CONTRACTS: HEADS OF TERMS

(A) WHAT ARE HEADS OF TERMS? The Heads of Terms are a document that sets out what the parties have agreed ‘in principle’ before the full details of the deal are known. This type of pre-contractual document has several other names, including ‘Heads of Agreement’, ‘Terms Sheet’, ‘Letter of Intent’ or ‘Memorandum of Understanding’. They are all broadly the same thing and can vary from being a basic ‘skeleton agreement’ to a detailed and lengthy document. Lawyers use them as a formal, written record of what has been agreed to date, as a timetable for future negotiations and, perhaps, as a vehicle for any binding obligations that are necessary early on, for example, as a quick means of keeping certain information confidential before a Non-Disclosure Agreement is drawn up. Current drafting advice is to state clearly within the document whether the parties intend for it to be legally binding. Without a statement that the parties intend to be legally bound by the Heads of Terms, the document will not normally compel the parties to enter into a contract on the terms it contains or even at all. It is possible to make only certain parts of the Heads of Terms binding upon the parties, for example, the sections on confidentiality, while the other sections carry no legal force; however, this must be stated.

(B) THE EFFECT OF THE WORDS ‘SUBJECT TO CONTRACT’ Below is the first section of the Heads of Terms between the owner of an office building and a potential renter. It would typically state the amount of the rent, the term, what the building can and cannot be used for, who will be liable for repairs, rights of sub-letting and other major points that should be considered early in the negotiation process. These general points of agreement can later be developed into a full contract. In the following example the parties have been careful to state that these Heads of Terms are not binding but are ‘subject to’ a final contract:

“These Heads of Terms set out the main terms and pre-conditions upon which Logan & Smith Recruitment Ltd (Tenant) is willing, in principle, to lease the Target Property the Mantel Building (Property) from Marsden Estates plc, (Landlord) subject to the agreement and signature by the parties of a legally binding commercial lease agreement. These Heads of Terms are not exhaustive nor are they intended to be legally binding between the Tenant and the Landlord, except where specifically provided to the contrary herein.”

However, this ‘subject to contract’ statement has not always had the intended effect. In the case of RTS Flexible Systems Limited v Molkerei Alois Müller GmbH (2010), the court found that where Heads of Terms are negotiated subject to contract and work begins before the final contract is executed, it depends on the circumstances as to whether the parties have in fact waived the subject to contract term by means of their conduct. In this case, the UK Supreme Court held that a valid contract had been formed by the Heads of Terms and subsequent conduct of the parties, despite the ‘subject to contract’ stipulation.

(C) AN EXTRACT FROM THE JUDGMENT 45. Whether there is a binding contract (1) ….. the parties and, if so, (2) ….. what terms, depends upon what they have agreed. It depends not upon their subjective state of mind, but upon a consideration of what was communicated between them (3) ….. words or conduct, and whether that leads objectively to a conclusion that they intended to create legal relations and had agreed upon all the terms, which they regarded, or the law requires (4) ….. essential, for the formation (5) ….. legally binding relations. Even if certain terms of economic or other significance to the parties have not been finalised, an objective appraisal of their words and conduct may lead to the conclusion that they did not intend agreement of such terms to be a pre-condition to a concluded and legally binding agreement.

46. The problems that have arisen in this case are not uncommon and arise (6) ….. of the parties agreeing that the work should proceed (7) ….. the formal written contract was executed in accordance with the parties’ common understanding. The first concerns the effect of the parties’ understanding that the contract would “not become effective (8) ….. each party has executed a counterpart and exchanged it (9) ….. the other” – which never occurred. Is that fatal to a conclusion that the work done was covered by a contract? The second frequently arises in such circumstances and is this: Leaving aside the implications of the parties’ failure to execute and exchange any agreement (10) ….. written form, were the parties agreed upon all the terms which they objectively regarded or the law required as essential for the formation of legally binding relations?