The pitfalls of preliminary agreements

A recent English High Court case has served as a reminder about the perils and pitfalls of preliminary agreements in commercial transactions.

What do we mean by preliminary agreements in commercial transactions?

A memorandum of understanding (MOU), a letter of intent or heads of terms are all examples of preliminary agreements. Some preliminary agreements are expressed to be legally binding, others are expressed to not be legally binding, and sometimes they specify that only certain clauses are legally binding.

They are often used at the start of a business relationship, as part of a joint bidding arrangement for a tender, or in order to secure funding. Sometimes they are used for reasons of speed to document key terms. Alternatively they can be used as a precursor to the parties entering into a main agreement setting out the full legal terms.

Unravelling the Sundorne Products v Geminor UK case

The Sundorne Products v Geminor UK [2024] EWHC 1666 (Ch) case involved an MOU entered into between two parties in relation to submitting a joint tender to the Isle of Anglesey County Council in respect of waste haulage and treatment services. The MOU envisaged that the parties would negotiate together in good faith with the aim of entering into a consortium agreement to define the scope of work and the obligations of the parties in more detail. The MOU did not specify that it was not legally binding nor did the parties specify that their negotiations were “subject to contract” whether in the MOU or otherwise. The MOU noted that it would stay in force until either the parties agreed in writing to terminate, or if the Council decided not to proceed with the services, or if the parties entered into the consortium agreement.

One of the parties (Sundorne trading as Potters) submitted the tender bid to the Council. The bid was accepted by the Council and a formal contract was concluded between Potters and the Council. Potters began negotiating the consortium agreement with Geminor but it was never concluded. In the meantime, the parties began to act on the MOU and the reception, haulage, and treatment of the waste bales began. There were disagreements between the parties as to the quality of the waste bales and the parties ended up in court. The High Court had to determine whether there was a binding contract in place between Potters and Geminor, and the basis of that contract.

Judge Hodge found that the parties had concluded a binding agreement with the intention of creating binding legal relations. They had concluded a contract which consisted of the MOU and certain associated letters. Reaching this conclusion, the judge noted that the parties had proceeded with the services and supply described in the MOU, that no grounds for termination had arisen (according to the MOU terms), and that the parties had not concluded the Consortium Agreement. The judge therefore concluded that the MOU was "…not just a stepping stone on the way to a future contract; it actually constituted a contract in and of itself".

Practical tips for preliminary agreements

• What's in a name: remember that just calling a document an “MOU” or a “letter of intent” will not be enough to make sure that it is not legally binding. You must be clear in the preliminary agreement whether it is legally binding, in whole or in part. If you do not intend it to be legally binding then you should also mark all related emails and documents with "subject to contract". This can help show that the parties have not yet reached agreement and do not intend to create legally binding relations.
• Be alive to the risk that conduct changes the nature of the agreement: you might have indicated in the preliminary agreement that it is not legally binding. However, there is a risk, as evidenced in the Sundorne case, that the courts could find the agreement to be legally binding where the parties have acted upon the agreement and have not concluded the main agreement (where applicable). This could mean that your business is bound to the obligations set out in the preliminary agreement and the provisions of that document may not cover all of the relevant issues needed to protect your position. 
• Talk to your counterparty about what you want to achieve: have an open conversation about whether a preliminary agreement is the best way forward. They are often used for reasons of speed. However, if you are using them as a precursor to a main, more detailed, agreement then you will be negotiating two agreements not one. It may be better to flush out the detail of the project in a main agreement at the outset.
• Impact on subsequent negotiations: be alive to the risk that the preliminary agreement makes it harder to introduce additional terms into the main agreement. The preliminary agreement is often used to summarise the key terms of the relationship but that can lead to disagreement about what was intended when the parties then look to negotiate additional detail (eg service levels, warranties, and the liability position).
• Keep it under review: in some scenarios a preliminary agreement may be the best option for your business. For example, you may need to conclude a preliminary agreement as part of a tender exercise or in order to help secure funding at a stage where you cannot commit to the main agreement (eg to demonstrate you have a book of customers). You might also find it a useful way to commit a counterparty to a transaction. Where that is the case you must keep the agreement under close review. You need to make sure that you and your counterparty do not exceed the scope of the preliminary agreement. As soon as possible you should conclude the main agreement or, if the project does not proceed, make sure that the preliminary agreement is terminated in accordance with its terms.
• Include clear termination rights in the preliminary agreement: make sure that the preliminary agreement is clear about the scenarios in which it will come to an end if all or part of the preliminary agreement is intended to be binding. A break clause will usually be appropriate to enable each (or just one of) the parties to walk away from the project. You don't want there to be any doubt as to whether the preliminary agreement is still in force.
• Use an entire agreement clause: if you use a preliminary agreement and then progress to concluding a main agreement, you must include a robust entire agreement clause. You should ensure it is clear that the main agreement supersedes and extinguishes the preliminary agreement.

Do you want to know more about the Sundorne case or about best practice concerning the use of preliminary agreements in your business?

Simply reach out to Sarah Daun, Peter Snaith or Stephen Anderson.