UK: Supreme Court In Contract Crunch Corner

Last Updated: 25 August 2010
Article by Paul Stone and Nick Mitchell

Would you commence work under a commercial agreement before finalising a written contract?

Paul Stone and Nick Mitchel comment on a recent Supreme Court decision which highlights the perils

RTS Flexible Systems Limited v Molkerei Alois Müller Gmbh & Company KG (UK Production) ("RTS v Müller") [2010] UKSC 14, 10 March 2010

Starting to perform a commercial arrangement before a formal contract has been concluded, relying only on draft contractual documents or a letter of intent and an "understanding" that a binding deal will be done as soon as possible, is always messy and highly risky if no final deal is concluded. Despite this, the volume of cases of this type continues to flow unabated, as commercial realities force contractors and their clients to start work to meet a deadline or take advantage of a window of opportunity before contractual niceties have been finalised.

Historically, the courts have tried to make sense of the situation by constructing a contract from the parties' conduct and implying into it the key terms based on the main pre-contract documents relied on by the parties in their negotiations. However, the viability of such an approach was thrown into real doubt by the decision of the Court of Appeal in RTS v Müller, which decided that a clause in draft contractual documents to the effect that no contract could be concluded until both parties had formally executed the contract (which had not happened) nonetheless prevented the creation of any contract based on the draft documents. The court effectively gave contractual force to the very clause which sought to block a contract being created. A paradoxical result if ever there was one.

Fortunately, the Supreme Court has now overturned that decision, on terms which avoid the real conceptual uncertainty created by the Court of Appeal but still exposes parties to considerable risk and uncertainty where work is started on a project before a binding contract has been concluded.

FACTUAL SUMMARY

RTS Flexible Systems Limited ("RTS") successfully bid to supply an automated packaging system for the wellknown dairy product company Molkerei Alois Müller Gmbh & Company KG ("Müller"), for the purposes of assembling multipacks of yoghurt.

The parties entered into a binding letter of intent dated 21 February 2005, under which RTS were to begin work on the basis that Müller had the right to cancel and to pay only expenses and cancellation costs up to the date of determination of the letter, if by then no concluded contract had been executed. The letter of intent stated that the eventual contract would be based on Müller's amended form of MF/1 contract. MF/1 is a model form of contract produced by the Institution of Engineering and Technology for use in the engineering industry. The letter of intent was renewed from time to time, but eventually expired on 27 May 2005.

By 25 May 2005 a form of draft contract had been largely agreed between the parties. The agreed section of the contract contained Müller's version of the MF/1 terms.

These contained limitations on the contractor's liability and liquidated damages provisions. They also included a "counterparts" clause at Clause 48 which stated:

"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 exchanged it with the other"

For reasons not explored at length in the judgment, a dispute subsequently arose and negotiations broke down after the expiry of the letter of intent but before a formal contract based on the draft had been finalised and executed.

Clauses like Clause 48 are of value not in the context of cases where contractual performance has already started as in this case, but because they re-emphasise and act as a statement of intent that all negotiations between the parties are "subject to contract". Hence where a final contract is not concluded it is far harder for either party to run the argument that a binding contract had already been agreed orally and/or in correspondence and therefore that the executed contract was simply confirmatory of a "done deal".

The clause is included in the contract so that the precontractual intention not to be bound until the contract is actually finally signed is clear and that any attempt to try to construe a contract in any other way is blocked. This makes complete sense so long as the parties don't actually start to perform. In a case where there is a letter of intent which contemplates that the parties will start to perform, the scope for future confusion is clear.

ISSUES

The main issues in dispute were:

  • was there a binding contract between the parties following the expiry of the letter of intent?
  • if so, what form did that contract take?

These issues were of immediate practical importance to the parties in determining which terms applied, if any, dealing with payment of the contractor and limiting its potential liability.

FIRST INSTANCE DECISION

Both parties submitted that there was some form of contract:

  • Müller argued that the letter of intent had expired and that the contract comprised certain documents and schedules which had been agreed upon.
  • RTS submitted that the letter of intent continued to be in force and that its terms governed the relationship. Alternatively they submitted that any contract incorporated the MF/1 conditions.

