Earlier this year, the Supreme Court overturned the Court of Appeal's decision in RTS Flexible Systems Limited v Molkerei Alois Müller Gmbh & Co KG and decided that a contract did exist, despite the fact that the parties had never entered into a formal written contract.

The decision follows a number of recent cases decided by the Court of Appeal on the issue of contract formation where a party has commenced work under a letter of intent/interim contract before the contract has been finalised. This decision is of interest when contrasted to the other decisions where the Court of Appeal has decided against the existence of a contract.

The Facts

As mentioned in our earlier Briefing Note on this subject, the case involved RTS (a manufacturer specialising in the supply of automated machines for packaging and product handling in the food industry) successfully tendering for a £1.68 million contract to supply Müller with an automated system for packaging yoghurt pots. In a nutshell, the parties agreed that RTS would start work on the basis of a letter of intent while they negotiated the terms of the final contract. The final contract was to be based on industry model standard conditions (MF/1) amended to reflect the project between the parties. Clause 48 of the MF/1 conditions stated that:

"This 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."

That clause was treated by all three Courts as being a "subject to contact" provision. A draft contract was prepared but was never signed by the parties. After the expiry of the letter of intent in May 2005, RTS continued to work on the project and the parties continued to negotiate the terms of the draft contract.

By 5 July 2005, the parties had reached substantive agreement on all major points. RTS continued its work throughout the negotiations, but ran into difficulties with the project between June and August 2005 which meant that it would be unable to meet the original delivery timetable (which led to the parties' agreement to vary the delivery plan).

A dispute then arose as RTS did not carry out the site acceptance testing stipulated in the tender document. Müller alleged that the equipment had defects and made partial payment (but refused to pay the outstanding balance). RTS sued Müller for the outstanding balance of the contract price.

Contrasting decisions of High Court and Court of Appeal

The High Court had found that there was a contract between the parties but on limited terms. RTS appealed to the Court of Appeal who disagreed with the High Court's finding and held that there was no contract between the parties.

The Court of Appeal accepted that the counterparts clause prevented a contract incorporating a schedule to the draft contract from coming into existence until a written agreement was signed. It went on to find that the existence of the counterparts clause meant that no contract came into existence post termination of the letter of intent. Müller appealed.

Supreme Court decides contract existed

The Supreme Court allowed the appeal and decided that Muller and RTS did reach a legally binding agreement which was not "subject to contract". The Supreme Court considered that three possible conclusions were open to it: (1) that there was no contract between the parties (as held by the Court of Appeal) (2) that there was a contract on the limited terms found by the High Court; or (3) there was an agreement between the parties on some other wider terms.

In reaching its decision that the third conclusion was the correct one, Lord Clarke took into account the following issues:

Both parties had accepted that a contract price of £1.68 million had been agreed. Therefore, it must have formed a part of the contract between the parties. If the price is to be a term binding on the parties then it cannot be a case of no contract.

A no contract solution would involve RTS agreeing to proceed with detailed work and to complete the whole contract on a non-contractual basis subject to no terms at all. In those circumstances, the no contract solution was unconvincing.
The parties had agreed to vary the contract in August 2005 without any suggestion that the variation was agreed "subject to contract".

It was a striking feature of this case (in contrast to many of the other cases), that essentially all the terms were agreed between the parties and that substantial works were then carried out by RTS. The parties treated the agreement reached in August 2005 as a variation of the agreement that they had reached by 5 July. Nobody suggested in August that there was no contract and, therefore, nothing to vary.

In reaching its decision, the Court also considered the issue of whether the parties had agreed to be bound by the agreed terms without the necessity of a formal written contract (or, in other words, had they agreed to waive the "subject to contract" clause?). On the facts, the clear inference was that the parties had agreed to waive the "subject to contract" clause. As Lord Clarke put it:

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

Lessons to be learnt

The decision highlights the importance of agreeing the terms of a contract before starting work. Although the Supreme Court decided that there was a contract on the facts of this case, it is clearly undesirable for parties to leave this issue in the hands of the Court to be determined. Lord Clarke summed up the lesson to be learnt as:

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

Of course, in reality, businesses will not always find it possible to act on that advice. Commercial pressures will often mean that a party starts work on the basis of what has been agreed in a letter of intent or interim agreement. In that situation, they should bear in mind that commencing work to carry out their side of the contract may result in them waiving the protection offered by a "subject to contract" clause.

Rebekah Black

20 July 2010

This note provides an update to a case covered in February 2010: The Perils of Starting Work Before a Contract is Concluded.