Summary and implications

It is not uncommon for parties to commence works under a letter of intent pending negotiation and execution of a full written contract which sets out the detailed terms and the conditions concerning performance of the contract.

However the Supreme Court has recently held that parties’ conduct after a letter of intent had expired can suggest that they intended to enter into a contract and as a result amount to a waiver of the “subject to contract” clause.1

Parties therefore need to be aware of risks associated with commencing works prior to signing a contract first. This case demonstrates how important it is, if possible, to agree the terms of a contract before starting work.

Facts – RTS continued work after the letter of intent had expired

  • Muller is a well-known supplier of dairy products. RTS is a manufacturer specialising in the supply of automated machines for packaging and product handling in the food and consumer goods industry.
  • It was agreed that RTS would begin work to supply and install machinery for packaging food products to Muller on the basis of a four week letter of intent while the parties negotiated terms of a final contract.
  • The letter of intent expired in May 2005 but RTS continued to work on the project and the parties continued to negotiate the terms of the draft contract.
  • By 5 July 2005 the parties had reached agreement on all major points with the exception of the provision dealing with liquidated damages. However these terms were “subject to contract” because of the counterparts clause.
  • RTS ran into difficulties and was unable to meet the original delivery date and the parties agreed to vary the project delivery plan on 29 August 2005. RTS subsequently delivered the project equipment however Muller alleged the equipment had defects. Muller only paid part of the contract price and RTS brought a claim against Muller for the outstanding balance of the contract price or alternatively damages.
  • The written contract was never executed by the parties and therefore the Court had to consider whether a contract had been entered into and on what terms.

Supreme Court decision found in favour of Muller – the parties had a binding agreement

  • The letter of intent had expired at the end of the initial four week period.
  • The parties had reached a binding agreement on or about 25 August 2005. The Supreme Court placed much weight on the fact that the price had been agreed and that extensive work had been undertaken.
  • The parties’ conduct after the letter of intent expired suggested that they intended to enter into a contract.
  • The parties’ conduct amounted to a waiver of the “subject to contract” clause. It is not necessary for there to be an express statement by the parties agreeing to waive the “subject to contract” condition.

Limiting risk

  • The clear message of the Judgment is that parties should agree first and start work later. However in practice this is often not possible.
  • Clear statements should therefore be used when drafting letters of intent. In addition parties should review their standard boilerplate clauses to check whether counterparts clauses could be interpreted to be a “subject to contract” provision.
  • If the letter of intent expires it should be expressly extended as necessary or the contractor should stop any further works.
  • Parties should seek legal advice at the outset of a project and throughout the negotiations.

Contract Formation

The law considers that a legally binding contract is created where the following elements are fulfilled:

  1. The parties reach an agreement on all the terms of the contract which they regard or the law requires as essential.
  2. The parties intend to create legal relations.
  3. There is consideration.

Where the contract has been fully or substantially performed the courts are strongly inclined to find the existence of a contract.