The pitfalls of preliminary agreements

Some of the key issues with preliminary documents are as follows, each of which we expand upon below:

1. Binding nature: it’s often unclear whether these agreements are legally binding. 
2. Incomplete or overly detailed terms: these agreements typically only cover broad terms, leaving out key details like warranties, and liability. Conversely, parties can include too much vague information. This can lead to disagreements when the parties try to finalise transaction documents.
3. Potential liability: statements made can lead to liability for fraudulent statements, misrepresentation, or negligent misstatement.

1. Binding nature
Some will say that preliminary agreements are not needed because they are generally non-binding. Indeed, in the UK, preliminary agreements are generally non-binding apart from certain clauses (such as confidentiality and exclusivity, which tend to be binding).

Regardless of whether the terms are non-binding, having material terms set out focuses the parties’ minds and creates a clear pathway for the parties to work towards. It does beg the question why someone would comply with an agreement if they are not legally bound to do so. One answer is that, although generally not legally binding, preliminary agreements reflect a commitment to the negotiation process and can limit a party’s negotiating position. It is therefore essential to take legal advice before making significant concessions!

By way of example, in Astra’s acquisition of PRB, a Belgian company, Astra had entered into non-binding HOTs before taking legal advice. The HOTs included specific unfavourable provisions, such as the acquisition agreement being drafted by the seller’s lawyers, governed by Belgian law, and containing only limited warranties. Although the HOTs were not legally binding, they significantly limited Astra’s flexibility in the subsequent negotiations as the seller insisted that the HOTs had set the agreed parameters, and they did not want them to be altered.

To avoid this assumption, in UK transactions, parties should use phrases like “subject to contract, ” indicating that the document serves as a preliminary framework for negotiating the final acquisition document, such as a share purchase agreement, rather than a binding agreement. This approach allows for a more flexible negotiation process, where the final terms can be thoroughly discussed and agreed upon without the pressure of immediate legal enforceability. Note that this wording will not prevent an agreement from having a binding effect if it is clear from the overall agreement that the parties intend some provisions of the document to have contractual force.

The parties should also clearly distinguish which clauses are binding and which are not, ensuring that all parties are made aware of any obligations they may have under the terms of the agreement and that they fully comply with any provisions they need to.

2. Incomplete or overly detailed terms
Since preliminary agreements cover many different elements, in some instances this can lead to a lack of detail on what is being agreed and the key points that need to be adhered. This can lead to conflict because of a lack of understanding amongst the parties – which is the opposite effect and intention of preliminary documents.

On the other hand, parties may include too much information, or vague and unclear information, which means too much time is spent negotiating preliminary agreements, or issues can occur when translating the wording in a preliminary agreement into an acquisition document. It is better to keep a document clear and concise.

A preliminary agreement may, for example, simply want to reference that warranties, indemnities, and limitations appropriate to a transaction of that type will be included in an acquisition document. In other cases, a party may want to set out its position on these points and spend time negotiating the details before signing a preliminary agreement. The right approach will depend on the nature of the transaction, the bargaining positions, and the relationship between the parties.  

Similarly, unless an issue is particularly complex or unique, a preliminary agreement would typically outline a principle and reserve the specifics for the acquisition agreement. For instance, it could mention the preparation of completion accounts.

An acknowledgement that the preliminary agreement is not exhaustive (i.e. does not cover every detail) can streamline the negotiation process at the preliminary stages and avoid parties getting bogged down in excessive detail early on. This approach allows the parties to establish key principles without the need to resolve every subsidiary issue at the outset.

Parties should clearly reference any key conditions that must be met before signing or completing the agreement and the allocation of procedural responsibilities. Identifying these conditions upfront helps ensure that all parties are aware of the essential steps required to finalise the deal. This might include obtaining necessary approvals, completing due diligence, or fulfilling specific contractual obligations.

3. Potential liability
Statements made in preliminary agreements, or in connection with the related negotiations, can potentially give rise to liability for misrepresentation or negligent misstatement, even if the preliminary agreements do not create a contract. To mitigate this risk, the parties should include an entire agreement clause in the final contract, explicitly excluding liability for misrepresentation.

Even though preliminary agreements do not establish a binding contract, statements made within them or during related negotiations can still lead to liability for misrepresentation or negligent misstatement.

This means that if any party makes false or misleading statements, they could be held accountable, despite the non-binding nature of the preliminary agreements. To reduce this risk, it is advisable for the parties to incorporate an entire agreement clause in the final contract. This clause should explicitly state that the contract represents the entire agreement between the parties, excluding all previous statements, etc. Including an entire agreement clause helps ensure that all terms and conditions are clearly defined within the final contract, leaving no room for ambiguity or reliance on previous statements.

Comment
The potential issues/pitfalls with preliminary agreements mean some regard them as a waste of time and money and consider that they put unnecessary pressure on the relationship between parties before a transaction has even begun. However, they do provide certain benefits (if drafted properly) and can help ensure a smoother negotiation process.

Whether to draft a preliminary agreement or head straight into the negotiations of the transaction may be a difficult decision to make. Ultimately, the decision will depend on several factors, such as the complexity of the transaction, the envisaged timeframe, and the relationship between the parties.

The key take away is the importance of any preliminary agreement being clear, concise, and well-drafted. If preliminary agreements are well-balanced, they can be an effective tool to reduce the overall time and cost spent on negotiation.

Contact our Corporate & Commercial team if you need advice concerning a preliminary agreement or are in the early stages of an M&A deal, we can help.