05 Dec 2013

Preliminary agreements: to be or not to be?

by Brian O'Callaghan, Justin Bernau

A decision of the NSW Court of Appeal reminds parties to a preliminary agreement to clearly specify whether or not the agreement is intended to be legally binding.

Preliminary agreements – such as heads of agreement, letters of intent, letters of comfort and memorandum of understanding – are commonly entered into in commercial negotiations.

A preliminary agreement may outline the commercial intent of the parties, or may set out the commercial framework for a complex deal or transaction, including by specifying agreed principles and a process and timetable for entering into formal transaction documents. Depending on the outcomes sought, the parties may intend that a preliminary agreement is legally binding, or that it simply set out agreements in principle without giving rise to legal obligations.

When negotiations fail and formal transaction documents are not entered into, the question arises whether the preliminary agreement is legally enforceable, and to what extent.

Disputed Heads of Agreement: Malago Pty Ltd v AW Ellis Engineering Pty Ltd

In Malago Pty Ltd v AW Ellis Engineering Pty Ltd [2012] NSWCA 227, the parties fell into dispute in negotiations for the sale of a super yacht marina business at Rozelle Bay in Sydney.

Their efforts to resolve the dispute culminated in mediation. At the conclusion of the mediation, they entered into a Heads of Agreement containing the key commercial principles for the sale of the vendor's interests in the business to the purchaser.

The Heads of Agreement contained the following clause:

"Without affecting the binding nature of these Heads of Agreement the parties within 7 days [are] to execute a formal document or documents as agreed between their respective solicitors to carry out and express in more formal terms and additional terms as these Heads of Agreement."

The post-Heads of Agreement negotiations failed, transaction documents to effect the sale were not entered into and the vendor party sought to enforce the sale of business under the Heads of Agreement. The question then was whether the parties had intended, as objectively determined, that having concluded the terms of their agreement, it remained merely to document those terms (as in Masters v Cameron (1954) 91 CLR 353), or whether they had intended to delay the formation of a binding legal relationship until a formal contract was drafted and signed.

Court of Appeal's decision:

The Court of Appeal held that:

  • whether the parties intended to make a binding contract must be objectively ascertained from the terms of the document when read in light of the surrounding circumstances;
  • even when a document recording the terms of the parties' agreement specifically refers to the execution of a formal contract, the parties may intend to be immediately bound; and
  • although the Heads of Agreement had been drafted at a high level of generality and lacked detail on some key points generally covered in an agreement for the transfer of business interests, the agreement was not void for uncertainty or incompleteness, and the Court noted that, so long as it is not completely devoid of meaning, an ambiguous provision is valid and bears such meaning as the court attaches to it, after due consideration.

To give effect to the obligation in the Heads of Agreement that the parties execute a further, formal contract, the Court ordered that the parties execute a formal contract on terms to the same effect as the Heads of Agreement.

The Court rejected the argument that this formal contract should contain additional provisions that had been the subject of post-Heads of Agreement negotiations, as the parties had not reached a binding agreement on these additional provisions. The decision is an example of the general proposition that, in commercial relationships, it is often inferred that an agreement is intended to create legally binding relationship.

Practical implications:

The decision provides a number of useful reminders to parties in commercial negotiations, namely that:

  • a preliminary agreement should contain an express clause stating whether or not it is intended to be legally binding;
  • a court will endeavour to give effect to the (objective) commercial intent of the parties to a preliminary agreement, where that agreement is intended to be commercially binding; and
  • the negotiation of key contractual provisions should be expressed to be "subject to contract" to avoid later argument that the parties intended to be bound by them prior to signing an agreement.

While preliminary agreements can play an important role in documenting agreed principles and facilitating complex commercial transactions, they need to be clearly drafted to avoid time-consuming, relationship-damaging and expensive disputes.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.