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 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 been considered in greater depth by the courts.
CATEGORY 1 – AGREEMENT TO BE BOUND WITH A MORE FULSOME AGREEMENT
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 initially agreed terms are binding on both parties, regardless of whether a formal contract comes into existence.
CATEGORY 2 – CONDITIONAL ON EXECUTION FOR FORMAL DOCUMENT
These circumstances arise where agreement is reached on all terms but the performance of one or more of the terms is conditional on the execution of a formal document.
For example, a signed heads of agreement may contain some binding terms such as confidentiality, however, other important terms of that preliminary agreement may be binding only on execution of a more formal contract.
CATEGORY 3 – BOUND ON EXECUTION OF FORMAL AGREEMENT OR CONTRACT
The parties only intend to be bound on the execution of a formal agreement or 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 the preliminary agreement.
CATEGORY 4 – IMMEDIATELY BOUND BY NEGOTIATED TERMS WITH SUBSTITUTION OF CONTRACT
These circumstances arise 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 an agreement on those extra terms, they still remain bound by the terms in the preliminary agreement.
An unintended consequence of a category 4 agreement was that the agreement was held to be binding on the execution of a Pro-forma heads of agreement, rather than at the later time the formal Contract of Sale was executed. As a result, CGT event A1 was triggered by the heads of agreement, not the contract of sale, and the taxpayer was denied access to the CGT small business concessions as the taxpayer did not meet the necessary criteria at that time.
The intricacies of these examples illustrate the importance of properly drafted and considered preliminary agreements to ensure that parties are only legally bound in accordance with their intentions.
how Can We Help?
Our Commercial team is well experienced in assisting clients with any agreements or other documents that may come their way. Whether you need help with drafting, interpreting or finalising any agreements, we can provide you with quality advice and assistance to ensure your interests remain protected throughout the process.
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