-contractual stage, parties typically agree to binding non-disclosure and access provisions, with the words "private and confidential" sometimes appearing stamped on the first page of an LOI or other documents. Such clauses are included to give the purchaser a meaningful opportunity to conduct due diligence in order to make an informed decision about entering into a transaction, while simultaneously protecting the vendor from the harmful effects of inadvertent or purposeful disclosure. For example, in order to prevent the disruption of one's daily business operations, one may want to restrict the purchaser's ability during site visits to disclose news of an upcoming sale to the vendor's employees, especially if the deal is not yet firm or the vendor has not yet had an opportunity to inform his staff. Alternatively, if the buyer is a direct business competitor of the vendor, it may be in the vendor's best interests at the LOI stage to insist that disclosure of sensitive financial and customer information can only occur upon the signing of a definitive APS.

A related, typically binding provision is an exclusivity clause, whereby the vendor agrees not to market the property to any other party as long as the LOI is in full force and effect. Sometimes referred to as a "no-shop" clause, a purchaser will desire its inclusion so that they can feel comfortable spending their time and money on due diligence, without having to fear that the vendor is "shopping the deal" around and looking for a better offer. Other binding provisions may be related to who shall pay for as well as own the work product of third party consultants with respect to their environmental audits, building inspection reports, surveys, appraisal reports, and other due diligence documents that they have created.

Another important function of the LOI is to provide a "roadmap" to the deal that sets out the timeframe by which the next steps of the transaction must be completed. For example, this may relate to the timing of due diligence deliveries, the timing of drafting and executing the APS, or the timing of delivering deposits to be held in a lawyer's trust account pending the closing of a transaction. In this way, mutual expectations are set and the parties have an understanding of what is required of one another at any given time. This is particularly essential in instances where three or more parties are involved in a transaction, as the guiding nature of the LOI can help to get everyone "on the same page".

What Are the Factors Involved with Choosing an LOI Route or a Direct-to-APS Route?

Firstly, one must consider whether the LOI is binding or non-binding overall. For instance, as previously described, if the only binding provisions relate to confidentiality, non-disclosure, access, and exclusivity, use of an otherwise non-binding LOI may enhance the balancing of the purchaser's and vendor's respective interests during the due diligence period. At the same time, the process of preparing a shorter LOI could help narrow complex issues at the outset of a transaction without having to get bogged down in the details of a lengthier APS. In this way, the initial momentum motivating the deal is maintained, the parties can determine if they will likely reach a "meeting of the minds", and the parties become committed to the proposed transaction without imposing all of the binding obligations and liabilities of a full APS on them.

However, if the LOI is binding overall, then it is better to proceed directly to the APS during the negotiation process. When later drafting the definitive APS, opposing counsel will invariably argue against the inclusion of any terms and conditions not present in the original binding LOI, usually on the basis that such issues cannot be raised at this later stage. Instead, they will likely insist that these new points of contention were never part of the initial bargain. In such a scenario, it would have been better to simply go directly to the APS and ensure that all terms, conditions, representations, warranties, covenants, indemnities, and other desired provisions had been included in the contract at the outset. Furthermore, if the binding LOI used mandatory contract language such as "shall" and had a clearly contrary position on an issue, then it will be quite difficult to change that position in the final form of the APS.

The recent case of Hurst Real Estate Service Inc v Great Lands Corporation[1] provides an example of how one might be unable to change such a contrary position. In that case, a realtor sued his former client – the vendor of a $10.8 million property – for unpaid commission.[2] Although the realtor introduced the vendor to the purchaser and facilitated the transaction, one of the vendor's arguments was that the final APS had a clause stating that neither party had engaged the services of any realtor in connection with the transaction.[3] The court noted that the vendor previously signed an LOI indicating that "[t]he Vendor shall be solely responsible for the payment of any brokerage commissions associated with the sale of the Property", stated that the vendor's alteration of this clause in the APS was a "breach of promise", and held that the vendor was not honestly performing his contractual obligations in good faith.[4] The use of the word "shall" in the LOI clause clearly did not assist the vendor in making his argument.

