Contract formation: Letters of intent, "subject to contract" and waiver by conduct
The Supreme Court ("the Court"), on appeal from the Court of Appeal, has given an important judgment in RTS Flexible Systems Limited v Molkerei Alois Müller Gmbh & Company KG (UK Production) ("RTS"). This will be of relevance to parties who continue works after the expiry of a letter of intent but before a formal written contract is finalised, and to those who intend to rely on "subject to contract" and "counterparts" clauses in contracts.
In RTS, the parties had initially intended to enter into a detailed written contract which would set out all the complex terms on which the work was to be carried out and the equipment supplied. However, as often happens, the terms were not finalised before it was agreed that work should begin. It was common ground that the parties entered into a contract formed by a Letter of Intent dated 21 February 2005 and a letter from RTS dated 1 March 2005 ('the LOI Contract'), the purpose of which was to enable work to begin on agreed terms. It was accepted that the LOI Contract was treated by the parties as expiring on 27 May 2005, and provided for the whole agreed contract price of £1,682,000, that not being limited to the price of the works to be carried out during the currency of the LOI Contract. The parties also intended from the outset that the full contract terms were to be based on Muller's MF/1 terms. In this case, essentially all the terms were agreed between the parties, substantial works were carried out, and the agreement was later varied in important respects before disagreements arose.
The essential issues in the appeal were whether the parties made a contract after expiry of the LOI contract and, if so, on what terms.
As to terms, the argument centred on whether the contract was subject to some or all of the MF/1 terms as amended by agreement before any formal contract following the LOI Contract was signed. That formal contract was never signed. The MF/1 terms contained detailed provisions, including a liquidated damages clause and the following counterparts clause:
"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".
The Court considered the effect of the parties' understanding, reflected in clause 48 of the draft contract, that the contract would "not become effective until each party has executed it and exchanged it with the other", which never occurred. Did this mean that the work actually done was covered by a contract or not? The Court agreed with the submission that, in a case where a contract is being negotiated subject to contract and works begin 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". The courts will not impose binding contracts on parties which they have not agreed. It will all depend on the circumstances.
The Court found that the parties did intend to create legal relations, and that a contract was in place after expiry of the LOI Contract. Because the price of £1,682,000 was agreed, it was held that the price must have formed part of a contract between the parties. It could not therefore be said that this was a case of there being no contract. Since the LOI Contract had expired, the contract containing the price had to be contained in some agreement other than the LOI Contract.
The Court held that by 25 August 2005 at the latest, when a variation was agreed, the parties' communications and actions led to the conclusion that they had agreed a contract that RTS would perform the work and supply the materials on the terms agreed by them "subject to contract" and as varied by the variation agreement. This was despite the fact that not all the Schedules to the agreement had been agreed and finalised. The Court said that the argument that there was no contract at all was unconvincing - such a contention would involve RTS agreeing to proceed with detailed work and to complete the contract on a non-contractual basis subject to no terms at all.
The Court then considered whether the parties had agreed to be bound by the agreed terms without the necessity of a formal written contract or, put another way, had they agreed to waive that requirement and clause 48, which was viewed as a "subject to contract" clause?
The Court agreed that before it could be held that there was a binding contract on the MF/1 terms as amended by agreement, unequivocal agreement that clause 48 had been waived would be required. However, the Court held that it was not necessary for the waiver agreement to be an express statement by the parties to that effect. Such unequivocal agreement could in principle be inferred from communications between the parties and conduct of one party known to the other.
The Court found that, on the facts, the parties had agreed to waive clause 48 . The price had been agreed, a significant amount of work had been carried out and the variation was not expressed to be subject to contract. The Court said the clear inference was that the parties had agreed to waive the subject to contract clause, clause 48, and that: "Any other conclusion makes no commercial sense. RTS could surely not have refused to perform the contract as varied pending a formal contract being signed and exchanged". 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, without the necessity for a formal written agreement.
Lord Clarke opened the judgment by saying:
"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 to is to agree first and to start work later".
Commercial reality often means that parties start works on contracts before all the terms are finalised in a signed contract. However, even if an unsigned contract contains a "subject to contract" clause which expressly states that it is not to be binding unless and until signed by both parties, the terms of the unsigned contract could become binding on the parties if, by their communications and conduct, they waive the requirement for signature. This may not be what the parties intended. This is more likely to be the case where, as in RTS, the price and nearly all the terms have been agreed.
To avoid uncertainty or being bound to terms that the parties do not wish to apply to future work, if relevant terms of a letter of intent (such as a contractual cap on the price or the time for expiry of the letter of intent) are about to expire the parties should finalise the formal contract that is to be entered into before proceeding with works. Should this not be possible then the terms of the letter of intent should be updated and agreed in writing. If these options are not possible then no further work should be carried out.