UK: Heads Of Terms - Key Issues To Consider

Last Updated: 6 May 2009
Article by Tom Coulson

Your commercial negotiations have reached a certain stage. You now wish to record the main points and the basis on which you agree to proceed with the transaction in the form of Heads of Terms (also known as heads of agreement, memoranda of understanding, term sheets or letters of intent). The Heads will only deal with commercial, and not legal issues, and therefore you don't need to involve the lawyers ... right?

Unfortunately not. Regrettably, it is relatively common for parties to enter into Heads of Terms without professional advice. Care should be taken when adopting this approach – a document recording the principal terms of a commercial transaction may create a legally binding contract despite your understanding that you had only signed a non-binding document. This article sets out some key issues to consider before signing off on any Heads of Terms.

Advantages Of Heads Of Terms

Many parties are of the view that the time involved in producing Heads of Terms could be more usefully employed in drafting and negotiating the commercial agreement. So why bother? It is true that if negotiation of the Heads stalls over points of unnecessary detail, this will delay preparation of the final contract and increase the length and cost of the negotiations. However where time spent negotiating the Heads is confined to discussing the commercial deal in principle, the Heads can become a useful commercial tool and may well prove to save time and costs in the long run. For instance:

  • Drawing up the document will serve to focus the minds of the parties and establish whether there is a sufficient measure of agreement to make the whole process worthwhile. Should the Heads highlight a major issue at an early stage, this would prevent you wasting time and money on further negotiations if that issue cannot be resolved.
  • By putting the basic terms into written form at an early stage, the parties have made clear their general intentions and entered into a 'moral' commitment to observe the terms agreed. It is certainly harder for the one party to back out on earlier commitments where these have been recorded in writing. Again the Heads provide you with comfort that the whole exercise will not prove to be a waste of time and expense.
  • Heads of Terms often contain clauses that are intended to be legally binding. These are important at the negotiating stage in order to provide comfort to a party who is in a sensitive commercial position. For example the Heads may contain confidentiality obligations, or may specify an exclusivity period during which the parties may not negotiate with third parties. The party relying on such provisions will want to ensure that these provisions are legally enforceable, and the Heads will allow this party to proceed with more confidence with these legally binding provisions in place.
  • Draft Heads of Terms can also provide a useful tool in instructing external advisers. Given that the Heads should set out the key terms of the proposed deal, advisers can be quickly brought up to speed on the transaction and perhaps highlight issues that have not previously been considered.
  • Heads of Terms can also provide the basis for submissions for tax clearance applications or guidance from competition authorities, thereby saving time in the process of finalising a deal later down the line.

Heads of Terms can therefore provide a very useful stepping stone on the way to completing your formal agreement. It is important to keep in mind however that, in general, the Heads should only relate to the important deal points. Discussions over the finer detail should be reserved for later on in the negotiations.

Legally Binding?

One of the main considerations to think about before drawing up your Heads is – are the terms going to be legally binding? In the majority of cases, the parties will not want the Heads to be legally binding. For example, in the case of an acquisition, the signing of the Heads will usually precede the formal due diligence on the target, which may prompt the proposed buyer to withdraw or renegotiate the transaction. The buyer will not want to be fully committed at this stage. Unfortunately normal practice is therefore to mark the document 'subject to contract'. Beware! This may lead to problems down the line.

Whilst Heads of Terms are generally not intended to be legally binding, they can create a legally binding agreement even when this is not the parties' intention. Whether your particular Heads are legally binding will depend on all the circumstances of the transaction, including the conduct of both parties. However by merely relying on the words 'subject to contract' you may be treading a dangerous path. Rather than simply including the words 'subject to contract', it is preferable for your Heads to spell out the parties' intention. This can be done by including further wording such as "these heads of terms are not intended to be legally binding between the parties except as specifically set out in this letter." You should also ensure that the language used in your Heads is consistent throughout in expressing that the document is not legally binding.

Particular care must be taken in international transactions. In many European jurisdictions there is a duty to negotiate in good faith and parties can be liable if they withdraw from the negotiations or fail to negotiate in good faith after signing Heads. Local law advice should be taken on international transactions and the Heads drafted accordingly.

Clauses To Consider Making Legally Binding

To ensure that you maximise the commercial benefits of your Heads of Terms, you should give consideration to those clauses which are intended to have legal effect and then identify these provisions clearly. For example, you may want to include legally binding confidentiality provisions, exclusivity/lock-out provisions, non-solicitation of employees or customers provisions or possibly even provision for recovery of 'failure' costs. These terms must be clearly identified.

Particular care should be taken in relation to exclusivity provisions. On an acquisition, a buyer may be reluctant to spend the time and money necessary to undertake a full investigation into the target's affairs unless he is granted an exclusive right for a certain period. Such a clause is enforceable provided that it is sufficiently certain. This means that your clause must be drafted as a 'lock out' provision – by excluding either one or both of the parties from seeking or entertaining approaches from third parties for a fixed and certain period. An agreement not to negotiate with third parties for a 'reasonable period' will not be enforceable. Furthermore your clause must not be expressed as a 'lock-in' provision (where you expressly agree to negotiate with each other). This is unenforceable because it is an 'agreement to agree' and therefore lacks certainty.

An agreement not to negotiate with a third party must also be supported by consideration. Where the exclusivity provision is one of the binding provisions of the Heads and these Heads impose confidentiality or other obligations on the buyer, the issue of consideration should normally be covered. However if in doubt, the prospective buyer could pay a nominal sum for the exclusivity agreement or the Heads could refer to the consideration given by the buyer in the form of costs incurred and time spent on due diligence and negotiations.

Summary

Heads of Terms have a number of advantages and can be a useful commercial tool. However they should always be drafted very carefully and in particular the Heads must make clear which provisions are intended to be legally binding.

Whilst it is tempting to sign up to the key terms of the transactions before you hand it over to the lawyers to start the detailed drafting, it may be advisable to have a lawyer review before signing off on any Heads.

www.lg-legal.com

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.

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