A heads of agreement records the terms that have been agreed in principle. It is not a contract, except when it is.
In commercial negotiations, parties frequently reach a point where the essential terms have been agreed but the formal documents are not yet ready to be signed. The heads of agreement, sometimes called a memorandum of understanding, term sheet, or letter of intent, is the document produced at that point to record the position.
The heads of agreement serves a useful function. It confirms that the parties are aligned on the key terms, provides a basis for preparing the formal documents, and can help each party obtain internal approvals or financing on the basis of what has been agreed. It can also be useful if the negotiations subsequently break down and there is a dispute about what was agreed and when.
The binding and non-binding question
The central legal question raised by any heads of agreement is which provisions, if any, are legally binding.
Many heads of agreement include a general statement that the document is not legally binding. This is often not an accurate description of the document's legal effect. Australian courts have found that certain provisions of a heads of agreement, including confidentiality obligations, exclusivity arrangements, dispute resolution clauses, and obligations to negotiate in good faith, can be binding even where the document states that it is not.
The reason is that whether a provision is enforceable depends on whether it satisfies the requirements for a binding contract: offer, acceptance, consideration, certainty of terms, and intention to create legal relations.
A provision that meets these requirements may be binding regardless of how the document labels itself.
Negotiating in good faith
Australian law does not recognise a general duty to negotiate in good faith. There is no implied obligation, in most commercial negotiations, to continue negotiating, to negotiate honestly, or to refrain from negotiating with competing parties.
The law in this area continues to develop, and the position is not straightforward.
However, parties can and do include express obligations to negotiate in good faith in heads of agreement, and in some cases courts have enforced such obligations. Where such an obligation is included, parties should understand what it requires of them, and what the consequences of breach might be.
The more common and more enforceable mechanism for protecting a negotiating position is an exclusivity clause: an obligation on one party (typically the vendor or licensor) not to negotiate with third parties for a defined period.
These clauses can be drafted to be clearly binding, and they provide more reliable protection than a vague good faith obligation.
What happens when the formal documents are not completed
A common situation is where parties execute a heads of agreement, begin due diligence or preparation of formal documents, and then the transaction does not proceed.
The question that arises is what, if anything, each party owes the other.
If the heads of agreement contains binding provisions on matters like confidentiality, exclusivity, or costs, those remain enforceable. If there are no binding provisions, there is generally no liability for deciding not to proceed, even if one party has incurred significant expense in reliance on the anticipated transaction.
This is a harsh result, and it is one that can sometimes be avoided with careful drafting. Parties who invest substantial resources in preparing for a transaction on the basis of a heads of agreement should consider whether the document adequately protects them if the other party withdraws.
When a heads of agreement becomes the contract
In some cases, a heads of agreement that was intended to be non-binding turns out to be legally enforceable as the final contract.
This occurs where the document contains sufficiently certain terms to constitute a concluded agreement, and where the conduct of the parties is consistent with the existence of a binding contract.
The fact that the parties intended to execute a further, more formal agreement does not necessarily prevent the heads of agreement from being enforceable.
Australian courts have on several occasions found that a contract was formed at the heads of agreement stage, even though formal documents were subsequently prepared and not executed.
The risk of unintended binding effect is a reason to draft heads of agreement with care, and to obtain legal advice before executing them, not only before executing the formal documents.