A preliminary agreement is an agreement that is entered into by the parties but which does not set out all of the terms of the contract. Examples of preliminary agreements include heads of agreement, memorandums of understanding and letters of intent.
Ordinarily, a preliminary agreement will either expressly or impliedly contemplate that a fuller agreement will eventually be drawn up to regulate the rights of the parties. The issue then arises as to whether, and to what extent, the preliminary agreement is binding. The position may be summarised as follows:
- whether a preliminary agreement is binding depends on the objective intentions of the parties;
- the courts will have recourse to a system of legal classes in answering that question. However the facts of a particular case will always be important in determining the result, which puts the matter back in the hands of the parties; and
- the best way to avoid any uncertainty over whether a preliminary agreement is legally binding is to clearly spell out the extent to which (if any) it is intended to be binding and when that will occur.
Where parties do not intend a preliminary agreement to be binding, the following matters should be considered:
- a clear statement to that effect should be included in the preliminary agreement;
- if any terms are intended to form an exception to the non-binding nature of the agreement, a clear ‘carve out’ provision should be included to deal with them;
- it should be assumed that an agreement to negotiate a formal contract in good faith may be enforceable;
- consider including an express statement that parties commence work at their own risk; and
- consider including an express statement that neither party is obliged to continue negotiations or to execute any formal contract that is prepared, and may cease negotiations or not execute a formal contract at any time at its absolute discretion.