The judge at first instance held that the continuation of work after the expiry of the letter of intent gave rise to the presumption that a contract of some form was in place. This is the classic analysis, but the real uncertainty that arises then is what terms are to be implied into such a contract, as by definition the parties have not actually committed themselves to the terms of the actual contract they were negotiating. This is where the real element of risk arises which will depend on an analysis of what the parties had actually agreed up to that point in their negotiations and also what had been agreed on the ground between the people responsible for the delivery of the contract (in many cases two very different things).

In this case the judge decided that the parties had concluded a contract without the inclusion of the MF/1 Terms, which were excluded by virtue of Clause 48. The actual contract that came into effect comprised certain documents in detailed schedules which had been agreed.

COURT OF APPEAL DECISION

RTS appealed the preliminary decision. However, they changed their position between the first instance decision and the appeal. Whereas in the High Court they had argued that the letter of intent continued to apply or alternatively that another contract existed comprising the MF/1 terms, in the Court of Appeal they argued that no contract had come into existence at all following the expiry of the letter of intent.

The Court of Appeal concluded that the first instance decision was wrong, in that Clause 48 did not just prevent the contract including the MF/1 Terms, it actually operated to prevent a contract coming into effect at all.

The judge at first instance was wrong to impose a contract in terms that had never been agreed by the parties, in circumstances where the basis of the draft contract was that no contract came into place unless agreed in writing:

"By simply selecting the schedules he achieved a bargain neither had entered into."

No contract of any type came into existence following the termination of the letter of intent. In the absence of a contract, RTS would be entitled to recover on a quantum meruit basis ("the amount he deserves") for the work done during this time and their liability would be limited to the amount of money that had been paid.

In a nutshell, the Court of Appeal gave overriding contractual effect to Clause 48. In essence there was a "pre-contract" between the parties where they had agreed to negotiate subject to the pre-condition in Clause 48. In a case like this such an analysis might have had more merit if the clause had been included in the letter of intent and had been expressed to survive the termination of that letter.

SUPREME COURT DECISION

The Supreme Court overturned the decision of the Court of Appeal, but did not revert entirely to the decision of the judge at first instance. The Supreme Court agreed with the original judgment that the conduct of the parties showed that there was a clear intent to create legal relations. A binding contract had been created.

However, the conduct of the parties also demonstrated that they had agreed to waive the need for a formal written contract as set out in Clause 48:

"The clear inference is that the parties had agreed to waive the subject to contract clause, viz clause 48. Any other conclusion makes no commercial sense."

Commonsense says that this must be right. Not only had a contract been agreed, but it was on wider terms than those set out by the judge, including the MF/1 terms. Crucially for RTS, this meant that the contract which had been agreed included the limitation on liability set out in the MF/1 conditions.

APPLICATIONS

The decision of the Supreme Court overturns the central element of the ruling by the Court of Appeal. The Supreme Court disagreed that a term in a draft contract which requires a fully-executed contract to exist could operate to prevent a binding contract coming into existence, where that term does not itself have contractual effect.

It may depend on the facts but it is to be hoped that the decision will prevent such a counterparts clause acting as a complete bar to a contract coming into effect. The decision is a sensible and practical one, especially in the application of the "reasonable, honest businessman" test:

"If one applies the standard of the reasonable, honest businessman suggested by Steyn LJ, we conclude that, whether he was an RTS man or a Müller man, he would have concluded that the parties intended that the work be carried out for the agreed price on the agreed terms [...] without the necessity for a formal written agreement, which had been overtaken by events."

However whatever decision a court will come to as to the existence (and terms) of any contract agreed between the parties will be very dependent on the facts:

"Whether in such a case the parties agreed to enter into a binding contract, waiving reliance on the 'subject to [written] contract' term or understanding will again depend upon all the circumstances of the case, although the cases show that the court will not lightly so hold."

Until a written contract is concluded, any work done by a contractor for an employer is performed against a background of considerable risk and uncertainty for both parties. The level of payment and any limitation of liability may or may not be agreed.

In RTS v Müller, three different courts reached three different conclusions as to whether a contract existed and the terms of that contract. It remains an important illustration of the need to finalise written contracts and to be sure of the contractual position before work begins.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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