Parties to an IT implementation project are often eager to commence work on the project as soon as possible.  The supplier may be motivated by the revenue stream that comes with commencing work, while the customer may be motivated by the competitive advantage of quickly taking a new product or service to market.

It is not uncommon for one of the parties to commence work on the project while a formal, written contract is still being negotiated.  Sometimes work is commenced on the basis of a letter of intent or some other similar written document while the parties continue negotiations.  So what are the legal consequences of commencing work before the final contract is signed?  Is there a binding contract between the parties governing the work, and, if so, on what terms?

General principles

In the recent case of Australian Securities and Investments Commission v Fortescue Metals Group Ltd [2011] FCAFC 19, the Full Court of the Federal Court of Australia discussed the relevant general principles.  These can be summarised as follows:

  • A mere agreement to agree or negotiate is not legally enforceable.
  • In determining whether there is a binding contract the court will consider two separate but related questions:
  1. On an objective view of the facts, did the parties intend to form a binding contract?
  2. Have the parties reached agreement upon such terms as are, in the circumstances, legally necessary to constitute a contract?  Asked another way, is what has been agreed sufficiently definite and explicit so that the parties’ intention can be ascertained with a reasonable degree of certainty
  • The more numerous and significant the areas the parties have failed to reach agreement, the slower a court will conclude that the parties had the requisite contractual intention.
  • Courts will strive to uphold bargains, and may imply terms or resort to considerations of reasonableness to fill in gaps in what the parties have reached agreement on.   However, courts will not do so if the parties have not agreed upon the essential terms and have not agreed to an objective standard to measure their obligations or to provide a mechanism to fix the content of essential terms (eg. third party determination).  

Example of no binding contract

In the Fortescue case, a number of “Framework Agreements” were signed which Fortescue described in public disclosures as binding agreements to build, finance and transfer the infrastructure of a very complicated project.  ASIC took action against Fortescue on the basis that such disclosures were misleading or deceptive because they were not binding agreements of the nature described.  The Framework Agreements contained minimal descriptions of the scope of work, no pricing and provision for the parties to negotiate and enter into fuller and more detailed agreements.  The Court held that the essential terms of subject matter, scheduling and price necessary for a binding agreement to build, finance and transfer project infrastructure had not been agreed by the parties, nor were there any agreed upon objective standard or mechanism to fix the content of these essential terms.  Subsequent correspondence exchanged between the parties demonstrated how far the parties were from a real consensus on subject matter and price.  As it was only necessary for the Court to decide whether the Framework Agreements were binding agreements of a certain nature, the Court did not determine whether the agreements should be categorised as agreements to agree or simply void for uncertainty.

Example of binding contract

In the Fortescue case, project work had not been commenced before the Framework Agreements were signed.  So what are the legal consequences of commencing work before the formal contract is entered into?   The UK Supreme Court considered this very scenario in RTS Flexible Systems Ltd v Molkerei Alois Müller GmbH & Co KG (UK Production) [2010] UKSC 14.

In the RTS case, the parties were negotiating a contract for the design and installation of two production lines in Müller’s factory.  Work was commenced on the basis of a letter of intent (LOI) dated 21 February 2005, which provided for the whole contract price and contemplated that the full contract terms were to be based on industry standard terms that were included in the attached draft contract (MF/1 terms).  The MF/1 terms contained a ‘subject to contract’ clause which provided that the contract will not become effective until signed counterparts have been exchanged.  The LOI contract expired in May and the parties continued to carry out work and make payments of some of the envisaged contract price.  Detailed negotiations of the draft contract proceeded and by 5 July almost everything in the contract had been agreed by the parties.  On 25 August, at Müller’s request, RTS agreed to vary the agreed order of installation.  The contract was never signed.  Following completion of the work and payment of approximately 70% of the contract price, a dispute arose between the parties as to whether the equipment supplied complied with agreed specifications.

The Court in the RTS case held that:

  • The fact that the work was performed is one relevant factor pointing to a binding contract, but the answer ultimately depends upon all the circumstances of the case.
  • By 25 August there was unequivocal conduct of both parties leading to the conclusion that:
  • the parties agreed on all essential matters requiring agreement by 5 July;
  • it was agreed that the project would be carried out by RTS for the agreed price on the terms agreed by 5 July as varied on 25 August; and
  • the ‘subject to contract’ clause in the MF/1 terms was waived by the parties.

While not fully explored before the Court, it also observed that the contract once concluded on 25 August must be treated as applicable to the whole period of contractual performance.

Although the Fortescue case applied an Australian line of authority and RTS case applied a UK line of authority, the applicable general principles discussed in both cases are consistent.

Take away points

Whether there is a binding contract, and if so on what terms, in situations where parties have commenced work on a project before a formal written contract is signed will in any given case depend very much upon its particular facts.  Further, one should not automatically assume that the mere existence of an agreed ‘subject to contract’ clause means that there is no binding contract governing the project until actual contract signature.  IT project participants should take heed of Lord Clarke’s warning in the RTS case that, at least where there are material sums or risks at stake: “The moral of the story is to agree first and to start work later”.