Why did the MF/1 terms not apply? The judge had concluded that the MF/1 terms did not apply because:

United Kingdom Letters of intent and contract formation RTS Flexible Systems Limited (Respondents) v Molkerei Alois Muller Gmbh & Company KG (UK Production) (Appellants) [2010] UKSC 14C Chris Hill and Jo Kern Norton Rose, London There have been several English law cases over the years which demonstrate the perils of beginning work without agreeing the precise basis upon which it is to be undertaken. The recent decision of the Supreme Court (which replaced the House of Lords in England as the court of final appeal) highlights the importance of ensuring that parties reach agreement on contractual terms before commencing work, where possible, and the basis on which work is to continue after the expiry of a letter of intent. The relevant facts It was common ground that the parties entered into a contract formed by a letter of intent (the LOI), the purpose of which was to enable work to begin on agreed terms for an agreed period. The contractor carried out works and was paid by the employer under the terms of the LOI whilst negotiations proceeded on the terms of the MF/1 contract which the parties proposed to enter (the MF/1 terms) which was to form schedule 1. Detailed negotiations and amendments to the MF/1 terms (including contract price, payment, warranties, guarantees, inspection, testing, delay, defects liability, limitations of liability and the like) had taken place. The fourth draft of the MF/1 terms with final tweaks was sent to the contractor on 16 May 2005. The parties agreed that the LOI contract expired on 27 May 2005. The final tweaks to the MF/1 terms were resolved between the parties on 5 July 2005 the employer told the contractor that he would put the MF/1 terms into a contract with all the schedules and send to the contractor for signature later that week. Problems arose between June and August 2005 with delay to some of the free issue equipment. These problems diverted attention away from finalisation of the contract documentation. No formal contract was ever executed between the parties. It was common ground between the parties that the contract terms between the parties were varied on 25 August 2005 at a meeting between the parties during which a discussion of the delay to some of the free issue equipment led to a variation of the delivery plans for the project. The decision at first instance there was a contract The judge held that after the expiry of the LOI when the parties continued negotiating the MF/1 terms the natural inference was that: there was a contract between the parties (for the contractor to carry out the works for an agreed price); it was not essential for the parties to have agreed all the terms and conditions of that contract; but the terms of contract did not include the MF1/ terms but a limited list of some of the agreed schedules. Why did the MF/1 terms not apply? The judge had concluded that the MF/1 terms did not apply because: the LOI stated that the final contract terms were not to be contractually binding until signature; that is, any agreement made between the parties was subject to written contract ; clause 48 of the MF/1 terms expressly provided that the contract would not become effective until each party had executed a counterpart and exchanged it with the other (this had not occurred); and the contract was designed to operate as a composite whole consisting of the agreement and its schedules which included the MF/1 terms (at schedule 1) and the remaining schedules. Although many of the schedules had been finalised, several had not been agreed. The importance of the MF/1 terms was that they contained detailed provisions on many matters including limitations of liability and liquidated damages provisions. The decision of the Court of Appeal The Court of Appeal had to decide whether: the judge was correct to hold that there was a contract between the parties after the expiry of the LOI; and if there was a contract whether it was right that it was not on the MF/1 terms? The Court of Appeal held that the judge s conclusion that there was a contract on limited terms resulted in the type of extraordinary result that the Court had rejected in British Steel Corporation v Cleveland Bridge and Engineering Co Ltd [1984] 1 AII ER 504 since the contractor would have been taken to have assumed unlimited liability for its performance which it would not have assumed under the formal MF/1 contract. Further, the Court of Appeal held that the effect of clause 48 of the MF/1 terms was to prevent any contract from coming into existence between the parties (not just a contract incorporating the MF/1 terms). Accordingly, the Court of Appeal held that there was no Construction Law International Volume 5 Issue 3 August 2010 35

