Using Heads of Terms (HOTs) for commercial transactions

What do we mean by Heads of Terms?
Heads of terms (HOTS) are also known as letters of intent, memoranda of understanding, heads of agreement, letters of potential interest, term sheets or protocols. This document sets out the terms of a commercial transaction agreed in principle between parties in the course of negotiations. HOTS evidence serious intent and have moral force, but do not usually legally compel the parties to conclude the deal on those terms or even at all.

When do we use Heads of Terms?
HOTS are commonly entered into at the beginning of a transaction, once preliminary terms have been agreed and before commencement of detailed due diligence and the drafting of definitive agreements (which is where the parties will begin to incur significant costs). The parties may enter into a series of HOTS throughout the negotiations, particularly when negotiations are prolonged.

What are Heads of Terms used for?
HOTS are used in a variety of commercial property transactions such as the sale, purchase or lease of a petrol station, but also loan finance and other transactions, including public mergers and acquisitions, joint ventures, project financing and private equity investments.

HOTS are used for a number of purposes:

• As written confirmation of the main terms agreed in principle.
• To outline the timetable and obligations of the parties during the negotiations.
• As a framework for certain preliminary legally binding clauses such as an exclusivity agreement (more on these in a future article).

Clear and relatively detailed HOTS are valuable. Have the parties considered the structure of the transaction? If a sale of a business, has the tax position been considered, the future of employees and the pros and cons of a transfer of a business as a going concern or a share acquisition? Failure to iron out such important features will likely result in increased legal costs so tackle them early.

Why are Heads of Terms important?
Lawyers find HOTs a useful reference point when negotiating the technical and legal points of contracts. There will still be legal points to thrash out, but the risk of any unexpected commercial issues arising during the final stages of discussions is reduced.

HOTs can include provisions to protect the confidentiality of the negotiations and restrict the parties from sharing details with third parties. An exclusivity period can also be established, stopping the parties entertaining other offers. However, this provides a moral obligation rather than a contractual one.

Are Heads of Terms legally binding?
If drafted inappropriately, particularly without legal advice, HOTS can be risky documents to use. Any ambiguity can cause uncertainty as to the exact nature of the relationship between the parties. There can be doubts over whether or not the parties had intended to be legally bound by the whole document or by particular terms within the document.

The basic legal requirements for the formation of a binding contract are:

• Offer
• Acceptance
• Consideration
• Intention to create legal relations
• Certainty of terms

Space does not allow us to examine each of these requirements in detail (yet another article!) but the Courts have had to examine what parties probably intended to be “heads of terms” and rule as to their enforceability.

However, most uncertainties can be eliminated or at least reduced by clear drafting.

The expression “subject to contract” may help to rebut the presumption of a legally binding contract. But simply labelling heads of terms “subject to contract” will not make them immune to the argument that a contract has been created, particularly if the parties start to perform the contract envisaged by the heads of terms. To make the position completely clear, it is preferable for heads of terms to spell out the parties’ intention expressly, rather than simply relying on the shorthand label “subject to contract”. For example:

“These heads of terms are not intended to be legally binding between the parties except as specifically set out in this letter“.

If parties do not include an express statement that the HOTs are not binding, the document must then make it entirely clear that the parties intend it to be a non-binding agreement, rather than a binding but conditional agreement. In the latter situation, a court may infer an obligation to use best or reasonable endeavours to satisfy the conditions. Courts have found that HOTS may carry moral force which could restrict a party’s future options.

Conclusion
Good quality HOTS are essential if parties wish for a smooth, non-protracted transaction. Too often we as lawyers are told “this one is straightforward” when what this actually means is that crucial aspects of the deal have not been negotiated. So, ensure you use professional agents, experienced at negotiating and drawing up HOTS and ensure that you speak with your accountants and lawyers at an early stage.