Businesses often enter into ‘heads of agreement’, ‘letters of intent’, or a ‘memorandum of understanding’ in the course of negotiating a deal, often without input from a lawyer. So which of these are binding, and which aren’t?
The answer is: none of them, and all of them. That is, these titles are just different names given to a form of ‘preliminary agreement’, and the name of the document has no bearing on whether all or only some of the terms are binding.
When it comes down to it, there are two things that matter in deciding whether your preliminary agreement is a contract that is binding:
- Will it be constructed in such a way that makes it a legally binding contract?
- Did you and the other parties intend to be bound by the preliminary agreement?
With these two things in mind, we explain what you need to consider when preparing a preliminary agreement.
1. Intention to be bound
Your preliminary agreement should contain a clear statement as to whether or not you and the other parties intend to be legally bound by its terms. This is the simplest way to let the world (and the court) know what you intended. But unfortunately, this alone will not be enough to make the document binding, (or not).
2. The Essential Terms
If you want your preliminary agreement to be binding, then all the ‘essential terms’ of your deal must be clearly set out in the document, such as:
- Who is a party to the agreement;
- The object of the agreement, e.g. a description of the assets or services proposed to be sold or provided;
- The consideration passing between the parties, e.g. the amount to be paid, or a formula for determining the amount to be paid;
- Any conditions precedent or subsequent to the agreement coming into effect; and
- The time frame for completion, or the term of the agreement.
Of course, each transaction will have its own ‘essential terms’, either in addition to or instead of the above.
3. Agreement to Negotiate
This is perhaps the most difficult aspect of preliminary agreements – and ties in with the requirement to set out all the ‘essential terms’. The general rule is that an ‘agreement to agree’ is not enforceable. But you may nevertheless wish to make your preliminary agreement binding, while still leaving some of the details to be worked out at a later date.
If you intend to negotiate a formal document to replace your preliminary agreement, then you should include a mechanism to resolve any dispute about the remaining terms, such as an agreement to mediate. This will provide some certainty as to the detailed terms, i.e. even if all the parties cannot agree, a third party can determine the terms on some objective basis.
If a clear mechanism to fill in the gaps is not included, then a court may find your preliminary agreement is not binding because there is no way to establish certainty of the intended terms.
4. Termination Clause
In most cases it will be appropriate to include a mechanism to terminate the agreement or dealing. This may be a simple ‘drop dead’ date, at which point in time the parties can start again, or a mechanism for termination based on the conduct of one or more of the parties. The key thing is not to lock yourself into a preliminary agreement – that may unnecessarily lock you out of other dealings for an indefinite period. As with all business transactions, think carefully about your ‘exit’ from the outset.
5. Confidentiality Clause
We also recommend that a confidentiality clause is included, particularly if there is sensitive information that may flow between the parties before concluding a more formal agreement, or completion (i.e. during due diligence in a business sale).
If the preliminary agreement as a whole is not intended to be binding, then it is still possible to nominate certain clauses that are binding on the parties. The confidentiality clause should be one of these specific binding clauses. Another clause you may wish to include as binding is who is to meet the costs of preparing the agreement.
If the preliminary agreement is not intended to be binding, then it is best to avoid using words that sound like they are binding such as “agrees”, “promises to”, “must”, “contract”, “agreement” or “this is an offer capable of acceptance”. Instead, words like “proposes” or “understands” should be used.
7. Statements and acts to encourage reliance
Finally, if you do not intend to be bound, then you must be careful of any statements or representations that might create an expectation or encourage reliance by the other party. This will protect you from potential legal action from the other party, if they have relied on the preliminary agreement to their detriment.
How we can help you
It is important to have a full understanding of the power of a preliminary agreement, and the relationship that it can create between you and other parties.
If you are contemplating entering into a business arrangement using a preliminary agreement, or already have one in place and would like to progress to a more formal and complete agreement, then call us on 1300 654 590 or email us for assistance.
If you have already signed on the dotted line and are worried about whether you are bound to a Heads of Agreement or other contract, read up about whether you can get out of the contract here.
The information contained in this post is current at the date of editing – 16 February 2024.