Don’t let Heads of Terms bite!

What is the issue?

From the outset of any real estate or development deal, landowners, potential occupiers and/or developers liaise with other parties and professionals to consider options, proposals, issues and potential terms. Various discussions, enquiries and negotiations take place before any formal contract documentation is completed.

‘Heads of terms’, ‘commitment letters’, ‘letters of intent’, ‘heads of agreement’, memoranda of ‘intention to proceed’ and the like, are commonly produced prior to completion of formal contracts. The aim is to cater for circumstances where parties nevertheless wish to carry out works, and start to incur costs.

It is often assumed that pre-contract negotiations are not legally binding. However, if not correctly managed, pre-contractual communications or documents can result in a contract being formed. Parties can become contractually bound to terms, obligations and liabilities to which they might never otherwise agree.

It is therefore essential for landowners, occupiers and developers to understand how terms can become binding. They need to know how to conduct negotiations, and how to exchange pre-contract communications and documents, without inadvertently becoming bound to unacceptable terms.

Why is this case of interest to landowners, occupiers, developers and real estate professionals?

Pretoria Energy v Blankney Estates [1] concerned a costly misunderstanding between a landowner and a prospective tenant.  One party believed that a ‘heads of terms’ document was binding.  The other did not.  A £56.4 million claim ensued.  The case highlights some key takeaways for negotiating parties and their advisers.

What are the key takeaways?

• A legally binding contract is formed when all of the following key elements are present: offer; acceptance; consideration (that is, money or money’s worth); certainty of terms; and intention to create legal relations.

• Contracts can be made orally (face-to-face or via some communication medium such as the telephone), via an exchange of e-mails or other correspondence, or they can arise by conduct.

• The courts specifically acknowledge that business people may record important agreements in a summary way.

• Crucially (with only limited exceptions), contracts can be formed without any written documentation or other formality whatsoever.

• In the same way that contracts can be formed without any formality, so too can they be varied without any formality.

• The label ‘heads of terms’ (or similar) is not conclusive. Heads of terms might be a non-binding record of the principles of a formal agreement yet to be made.  They might equally be a binding contract which governs parties’ relations with legal force until a more detailed agreement is completed.

• Whether a binding contract has come into existence depends upon whether the key contractual elements are present. To determine that, a court will objectively consider what was communicated between the parties by words (oral or written) and conduct.

• Parties often expressly demonstrate that they do not have contractual intention by including the phrase ‘subject to contract’. However, absence of that phrase does not mean that contractual intention is present.

• On the question whether a contract exists, the whole course of dealings between the parties will be considered. Events after the alleged making of the contract can be admissible [2].

• Where terms seem inconsistent with an intention to be contractually bound, that can suggest a contract does not exist.

• It is possible for parties to be contractually bound to some terms even if other terms remain to be agreed.

• Where parties intend to be contractually bound but an agreement is informal or incomplete, the court may imply terms to fill apparent gaps, particularly in dealings between commercial parties.

What practical advice arises?

• Remember that the name of a document is not conclusive. Merely naming a document ‘heads of terms’ (or similar) will not prevent a contract arising.

• In pre-contract communications (whether written or oral) and documents, the phrase ‘subject to contract’ should be used where parties do not intend to be contractually bound.

• However, whilst the ‘subject to contract’ label will definitely assist, it is not fool proof. In any dispute, the main body of the document, the surrounding circumstances of the negotiations and the objective actions of the parties will be considered.

• It is possible for ‘subject to contract’ protection to be lost, and a binding agreement to be formed, if that is what communications and/or conduct actually indicate. A common pitfall is where a party commences work or otherwise begins acting in accordance with the terms of hitherto ‘subject to contract’ pre-contract documentation or correspondence.  The party may, by that conduct, inadvertently waive the requirement for the terms to be formally consigned to a completed contract document.

• If the whole of a document is intended to be non-binding, this should be made clear. For example, parties should make sure that the ‘subject to contract’ label or similar wording is used in the heading of the document and/or repeated on each page.

• If only some sections of a pre-contract document are intended to be legally binding, the document itself and each of its terms should be clear as to which provisions are binding and which are not.

• Landowners, occupiers and developers should review their negotiating practices, any precedent heads of terms, commitment letters (or similar) and any ongoing negotiations. They should clearly record whether any agreement reached is intended to have legal effect, or whether the parties require any such agreement to be formally documented and signed by the parties before it has contractual force.

• Businesses should review, and make sure that their employees understand, the scope of individual staff members’ authority to contract. Where an employer does not want a member of staff to be able to legally bind the business, that should be explained – both to the employee and to any contracting counter-parties.

• It is essential that businesses educate their staff as to the risk of informal or inadvertent contract formation and as to the fact that heads of terms (and similar) may or may not have legal force, depending upon both their terms and the circumstances.

What happened in the particular case?

The claimant prospective tenant had entered into a document entitled ‘Heads of Terms of Proposed Agreement… Subject to Full Planning Approval and appropriate consents and easements’ (the ‘HoT‘) with the defendant landowner. The claimant contended that the HoT was a binding agreement under which the defendant agreed to grant a lease.

The HoT included site, term, rent, and rent review clauses. It provided that the lease would be contracted out of the security of tenure provisions in the Landlord and Tenant Act 1954. The HoT also contained a lockout clause, which prevented the parties from negotiating with other parties until after a certain date.

When the defendant landowner opened up the sale of its land to a competitive process, the claimant alleged breach of contract and sued for £56.4 million. The defendant argued that the HoT was not binding, other than in respect of the lockout clause. The court agreed with the defendant.

The inclusion of the lockout clause was proof that the HoT was not intended to be binding. If the parties could negotiate with others after the lockout period, it could not be that the defendant was already bound to grant a lease to the claimant.

The reference to the 1954 Act contracting out procedure suggested that there was no intention to create a binding agreement for lease via the HoT. The 1954 Act contracting out process must be completed before a tenant becomes contractually bound to take a lease, and the procedure had not yet been followed.

An earlier draft of the HoT had contained a clause saying: “both parties, on signature, agree to be bound by… adherence to all the terms, pricing and conditions of these Heads of Terms until the Final Agreement is accepted and signed.” Removal of that clause evidenced that the parties did not intend to be bound.

Finally, while key lease terms such as rent etc. had been included, the claimant’s prospective use of the site as an anaerobic digestion plant would require bespoke drafting.  The HoT did not, therefore, include agreement of all terms that would be essential for the creation of legally binding relations. This would have undermined the claimant’s ability to establish ‘certainty of terms’, another essential element of a binding legal contract.  However, given the conclusion that there was no intention to create legal relations, there was no need for the court to consider certainty.

How we can help

Pre-contractual communications and negotiations can be a minefield. An understanding of some key contractual principles, as well as an awareness of the practical scenarios in which such risks may arise for any particular business, will be key to getting the balance right between being able to quickly obtain sufficient comfort to enable parties to proceed with their plans, and becoming legally bound only when that is actually required.

If you would like further information or staff training in relation to pre-contract traps and tips, or for advice and assistance if and when any real estate- or development- related contractual dispute does arise, please contact Louise, or Kathryn, who will be very happy to help.

[1] [2022] EWHC 1467 (Ch)

[2] contrast this with the position in a contractual interpretation dispute, where such evidence would not be admissible. See our earlier briefing for more information.