Legal Briefing

Agreement not enforceable where negotiations for connected package of contracts had broken down

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Corporate & Commercial | 01 October 2011

In the recent case of Destiny 1 Ltd v Lloyds TSB Bank plc [2011] the Court of Appeal was asked to consider whether Judge Richard Seymour QC was correct to reject a claim that a legally binding contract had been created where that agreement was one of many in a ‘contractual package’ and the negotiations for that package had subsequently broken down.

The decision provides useful guidance as to when a contract has been formed, and the impact upon the perceived intention to create legal relations where there have been negotiations for a number of different, but related, agreements. It is particularly relevant to those people that want to ensure individual contracts survive the breakdown of wider negotiations.

FORMATION OF A CONTRACT

Contracts are generally viewed as having been formed when an agreement (an offer made by one party that is accepted by another party) is supported by consideration and it is the parties’ intention to create legal relations. All of the elements must be present. An agreement that the parties intend to be legally binding will not be enforced by the courts if there was no consideration given. Equally, an agreement that was supported by consideration will not be enforced by the courts if it was made without any intention of creating legal relations.

FACTS

Destiny 1 Ltd (Destiny) was a private company owned and controlled by an individual, Mr Khalid. Mr Khalid carried on business as a shopkeeper. In 2002 he opened a general convenience store under a Costcutter franchise. In order to do so Mr Khalid obtained a loan from HSBC Bank secured on the shop premises.

By early 2008 Mr Khalid had plans to open a second store using a supplier called Nisa. The account with Nisa was to be in the name of Destiny, which was asked to provide security. Mr Khalid approached Lloyds TSB (Lloyds), with whom he had opened a personal account and struck up an association with a business relationship manager, to see if they would issue a guarantee in favour of Nisa.

In August 2008, Lloyds gave Mr Khalid a document entitled ‘ofassociate, and Martin Henshall, traineefer letter’. The offer letter confirmed that Lloyds was willing to:

  1. issue a guarantee for £30,000 to Nisa on behalf of Destiny;
  2. open an additional overdraft facility to provide additional finance for Destiny; and
  3. refinance Mr Khalid’s HSBC debt, which, at that stage, stood at approximately £230,000.

The letter went on to explain that Mr Khalid’s and Destiny’s obligations would be secured by:

  1. a debenture in favour of Lloyds granted by Destiny;
  2. a personal guarantee provided by Mr Khalid; and
  3. charges over various properties owned by Mr Khalid.

In September 2008, Lloyds wrote to Mr Khalid stating that it agreed to provide a guarantee to Nisa on Destiny’s behalf if Destiny agreed to a number of conditions. Mr Khalid, on behalf of Destiny, indicated his agreement to those conditions by signing and returning the letter as required. Judge Seymour QC, at first instance, called this agreement the Lloyds guarantee.

As agreed, Destiny provided a debenture in favour of Lloyds (the debenture) and Mr Khalid executed a personal guarantee (the Khalid guarantee). However, Lloyds ultimately decided against refinancing the HSBC debt and the whole transaction broke down.

HIGH COURT

Destiny brought proceedings against Lloyds for breach of contract. Destiny alleged that the Lloyds guarantee constituted a legally binding agreement whereby Lloyds was obliged to issue a guarantee to Nisa. Destiny argued that Lloyds’ failure to issue that guarantee following its decision not to refinance the HSBC debt had caused Destiny substantial losses, as it was prevented from opening the new store. Lloyds argued that the purpose of its letter was to obtain Destiny’s agreement to the terms on which a guarantee would be issued if the parties agreed all of the other elements of the package. Lloyds further argued that the refinancing of the HSBC debt had been the most important part of the package as this was where it stood to make the greatest financial gain.

Judge Seymour QC held that the parties had merely been negotiating the details of the various agreements comprising the package as set out in the offer letter and that, until everything had been agreed, either side was free to pull out. Accordingly, the Lloyds guarantee was not to be regarded as a separate legally binding agreement. Destiny appealed.

COURT OF APPEAL

The lead judgment of the Court of Appeal was delivered by Lord Justice Moore-Bick. The Court’s decision was based on the following two legal principles:

  1. Where there is a series of oral and written exchanges over a period of time, the Court will view them as a whole. The Court recognised that to view a communication in isolation would increase the likelihood of reaching a conclusion that did not accord with the intention of the parties. Moore-Bick LJ said this was well-established law; and
  2. When deciding whether a contract has come into existence the Court will conduct an objective assessment of what each party said to the other. The Court will view any communication as a reasonable person in the position of the recipient would have understood it.

