When two or more parties agree in principle to enter into a commercial arrangement, it is best practice to record the headline terms in a document, usually called the “heads of terms”.
The main purpose of the heads of terms is to inform the drafting of and to limit the scope of what needs to be negotiated in the formal contractual documentation, saving time and resources. The principal terms should be recorded in enough detail to ensure that the deal reached between the parties is accurately reflected in the legal documents. However, they are not a substitute for the legal documentation and should not be relied on as such.
What is the legal status of heads of terms, though? Are they binding? What terms are often missed? Can I rely on an argument of good faith? This article aims to address those queries as well as some of the usual misconceptions and pitfalls.
Are heads of terms legally binding?
In most cases, no, even if they are signed. In any event it is almost always preferable for the heads of terms not to be binding as their purpose is to form the basis of an agreement on which formal, binding, legal documentation can subsequently be created. Therefore, heads of terms will often be marked as “subject to contract” which, expresses the intention of the parties not to be legally bound by them.
There is no underlying principle of “good faith” and so parties can agree heads of terms and commence legal drafting and negotiation with either party free to withdraw without liability to the other (save for in unusual circumstances). Parties will therefore not be bound until the formal documentation is agreed and completed.
If there are matters in the heads of terms which the parties do want to be binding, for example an exclusivity period or confidentiality, these should be documented separately, such as in an exclusivity agreement or non-disclosure agreement. Such documents can be drafted to be binding even after a party withdraws from the transaction.
Strike a balance
There are a broad range of matters which may need to be covered, but the contents of each set of heads of terms will depend on the circumstances of the individual property and transaction. A balance needs to be found in covering all the key topics whilst avoiding going into unnecessary amounts of detail. An overly detailed approach should be avoided as this can result in unnecessarily protracted negotiations or a document so long it could be mistaken for the final contract. This might also delay commencement of the underlying legal work and even make it harder to draft and agree the formal documents.
Heads of terms should cover the key commercial and legal terms and practical points such as parties’ agents, solicitors and advisors.
Key terms
Key terms for parties on a freehold sale are likely to include:
- Purchase price
- Property details
- VAT status
- Financing i.e. cash or lender
- Conditionality
- Tenancy details/schedule and treatment of arrears (let property)
Key terms for parties when granting a new lease are likely to include:
- Rent
- Term
- Demise details (internal, whole or part?)
- Rent Free Period or other concession
- Security of Tenure
- Rent review (basis and frequency)
- Permitted Use
- Break dates
- Break conditions (especially important for a tenant to ensure these are clear at this stage)
- Repairing obligations
- Permitted alterations
- Permitted dealings (assignment, underletting, sharing of occupation)
- VAT status
- Tenant fit out works
- Tenant security (guarantor, rent deposit etc.)
Whilst not comprehensive, the above lists include many of the key matters which parties should consider at an early stage.
Summary
Without heads of terms, it is much easier for a party to a deal to dispute what has been agreed in principle once the legal drafting is underway. This can cause delays and sour relations between parties. Having the key terms clearly set out and detailed from the start can limit the potential for misunderstanding or delay. Despite not being legally binding, heads of terms hold a certain moral authority and therefore once agreed, it is more difficult for parties to renege on them or dispute their terms.
The above is by no means a comprehensive summary of the relevant background law and considerations. If you have any questions on the above or require advice in this area, please contact our Real Estate team.
Aidan Welton