Date 20 July 2010
It’s only natural to want to get on with the job as soon as you’ve won the order or contract. Suppliers want to get orders out so they can start billing, buyers want their orders fulfilled quickly and, in many cases, parties will start work before agreeing formal terms and continue to negotiate these whilst the initial phases of a project are performed. There is nothing wrong with this provided terms are put in place to govern the work carried out before the full blown contract is signed. Such terms are commonly set out in letters of intent, memoranda of understanding and heads of terms. It doesn’t really matter what the document is called but the key points to ensure are that it:
- makes clear which of its provisions are intended to be legally binding and which are not; and
- covers all of the issues and risks you need to address to safeguard yourself once work has started but before a final contract is completed.
If no such provisions are agreed, or any interim terms are allowed to lapse, then the risks of starting work (or allowing work to be started) can be significant. To quote Lord Clarke from his speech in RTS Flexible Systems Limited v Molkerei Alois Műller Gmbh & Company KG [2010] UKFC 14:
“ [the case] demonstrate[s] the perils of beginning work without agreeing the precise basis upon which it is to be done. The moral of the story is to agree first and to start work later.”
This makes perfect common sense but as anyone in business knows, sometimes common sense has to yield to commercial reality. Both Műller and the Whittle Movers cases which are discussed below illustrate some of the issues which can arise in this area and are excellent examples of how commercial relationships which often seem rosy at the outset can quickly sour and throw up unforeseen and expensive legal and commercial issues. The risk of this happening can be mitigated by taking a step back, ensuring that you agree suitable interim terms before you start work and:
- checking and ensuring that you understand which, if any, parts of any heads of terms or equivalent are intended to be legally binding and which merely record statements of intent to help shape the negotiation of the main agreement. If the document is stated to be entirely “subject to contract” insist on some binding interim terms;
- ensuring that the parts of any letter of intent or equivalent which are intended to be binding cover the significant issues which are likely to arise during the period it is intended to cover, including the renewal/termination of its term, price, quantity, quality/specifications, delivery dates or other contractual milestones and how these are to be documented/measured, limitations and/or exclusions of liability (including liquidated damages if appropriate) and the incorporation of any industry standard terms or your own usual terms of business in so far as these might be applicable;
- checking any standard terms your counterparty wants to incorporate: the acid test with these is, are they appropriate to a short term arrangement?
- diarising (with early and frequent reminders) the expiry date of any interim agreement or dates by which notice to terminate this must be served;
- checking for the existence of a counterparts clause (see below the Műller case below) or any other “subject to contract” type wording, as well as considering how this might operate in practice;
- checking whether any terms which are incorporated into an interim agreement by reference are not inconsistent with either the express terms of any interim agreement or the circumstances the short term provisions are intended to cover;
- not relying on boilerplate provisions or terms from other projects (however similar they were) without scrutinising them carefully - they are probably designed for use in longer term agreements and may well be unsuitable for short term use; and
- getting on with negotiating the terms of the final agreement and completing it as quickly as possible.
When a Letter of Intent Expires
Műller concerned a £1.68 million project to supply an automated system for packaging yoghurt pots. RTS began work on the system on the basis of a four week letter of intent which was supposed to cover the period in which the terms of the final contract were negotiated. The negotiations were successful and led to the production of a draft contract but this was never signed and, crucially, the letter of intent expired before the negotiations were concluded.