The Court of Appeal accepted that the most important transaction to Lloyds had been the refinancing of the HSBC debt as it was ‘on any view the most substantial element of the transaction’. Therefore, the key question for the Court was whether the parties had contemplated that Lloyds might enter into an obligation to Destiny to issue a guarantee to Nisa regardless of whether it also agreed to refinance the HSBC debt. Moore-Bick LJ said that it was clear that throughout the discussions the parties were aiming to reach an agreement on a contractual package. The relationship between the parties was that Lloyds would enter into various contractual arrangements for the purpose of providing financial support to Destiny and in return security would be provided by Destiny and Mr Khalid. The Lloyds guarantee was between Destiny and Lloyds, and did not include Mr Khalid. Moore-Bick LJ said that there had never been any attempt to conclude an agreement that was only between Destiny and Lloyds. The agreement with Destiny was inextricably linked to the agreement with Mr Khalid: any liability on the part of Destiny to reimburse Lloyds in respect of a payment under a guarantee to Nisa would have been secured by Mr Khalid’s personal guarantee, which would in turn have been secured by the charges over Mr Khalid’s properties.

The Court of Appeal upheld the decision of Judge Seymour QC and dismissed the appeal.

COMMENT

The Court of Appeal indicated a willingness to approach questions of severing one contract from a package of other agreements on a case-by-case basis, depending on the facts that were present. The court will conduct an objective assessment of the entire dealings between the parties in order to reach its decision. ?

The ruling gives rise to a number of considerations:

When parties are negotiating multiple contracts, when will they be regarded as negotiating a contractual package rather than individual contracts?

The question the court will ask is whether the contracts were inextricably linked; that is, whether the parties intended that Contract A would be binding if they did not later come to an agreement with regards to Contract B?

There may be clear indicators that the parties were negotiating separate contracts. For example, different individuals for each party may have handled the negotiations for each contract or it may be possible to show that the subject matter of each contract was completely unrelated. In these circumstances a reasonable person may come to the conclusion that each party intended the contracts to be treated as separate stand-alone contracts. The failure of one is unlikely to have any impact on the other.

On the other hand, it may seem clear from an objective perspective that a number of contracts were inextricably linked and formed part of a package. In Destiny, the different aspects of the package marked different parts of the consideration moving between the parties. To allow the Lloyds guarantee to stand in isolation would have been unfair to Lloyds, as it would have been the sole party obliged to perform under the agreement and would not have received any benefit in return, fmost notably, the rights under the refinancing agreement. The Court held that this would clearly not have been the parties’ intentions and all contracts would need to be executed for the others to remain in force.

Where it might not otherwise be obvious, what can a party do to demonstrate to the court that it did intend an individual contract to be legally binding?

A party that wants certain individual contracts to be legally binding must take care to clearly evidence the relevant intention within the contract itself. Rather than relying on correspondence, a party should require a longer form contract to be executed and consider whether it would be appropriate to include relevant boilerplate clauses.

Entire agreement clauses operate to exclude pre-contractual statements that do not appear in the written contract. In this context it should be made clear that any previous discussions between the parties are superseded by the terms of the contract.

A severance clause allows the court to sever unenforceable parts of a contract and enforce the remaining parts. In this context, a severance clause could be inserted that said that the individual contract should be severed from the package and enforced if that package was terminated. The severance clause could then be used to demonstrate to a court that the parties had intended that the individual contract would be enforceable even in the event that the wider package collapsed.

How can a party ensure that a package of contracts operates only as a whole and demonstrate to the court that it did not intend for an individual contract to operate in isolation?

It is important for a party to carefully consider any correspondence that is sent to the other party in order to avoid inadvertently entering into a binding contract. A party would be wise to mark any correspondence ‘subject to contract’ to indicate that it does not intend to be bound by anything that is has said until a contract has been executed. Each individual contract should include a clause that makes the contract conditional upon the other contracts that are part of the package being agreed. In Destiny, the offer letter could be relied upon to show that the various agreements were all part of the same package and subsequent negotiation was viewed as taking place in accordance with the contents of the offer letter.

CONCLUSION

Destiny provides another example of how important it is for the parties to an agreement to evidence their intentions clearly. It might be especially important for businesses that enter into various different agreements with certain counterparties to ensure that the various contracts are properly classified as operating in isolation or strictly as part of a package. Had Mr Khalid wanted to ensure that the Lloyds guarantee was effective despite the breakdown in other negotiations, he would have needed to make this clear to Lloyds at an early stage whereby the objective intention of the parties might have been viewed differently by the courts.