It is crucial to know when a contract is formed and what its terms are. However, many contract disputes are arguments about whether or not there is a contract at all. Some disputes arise where people have made obvious mistakes. But not all. Although the basic rules for contract formation are clear, applying them in the real world is not always so easy.

In this the first part of our 'before you take the plunge - back to basics on contracts' mini series, we look at a case which went all the way to the Supreme Court to determine whether there was a contract, and upon what terms. We also consider some practical tips to help you achieve contractual certainty.

The facts of the case

In RTS Flexible Systems Ltd v Molkerei Alois Muller Gmbh, both parties were substantial companies with access to legal advice who were negotiating the purchase of a large piece of production equipment.

RTS needed to develop the equipment quickly to meet Muller's timescale. There was insufficient time to agree the contract before RTS started development work. Muller and RTS were alive to the considerable uncertainties that a lack of an agreed contract causes. They therefore agreed heads of terms, setting out the principles of the arrangements on a non-contractually binding basis, and agreed on a binding basis that RTS could start work and incur costs to certain limits. The heads of terms expired after a month, by which time the contract was to have been finalised and signed.

The parties agreed much of the contract content, except for some important points, such as the liquidated damages due on certain events. Therefore there was no final signed contract when the heads of terms expired.

Problems arose with the equipment and a dispute ensued. What was the contractual position?

  • Was there a contract?
  • If so, was it on RTS's standard terms of supply?
  • Or was it on the terms of the nearly agreed but not signed contract?
  • Or was it on some other terms?

The courts' findings

The High Court held that there was a contract, although only on the implied terms that were necessary. The judge said that the counterparts clause (which stated the contract had no effect until signed by both parties) meant the nearly agreed contract was irrelevant. So specific protections for both parties in the nearly agreed contract (such as the liability cap and liquidated damages) did not apply.

The Court of Appeal held that there was no contract at all, as there are alternative concepts in law that are adequate to cover such situations. This includes 'quantum meruit', whereby if someone receives something of value they should pay for it, and a contract is not needed to underpin that. So it was no more than 'pay as you go'.

Finally, the Supreme Court held that there was a contract, but on the terms of the nearly agreed contract.

So one dispute culminated in three different decisions, not just about what terms applied, but whether there was even a contract at all.

Practical tips

The key lesson from this case is not how to analyse an arrangement to identify a contract, but that if you fail to make the position clear you generate considerable risk and expense. As the Supreme Court said in this case, "...the moral of the story is to agree first and to start work later".

These practical tips should help ensure contractual certainty:

1 Assume a contract is going to be formed unless you say otherwise

Where businesses are involved, the courts will often assume that the parties expected to create a contract unless the contrary is made clear. If you do not want to create a contract, use the words "subject to contract".

2 A contract does not need to be in writing

Contracts do not always need to be in writing, printed off and signed to be effective. A handshake, conversation, phone call or, most dangerously, email can all be enough to create a legally binding contract. It should be noted that special rules apply to certain kinds of contracts such as the sale or other disposition of an interest in land.

3 "Subject to contract" is powerful but...

The words "subject to contract" will normally be effective to exclude a contract. But the courts will look to see what the parties have done. If the parties have acted as if there is a contract, the courts might decide that there really is one. If one party is going to start work, spending money or mobilising, make sure it is clear whether or not there is a contract.

Either make it clear that if the other party starts work/mobilising, it is at its risk, or establish a mini contract on that initial step while you sort the main contract. This would be limited in time and so you do need to finalise the main contract, or down tools, when it expires. This would need to be policed, as exactly the same stop gap solution failed in the case above!

4 Uncertainty might be worse then an imperfect deal

Contract negotiations may become protracted and parties start work regardless because they need to do so commercially. This presents considerable risk - the parties may not know what they are meant to supply and when, the effect of late delivery, what warranties are given, whether liability is limited or how much is due and when. Consider how to conclude such negotiations quickly (compromising or threatening to walk away). Entering an imperfect deal may be better than the uncertainty of starting work without a contract at all!