On 10 March 2010 the Supreme Court delivered judgment in RTS Flexible Systems Limited v Molkerei Alois Muller Gmbh [2010] UKSC 14. The case, which we previewed here, concerns a problem which frequently arises in business practice: where commercial parties begin carrying out work on the basis of an initial letter of intent, with a full contract to follow, but do not then execute that contract even after the letter of intent has expired, has a binding agreement been reached? 

In this instance the Justices (Lords Phillips, Mance, Collins, Kerr and Clarke, with the last giving the sole judgment of Court) found, unanimously allowing Muller’s appeal, that a binding agreement had been reached based on an objective assessment of the parties’ intentions. The Court’s judgment does not break any new ground, but it does contain a clear restatement of the relevant principles, in particular the fact that (i) the Court will apply the “reasonable honest businessman” test (per Steyn LJ in the Percy Trentham case) to objectively assess whether or not the parties intended to be bound, and (ii) ‘subject to contract’ clauses can be waived by the parties, if their conduct subsequently shows that they did intend to be bound. The case is also notable for the fact that the Supreme Court, Court of Appeal and High Court all reached different conclusions. The result for the parties has been an expensive legal mess, about which Lord Clarke had this to say: “The different decisions in the courts below and the arguments in this court demonstrate the perils of beginning work without agreeing the precise basis upon which it is to be done. The moral of the story is to agree first and start work later.”   

