Use heads of terms to set expectations
Unfortunately, our team of commercial property lawyers find ourselves time and again dealing with transactions that drag on for months and go way over budget because of a lack of properly considered heads of terms.
To give you an example, I have one matter that has been ongoing for nearly 9 months! The client instructed us on the basis of a sophisticated agreed set of heads of terms. Despite numerous conversations, it only became apparent when we neared engrossment stage (finalising the lease agreement) that in fact they had no clue when agreeing heads and then involved an agent to try and agree better terms! Suffice to say I don’t think the Landlord is overly impressed.
When you’re looking to enter into a commercial lease agreement, the use of heads of terms sets out basic future intentions and expectations ahead of the lease being prepared, without being (usually) legally binding. In the event there are no heads of terms, or where they are poorly negotiated, this can add unnecessary delays and costs to getting a deal over the line. This article will consider some of the pitfalls of not getting the heads of terms right, with some tips on how to get it right at the start.
- Use heads of terms to set expectations
- Issues with heads of terms and how to avoid them
- Once heads of terms are agreed, can the tenant move into the property while the documents are being negotiated?
- Who should be involved in negotiating and drafting heads of terms?
- Tips to remember when negotiating heads of terms
Issues with heads of terms and how to avoid them
Cover key points
Heads of terms should be a clear and accurate reflection of what the parties have agreed. They do carry a certain commercial and moral weight. It is tough for solicitors to argue against a provision clearly set out in the heads of terms. They ought to provide sufficient detail to avoid the need for further, extended negotiations at the legal stage but not so detailed that they prevent the transaction moving on to its next stage.
Please see our separate article on heads of terms setting out the details usually covered in the heads of terms document.
Many of the key details will have been discussed via phone or email, but unless they’re drafted onto one document, the information can become lost in translation, forgotten or altered.
The bargaining power of each party can tip the balance of how favourable the heads of terms are for each party. It is recommended each party has separate professional representation to negotiate the heads of terms. The advisors will have the skills and experience to determine the points which must be negotiated and to assist in explaining what can be considered reasonable in the circumstances.
Consider the implications
Careful consideration needs to be applied to the key terms being proposed and the implications to the relevant party before agreeing those terms.
For example, some of the more controversial terms of a lease might cover the following:
It is essential that the term of the lease fits in with a tenant’s short term and long term commercial objectives. If a tenant has longer term plans to relocate or purchase, a shorter lease may be preferable, especially if there are going to be restrictions on the ability to break, assign or sublet the lease.
Rights to break the lease during the term are common but details of when and how must be negotiated, together with any conditions to be attached to a break clause. Even where a break right does exist, the landlord may insist they share the same break rights as a tenant which could create uncertainty for the tenant.
- Assignment and underletting
Leases can prohibit any transfer or subletting to a third party, so a tenant will want to ensure they consider if they may need an exit strategy during the term, and negotiate the ability to assign or underlet. There are usually a number of conditions attached to such a dealing. For example, with an assignment a tenant will usually continue to be responsible for the incoming tenant’s ability to comply with the terms of the lease.
- Security of tenure
The Landlord and Tenant Act 1954 gives commercial tenants a statutory right to renew their lease when it expires (called security of tenure), which the landlord may object to in certain circumstances. A landlord may seek to exclude this right within the terms of the lease, to ensure they have full discretion regarding whether or not to grant a renewal lease. A tenant may seek to negotiate that the lease will allow them security of tenure, so that they can consider whether to request a renewal towards the end of the term.
Most new commercial leases are fully repairing and insuring so it is a tenant’s responsibility to repair and pay for the insurance of the property. The standard of repair will depend on the wording of the lease and a tenant may look to limit the extent of their obligation, such as by reference to a schedule of condition, so that they do not need to return the property in any better condition than at the start of the lease. It is important for both parties to decide on the degree of responsibility at the outset, to avoid litigation in future.
- Rent review
Rent reviews involve the reassessment of the rent payable, at one or more points of the lease term, especially where the lease is for a longer term. Rent reviews can be very complex and based on a variety of different mechanisms. An upwards only market rent review is still the most common, but the type and frequency of rent review is all up for negotiation.
If heads of terms were legally binding, it would be contrary to their purpose, and would run the risk of the parties being committed to an agreement which may not meet their requirements. Sometimes the terms of the deal must change after the heads of terms are drafted. The name of a document does not determine its legal status and calling a document ‘heads of terms’ will not ensure that it is not legally binding. They should be marked ‘subject to contract’ which will help to clarify they are not considered legally binding, although that is also not guaranteed.
Once heads of terms are agreed, can the tenant move into the property while the documents are being negotiated?
If negotiations are likely to take some time, and the tenant urgently needs to move into the property, then both parties should consider whether to agree a tenancy at will, or a licence, as a temporary legal arrangement while the lease is being negotiated.
If the matter does not proceed and the tenant is already occupying the property, the parties may find themselves in a situation where the landlord requires immediate possession of the property, but the tenant needs some time to vacate and this can cause legal disputes as well as business continuity issues for the parties.
Who should be involved in negotiating and drafting heads of terms?
Producing detailed and effective heads of terms can be complicated. A surveyor deals with heads of terms on a daily basis and can add value by advising whether the terms are commercially acceptable. Parties should also consider instructing a commercial property solicitor at the point heads of terms are being negotiated. This will ensure that all potential legal issues can be identified and addressed prior to any detailed negotiations. The parties may want to instruct other professionals to assist them with other aspects of the deal at the heads of terms stage, such as accountants, tax advisors, planning consultants/architects and particular tradesmen.
Tips to remember when negotiating heads of terms
- Heads of terms should set out the structure for the transaction
- Heads of terms should be sufficiently detailed to cover key points as this will help to avoid protracted negotiations, which will only result in delays and higher legal costs
- Heads of terms should expressly state they are 'subject to contract', unless the parties do intend for them to be legally binding