Letters of Intent: proceed with caution
Posted: Tuesday 20 July 2010
In time and cost sensitive construction projects it is becoming increasingly common for a Contractor to begin work under the terms of a Letter of Intent (LOI) while negotiations continue with the Employer regarding the full terms of the Building Contract.
But what happens when no formal Building Contract is actually put in place?
The English Supreme Court case of RTS Flexible Systems Ltd v Molkerei Alois Muller Gmbh & Company KG (UK Production) ([2010] UKSC 14) considers exactly that. In highlighting the important factors that a court will consider when deciding whether a formal Building Contract can be implied or not, this case strongly reminds the industry of the risks involved in not entering into a formal Building Contract.
The facts of the case
In January 2005 RTS won a tender to supply Muller with a system for packaging yoghurt pots.
Although the terms of a formal Building Contract were still being negotiated, a LOI had already been entered into. This set out, amongst other things, the contract price and stated that RTS was to begin work immediately. The LOI also stated that the parties would enter into a full Building Contract, to be based on Muller’s standard contract and that this was to be finalised and signed within 4 weeks of signing the LOI. The LOI was also subject to an expiry date of the 27 May 2005.
RTS commenced work on this basis.
Unsurprisingly, the four week deadline for signing a formal Building Contract came and went with no formal contract in sight. The LOI expired but RTS nevertheless continued to work.
In July 2005 a final draft Building Contract was produced, which contained a clause stating that the contract would not become effective until each party had executed and exchanged a counterpart. Again, unsurprisingly, this did not happen.
By August 2005 numerous amendments had been made to the draft contract but RTS continued to work in the absence of a signed contract.
And you can guess what happened next … a dispute arose between the parties. The actual background to the dispute is not really relevant in this case as it was not discussed in court at this stage. The court in the first instance was more concerned with ironing out the preliminary issue which came before it. Had RTS and Muller entered into a contract and if so what were the terms?
The court’s decision
The High Court decided at first instance that the parties had entered into a contract after the expiry of the LOI. At the Court of Appeal stage this decision was reversed and it was decided that no contract had come into existence. As a result, the case made its way to the Supreme Court.
Unanimously the Supreme Court held that the parties had reached a binding agreement and that the counterpart clause (which had been a point of discussion at the Court of Appeal stage) had been waived by the parties in terms of their contract.
On the facts of this case, the court came to the conclusion that it would be unfair and unrealistic to suggest that the parties had no intention of creating a legally binding contract. This was on the basis that the full contract price and all other essential terms were agreed and substantial works had been carried out by RTS. If it was decided that there was no contract in place, this 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. Finally, the court considered that as the draft Building Contract had been varied in important respects with there being no suggestion by the parties that there was not a contractual variation, a contract had to be considered to be in place.
Lessons to learn
This case sends important messages to the industry:-
1. The test that a court will apply when deciding whether or not there is a binding contract in place between the parties should be whether a ‘reasonable and honest businessman’ would come to the conclusion from the parties’ words and conduct that they intend to create legal relations. It will also consider whether the parties had agreed on all the essential terms of the contract. Terms of a contract that the court may regard as essential terms are:
- Details of the Parties;
- Price of the Contract;
- Term of the Contract; and
- Description of the Works to be carried out
2. The fact that work has already begun on a project will not automatically mean that the parties have entered into a binding contract. The court will consider all the circumstances of a case, but commencement of work will definitely be an important factor.
3. In starting to perform your part of the contract, depending on the other circumstances of the case, you may be waiving the protection offered by a ‘subject to contract’ provision.
4. In organisations where it is common to use counterparts for signature, it may be worthwhile reviewing the boilerplate clauses to check if they may be construed as ‘subject to contract’ provisions.
Letters of Intent will still continue to be commonplace in the construction industry and they do serve a valid purpose. This case however is a useful reminder that wherever possible a formal contract should be entered into to make sure that the intentions of both parties are very clearly stated. Otherwise the decision may be in the hands of the court!
Alan Henderson, Senior Solicitor
