Any type of business, whether a non-profit or for-profit corporation, may decide that forming a relationship with another organization is their best interest. When deciding the details and structure of this relationship, it is up to the parties involved to decide which form best suits their individual and collective needs. There are many possibilities to choose from and the parties’ needs, goals, and relationship are important factors in determining which form it will take. Potentially the least formal, a memorandum of understanding (“MOU”) is one alternative the parties can take. Although each party may sign the MOU at the bottom, it is important to note that an MOU is not necessarily a legally binding contract. Whether or not an MOU will be considered legally binding depends on basic contract law.
Relationship Between MOU and Contract
Contracts and MOUs are alternative document forms; each is best suited for different situations. The purpose of a contract is to document each party’s obligations and responsibilities, while also minimizing each party’s risks during the performance of the agreement and providing for dispute resolution and laying out remedies if either party doesn’t perform. A memorandum of understanding plays a similar role in that an MOU prevents misunderstandings and disputes by clarifying the expectations of the partners, but doesn’t normally offer either party any protections. MOUs are often used to represent international agreements, as well as those involving American Indian tribes.
A contract is almost always legally binding on the parties who sign it, while an MOU may or may not be legally binding. Usually, parties choose an MOU specifically when they do not want to be legally bound. Whether or not an MOU is legally binding depends on the language used in the document—if it contains many of the clauses that are present in standard contracts, it will most likely be considered enforceable by a court. Also, it is possible for certain provisions of an MOU to be legally binding, while others are not. This may be the case concerning a confidentiality or non-disclosure clause, which might contain language making it specifically legally binding.
An MOU may be the best choice when the parties are willing to take on some risk as long as they have some assurances in writing—despite the existence of unknowns or documentation gaps. For example, this may be the case when: parties are new to each other and would rather form a trial business partnership; when the outcomes of a proposed collaboration are unknown or unclear; when the parties want to first test market demand for their combined offerings, or when there is a big opportunity and trust exists between the parties, but the procedures needed for full operation are not yet in place. It may be unrealistic to draft a formal contract when important details or facts are unclear or if there is a question regarding the commitment of one or more parties. Sometimes it comes down to a question of time, as the forming of an official contract can be time consuming. An MOU might be beneficial when one party wants to avoid the potential insult, resentment, or distrust that comes from asking someone to sign a binding contract.
An Australian law firm describes the relationship this way: “…if a contract is like marriage, than an MOU is akin to living together with some house rules to test relationships. Marriage separation involves legal processes, ending a trial period of living together as a housemate usually involves none.”[i]
Legal Definition of a Contract
The legal definition of a contract is “a promise or a set of promises for the breach of which the law gives a remedy, or the performance of which the law in some way recognizes as a duty. Going further, a promise is considered “a manifestation of intention to act or refrain from acting in a specified way…”[ii] This means that each party must intend to either do something they don’t have to do, or to refrain from doing something they have the right to do—a contract creates obligations. A breach is when one party fails to fulfill their contractual obligation and when that happens, the other party has the right to sue. Standard contract terms that may not be included in an MOU are: indemnification, limitation of liability, dispute procedures, warranty, and damages.
When an MOU is Legally Binding
In order for an MOU to be enforceable in court, it must contain the essential contract elements. Courts have held that a “valid contract requires a person able to contract, a person able to be contracted with, a thing to be contracted for, a sufficient consideration, clear and explicit words to express the agreement and the assent of both contracting parties.”[iii] Another important element is the “parties’ intent to be bound, i.e., whether there was a “meeting of the minds” regarding the material terms of the transaction.[iv]
Even if an MOU includes a clause that defines it as “interim” or indicates that a “final agreement will follow,” a court may nevertheless determine that it is legally binding if it also contains all of the essential contract elements.[v] However, if the MOU is “merely a memorialization of preliminary negotiations” and essential terms are missing, the memorandum will most likely be found not to be legally binding.[vi] If the parties make plain that they do not intend to be bound, meaning that they do not intend the MOU to be legally enforceable, the MOU will mostly likely not considered a contract.[vii]
An MOU can be an attractive option because they are often straightforward and simple when compared to contracts which can be lengthy, complicated, and hard to understand. However, it can be risky to enter an MOU depending on what is at stake. An MOU should be used with caution and not entered into without a full understanding of the potential resulting obligations.
145 A.D.2d 457, 457-458, N.Y.A.D. 2 Dept., 1988; See also Silverman v. Member Brokerage Services, LLC., 298 A.D.2d 381, 751 N.Y.S.2d 245 (2d Dep’t 2002).