Other considerations to keep in mind are how quickly the parties want to close, the level of sophistication of the parties, and the degree to which the parties are acquainted with one another. As previously mentioned, the LOI can lengthen and potentially drag out the negotiation process as it involves the extra step of creating a preliminary document, which may not even be necessary if the transaction is fairly simple and straightforward. If the deal only involves one property being sold on an "as is, where is" basis, does not involve the selling of an associated business, the purchase price has been more or less settled, and only conventional adjustments and boilerplate clauses have been included, then complexity is not at issue and it is likely better to proceed directly to the APS to save time and money. Moreover, if the parties are also sophisticated and know each other well, then proceeding directly to the APS appears to be an even more attractive route. Conversely, if the parties are less sophisticated and not well-acquainted with one another, then the guiding nature of a shorter LOI may demystify the seeming complexity of the transaction as well as the apparent mysteriousness of the opposing party.

How Have the Courts Ruled with Respect to Whether LOI's are Binding or Non-Binding?

The case of Wallace v Allen[5] demonstrates that the courts will look to the language of the LOI and the conduct of the parties in determining whether said LOI is binding or non-binding. In that case, the purchaser was a friend and neighbour of the vendor at the time they began negotiating.[6] An LOI was signed on September 24, 2004 which all parties agreed contained "all of the terms they considered necessary or essential to the transaction", with a more complex Share Purchase Agreement intended to be signed on December 29, 2004.[7] About two weeks after signing the LOI, the vendor held a special employee meeting where he announced his retirement, before ultimately introducing the purchaser to the staff and indicating he had sold the business to him.[8] Also, during this 3-month period, the purchaser began attending the business premises daily in order to learn the business, and instituted efforts to get his two sons involved in the business.[9] However, a week before signing the Share Purchase Agreement, the purchaser went to Florida with his family.[10] When he did not return by the closing date, the vendor refused to close the transaction.[11]

In making their decision, the court relied on the following language from the APS:

"IT IS ALSO AGREED BY THE PARTIES THAT THERE WILL BE MUCH LEGAL WORK TO BE DONE UPON ACCEPTANCE BY BOTH SIDES AND THAT THE WORDING OF THIS AGREEMENT MAY ALTER SOMEWHAT and...THIS LETTER OF INTENT MUST BE REDUCED INTO A BINDING AGREEMENT OF PURCHASE OF SALE BY THE PARTIES WITHIN THE NEXT 40 DAYS" [emphasis in original].[12]

Combined with the parties' aforementioned admission that all essential terms were agreed upon in the LOI, the court found that the use of the phrases "it is agreed", "upon acceptance", and "this agreement" indicated an intention to be bound by signing the LOI, especially since the "parties used the language of contract".[13] It was further decided that the conduct of the parties – namely, the purchaser attending the business premises daily, involving his two sons, and the vendor's announcement at the special employee meeting – indicated that the parties considered themselves bound by the LOI.[14]

Similar to the Hurst case where the word "shall" was used in the LOI, the courts considered the use of contractual language a key indicator in Wallace. Accordingly, if choosing to proceed via the LOI route rather than going directly to the APS, care should be taken when drafting to avoid similarly mandatory words such as "must" or "will" in favour of more permissive language such as "may" or "would". In the same vein, words such as "proposed transaction" should be used in place of "agreement". Lastly, language such as using "best efforts" or negotiating in "good faith" should be avoided altogether due to the way such phrases could be construed, so as not to unintentionally create a valid contract with a good faith duty to complete the transaction.

In Hurst, which was decided in 2018, it was recognized that the vendor did not act in good faith or honestly perform his contractual obligations. The case cited the Supreme Court of Canada's 2014 landmark decision of Bhasin v Hrynew[15], which stated that:

"It is appropriate to recognize a new common law duty that applies to all contracts as a manifestation of the general organizing principle of good faith: a duty of honest performance, which requires the parties to be honest with each other in relation to the performance of their contractual obligations".[16]

While the Supreme Court was notably silent about the issue of whether this duty of honest performance applied to pre-contractual negotiations in addition to contractual obligations, it should be noted that the previously decided 2011 case of Carttera Management Inc v. Palm Holdings Canada Inc[17] briefly touched on a similar issue as well. Carttera involved an LOI signed regarding the purchase of a Toronto Hotel, which required the parties to "proceed in good faith to negotiate and finalize the terms of the [APS]".[18] However, before closing, the vendor attempted to terminate negotiations with the purchaser, as he received information he could potentially get a better offer.[19] It is important to note the LOI included the following provision:

