Heads of Terms – morally or legally binding?

Heads of terms (or ‘heads’, letters of intent, memoranda of understanding, heads of agreement and term sheets, to name but a few), all serve the same purpose in that they set out the key commercial terms or principles that have been agreed between parties and set a precursor to more in depth negotiations of a much larger contract, perhaps a company acquisition, a loan, a supply arrangement or a services contract. There are many advantages to having heads of terms:

• help remove any misunderstandings;
• save time in negotiations;
• allow parties to assess whether it is worthwhile entering into more formal negotiations before incurring significant management time and professional costs;
• they may be needed for reference by a third party such as a board of directors, professional advisors or a regulatory body; and
• they act as useful guidance in terms of timescales.

Whilst they serve a useful purpose, parties to these types of document should use them and proceed with caution. They also have many disadvantages if not used in the correct circumstances and can sometimes unintentionally tie the hands of a party in a way that was not anticipated.

It is not always necessary to enter into heads of terms, this could be because the nature of the contract or transaction simply does not warrant it (for example, the transaction is simple) or there simply isn’t sufficient time and parties could run the risk of agreeing the same set of terms twice. Their use should be considered and proportionate.

In this update we briefly set out some of the key considerations before entering into a set of heads of terms.

Legally binding?

Typically, heads of terms are not regarded as ‘legally binding’ and they usually state as much, save for perhaps some express provisions. Parties are therefore relying on a moral obligation to commit to an ongoing relationship on the ‘agreed’ terms. This moral commitment is not strictly legally binding but is generally regarded as more difficult to renege on as it evidences a party’s intentions, but that’s not to say that circumstances cannot change. A reputation can be made if your way of doing business is to constantly move away from previously agreed heads of terms without good reason.

However, it often suits both parties to have some clauses which carry legal force, such as confidentiality (if you do not want the nature of the transaction or arrangement made public) or exclusivity (if you do not want a party speaking with other third parties whilst you spend time and money in your own negotiating process).

However, it is not always clear cut. For example, what if the document is silent on whether or not it is legally binding? There could be issues if the parties intend certain elements (or all) of the terms to be binding, but they are not. Or what starts out as a non-binding agreement could, by accident or even design by one party, create unintended legally binding obligations.

It is therefore fundamental that heads of terms clearly represent the intentions of the parties and expressly state what is and is not legally binding. Vague language helps neither party and is best avoided.

If they are not legally binding, do I need legal advice?

Parties can often negotiate a set of heads of terms themselves which can be risky as they may not have given full consideration to wider legal or commercial issues that advisers can often see. It can lead to ambiguities which can in turn lead to problems down the line and there can be confusion as to whether the heads of terms are, or were intended to be, legally binding. If you do not engage your solicitor to draft and negotiate, or at the very least review your heads of terms, you could end up accepting some unintended consequences.

Care should also be taken when heads of terms are being negotiated with a party based outside England and Wales. Legal terms and concepts often vary greatly depending on the jurisdiction and therefore a party could inadvertently create or be subject to obligations that they had not intended. The heads should also state which law applies and appropriate advice should be considered from a lawyer in the relevant jurisdiction.

Reliance

Sometimes negotiations take longer than expected and the need to start work before a contract is entered into becomes imperative. For example, there could be a larger project whereby failure to start works could result in financial penalties for one party.

Heads of terms may be an appropriate starting point here and depending on subsequent actions of and correspondence between the parties may be enforceable, but they will inherently lack detail and are therefore unlikely to be sufficient. Recent case law has also shown that the courts will, if appropriate, enforce the terms of a letter of intent in the absence of a full contract. Therefore, to avoid any unintended or uncertain positions, ideally the main contract should always be entered into before any work is under that contract. If that isn’t commercially feasible then the parties should proceed with caution and take appropriate legal advice.

Summary

Heads of terms can be useful tools on large transactions saving time and money if used effectively. If not they can lead to unintended consequences with parties being subject to terms they did not want (or no terms at all!) and being exposed from a liability perspective. Any heads of terms should:

• State which elements are legally binding and more importantly which are not;
• Be clear in content;
• Be reviewed by appropriate legal (and other) advisors;
• Cover the key principles of the proposed contract;
• Contain any appropriate conditions (e.g. third party approval or due diligence); and
• Contain any assumptions made by a party when agreeing to the terms.

If you would like further advice, please contact Jamie Gill on 01543 431185 or email him at jgill@ansons.law