When do you create a Memorandum of Understanding?
It is a common occurrence: you’ve had exploratory discussions with a potential supplier/investor etc., leading to an understanding of core issues that justifies starting serious negotiations. You don’t want the understanding fixed in stone just in case you need to renegotiate, or the negotiations go nowhere.
Meanwhile, the supplier wants to rely on that understanding - either because there is no point in further negotiating without it or because it needs to spend money on the next stage and is only willing to do that if the understanding can be relied upon.
So, despite having diametrically opposed motives, you both sign a memorandum of understanding (also known as a ‘heads of terms’, and sometimes as a ‘term sheet’). It is written loosely to accommodate the contradictory motives.
Typically, memorandums (or memoranda) focus on headline topics: who, what, where, when and how much? Stage two of negotiations cover the 1,001 points of detail that are essential for a contract to actually function as intended (e.g., quality standards, ordering/delivery process, invoicing, problem resolution, etc.)
Problems arise when stage two never happens or goes nowhere, but one of the parties has begun to take (expensive) steps in expectation of a contract. Their fall-back position is to claim the memorandum was a binding interim agreement, not a non-binding record of negotiations. Where such cases end up in court, the judge will go back to the very basics of contract formation.
The starting point is that a contract is automatically formed when two parties who are (i) able to form a contract (e.g., not 5-year-olds) want to (ii) do something legal, with (iii) the intention of forming a legal relationship to do it (negotiating an imaginary deal doesn’t count) and (iv) have agreed on enough core terms to allow the contract to actually be carried out and (v) one of them has made an offer to deal which the other has accepted and (vi) some form of benefit has been exchanged or promised between them (otherwise one is simply making a gift to the other).
Common mistakes with Memorandums of Understanding
The mistake businesses make is to assume that merely by entitling a document a memorandum, they automatically sidestep the above contract formation test. That is incorrect. If the above requirements are met, then a contract is formed – which could be very bad news for one of the parties - if only because not all the important terms would have been covered in the memorandum.
Are Memorandums of Understanding legally binding?
The cases that come before the court are invariably those where one party says the memorandum is legally binding, but the other disagrees. In such cases the court has basically applied the old abductive (no pun intended) test: if it looks like a duck, walks like a duck and quacks like a duck then it probably is a duck. This means that the more the memorandum looks like a contract, the more likely it is that the court will agree with the party claiming that it is a binding contract.
To avoid this, make sure that your memoranda are not written as if they were contracts: consider not signing them; try not to use wording like ‘the parties have agreed…’ or ‘the parties shall…’. Make sure that the memorandum is headed ‘subject to contract’ and is liberally sprinkled with reminders that it is not intended to be legally binding. Of course, if you want the option to be able to claim that the memorandum is binding, then write it as if it were a contract.