“Subject to” Contracts and Agreements “Not Completed”

“The moral of the story is to agree first and start work later.” So observed Lord Clarke recently, in delivering the unanimous judgment of the United Kingdom Supreme Court in RTS Flexible Systems [“RTS”] v. Molkerei Alois Muller Gmbh [“Muller”]. The judgment considers several questions of law that are of significance to long-term commercial contracts, particularly when there is doubt as to whether the parties have at all concluded a contract in the first place.

One may wonder why parties would choose to proceed with a significant commercial relationship in the absence of a clear and concluded contract. For a variety of commercial reasons, however, the execution of a project sometimes predates the conclusion of the contract. In these circumstances, parties commence work in the expectation that they will reach agreement in the near future on their contractual relationship. When, however, they fail to do so, their contractual relationship can only be derived from conduct, and the legal principles governing this exercise were the subject matter of discussion before the UK Supreme Court in RTS.

In this case, Muller sent a “Letter of Intent” [“LoI”] to RTS in 2005 indicating its intention that RTS execute a certain long-term project for Muller. The LoI indicated the price payable, delivery date, and provided that full contractual terms would be agreed within four weeks from the date of the LoI. The LoI provided that this agreement would be based on a Muller standard form known as MF/1, suitably modified. Both parties envisaged at the time that such an agreement would in fact be reached, and RTS commenced work immediately. A draft contract was then sent to RTS, which, as is common in these transactions, was a lengthy and detailed contract. It contained the essence of the MF/1 clauses, of which one was Limitation of Liability. Another clause, known as the Counterpart Clause, provided 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”.

The parties began negotiating on various terms of this contract, and subsequent correspondence indicated that the parties had more or less reached agreement on the contract, which was to be prepared for signature. Payments were made periodically to RTS, and the parties also agreed a modified delivery schedule to address certain anomalies in one of the components of the Project. Subsequently, however, disputes arose, and RTS brought an action for the contract price and, in the alternative, damages. RTS argued (omitting some detail) that the parties had not agreed any contract, or, in the alternative, had concluded a contract that included the MF/1 terms embodied in the draft exchanged by the parties. In the first alternative, the contract price would only represent what the parties presumably considered a reasonable sum for quantum meruit. The judge at the first instance and the Court of Appeal reached differing conclusions as to the existence of the contract and its terms. The Court of Appeal had held that there was no effective contract between the parties mainly because the counterpart clause had not been satisfied.

The Supreme Court begins with a very useful summary of the general principles to apply in these circumstances. With an “objective” theory of contract formation, whether there is a binding contract between the parties

… 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. Even if certain terms of economic or other significance to the parties have not been finalised, an objective appraisal of their words and conduct may lead to the conclusion that they did not intend agreement of such terms to be a pre-condition to a concluded and legally binding agreement [emphasis mine].

In this case, therefore, there were two issues the Supreme Court had to consider – whether the parties had agreed upon “all the terms which they regarded or the law requires as essential…” and the effect of not complying with the counterpart clause. As to the first, while a court cannot presume the existence of a contract from the fact that the parties have commenced work ostensibly in furtherance of it, it is a significant factor. One of the most important cases to have considered these principles is Pagnan SPA v. Feed Products, [1987] Lloyd’s Rep 601, which the Supreme Court approved. In that case, the Court of Appeal had observed as follows:

It is sometimes said that the parties must agree on the essential terms and it is only matters of detail which can be left over. This may be misleading, since the word ‘essential’ in that context is ambiguous. If by ‘essential’ one means a term without which the contract cannot be enforced then the statement is true: the law cannot enforce an incomplete contract. If by ‘essential’ one means a term which the parties have agreed to be essential for the formation of a binding contract, then the statement is tautologous. If by ‘essential’ one means only a term which the Court regards as importantas opposed to a term which the Court regards as less important or a matter of detail, the statement is untrue. It is for the parties to decide whether they wish to be bound and if so, by what terms, whether important or unimportant.

Applying these principles, the Court found that the conduct of the parties did indicate the existence of a contract – the fact that payments were made in proportion to an agreed contract price, alterations in delivery schedule, conformity with other parts of the draft contract, and so on. That left the counterpart clause, which the Supreme Court held prevents the formation of a contract unless the “parties have by their exchanges and conduct waived the ‘subject to contract’ condition or understanding”. The Court, applying the standard of a “reasonable, honest businessman” by way of analogy, concluded that neither party intended the counterpart clause to continue as a precondition to contract, as it had “been overtaken by events”.

In conclusion, it was too often thought that the mere fact of work could lead to a presumption of contract (or the converse). The UK Supreme Court’s careful and detailed analysis has done much to clarify that it ultimately depends on an analysis of the intention of the parties. It is interesting to note that in January 2010, the Supreme Court of India – in Trimex International FZE v. Vedanta Aluminum – reached more or less the same conclusion, relying partly on Pagnan.