The project ran into significant difficulties, in particular, in relation to delivery timescales. Műller only paid part of the contract price (which had been specified in the letter of intent) and RTS sued for the balance or, alternatively, damages. The case went from the High Court (where Műller won) to the Court of Appeal (where RTS was successful) and onto the Supreme Court (where Műller ultimately prevailed). Much of the argument focused on whether or not the following wording, which appeared in some industry standard terms and conditions which were incorporated by way of a schedule to the draft contract, effectively prevented any contract being created until its terms had been complied with:
“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 purpose of “counterpart clauses” like this one is to facilitate easier completion arrangements: each party can execute a separate copy of the contract, rather than having to pass one original between them by post or having a meeting to sign, and they make good commercial sense. All three courts which considered the case found that the effect of the counterparts clause was to render the draft agreement “subject to contract” and it was therefore potentially capable of preventing a contract coming into force at all until each side had executed and exchanged a counterpart with the other. This interpretation is not surprising and parties might well take comfort from the protection that the clause gives in terms of preventing themselves from being bound by an agreement before they want to be. However, the Supreme Court found that by their conduct RTS and Műller had effectively agreed to waive the subject to contract provision. Applying the standards of a reasonable, honest businessman referred to in previous case law, the court concluded that they intended the work carried out by RTS to be done for the price which had been agreed in the letter of intent.
The takeaway point from this is that by beginning to perform its part of a contract, a business may waive the protection it could otherwise have derived from a “subject to contract” provision. If you use standard terms which contain a counterparts clause you should review this and consider whether or not it may work in your favour in light of the agreement you may or may not want to contend for if you are starting work on the basis of a draft unsigned agreement as is often the case when one side or other refers to such terms as a quick fix to get the ball rolling on a project.
But There’s Always a Contract, Isn’t There?
Műller is a significant decision because it may end a trend which has developed in the Court of Appeal of late in contract formation cases where the court has on several occasions found that no contract has been formed and awarded alternative remedies, such as orders for a quantum meruit payment (where a contractor is awarded a reasonable sum for work done) or required an inquiry into whether one party has been unjustly enriched at the expense of the other. An example of this is Whittle Movers Limited v Hollywood Express Limited [2009] EWCA Civ 1189, in which the court was of the view that it should not strain to find a contract because an alternative remedy can solve some of the legal acrobatics it might otherwise have to perform to find a contract on the facts of a case.
Whittle is another letter of intent case and it highlights the risks of starting work on the basis of interim terms but then acting as if a long term agreement has been put in place. In the case Hollywood had to provide distribution services for the UCI and Odeon cinema chains as well as the Blockbuster film rental business. It was able to subcontract these services and selected Whittle as its prospective subcontractor. Hollywood sent a letter of intent to Whittle which stated:
“The implementation of this letter of intent is subject to the negotiation and execution of mutually satisfactory and legally binding documentation. The contract will be on the terms of the draft contract attached to [Hollywood’s] invitation to tender, amended to take into account the commercial details agreed during the tender process. The first draft of this contract will be issued by [Hollywood’s] legal team. For the avoidance of doubt, this letter of intent does not bind either party to enter into a contract for supply of distribution services, and any work undertaken by either party in anticipation of such contract shall be at that party’s cost and risk…”
Whittle subsequently began to perform distribution services under the terms of the proposed long term contract before its terms had been agreed, let alone signed. Whittle invoiced Hollywood on the basis of the prices negotiated for the proposed long term deal and Hollywood paid what was asked of it.
Several months later, Hollywood’s owners decided to sell it and a year after Whittle started providing its services, Hollywood gave it six months’ notice to terminate any contract with it. The ensuing dispute ended up in the Court of Appeal which found that as a result of the relationship between the parties, Whittle had only been paid at prices appropriate to a long term contract as opposed to a higher rate which it would no doubt have sought to impose to reflect the risks inherent in a short term deal, and ordered an inquiry into whether Hollywood had been unjustly enriched by this. These inquiries can be complex and expensive and this was almost certainly not the outcome Whittle envisaged when it started work in the first place.
If you would like more information or advice on contractual issues or disputes, please contact Simon Walsh on 01727 798085 or by email at simon.walsh@salaw.com
© SA LAW 2010
Every care is taken in the preparation of our articles. However, no responsibility can be accepted to any person who acts on the basis of information contained in them. You are recommended to obtain specific advice in respect of individual cases.