Letters of Intent and Contract Formation [An Insightful Piece]

Letters of intent has caused many problems for parties and it is something that should be approached with great circumspect and care.

We reported on the perils of beginning work without agreeing the precise basis upon which it is to be done in both our June 2008 Updater report on RTS Flexible Systems Ltd v Molkerei Alois Muller GMbh & Co KG [2008] EWHC 1097 and our March 2009 Updater report on the Court of Appeal decision in the same case. In RTS Flexible Systems Ltd v Molkerei Alois Muller GmbH & Co KG [2009] EWCA Civ 26 the Court of Appeal reversed a key finding of the lower court. The case has now gone to the Dispute Court.

The moral of the story from the decision of the Supreme Court (which replaced the House of Lords as the court of final appeal) is to agree the terms of contract first and start work later.

RTS Flexible Systems Limited (Respondents) v Molkerei Alois Muller Gmbh & Company KG (UK Production) (Appellants) [2010] UKSC 14

The relevant facts

• It was common ground that the parties entered into a contract formed by a letter of intent (the LOI), the purpose of which was to enable work to begin on agreed terms for an agreed period.
• The contractor carried out works and was paid by the employer under the terms of the LOI whilst negotiations proceeded on the terms of the MF/1 contract which the parties proposed to enter (the MF/1 terms) which was to form schedule 1.
• Detailed negotiations and amendments to the MF/1 terms (including contract price, payment, warranties, guarantees, inspection, testing, delay, defects liability, limitations of liability and the like) had taken place.
• The fourth draft of the MF/1 terms “with final tweaks” was sent to the contractor on 16 May 2005.
• The parties agreed that the LOI contract expired on 27 May 2005.
• The final tweaks to the MF/1 terms were resolved between the parties on 5 July 2005 – the employer told the contractor that he would put the MF/1 terms into a contract with all the schedules and send to the contractor for signature later that week.
• Problems arose between June and August 2005 with delay to some of the free issue equipment. These problems diverted attention away from finalisation of the contract documentation. No formal contract was ever executed between the parties.
• It was common ground between the parties that the contract terms between the parties were varied on 25 August 2005 at a meeting between the parties during which a discussion of the delay to some of the free issue equipment led to a variation of the delivery plans for the project.

The decision at first instance – there was a contract

The judge held that after the expiry of the LOI – when the parties continued negotiating the MF/1 terms – the natural inference was that:

• there was a contract between the parties (for the contractor to carry out the works for an agreed price);
• it was not essential for the parties to have agreed all the terms and conditions of that contract; but
• the terms of contract did not include the MF1/ terms but a limited list of some of the agreed schedules.

Why did the MF/1 terms not apply?

The judge had concluded that the MF/1 terms did not apply because:

• the LOI stated that the final contract terms were not to be contractually binding until signature i.e any agreement made between the parties was “subject to written contract”;
• clause 48 of the MF/1 terms expressly provided that the contract would not become effective until each party had executed a counterpart and exchanged it with the other (this had not occurred); and
• the contract was designed to operate as a composite whole consisting of the agreement and its schedules which included the MF/1 terms (at schedule 1) and the remaining schedules. Although many of the schedules had been finalised, several had not been agreed.

The importance of the MF/1 terms was that they contained detailed provisions on many matters including limitations of liability and liquidated damages provisions.

The decision of the Court of Appeal

The Court of Appeal had to decide whether:

• the judge was correct to hold that there was a contract between the parties after the expiry of the LOI; and
• if there was a contract whether it was right that it was not on the MF/1 terms?

The Court of Appeal held that the judge’s conclusion that there was a contract on limited terms resulted in the “extraordinary result” that the court had rejected in the British Steel Corporation v Cleveland Bridge and Engineering Co Ltd [1984] 1 AII ER 504.

• In short, Robert Goff J had concluded in British Steel that there was no contract between the parties on the basis that contracts for the supply of goods/services were often subject to a contractor’s standard terms of the contractor which typically limit liability;
• it was impossible to predict, during negotiations what liability (if any) a contractor would assume for his performance under the finalised form of contract; and
• if the contractor commenced performance before the formal contract was entered into, it would be an “extraordinary result” if, by taking steps to perform, the contractor assumed unlimited liability for its performance, which it would not have assumed under the formal contract.

Further, the Court of Appeal held that the effect of clause 48 of the MF/1 terms was to prevent any contract from coming into existence between the parties (not just a contract incorporating the MF/1 terms).

Accordingly, the Court of Appeal held that there was no contract between the parties after the LOI expired.

