Heads of agreement are commonly used in a variety of corporate transactions as a precursor to formal binding documentation. Generally, in the context of a sale of business or shares, a heads of agreement is intended to be a non-binding summary of the key terms of the proposed transaction. They are often entered into at an early stage of the negotiations to ensure there is a sufficient alignment of intentions between the parties in order to proceed with due diligence and more fulsome documentation. Typically, it is only the confidentiality and exclusivity obligations contained in a heads of agreement which are intended to be binding on the parties.
The preliminary documents used for this purpose go by many names – letter of intent, term sheet, memorandum of understanding and so on. Regardless of the name that is used, all of these documents share some common legal issues and have potential pitfalls that need to be avoided.
Is the heads of agreement legally binding or not?
A heads of agreement may or may not be intended to be binding. Whether or not a heads of agreement is binding as a matter of law will depend on the circumstances and the drafting of the heads of agreement itself.
The best way to evidence the intention of the parties is to include a clear statement in the heads of agreement as to whether or not the heads of agreement is binding. If only specific clauses are intended to be binding, a clear reference should be made to those clauses. However, a statement of intention may not be the only determining factor.
If a heads of agreement is intended to be binding, the parties will need to ensure all of the essential elements of a contract are present – the parties are identified, the terms are sufficiently certain and complete and there is consideration. For example, an agreement to buy shares at a “price to be agreed by the parties” will generally not be enforceable as it is incomplete and too vague.
If a heads of agreement is intended to be non-binding, the parties need to ensure that any subsequent conduct is consistent with that intention. If, after signing a heads of agreement that is stated to be non-binding, a party subsequently acts as if the heads of agreement is binding, a Court may hold that a binding agreement exists.
Even where a heads of agreement is non-binding, it can be difficult to “re-negotiate” a term of the transaction once it has been recorded in a non-binding heads of agreement. Therefore, the parties need to be very careful about what they agree upon.
The most obvious example of this is where a fixed purchase price is agreed in the heads of agreement, prior to due diligence being completed by the purchaser. When acting as the purchaser, a good heads of agreement containing a fixed purchase price will provide for a clear right for the purchaser to adjust the purchase price to account for any issues that may be uncovered in due diligence. Any such re-negotiation may also be assisted where the heads of agreement expressly states the basis on which the purchase price has been calculated (e.g. a multiple of NPAT or EBITDA) to make it clear that any issues uncovered in due diligence that will have a material impact on that calculation will have a flow-on effect to the purchase price.
Another common issue we see is that the parties specify the purchase price in the heads of agreement, without adequately articulating or even contemplating the appropriate adjustments to the purchase price (e.g. a working capital adjustment or net asset adjustment). Where such adjustments have not been contemplated by the heads of agreement, any steps by a party to introduce those adjustment mechanisms may present difficulties for negotiations. Whilst we have used the purchase price as an example, this principle equally applies to all other terms set out in the heads of agreement.
Obligations to negotiate in good faith
Often, a non-binding heads of agreement imposes an obligation on the parties to negotiate in good faith the terms of a more complete agreement on or before a specified date. Two questions arise in this context: (1) can an obligation to negotiate in good faith be enforced; and (2) if the answer is yes, is there any point in doing so?
Traditionally, an obligation to negotiate has been treated as unenforceable for its lack of certainty. However, based on more recent case law1, it is possible that an obligation to negotiate in good faith may be treated as a binding obligation in circumstances where clear criteria of what is required of the parties to satisfy this obligation are agreed. Having said this, in the context of an obligation to negotiate a more complete agreement for the sale of a business or shares, it may be difficult to articulate an appropriate and commercially acceptable set of criteria.
The enforceability of any obligation to negotiate in good faith will entirely depend on the drafting of the obligation and the context in which it is used. A basic obligation to negotiate in good faith by itself is unlikely to be enforceable. Even if was enforceable, it is unlikely to require a party to do little more than be honest and actually engage in negotiations.
Of course, an obligation to negotiate in good faith does not impose an obligation to ultimately agree the terms of a transaction. Even if a party is successful in a claim that another party failed to meet an enforceable obligation to negotiate in good faith, the question becomes what remedies are available? Given that an obligation to negotiate in good faith does not impose a duty to conclude the agreement, the loss suffered will not equate to the value of the transaction. At best, the loss suffered will be limited to expenses incurred by the party attempting to negotiate and the loss of the chance to conclude the transaction or engage in an alternate transaction, which will be difficult to quantify.
Therefore, even if a party breaches an enforceable obligation to negotiate in good faith, it is unlikely that it will be worth the time and costs of pursuing Court action. For all of these reasons, we recommend that very little value is placed on an obligation to negotiate in good faith a more complete agreement.
How do you deal with warranties?
If you are the purchaser, it is important to make it clear that the transaction is subject to an agreement on warranties. We would advise against providing any specific details or examples of warranties that will be required by the purchaser, as they may only serve to limit the negotiation of the nature or scope of the warranties later on in negotiations. We would also avoid references to the effect that the purchaser will require “warranties that are usual for a transaction of this kind” as warranties in all transactions vary considerably depending on the nature of the business and the material risk areas for that business. Therefore, statements to this effect are fairly meaningless.
If you are the seller, you should make it clear that any warranties will be subject to qualifications and limitations to be agreed by the parties. Again, we would recommend against agreeing any specific limits or qualifications on the warranties in the heads of agreement (e.g. maximum dollar liability or time limit) as this may serve to limit the introduction of other qualifications or limits on the warranties.
In our view, the detail of the warranties and indemnities is best left to the final transaction document, as any attempt to summarise these provisions is likely to prove problematic for both sides.
Will a Heads of Agreement attract stamp duty?
When entering a heads of agreement, you need to be careful to ensure that entry into the heads of agreement alone does not trigger a liability for stamp duty or any other tax liability.
Parties should bear in mind that a binding heads of agreement that relates to the transfer of ‘dutiable property’ under the laws of the relevant State in which the property is located may attract a liability for stamp duty upon signing of the heads of agreement.
If you are ASX-listed, do you need to disclose a Heads of Agreement?
If you are ASX-listed, a non-binding heads of agreement that is subject to negotiation and signing of legally binding documentation would not normally require disclosure to the ASX on the basis that the matter is still incomplete and insufficiently definite to warrant disclosure2.
In the case of a binding heads of agreement regarding a transaction that is likely to have a material effect on the price or value of the entity’s securities, the position is less clear. However, it is likely, in this case, that the transaction is sufficiently complete to warrant disclosure immediately upon the signing of the heads of agreement.
In either case, if confidentiality of the transaction is lost at any point, disclosure may need to be made by the parties. This is the case even where the transaction is still an incomplete proposal. It is important to bear in mind that any obligation to disclose under the Listing Rules will override the obligations of the parties to each other under any confidentiality deed or agreement.