Allens

Construction & Major Projects

Focus: Dangerous liaisons – letters of intent

22 June 2012

In brief: A recent United Kingdom Supreme Court decision highlights the perils of an all-too-common commercial practice: of starting work on a project without formally agreeing the precise basis upon which it is to be done. The court held that, although no final contract had been executed, the parties reached a legally binding agreement through their conduct and communications (including a letter of intent), despite the existence of a 'subject to contract' clause. Partner Ren Niemann (view CV) and Lawyer Amanda Dominick report.

How does it affect you?

  • The case sheds further light on the risky approach of commencing work pending negotiation and execution of a finalised contract.
  • Use of letters of intent should be carefully scrutinised. They should only be used in very limited circumstances and only on very clear terms as to the scope of the works, duration of application and obligations of the parties (including price and payment). If a letter of intent expires, it should be expressly extended as necessary or the contractor stop any further works until a full and finalised contract is executed.
  • The case confirms that parties can, through their conduct and communications, waive 'subject to contract' provisions. As Lord Clarke said, 'the moral of the story is to agree first and start work later'.

Background

The respondents, RTS Flexible Systems Limited (RTS), specialised in the supply of automated machines for packaging and product handling in the food industry, while the appellant, Molkerei Alois Müller GmbH (Müller), is a well-known European dairy company.

In 2004, RTS produced a range of quotations to supply Müller with automated machines for collating and flow wrapping multi-packs of different flavoured yogurt pots. The last of these, 'Quotation J', included a pricing schedule that specified a fixed price and set out the scope of the work that was to be carried out by September 2005. It also provided for liquidated damages of 0.5 per cent of the fixed price if the site acceptance test of the equipment was delayed from the agreed program date and the delay was entirely due to the fault of RTS.

In order to meet the projected timeframes, RTS agreed to commence work on the basis of a letter of intent (LOI), dated 21 February 2005, from Müller to RTS. In the LOI, Müller expressed its wish to 'proceed with the project as set out in [Quotation J] subject to the following terms' which included:

  • the fixed price;
  • that RTS would commence all work required in order to meet Müller's deadline for full production of 30 September 2005; and
  • that the full contractual terms would be based on Müller's amended form of 'MF/1 Contract', which would be finalised, agreed and signed within four weeks of the date of the LOI. (The MF/1 Contract was a standard form contract which included a limitation of liability clause – in RTS's favour – and a clause that stated the contract would not become effective until each party had executed and exchanged their signed counterpart.)

With only the LOI in place, RTS commenced work and subsequently issued invoices to Müller, claiming specific percentages of the fixed price. Accordingly, Müller paid RTS 30 per cent of the fixed price on or about 28 April 2005, a further 30 per cent in September 2005 and 10 per cent in January 2006.

Despite the LOI's stipulation that a final contract would be entered into within four weeks of its date, nothing ever eventuated and the LOI expired. A dispute then arose in relation to defective equipment. RTS sought payment for its work from Müller, which then counterclaimed for its losses from the failure of the new production line.1

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The decision

On an objective assessment of the parties' intentions, the Supreme Court found that a binding contract had been established on wide terms which included the provisions of the MF/1 Contract. In coming to the decision, Lord Clarke summarised the general principles as to whether there was a binding contract:

The general principles are not in doubt. Whether there is a binding contract between the parties and, if so, upon what terms depends upon what they have agreed. It depends not upon their subjective state of mind, but upon a consideration of what was communicated between them by words or conduct, and whether that leads objectively to a conclusion that they intended to create legal relations and had agreed upon all the terms which they regarded or the law requires as essential for the formation of legally binding relations.2

In assessing whether the parties had established a contract on wider terms that incorporated those of the MF/1 Contract, the Supreme Court looked at whether the parties departed from the understanding that any formal agreement was to be subject to contract; and whether the parties intended to be bound by what was agreed; or whether there were further terms that they regarded as essential; or that were essential in order for the contract to be legally enforceable. In relation to these two questions, the Supreme Court concluded that:

  • the parties had agreed on all essential terms by July 2005, including 'to all intents and purposes' those in the MF/1 Contract; and
  • through communication and conduct, the clear inference was that the parties had waived the 'subject to contract' provision in the MF/1 Contract.

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Comment

The decision provides a clear message to contracting parties of the dangers of using letters of intent and starting work without a formal contract. Importantly, a failure to agree and formally document terms before work starts may lead to unintended contractual obligations and liabilities.

Footnotes
  1. RTS Flexible Systems Limited v Molkerei Alois Müller GmbH & Co [2010] UKSC 14 and 38.
  2. RTS Flexible Systems Limited v Molkerei Alois Müller GmbH & Co [2010] UKSC 14 at paragraph 45.

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