Generally, they are designed to outline the principal terms without being legally binding. They do not usually carry the level of detail necessary fully to describe the proposed contractual arrangement between the parties, and so unintentionally creating legally binding heads of terms is a pitfall that should be avoided.
To avoid any ambiguity whatsoever, an express provision should always be included in the heads of terms to state that they are not legally binding: they should be marked “subject to contract”. These words should create a presumption that the intention of the parties is not to be bound by the heads of terms. However, this is not guaranteed as in some cases the parties might start to perform the contract described by the heads of terms before formal contracts are completed.
A good example of when this might occur is in the case of short-term leases (i.e. with a term of three years or less) as these do not need to be created by deed. Accidentally performing the contractual arrangement envisaged by the heads of terms before signing the lease could be problematic for both the landlord and the tenant, particularly where the tenant is carrying out a business at the property and so might benefit from the security of tenure provisions in the Landlord and Tenant Act 1954.
When producing heads of terms, the drafter should also bear in mind that their contents can ultimately overrule a completed legal document. In the case of Daventry District Council v Daventry & District Housing Ltd [2011] EWCQ Civ 1153, the Court of Appeal rectified a completed contract to bring it into line with the heads of terms. The case concerned the transfer of council housing to a registered social landlord (the “Company”). The housing department staff and their pensions were also to be transferred. It was recognised that a £2.4 million deficit in the pension fund would have to be filled.
If interpreted objectively, the heads of terms indicated that the Company should be liable for the pension deficit once the transfer had taken place. The Company did not believe that this was the case. Lawyers acting for both parties failed to document the point correctly, as the drafts that were circulating suggested the council would cover the deficit. This was not picked up by anybody other than the chief negotiator for the Company who chose to exploit the ambiguity in the Company’s favour by not pointing out to anybody that the point had not been documented correctly. Four days before the contract was completed, a new sub-clause was proposed by the Company providing that the council had to pay £2.4 million to the pension fund within 5 days of completion. The council and its lawyers agreed the amendment, not realising that it contradicted the agreement in principle.
The contract was completed. When the council realised what had happened, it sought rectification on the basis that the agreement had been that the Company should cover the deficit. The question turned on how an objective observer would understand the outward expression of the original agreement and the Court of Appeal was prepared to grant rectification in the circumstances.
When drafting heads of terms, the drafter needs to strike a balance between including too much detail which could tie the respective parties’ hands and too little detail which would leave lawyers negotiating some of the commercial aspects of the deal at a later date. Too much detail means that agents are effectively negotiating legal agreements; too little detail means that lawyers incur extra costs negotiating commercial arrangements. When drafting heads of terms for all but the most routine property matters, it is worth the agent and the lawyer liaising closely over their contents before they are released. Aside from the concern that they might inadvertently be legally binding, case law shows that they can be used to evidence a claim for rectification which could turn a completed transaction on its head.