Legal Briefing

Supreme Court warns: agree first, start work later

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Corporate and commercial | 01 May 2010

There is a situation more common than most people would think, particularly in the construction industry whereby parties commence work under a letter of intent, pending the negotiation and execution of a full written contract, setting out all the detailed terms and conditions governing contract performance. This often occurs where projects are time and cost sensitive.

The recent RTS Flexible Systems Ltd v Molkerei Alois Müller Gmbh & Company KG (UK Production) [2010] clearly demonstrates the perils of beginning work without agreeing the precise basis on which it is to be done and finalising a contract to that effect.

RTS FLEXIBLE SYSTEMS: FACTS

In January 2005 RTS Flexible Systems Ltd (RTS) won a tender for a project worth £1.68m to supply Molkerei Alois Müller GmbH & Company KG (UK Production) (Müller) with an automated system for packaging its yoghurt pots.

While negotiation of the full contract terms was on-going, Müller sent RTS a letter of intent (LOI) that set out the contract price and requested RTS to commence work immediately to meet Müller’s deadlines. The LOI also stated that the full contractual terms would be based on Müller’s standard MF/1 contract, and contemplated that the full terms and the relevant technical specifications would be finalised and signed within four weeks from the date of the LOI. RTS commenced work, the LOI expired but no formal contract was executed. Despite this, the work by RTS continued.

By 5 July 2005, a final draft contract was produced, which contained a clause stating that the contract would not become effective until each party had executed and exchanged a counterpart. No execution or exchange of counterparts of the draft contract was ever made.

On 25 August 2005, the parties had a meeting to discuss the project and certain variations to the delivery plan were agreed. RTS continued its work in the absence of any signed formal contract. Ultimately, a dispute arose between the parties leading to litigation.

A preliminary issue before the court was whether RTS and Müller had entered into a contract and, if so, on what terms.

High Court

Clarke J (the trial judge), at first instance, held that the parties had entered into a contract after the expiry of the LOI, based on conduct and negotiations that took place prior to the draft contract. He declined to uphold the draft contract of 5 July 2005 (which included Müller’s MF/1 terms) because:

  1. not all the essential terms of the 5 July 2005 contract were agreed; and
  2. by the effect of its counterpart clause (which the court viewed as a ‘subject to contract’ provision), the 5 July 2005 contract cannot have been validly concluded as no signed counterparts were exchanged.

Court of Appeal

RTS appealed the trial judge’s decision. The Court of Appeal, citing Goff J’s remarks in British Steel Corporation v Cleveland Bridge and Engineering Co Ltd [1984], held that the counterpart clause had the effect of preventing a contract from coming into existence until a written agreement was signed.

In particular, Waller LJ said that the factors that influenced Goff J to conclude that there was no binding contract in British Steel applied with equal force to the facts in RTS Flexible Systems. Those factors were:

  1. Where a supply of goods contract is made, it is generally subject to standard terms and conditions, which are usually the standard terms of the seller.
  2. If the buyer asks the seller to begin work pending the parties entering into a formal contract and the seller acts on that request, it is difficult to infer that the seller is assuming any responsibility for their performance, except for the responsibility that will rest on them under the terms of the contract that both parties confidently anticipate they will shortly enter into. It would be an extraordinary result if, by acting on such a request in those circumstances, the seller were to assume an unlimited liability for their contractual performance, when they would never assume such liability under any contract that they entered into.

As a result, the Court of Appeal found no contract had come into existence after the expiry of the LOI.

Supreme Court

Müller appealed the Court of Appeal’s decision. The Supreme Court unanimously held that the parties had reached a binding agreement on or about 25 August 2005 on the terms agreed on 5 July 2005, with subsequent variations on 25 August 2005 and that the counterpart clause had been waived by the conduct of the parties.

principles

Lord Clarke, in delivering the judgment, made it clear that in determining whether there was a binding contract between the parties and, if so, on what terms, the test was whether a ‘reasonable and honest businessman’ would conclude from the parties’ words and conduct that they intended to create legal relations and had agreed on all the terms that they regarded or the law required as essential for the formation of legally binding relations (ie terms without which the contract as a whole would be unworkable or void for uncertainty).

Further, Lord Clarke stated that where a contract is being negotiated ‘subject to contract’ and work begins before the formal contract is executed, it cannot be said that there will always or even usually be a contract on the terms that were agreed ‘subject to contract’. That would be too simplistic and dogmatic an approach. The court was not to impose binding contracts on the parties that they had not reached. All would depend on the circumstances of each individual case.

The contract and its terms

The Supreme Court agreed with the trial judge that it was unrealistic to suggest that the parties had no intention to create legal relations given that:

  1. the full contract price and all other essential terms were agreed;
  2. substantial works were carried out by RTS at the request of Müller;
  3. a no-contract solution would involve RTS agreeing to proceed with detailed work and to complete the whole contract on a non-contractual basis, subject to no terms at all; and
  4. the agreement was subsequently varied in important respects on 25 August 2005, without any suggestion that there was not a contractual variation.

The Supreme Court accepted the trial judge’s findings that the parties did not proceed on the basis of all the terms and conditions having been agreed conditions, and that not all of the schedules were agreed, but took the view that such failure did not prevent the contract from having a binding effect. The Supreme Court applied the ‘reasonable and honest businessman’ test and found that the parties had reached an agreement on all of the essential terms on 5 July 2005. The agreement was subsequently amended on 25 August 2005.

Subject to contract

The Supreme Court held that the requirements for signature and exchange of counterparts had been waived by the parties’ correspondence and conduct. This distinguished RTS Flexible Systems from British Steel on the grounds that all the terms that the parties treated as essential were agreed and the contract was being substantially performed without a formal contract being signed or exchanged, whereas in British Steel the parties were still negotiating terms that they regarded as essential. Lord Clarke found that the only reasonable inference to draw in RTS Flexible Systemswas that the parties had, in effect, agreed to waive the ‘subject to contract’ provision encapsulated by the counterpart clause.

 

at-a-glance guide

RTS Flexible Systems Ltd v Molkerei Alois Müller Gmbh & Company KG (UK Production)[2010] is a reminder to commercial parties and those advising them of the danger of beginning work before a contract has been finalised. The key points to take away from this decision are as follows:

  1. Whether a court will hold that a binding contract has been made will depend on all the circumstances of the individual case, but the test it will apply is an objective one from the perspective of the ‘reasonable and honest businessman’.
  2. The fact that work has commenced does not automatically mean that the parties must have entered into a binding contract. However, it is definitely an indicator of that position.
  3. By starting to perform your part of the contract, you may waive the protection offered by a ‘subject to contract’ provision.
  4. Businesses should review boilerplate counterpart clauses to check if they may be construed as a ‘subject to contract’ provision.