Jerome O’Sullivan, Senior Associate, discusses the risks involved in commencing work on a project before a formal contract is agreed and signed.
It is quite common in commercial contracts, particularly construction, for the parties to commence performance based upon partially agreed draft terms, or letters of intent. In RTS Flexible Systems Limited v Molkerei Alois Muller GMBH  UKSC 14, the Supreme Court has again considered this recurring problem.
Muller were a producer of dairy products and entered into negotiations with RTS to install two new production lines at its factory in Market Drayton. The parties entered into a Letter of Intent on 1 March 2005, with a view to the parties agreeing a full set of terms and conditions. When the Letter of Intent expired on 27 May, no final agreement had been arrived at.
By July, the fixed price for the work had been agreed in the sum of £1.682 million and almost all the contractual terms referred to as MF1 and most of the schedules had been agreed. The MF1 terms were a model form drafted by the Institute of Electrical Engineers.
Clause 48 of the draft long form contract contained a subject to contract clause, which stated that the contract “shall not become effective until each party has executed a counterpart and exchanged it with the other”.
RTS completed the installation of the two production lines. However, in November 2005 the two new production lines failed, in a scene described by Muller’s Counsel as “resembling a Wallace & Gromit movie”.
RTS issued proceedings for the balance outstanding of the price agreed. Muller counterclaimed for its losses arising from the failure of the production lines.
At first instance, Christopher Clarke J held that the parties had concluded a limited contract for the agreed price as set out in the Letter of Intent. The Court relied on the approach taken by Steyn LJ in Percy Trentham v Archital Luxfer  1 Lloyds LR 25 in which the Court held it was unrealistic to suppose the parties had not intended to create legal relations, when in fact substantial performance had already occurred.
However, the Court held that the MF1 terms were not incorporated and relied particularly on Clause 48 as demonstrating a clear intent that those terms would not take effect until the contract was signed by both parties.
MF1 also contained a liquidated damages clause, which was effectively a limit on RTS’ liability to Muller for the failure of the production line. In the absence of this clause, RTS was held to have assumed unlimited liability for the loss and damage suffered by Muller.
Court of Appeal
RTS appealed but changed its position. It attempted to argue that there had been no contract following the expiry of the Letter of Intent. It therefore argued that it was entitled to payment for work on a quantum meruit basis. Failing that, its liability will be limited to repaying the money it had received from Muller.
The Court of Appeal agreed, ruling that the subject to contract clause should prevail, applying the principle set out by Robert Goff J in British Steel Corporation v Cleveland Bridge & Engineering Co Ltd  1 All ER 504.
In the Supreme Court’s decision, Lord Clarke summarised the issues as follows: “The general principles are not in doubt. Whether there is a binding contract between the parties and, if so, upon what terms, depend upon what they have agreed. It depends not on their subjective state of mind, but upon a consideration of what was communicated between them by words or conduct, and whether that leads objectively to a conclusion that they intended to create legal relations and had agreed upon all the terms which they regarded, or the law requires, as essential to the formation of legally binding relations.
Even if certain terms of economic or other significance to the parties have not been finalised, an objective appraisal of their words and conduct may lead to the conclusion that they did not intend agreement of such terms to be a pre-condition to a concluded and legally binding agreement”.
The Court should consider whether the parties had reached “essential agreement”. That is, whether they intended to be legally bound by what was already agreed. This finding is more likely where the transaction had already been performed by both sides.
Alternatively, if there are further terms which the parties regard as essential which have not been agreed, the Courts will be slow to impose a binding contract which the parties themselves have not yet reached. The test to apply was whether an “honest, sensible businessman” when objectively considering the parties’ conduct would reasonably conclude that the parties intended to be bound or not.
In regard to the subject to contract clause, the Court held that the question was whether the parties have nevertheless agreed to enter into contractual relations on particular terms, notwithstanding their earlier understanding or agreement. In effect, the parties could agree by conduct to waive their earlier agreement not to be bound. Court needs to consider the facts of the case and what seems commercially probable.
The Court distinguished British Steel, where there had been a fundamental disagreement about the terms applying to the relationship and applied the Percy Trentham principle, as substantial performance had already occurred on both sides. The Court held that by their conduct the parties had affirmed the existence of the contract by carrying out the works, making payments and agreeing a variation to the delivery programme on 25 August 2005. The parties had implicitly accepted that there was a contract already in place and to deny the existence of one would therefore make no commercial sense. The Court held that it was unconvincing to think that RTS was agreeing to proceed with detailed work and to complete the whole contract on a non-contractual basis subject to no terms at all.
The Supreme Court therefore held that a contract had been created after the expiry of the Letters of Intent and it did incorporate the MF1 conditions. The Court ruled that a “reasonable honest businessman” would have concluded that some agreement had been reached after the expiry of the Letter of Intent, not just because performance had started but also because essential terms such as the price had already been agreed and negotiations for the long form of contract were so well advanced that there were, in reality, only a few non-essential terms outstanding.
In regard to Clause 48 the Court held the parties had agreed to waive its effect and had decided to “let sleeping dogs lie”.
The decision can be seen as the latest progression in a line of cases beginning with Lord Hoffman’s speech in Investors Compensation v West Bromwich Building Society  UKHL 28, where the Courts have been willing to adopt a commercial, rather than an overly legalistic approach. The parties’ intention, given the circumstances of the case, should not be viewed through the eyes of lawyers, but through the eyes of reasonable honest businessmen stepping into the parties’ shoes.
As Lord Clarke commented, “The different decisions in the Courts below and the arguments in this Court demonstrate the perils of beginning work without agreeing the precise basis on which it is to be done. The moral of the story is to agree first and start work later”. He also observed that the dispute had taken almost 5 years to reach the Supreme Court.
The dispute was a classic example of the risks involved of commencing a large project without finalising a proper contractual agreement, signed by all parties. When a dispute arises, a time-consuming, expensive and fact-intensive analysis needs to be carried out by the Courts to determine the legal position of each party.
When a contract has not yet been completed, parties should maintain and circulate clear schedules of where the contract negotiations have arrived at, what arrangements have been agreed and whose responsibility each action point is to resolve. This would leave less room for confusion at a later date as to what has, and has not, been agreed.
The author of this article has significant experience in advising clients involved in complex and high value commercial litigation. For advice and information in relation to the issues set out in this article, please contact Jerome O’Sullivan of Healys LLP on 020 7822 4144 or Jerome.firstname.lastname@example.org.