When are heads of terms a binding agreement for lease?

Agreeing heads of terms prior to a lease being further negotiated and entered into is far from unusual practice.

What happens however when things don't go to plan – can parties be tied into an agreement for lease resting on heads of terms alone?

That is a question recently considered by the Court of Appeal in England in Pretoria Energy Company (Chittering) Limited and Blankney Estates Limited. Although not a Scottish case, some equally applicable key principles and lessons can be taken from the decision. 

The heads of terms

Heads of terms were negotiated and entered into between Blankney and Pretoria for the lease of a site in Lincolnshire, plus other commercial arrangements. The site housed an existing factory, which was to be demolished and planning permission would be sought by Pretoria, the proposed tenant, for construction of an anaerobic digestion plant at the site.

The final HoTs document was described as "Heads of Terms of Proposed Agreement". It was marked as being "Subject to Full Planning Approval and appropriate consents and easements", however it was not said to be "subject to contract".

The HoTs consisted of four parts, the first of which contained the proposed lease terms. The lease was to be for a period of 25 years with an initial rent of £150,000 per annum. Parties agreed the other three parts of the HoTs were not intended to create legally enforceable obligations.

The final part of the HoTs provided that they were "agreed and signed on the understanding that the formal agreement will be drawn up within 1 month from planning consent being achieved and subject to the consents and easements being obtained…"

There was also an exclusivity period, whereby parties agreed not to enter negotiations with any third parties relating to the proposals in the HoTs. They agreed this created a legally binding lock-out agreement. 

The legal issues

Planning permission was granted, after which solicitors started drafting the lease. Progress was however halted when the planning authority objected to demolition of the existing factory on site. After the exclusivity period expired, Blankney entered into alternative arrangements with a third party. Pretoria argued they could not do so, having bound themselves into an agreement for lease in the HoTs.

The issue for the Court was therefore whether the first part of the HoTs relating to the lease created a contractually binding agreement for lease.

The key questions the Court considered were:

1. Was there an objective intention to create a binding contract between the parties?
2. Were all the terms which parties consider essential, or the law requires for the formation of a legally binding contract agreed?

The decision

When looking at the parties intentions, the Court said that if the HoTs had been headed "subject to contract", this "would have put it beyond doubt that the parties did not intend to be contractually bound by any part of the HoT."

It was however of "considerable significance" that the HoTs stipulated that a formal agreement should be drawn up. That doesn't of itself prevent the HoTs constituting a binding agreement, as it could just be intended that a formal agreement be prepared to document what has already been agreed. However, the more complicated the situation, such as a 25 year lease for a plant which is still to be constructed following demolition of an existing plant, the less likely that was to be the case.

The fact that a limited exclusivity period was agreed was also considered important – it doesn't make sense for the HoTs to be a binding agreement to enter a 25 year lease when parties were only prevented from negotiating with third parties for a short period of time.

When looking at whether the essential terms were agreed, the Court considered there were a number of important terms that were left open for negotiation, such as terms relating to the initial construction, repair, insurance, alienation, what happens to the plant at lease end etc, none of which were covered in the HoTs. While the Courts have been prepared to imply terms into straightforward contracts of sale, given the complexity of the lease in question, it was considered there was far too much left open for parties to infer parties intended to be bound by the HoTs alone.

Importantly, it was also held that the start date of a lease is an essential term required by law for the creation of a binding contract for lease. The HoTs didn't specify a start date and the Court did not consider this could otherwise be deduced from the content of the HoTs. The absence of this was another indicator that parties didn't intend to be bound by the HoTs.

The appeal was accordingly dismissed, with parties found not to be bound by the HoTs.

The takeaway?

To avoid any doubt, heads of terms which aren't intended to be binding should be clearly marked as being subject to contract.

In the absence of that wording, the intentions of the parties to create a binding contract and whether the essential terms are covered will be considered – but ultimately the more vague and uncertain HoTs are, the less likely they are to be held legally binding.