"14. Non-Binding: Except for Paragraphs 12 (Confidentiality) and 13 (No Solicitation) hereof, this letter shall only constitute a letter of understanding and is not contractual in nature and shall not bind any party hereto or create any legal or other obligations relating to the Property or otherwise. No binding agreement of purchase and sale of the Property shall exist between the parties unless and until the parties are satisfied, in the respective sole and absolute discretion, with all of the terms and conditions of the Agreement and such Agreement has been executed" [emphasis in original].[20]

Despite the presence of this provision, the judge still determined it was a triable issue as to whether there was sufficient evidence to establish the existence of a signed APS.[21] In this regard, the court seemed to agree with the purchaser's position that an APS could have been settled through e-mail communications between the parties, and stated that:

"Whether on a complete determination on the facts there is sufficient evidence in written form signed in some fashion by e-mail or correspondence that would be held to comply with the Statute of Frauds remains to be seen".[22]

This was the position taken despite the fact that the Statute of Frauds requires agreements for land to be in writing and signed by the parties, and the e-mail communications in the instant case all included a boilerplate statement in the signature line indicating that this "transmission was not a digital or electronic signature and could not be used to form a contract".[23]

Unfortunately, there does not appear to be any further decision in Carttera other than a motion to remove a solicitor of record,[24] and the case was presumably settled out of court. However, it does highlight once more that the conduct of the parties will be very important in determining whether an LOI is binding or non-binding,[25] perhaps even more so than the court's interpretation of contractual language. Just as Wallace showed that parties should avoid making premature announcements to their employees about selling their business and who the new owner will be, Carttera shows that e-mails should be written with care and should not suggest that the terms and conditions of an LOI are potentially legally binding. Moreover, even disclaimers in signature lines of e-mails apparently will not provide parties with a saving grace. Indeed, it appears that if parties do not wish to be potentially bound by an LOI, they would serve themselves best by acting as if a binding agreement does not exist at all.

Conclusion

Ultimately, when in the pre-contractual negotiation phase, the question of whether it is best to proceed by engaging in the LOI process or going straight to drafting an APS will involve a case-specific answer that involves weighing multiple factors. One will want to consider the level of sophistication of the parties, the extent to which the parties are acquainted with one another, if there are three or more parties involved, the complexity of the legal and business issues involved, and the extent to which the parties desire for the LOI to be binding or non-binding.

In most cases, an LOI is most helpful and an appropriate document if it is intended to be non-binding overall, with some binding provisions included related to confidentiality, non-disclosure, access, and exclusivity in order to assist the pre-contractual negotiation process. However, as case law demonstrates, great care must be taken when drafting non-binding LOIs to ensure permissive language such as "may" or "would" is used instead of mandatory language such as "must", "will", or "shall". Contractual language such as "it is agreed", "upon acceptance", or "this agreement" should certainly be avoided in such scenarios. Indeed, it may be prudent to specify a deadline for the end of negotiations if a definitive APS is not reached.

Parties must also be very careful with their conduct during pre-contractual negotiations, as the courts will look carefully at public announcements, e-mail correspondence, and perhaps even if parties are acting in "good faith" when determining if an LOI is binding or non-binding. If the Supreme Court's Bhasin decision is expanded to apply to pre-contractual negotiations, it will be particularly important for parties to conduct themselves appropriately. After all, it is possible that parties will become legally prohibited from deceiving or misleading others when bargaining and instead obligated to be cooperative and forthright during the negotiation process, depending on how the duty of honest performance is interpreted by the courts in future.

Footnotes

[1] 2018 ONSC 4824 [Hurst].

[2] Ibid at para 1-5.

[3] Ibid at para 56.

[4] Ibid.

[5] 2009 ONCA 36, 93 OR (3d) 723 [Wallace].

[6] Ibid at para 1.

[7] Ibid at para 13, 21.

[8] Ibid at para 17.

[9] Ibid at para 16, 33.

[10] Ibid at para 16.

[11] Ibid at para 23.

[12] Ibid at para 27.

[13] Ibid at para 29-30.

[14] Ibid at para 32.

[15] 2014 SCC 71, 3 SCR 494 [Bhasin].

[16] Ibid at para 93.

[17] 2011 ONSC 4573 [Carttera].

[18] Ibid at para 2.

[19] Ibid at para 1, 17.

[20] Ibid at para 2.

[21] Ibid at para 13.

[22] Ibid.

[23] Ibid at para 12.

[24] Carterra Management Inc v Palm Holdings Canada Inc, 2011 ONSC 7087.

[25] Ibid at para 2.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.