The issues before the Supreme Court

The issues before the Supreme Court were:

• whether there was a binding contract between the parties following expiry of the LOI?
• If there was a contract, what were the terms of that contract?

Was there a contract between the parties: the legal principles

The Supreme Court noted that the general principles were not in doubt. Whether there was a binding contract between the parties depended not upon the parties’ subjective state of mind but on a consideration of what was communicated to them by words or conduct and whether that led objectively to a conclusion that they intended to create legal relations and had agreed on all the terms which they regarded or the law regarded as essential for the formation of legally binding relations. If certain terms of significance to the parties had not been finalised, an objective appraisal of their words and conduct might lead to the conclusion that they did not intend agreement of all such terms to be a pre-condition to a concluded and legally binding agreement.

These principles were set out in the authorities reviewed by the Supreme Court including the British Steel case (which featured prominently in the Court of Appeal but had not been put before the judge). The authorities confirmed that:

1. Percy Trentham Limited v Archital Luxfer [1993] 1 Lloyd’s Rep 25:

• a contract can come into existence not simply as a result of offer and acceptance, but partly by reason of written exchanges, partly by oral discussions and partly by performance of the transaction; and
• a transaction which has been executed rather than executory can be very relevant because it may be unrealistic to argue that there was no intention to enter into legal relations or that the contract was void for uncertainty.
• the fact that the transaction is executed may make it possible to treat terms not finalised in negotiations as inessential.

Pagnan SPA v Feed Products Ltd [1987] 2 Lloyd’s Rep 601 – determining whether a contract had been concluded in the course of correspondence as well as by oral communications and conduct involved a consideration of the parties’:

• communications – whether by word or conduct;
• intention to create legal relations;
• agreement of all the terms which the parties regarded (or the law required) as essential for the formation of legally binding relations.

Agreement of all terms was not necessarily a precondition to the conclusion of a contract – minor details could be sorted out later once a bargain was struck.

There was no conflict between the Percy Trentham case and the British Steel case because each case was dependent upon its own facts. In Percy Trentham the substantial performance of the work was a very relevant factor pointing to the conclusion of a contract. In British Steel although performance had begun, there was no binding contract.

In cases which are “subject to written contract” the question which should be considered was: despite the fact that the parties may initially have required that any agreement they conclude was not effective until they have entered into a formal written contract, have the parties waived reliance on this earlier understanding through their communications and/or conduct during the course of negotiations? This question depended on all the circumstances of the case.

The decision of the Supreme Court

The Supreme Court considered that there were three possible conclusions which could be reached and addressed each in turn, namely:

• as the Court of Appeal held, that there was no contract between the parties;
• as the judge held, there was a contract between the parties but on the limited terms found by the judge; or
• that there was a contract between the parties on wider terms.

Conclusion 1: no contract

The Supreme Court agreed with the judge that it was unrealistic to suppose that the parties did not intend to create legal relations.

This was tested by asking whether the price for the works was agreed – both parties agreed that it was. Therefore, the agreed price of £1,682,000 must have formed part of a contract between the parties. As the LOI had expired, the contract containing the price must have been contained in some agreement other than the expired LOI and it could not on conventional principles be a case of no contract.

The Court of Appeal’s decision that there was no contract between the parties involved holding that there was no binding agreement as to price or anything else and that evidence of the agreed price was no more than evidence of what a reasonable price would be on a quantum meruit basis. This was not correct for the following reasons:

• neither party suggested in the course of the project that the price was not agreed (percentages of the price were invoiced by the contractor and paid by the employer);
• the agreed price of £1,682,000 for the whole of the project was included in the LOI with express reference to the contract being based on the MF/1 terms; and
• there was an agreed variation to the contract being negotiated between the parties on 25 August 2005 which neither party suggested was not a variation to the contract.

The Supreme Court concluded that Conclusion 1 was not convincing. Moreover, it involved the contractor agreeing to proceed with detailed work and to complete the whole contract on a non-contractual basis subject to no terms at all.

Conclusion 2: contract on the terms found by the judge

The Supreme Court agreed with the judge that the parties initially intended that there should be a written contract between them which was to be executed by each and exchanged between them.

If this position was tested on 5 July 2005, the correct conclusion might well have been that based on the facts there was no binding agreement not because the parties had not reached agreement on all the essential terms but because the agreement they had reached was at that point still “subject to written contract”.

However, the striking feature of this case was that – essentially all the terms of contract were agreed between the parties and substantial works were carried out – but the agreed contract terms were subsequently varied by the parties in important aspects.

