I think it is hardly probable that they had a working prototype without any kind of deal signed, they would have in the least a DOA or something of sort even more because Sony was touching Nintendo IPs (not games necessarily) to do it.
Have this whole team of SE left the company and joined Nintendo at the time of FFVII? Or are you talking something much more recent?
The was a partnership in place which is different from a signed deal as a partnership is when two or more entities come together on a business venture a partnership can be agreed but doesn't exactly have to be seen through which is common. The partnership here clearly had the intent of a cd based platform but no contract was in place for the actual product itself when it came into being.
Monolith are a former SE team they did Xenogears, at the time of FFVII Square put a lot of their focus on VII over other projects and even pulled people from other teams to work on it one of the teams who got hit hard was the Xenogears team this left the game in an inconsistent state (elements of that were even used in VII) when released and to make things worse Square began focusing less on non FF projects due to VII's success so the full vision and planned future installment were put on hold which prompted the team lead by Takahasi and his wife to leave in 1999 and form their own studio. They had a stint with Namco before being bought by Nintendo in the tail end of the Gamecube era Monolith are now Nintendo's current top first party team outside of the internal EPD units.