Navigating Pre-Contract Agreements: What You Need to Know

Defining Pre-Contract Agreements

Pre-contract agreements are documents created prior to a contract being entered in to by the parties. Their purpose is to give some certainty to the parties as to whether or not they will enter into a formal agreement at a later stage. They are typically used prior to parties entering into an employment contract. For example, a company may offer an employee a role but advise them that the formalities of obtaining a VISA for work purposes will be undertaken prior to the formal offer being made. A variation on this is where one party agrees to be bound to enter into a contract in a fixed period of time. For example, a company may offer their tenants a reduction in the rent they are required to pay in the next quarter in return for a reduction in their lease length of 6 months to reflect the reduction in rent they will be required to pay. This would only happen if the tenant agreed to a lease extension at the reduced rent rate.
This informal pre-contract agreement, if entered into at the same stage, could have the same binding contractual impact as a formal contract . However, often parties to a pre-contract agreement do not intend to be bound. This is often the case, for example, when negotiations are ongoing which means that there is a possibility that a contract will not be entered. A common example is during a property transaction. If an indemnity is entered into, it may become a contract in itself when signed by the parties, or it may cross-refer to a future agreement. The most common way that parties to an agreement make it clear whether or not they intend to be legally bound is shown through use of "subject to" clauses. These clauses can protect parties from the risk of premature liability by making the performance of a certain obligation conditional on a further event. In some circumstances, it may even be that no contract exists until a later time. Courts will consider the conduct of the parties and the context in which the agreement was entered into to determine the intention of the parties.

The Components of a Pre-Contract Agreement

There are a number key factors that should be included in a pre-contract agreement, including: (i) the terms of negotiation; (ii) the introduction of a legally binding contract; (iii) confidentiality clauses; (iv) potential penalties for breach; and (v) other points as may be relevant to that party.
Terms of negotiation
Both buyer and seller must agree not to directly attempt to negotiate with each other, unless represented by their respective agents. If parties are introduced by a third party, for example, a real estate agent, then in addition, each party should agree to notify the third party immediately if they decide not to proceed with negotiations.
Introduction of a legally binding contract
The contract should also establish if the supplier’s proposal is not binding on either party until legally executed by the parties.
Confidentiality clauses
A clause should also explain that all information exchanged between the parties during the negotiation phase is confidential and cannot be divulged to third parties, or used in negotiations with other parties.
Penalties for breach
Thirdly, the contract must also include penalties for breach by either party. It is common for the supplier to enter into a legally binding "Trial Period" agreement before the terms of the contract are mutually signed and agreed to by both parties. In such cases, a party that does breach a trial period may be liable to reimburse wasted costs and time to the aggrieved party.

Advantages of Pre-Contract Agreements

The advantages offered by a pre-contract agreement are substantial. Their primary use is to mitigate the risks faced by both sides. The party with more power in negotiations may want to shield themselves from future financial loss if the deal falls through, and the pre-contract agreement allows them to do this. Meanwhile, the weaker party will often want a degree of reassurance that they will not be strung along indefinitely with no prospect of a successful outcome. In other circumstances, particularly with joint ventures, parties are concerned about the business and management risks of using a joint venture vehicle or other partially incorporated structure. Clarity in negotiations will usually be improved by a pre-contract agreement. Before the parties can sign the contract itself, they effectively have a preliminary form of contract in place, which has introduced a binding framework for their negotiations. The formal structure of a pre-contract agreement sets preliminary expectations, which can simplify the transaction timetable.

Pre-Contract Legalities

Legal Implications in Pre-Contract Agreements
The enforceability of a pre-contract agreement is a significant concern for the parties. If any of the parties are found to not be legally bound by the pre-contract agreement, the other party may have a grounds for a claim. A pre-contract agreement may have force and effect of the final contract, and having the full terms and conditions of the final contract also in the pre-contract agreement may further support that the parties intended the agreement to be binding. To avoid claims that the pre-contract agreement was not intended to be binding, careful attention should be paid to how the agreement is drafted to make clear whether it is binding or non-binding.
It is generally accepted in the United Kingdom that English law should apply to any domestic pre-contract agreement. However, if the parties conduct business in a jurisdiction outside the United Kingdom, the foreign laws may govern the pre-contract agreement. Therefore, unless otherwise stated, the pre-contract agreements drafted within the United Kingdom will be governed by English law. Parties may want to consider where the primary business will be conducted to assess whether a different jurisdiction should govern the pre-contract agreement.
In the event the matter goes into litigation or arbitration, the parties may want to consider the governing jurisdiction given the foreign laws that might apply in the alternative jurisdictions. When drafting or signing a pre-contract agreement, the parties should consider whether they foresee potential legal challenges that may arise in certain jurisdictions so that the agreement can seek to preemptively address those concerns as needed.

