Formation of Contract

06/04/2010

In the much litigated area of contract law relating to the creation of contracts and intention to create legal relations, the Supreme Court recently held that a legally binding contract existed between parties even though there was no formal executed written agreement and the letter of intent incorporated a 'subject to contract' provision.

Facts
In January 2005, RTS Flexible Systems Limited ("RTS"), a supplier of automated machines for the food industry won a tender to manufacture and deliver an automated system for packaging yoghurt pots to Molkrti Sloid Muller Gmbh & Co Kg ("Muller"), a renowned supplier of dairy products. Parties signed a four week letter of intent ("LOI") with the terms of a final contract to be agreed so as to allow RTS commence work and meet the project time scales. The LOI stated that the final contract would incorporate, inter alia, the "MF/1" terms and conditions which were model form terms of the Institute of Electrical Engineers. The MF/1 terms and conditions included a 'subject to contract' provision which provided that the agreement was not effective until it was signed.

The LOI was extended twice but finally expired in May 2005 and negotiations continued. In the meantime, RTS worked on the project and completed the same in September 2005. Muller paid 70% of the final quote of £1.682 million previously provided by RTS. RTS issued proceedings against Muller for the outstanding balance of the contract price, or alternatively damages. Muller counterclaimed that the machines were defective.

The question of whether parties had entered into a legally binding contract following the expiry of the LOI and if so, on what terms, were tried as preliminary issues.

The ruling
The High Court and Court of Appeal drew different conclusions. The High Court held that a contract had come into existence which contained part of, but not all the terms negotiated in the draft formal agreement. The High Court relied on the decision in G Percy Trentham Ltd v. Archital Luxfer [1993] 1 Lloyds Rep 25 where it was held that as substantial performance had taken place, it was impractical to decide that parties did not intend to create legal relations. The Court of Appeal, however, adopted the approach in British Steel Corporation v. Cleveland Bridge and Engineering Co Ltd [1984] 1 All ER 504 and went on to decide that there was no contract as the 'subject to contract' provision had been clearly agreed by parties. This prevented the whole of the draft contract from being effective.

It is helpful to note at this point that the 'subject to contract' clause in this case was in fact originally drafted as counterparts provision. A counterparts provision generally allows parties to execute separate copies of an agreement, which is a useful provision to have where parties are not all physically present at the same place during signing. This clause provides certainty as to when an agreement becomes effective. In this case, the clause stated that 'the Contract may be executed in any number of counterparts provided that it shall not become effective until each party has executed a counterpart and exchange it with the other.'

The Supreme Court considered the conflicting decisions but finally held that a contract was created after the expiry of the LOI and parties had, by conduct, (1) agreed all the essential terms including, inter alia, that the project would be carried out by RTS at an agreed price, and (2) waived the 'subject to contract' provision that was incorporated into the LOI. It concluded that in the opinion of an honest reasonable businessman, negotiations for the final contract were well into advanced stages and only non-essential terms remained outstanding.

The Supreme Court confirmed that the general principles of contract formation are not in doubt, but whether a court will ultimately hold that a binding contract has been created will always depend on the individual circumstances of each case.

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 upon which it is to be done. The moral of the story is to agree first and start work later."

Observations

1. As boilerplate clauses contained in contracts are sometimes glossed over as 'standard terms' by businesses during negotiations, in view of this decision, it is prudent to review the drafting of boilerplate counterpart clauses to prevent them from being construed as 'subject to contract' provisions.
2. The general principles of the law state that a contract is formed when parties intend to create legal relations, i.e. parties have agreed to all the essential terms. However, commercial reality is such that sometimes an entity/individual begins performance even before a final agreement is documented. Based on this decision, parties must be aware that in doing so, they run the risk of waiving rights to protection under 'subject to contracts' clauses contained in any draft contracts, letters of intent or similar documentation which may consequently result in disputes and long drawn out proceedings.

Contact: xiaohanguo@city-law.net

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