The parties treated the agreement to amend the delivery plans for the project on 25 August 2005 as a variation of the agreement that had been reached by 5 July 2005. Neither suggested that there was no contract and thus nothing to vary. It was only when the parties were in dispute that arguments arose as to whether there was a contract or not.

The Supreme Court was of the firm view that the parties’ written communications and actions by 25 August led to the conclusion that they had agreed that the contractor would perform work and supply materials on the terms agreed between them up to 5 July, as varied by the agreement of 25 August 2005. It did not make commercial sense to hold that the parties were agreeing to the works being carried out either without any relevant contract terms or on some but not all the terms agreed by 5 July 2005.

Conclusion 3: contract was wider than that found by the judge

There were two issues that needed to be considered. First, did the parties intend to be bound by what was agreed or were there further terms which they regarded as essential or which the law regarded as essential in order for the contract to be legally enforceable?

The Supreme Court held that:

• the judge was correct to conclude that the fourth draft of the contract sent with the email of 16 May 2005 was designed to operate as a composite whole;
• the judge correctly recorded the employer’s recognition that the parties had reached a final draft of the contractual terms and conditions which contained the MF/1 terms as modified in the emails of 19 May, 25 May and 5 July 2005 (albeit some of the schedules were not agreed);
• essential agreement was reached by 5 July 2005;
• none of the issues which remained after that date to be agreed were regarded by the parties as an essential mater which required agreement before a contract could be binding;
• on a fair view of the negotiations and all the circumstances of the case, neither party intended agreement of those issues to be a precondition to a concluded agreement.

The second issue was: did the parties depart from the understanding that the agreement which they were negotiating was to be subject to a written contract, as had been the original understanding of the parties and as expressly provided in clause 48?

The Supreme Court accepted that no formal contract was ever signed or exchanged between the parties, so that, unless and until the parties agreed to vary of waive clause 48, the contract would not become binding or effective.

However, although the Court of Appeal considered that it would need a “clear express variation” of clause 48 before it could be said that a contract was concluded between them, the Supreme Court was of the view that it was possible for the waiver to be inferred from communications between the parties and the conduct of one party to the other.

On the facts, the Supreme Court held that the parties had agreed to waive the requirement of clause 48:

• the circumstances pointed to the fact that there was a binding agreement and that it was not on the limited terms held by the judge;
• final agreement of the essential terms had been reached by 5 July 2005;
• the subsequent agreement to vary the contract was reached without any suggestion that the variation was agreed subject to written contract;
• it was possible to draw a clear inference that the parties agreed to waive the express requirement in clause 48 – any other conclusion did not make commercial sense;
• a reasonable, honest businessman would have concluded that the parties intended that the work should be carried out for the agreed price on the agreed terms, including the terms as varied by the agreement of 25 August, without the necessity for a formal written agreement, which had been overtaken by events;
• this was not a case like Percy Trentham because that case was not a “subject to contract” case, but it was equally not a case like the British Steel case because in this case all the terms which the parties treated as essential were agreed and the parties were performing the contract without a formal contract being signed or exchanged whereas in British Steel the parties were still negotiating terms which they regarded as essential.
• The parties had chosen to “let sleeping dogs lie” rather than signing the contract as neither party wanted the negotiations to get in the way of the project. The only reasonable inference was that by or before 25 August they had waived the “subject to contract” provision of condition 48.

Editors’ comments

The Supreme Court reached a different conclusion from both the judge and the Court of Appeal. The judge’s decision that there was a contract between the parties resulted in the contractor’s potential liability to the employer being far greater than it was prepared to undertake during negotiations between the parties. This was an “extraordinary result” which highlighted the dangers to a contractor proceeding under an expired LOI.

The Court of Appeal’s decision that there was no contract between the parties resulted in the contractor undertaking no contractual liability whatsoever to the employer – arguably, also an “extraordinary result”- which highlighted the dangers to an employer of proceeding under an expired LOI.

The Supreme Court’s finding that a contract had come into being that incorporated the MF/1 terms accords with the sensible view that it would be almost inconceivable that the parties would have entered into an agreement for the performance of the whole project which was not based on detailed terms. However, parties need to be aware that acting as if the terms are agreed may led the court to conclude that contract terms are agreed, even if there is a requirement that the contract be signed and counterparts exchanged before the contract comes into effect.

If employers and contractors wish to preserve the term “subject to written contract” then they must ensure that no inference from either their conduct or communications can be drawn to waive such a requirement.

This decision highlights the importance of ensuring that parties’ reach agreement on contractual terms before commencing work, where possible, and the basis on which work is to continue after the expiry of a letter of intent.

Culled: Lexology

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