Pitfalls to Avoid

The most common mistake that we see made, is drafting the definition of pre-contract in vague terms. It’s absolutely vital that the definition of pre-contract clearly describes the agreements that will be executed, which parties must sign them and on completion of what steps . The second most common mistake, is failing to seek legal advice prior to executing pre-contracts, particularly in a situation where they are being used to facilitate parties relocating offices overseas, potentially into multiple jurisdictions. There is an enormous amount of legal, tax and accounting risks. By failing to seek advice beforehand, parties can quickly find themselves stuck with insurmountable problems, and costs, after the documents have been signed and the process is already underway.

Examples of Pre-Contract Agreements in Action

Pre-contract agreements are not just important because we say so. Numerous court cases have examined pre-contract agreements, demonstrating that they are an essential part of a competent business law attorney’s practice. Here are two examples (there are many):

1. Sternberg v. Fencl (1987): In this important contract case, the Michigan Court of Appeals held that a letter of intent and related purchase agreement for the sale of a car wash business created enforceable binding legal obligations for the parties. The court found both agreed that the seller would not negotiate the sale of its property with any other buyer during the period between the date of the LOI and the expiration of the due diligence. Even though "buyer’s counsel [had] made it clear that its due diligence was essentially a ‘formality" and that "it will proceed with the purchase without additional delay on the following day," court found binding agreement was made.
2. Fayyazi v. Juno Lighting, Inc. (2006): In this important business dispute involving embezzlement, theft of trade secrets and breach of contract, the shareholders of a company formed a majority, signing a buy-sell agreement. Defendant shareholder voided the agreement, but then tendered several checks to plaintiff shareholders as reimbursement payments. Defendant shareholder asserted defenses, including accord and satisfaction, waiver, laches and estoppel. The court held that plaintiff shareholders were entitled to damages because defendant shareholder tendered the checks to plaintiffs without an agreement. Court held that there was no accord and satisfaction and that there was uncompensated consideration for the contracts.

How to Create an Effective Pre-Contract Agreement

The first stage of any pre-contract negotiation is to conduct the negotiations for an enforceable letter of intent. Once this is complete it may be possible to include it in your pre-contract negotiations. As the parties negotiate the terms of a pre-contract agreement, it is important for both parties to seek legal advice. Areas of strength and weakness of the clauses need to be identified and both parties need to have a clear understanding of the risks that will be taken. Once the pre-contract has been agreed and both parties are happy with its provisions, it is imperative that it is finalised to ensure that both parties intentions have been fully recorded. Consideration also needs to be given to how the agreement should be executed by the parties. Execution could be in accordance with Companies Act 2006 (Promoters and Directors) or could be in accordance with the documents Articles of Association and seal.

Moving from Pre-Contract to Final Contract

Transitioning from a "Pre" Contract to a Final Contract
As is clear by the analysis, the requirements of and the obligations and the rights under a pre-contract agreement are very different from those in a final or definitive contract. Unfortunately, however, there is a tendency for parties to regard the two contracts as essentially interchangeable. In most cases, this is not a viable proposition given the substantial differences between the two forms of contract.
In the context of English law, there is generally no legal obligation to enter into a final contract following a pre-contract agreement, it is easy to see why parties would want to retain pre-contractual rights and obligations even after a final contract has been entered into.
In this respect , the intention of the parties is decisive. In most pre-contractual arrangements, it is the intention of the parties not to be bound by the pre-contract agreements but instead the intention is to be bound by a later (more formal) final agreement. For example whilst a letter of intent may contain conditions precedent such as share transfers or the completion of certain environmental work, it is unlikely that these obligations will remain in subsequent agreements (whether as conditions, representations or otherwise), as both parties would understand that upon entering into a final contract, they will be assuming the obligations which were intended to be included in the final arrangement.