How legally binding is a memorandum of understanding?

I’ve met a guy who seemed like a good fit for a partner and we’ve signed a memorandum of understanding (MoU).

But it turned out he had very different ideas of how the business should be built. At some point he just distanced himself, doing nothing.

So I decided to terminate the MoU, as I’ve found another person who could take the role. But that guy now says that part of the company (which is not yet incorporated) belongs to him, and if I want him out, I need to buy him out.

To be honest, I’m shocked. Especially as he didn’t invest any money, just a few hours in some not-very-productive meetings.

So it looks like by signing a MoU I’ve locked myself up, and this paper has some legal value, and a partner can still take advantage of you.

Am I right?

It is common for parties who have negotiated the key terms of a proposed relationship to enter into a preliminary written agreement, with the intention of recording their agreement in a more formal way in the future. These agreements are often referred to as a ‘memorandum of understanding’, ‘MoU’, ‘heads of agreement’ or ‘term sheet’.

The issue to remember with these arrangements is to know whether there is a binding agreement or whether neither party is bound unless a formal agreement is entered into.

Arrangements of this type generally fall into one of three categories. Whether the arrangement has any ‘legal value’ will depend upon which category your arrangement falls into.

In many of these cases the ‘legal value’ does not depend on what you call your arrangement, be it a ‘MoU’ or ‘heads of agreement’. Rather, it depends on the terms and wording of the arrangement.

Intend to be immediately bound

The first category is where the parties have finalised all the terms of their agreement and intend to be bound immediately but will put those terms in a form that is more precise (but no different in effect).

For example, the parties may agree on all the terms of an agreement between themselves and draw them up and sign them but also state they will engage a solicitor to put those terms into a formal agreement.

An agreement will usually fall into this category if it is clear that the parties intended it to be binding and the terms are clear and certain enough so as to be legally enforceable. The introduction will also usually seek to clarify that the document is intended to be legally binding.

If your agreement falls into this class then you will be bound by it even if no formal agreement is ever signed, and even if you have called it a MoU.

Intend to be bound to enter into formal agreement

The second category is where the parties may have agreed on all the terms of their proposed relationship and do not intend to vary them, but have made performance of the terms conditional on signing a formal document.

In this case, there is likely to be a binding contract for the parties to enter into a formal contract only.

If your MoU falls into this category, then your former partner may need to go to court and convince the court to order that both of you sign a formal contract based on the MoU.

Intend not to be bound unless formal contract executed

The third category is where the parties do not intend to make a binding agreement at all unless they execute a formal contract. Agreements of this type often use words such as ‘subject to contract’, ‘subject to formal contract’ and ‘non-binding’.

From experience, this is the most common category.

Agreements falling into this category are often used to set out the parties preliminary intentions with respect to the proposed arrangement and to assist them to work out commercial details, so that the preparation and finalisation of any formal development agreement based on those general terms can proceed more smoothly.

It also serves as an indication of some commitment by the parties to proceed with the project (even though it is legally not binding).

If your agreement falls into this category, then the MoU would not be binding on the parties.

Which category do you fall into and what should you do?

Whether you are bound by the MoU or some other arrangement you have signed will depend upon a consideration of the above factors and the actual terms of the MoU or the arrangement. In particular, the language used in the MoU and the certainty of the terms will be important considerations. It is also possible that some parts of the MoU or arrangement are binding while other parts are not binding.

To further complicate things, it is also possible that there may be a verbal agreement that sits ‘alongside’ the MoU that is legally binding. Remember not all legal agreements have to be in writing!

Therefore, it will be important for you to seek advice about the terms of the MoU to find out what legal effect it has.

Going forward, in order to avoid arguments with partners if things go wrong, it is always better to be clear from the start about what the relationship is between the parties, and to have this relationship fully documented in writing. In addition, it is important to be clear on whether or not the arrangement is binding, or what part is binding and what is not binding.

The trap is to think that what you have entered into is not binding (and therefore you have not negotiated or pushed as hard) but end up realising that it was legally binding. I have seen situations in the past where a party makes an agreement less intimidating by ‘masking’ it as a memorandum of understanding or heads of agreement, but when it was actually legally binding.

Therefore, if you are ever in doubt, it is always a good idea to seek professional advice before signing or agreeing to anything.

This article was originally published on June 25, 2012.

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