Could you be legally bound by negotiations in the absence of a formal contract? What about when a preliminary agreement states that negotiations are ‘subject to contract’?

The answer from the courts is potentially yes – negotiations and preliminary agreements such as letters of intent, heads of agreement and memorandums of understanding can have serious and binding consequences, as well as unintended taxation implications, highlighting the need for these to be drafted by a lawyer to ensure that commercial parties are only legally bound in accordance with their intentions. 

Three generally accepted categories of preliminary agreements exist, although a fourth has recently been considered in greater depth by the courts.

CATEGORY 1

The parties reach final terms and intend their agreement to be binding, on the understanding that a ‘formal contract’ containing a fuller or more precise form of the agreement will be signed later.

Here, the initial agreed terms are binding on both parties, regardless of whether a formal contract comes into existence.

This category of agreement is highlighted by the ongoing litigation between Archer Capital and The Sage Group plc in relation to the British technology company’s withdrawal from the purchase of MYOB in August 2011 after acceptance of their written offer for the company which was stated to be ‘subject to contract.’

CATEGORY 2

Arises where agreement is reached on all terms, but performance of one or more of the terms is conditional on execution of a formal document.

For example, a signed Heads of Agreement may contain some binding terms, such as confidentiality of dealings, however other important terms of that preliminary agreement may binding only on execution of a more formal contract.

CATEGORY 3

The parties only intend to be bound on execution of a formal contract.

For example, the parties may have stated their intent to enter into a formal contract, but until that contract is executed, the parties will not be bound.

Importantly, an agreement that is ‘subject to contract’ does not always place it in this third, non-binding category of preliminary agreement.

CATEGORY 4

Arises where the parties agree to be immediately bound by their negotiated terms, but expect to make a future contract in substitution of the first contract containing, by consent, additional terms.

If the parties cannot reach agreement on those extra terms, they still remain bound by the terms in the preliminary agreement.

A recent case illustrates the Capital Gains Tax (CGT) effects of an unintended category 4 agreement that was held to be binding on execution of a pro-forma Heads of Agreement, rather than at the later time the formal Contract of Sale was executed.

As a result of the finding that CGT event A1 was triggered by the Heads of Agreement, not the Contract of Sale, the taxpayer was denied access the CGT small business concessions, as he was did not meet the necessary criteria at that time.

The intricacies of these examples and the commercial and taxation consequences illustrate the importance of preliminary agreements to be drafted by a lawyer to ensure that commercial parties are only legally bound in accordance with their intentions.