The Facts

RTS, a supplier of automated machines for the food industry, had been asked to manufacture and deliver an automated system for packaging yoghurt pots by Muller, the well-known supplier of dairy products. Negotiations as to the exact form of the contract went on for some time and included several different quotations provided by RTS as the scope of the project evolved. The last of these, Quotation J, included a fixed price of £1,682,000 and set out in outline the scope of the work which was to be carried out by September 2005. In order to meet the projected timescales in February 2005 RTS agreed to commence work based on a Letter of Intent (the “LOI”) in which Muller expressed their wish “to proceed with the project as set out in [Quotation J]”, with a long form contract to be agreed and signed within four weeks.  The LOI went on to state that the long form contract would be based on amended ‘MF/1’ terms and conditions (a model form contract devised by the Institute of Electrical Engineers), plus other technical terms to be contained in schedules. Clause 48 of the draft long form contract contained a ‘subject to contract’ clause which expressly stated it would not take effect until executed.
The LOI ultimately expired in May 2005, despite being extended twice as negotiations on the long form contract continued (by email in particular). Nevertheless, RTS continued to work on the project, delivered the machines in September, and were paid in the region of 70% of the £1.682m. Although the parties had by this stage reached agreement on most of the terms of the long form contract, it never came to be signed as a dispute broke out as to whether the delivered machines matched Muller’s performance requirements. RTS then issued proceedings claiming “moneys due under a contract, alternatively damages“. 
First Instance and Court of Appeal
Akenhead J ordered a trial of specific preliminary issues, namely whether the parties had entered into a contract following the expiry of the LOI, and if so, on what terms. The trial judge, Christopher Clarke J, held that the parties had concluded a contract, albeit a limited one, under which RTS would carry out the agreed work for the £1.682m price as set out in the LOI.  The judge relied in particular on the approach taken by Steyn LJ in Percey Trentham v Archital Luxfer [1993] 1 Lloyds LR 25, in which it was held to be unrealistic to suppose that the parties had not intended to create legal relations when in fact substantial performance had already occurred.  He refused to accept however, as was argued in the alternative by RTS, that the contract also incorporated the MF/1 terms, citing in particular clause 48 and the correspondence between the parties as demonstrating a clear intention that those terms would not take effect until signed.
The significance of MF/1 in particular was that it contained a liquidated damages clause: if MF/1 was part of the agreement, then RTS’ liability to Muller in respect of failing to deliver the machines as promised would be restricted; if it was not, as Clarke J found, then RTS had assumed unlimited liability.
RTS appealed but changed its primary submission before the Court of Appeal, arguing that there had been no contract at all following the expiry of the LOI such that it was entitled to payment for work carried out on a quantum meruit basis, or at the very worst its liability would be limited to repaying the money it had received from Muller.  The Court of Appeal (Waller, Moses and Hallett LJJ) agreed and unanimously allowed the appeal.  The Court of Appeal’s reasoning was that the ‘subject to contract’ clause should prevail, on the basis of the approach taken by Robert Goff J in British Steel Corporation v Cleveland Bridge and Engineering Co Ltd [1984] 1 ALL ER 504 – which was to the effect that since the long form contract was to include limited liability, it would be an extraordinary result for the Court to find that the parties had in fact agreed a contract for unlimited liability in the interim. It would be better, in those circumstances, to find no contract at all.
The Supreme Court’s Decision
The Supreme Court considered the conflicting decisions below, and identified the general principles to be applied – in particular, as to (i) the test for ascertaining whether there is a binding contract between the parties, and (ii) the effect of subject to contract clauses. 
As to (i) Lord Clarke gave the following summary (paragraph 45):
“The general principles are not in doubt. Whether there is a binding contract between the parties and, if so, upon what terms depend upon what they have agreed. It depends not on 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.”
In other words, the court should consider whether the parties had reached “essential agreement” – meaning that they intended to be legally bound by what was already agreed. This would be more likely where, as in Percy Trentham, the transaction in question was already being performed on both sides. Alternatively, if there were further terms which the parties regarded as essential (or indeed the law regards as essential in order for the contract to be legally enforceable) which had not yet been agreed, the courts should be slow to impose a binding contract which the parties themselves had not yet reached.  The test to apply, per Steyn LJ in Percy Trentham, was whether an “honest sensible businessman” when objectively considering the parties’ conduct would reasonably conclude that the parties intended to be bound or not (paragraphs 50 and 86).
As to (ii), the question “is whether the parties have nevertheless [i.e. in spite of the subject to contract clause] agreed to enter into contractual relations on particular terms notwithstanding their earlier understanding or agreement“. In other words, the parties could agree by conduct to waive their earlier agreement not to be bound. The logic of British Steel was not that a subject to contract clause would always be upheld: the Court needed to look at all the facts of each case, and if it seemed commercially improbable that the parties intended to be bound, as in British Steel, no contract should be found – whereas other cases, such as Percy Trentham where substantial performance had already occurred, may fall on the opposite side of the line. 
Applying those principles to the facts of the case, the Supreme Court held that a contract had been created after the expiry of the LOI, and that it did incorporate the wider MF/1 conditions. Hence, Muller’s appeal was allowed, the victory was perhaps a pyrrhic once given that RTS can now claim the benefit of the liquidated damages clause. In reaching this conclusion, the Supreme Court effectively amalgamated the logic of both the High Court and the Court Appeal and created a commercially sensible solution. The Justices agreed with Clarke J that it was unrealistic to suppose that the parties did not intend to create legal relations. A reasonable honest businessman would have concluded that some agreement had been reached after the expiry of the LOI, not just because performance had started, but also because essential terms such as the £1.682m price had already been agreed, and in fact negotiations for the long form contract were so well advanced that there were in reality only a few non-essential terms outstanding. 
However, as the Court of Appeal had held, it did not make commercial sense to conclude that the work had been carried out on partially agreed terms. The parties had clearly intended that the long form contract should be one complete whole, and expressed as much in clause 48.  The Justices agreed that either clause 48 prevented the contract from taking effect or it did not.  On the facts, the court considered that the parties had agreed to waive its effect – they had decided to “let sleeping dogs lie” (or, in counsel’s words, “neither party wanted the negotiations to get in the way of the project”).
The decision can be seen as the latest in the line of cases, beginning with Lord Hoffman’s speech in Investors Compensation v West Bromwich Building Society [1998] UKHL 28 and developing through Chartbrook v Persimmon Homes [2009] UKHL 38 and Re Sigma Finance [2009] UKSC 2, where the House of Lords or Supreme Court has been willing to adopt a commercial rather than overly legalistic approach. The question of what the parties intended on the facts should not viewed through the eyes of lawyers, but through the eyes of reasonable businessmen stepping into the parties’ shoes. 
The court has also given a useful re-statement of the underlying principles of contract formation. However, that is not to say that similar problems will not arise in the future. What is clear from the judgment is that the individual facts of each case will ultimately determine the outcome in this much litigated area of contract law. Their lordships were clearly swayed by the fact that in this instance essential terms had been agreed during negotiations which had reached an advanced stage.  Leaving aside the difficulties of ascertaining what the parties viewed as “essential terms”, it seems quite likely that a similar case, but one in which more significant terms had not yet been agreed would be interpreted differently.  
As Lord Clarke commented, the moral of the story for any would be buyer or seller is to think carefully before starting work on a project before full form contracts have been agreed.  A failure to agree and document terms before work starts may lead to unintended contractual obligations, and potentially costly legal proceedings.

Oliver Gayner is an associate and Richard Foster a trainee in Olswang’s commercial litigation team