contract between the parties after the LOI expired. The issues before the Supreme Court The issues before the Supreme Court were: whether there was a binding contract between the parties following expiry of the LOI? if there was a contract, what were the terms of that contract? Was there a contract between the parties: the legal principles? The Supreme Court noted that the general principles in English law were not in doubt. Whether there was a binding contract between the parties depended not upon the parties subjective state of mind but on a consideration of what was communicated to them by words or conduct and whether that led objectively to a conclusion that they intended to create legal relations and had agreed on all the terms which they regarded or the law regarded as essential for the formation of legally binding relations. If certain terms of significance to the parties had not been finalised, an objective appraisal of their words and conduct might lead to the conclusion that they did not intend agreement of all such terms to be a pre-condition to a concluded and legally binding agreement. These principles were set out in the authorities reviewed by the Supreme Court, which confirmed that: G Percy Trentham Limited v Archital Luxfer [1993] 1 Lloyd s Rep 25: - a contract can come into existence not simply as a result of offer and acceptance, but partly by reason of written exchanges, partly by oral discussions and partly by performance of the transaction; - a transaction which has been executed rather than executory can be very relevant because it may be unrealistic to argue that there was no intention to enter into legal relations or that the contract was void for uncertainty; and - the fact that the transaction is executed may make it possible to treat terms not finalised in negotiations as inessential. Pagnan SPA v Feed Products Ltd [1987] 2 Lloyd s Rep 601: Determining whether a contract had been concluded in the course of correspondence as well as by oral communications and conduct involved a consideration of the parties : - communications whether by word or conduct; - intention to create legal relations; - agreement of all the terms which the parties regarded (or the law required) as essential for the formation of legally binding relations; Agreement of all terms was not necessarily a precondition to the conclusion of a contract, minor details could be sorted out later once a bargain was struck. In the Supreme Court s view, in cases which are subject to written contract the question which should be considered is: despite the fact that the parties may initially have required that any agreement they conclude was not effective until they have entered into a formal written contract, have the parties waived reliance on this earlier understanding through their communications and/or conduct during the course of negotiations? This question depends on all the circumstances of the case. The decision of the Supreme Court The Supreme Court considered that there were three possible conclusions which could be reached and addressed each in turn, namely: as the Court of Appeal held, that there was no contract between the parties; as the judge held, there was a contract between the parties but on the limited terms found by the judge; or that there was a contract between the parties on wider terms. Conclusion 1: no contract The Supreme Court agreed with the judge that it was unrealistic to suppose that the parties did not intend to create legal relations. This was tested by asking whether the price for the works was agreed both parties agreed that it was. Therefore, the agreed price of 1,682,000 must have formed part of a contract between the parties. As the LOI had expired, the contract containing the price must have been contained in some agreement other than the expired LOI, and therefore it could not, on conventional principles, be a case of no contract. The Court of Appeal s decision that there was no contract between the parties involved holding that there was no binding agreement as to price or anything else, and that evidence of the agreed price was no more than evidence of what a reasonable price would be on a quantum meruit basis. This was not correct for the following reasons: neither party suggested in the course of the project that the price was not agreed (percentages of the price were invoiced by the contractor and paid by the employer); the agreed price of 1,682,000 for the whole of the project was included in the LOI with express reference to the contract being based on the MF/1 terms; and there was an agreed variation to the contract being negotiated between the parties on 25 August 2005 which neither party suggested was not a variation to the contract. The Supreme Court concluded that Conclusion 1 was not convincing. Moreover, it involved the contractor agreeing to proceed with detailed work and to complete the whole contract on a non-contractual basis subject to no terms at all. 36 Construction Law International Volume 5 Issue 3 August 2010

Conclusion 2: contract on the terms found by the judge The Supreme Court agreed with the judge that the parties initially intended that there should be a written contract between them which was to be executed by each and exchanged. If this position was tested on 5 July 2005, the correct conclusion might well have been that based on the facts there was no binding agreement, not because the parties had not reached agreement on all the essential terms, but because the agreement they had reached was at that point still subject to written contract. However, the striking feature of this case was that essentially all the terms of contract were agreed between the parties and substantial works were carried out, but the agreed contract terms were subsequently varied by the parties in important aspects. The parties treated the agreement to amend the delivery plans for the project on 25 August 2005 as a variation of the agreement that had been reached by 5 July 2005. Neither suggested that there was no contract and thus nothing to vary. It was only when the parties were in dispute that arguments arose as to whether there was a contract or not. The Supreme Court was of the firm view that the parties written communications and actions by 25 August 2005 led to the conclusion that they had agreed that the contractor would perform work and supply materials on the terms agreed between them up to 5 July 2005, as varied by the agreement of 25 August 2005. It did not make commercial sense to hold that the parties were agreeing to the works being carried out either without any relevant contract terms or on some but not all the terms agreed by 5 July 2005. Conclusion 3: contract was wider than that found by the judge There were two issues to be considered. First, did the parties intend to be bound by what was agreed or were there further terms which they regarded as essential or which the law regarded as essential in order for the contract to be legally enforceable? The Supreme Court held that: the judge was correct to conclude that the fourth draft of the contract sent with the email of 16 May 2005 was designed to operate as a composite whole; the judge correctly recorded the employer s recognition that the parties had reached a final draft of the contractual terms and conditions which contained the MF/1 terms as modified in the emails of 19 May, 25 May and 5 July 2005 (albeit some of the schedules were not agreed); essential agreement was reached by 5 July 2005; none of the issues which remained after that date to be agreed were regarded by the parties as an essential mater which required agreement before a contract could be binding; on a fair view of the negotiations and all the circumstances of the case, neither party intended agreement of those issues to be a precondition to a concluded agreement. Second, did the parties depart from the understanding that the agreement which they were negotiating was to be subject to a written contract, as had been the original understanding of the parties and as expressly provided in clause 48? The Supreme Court accepted that no formal contract was ever signed or exchanged between the parties, so that, unless and until the parties agreed to vary or waive clause 48, the contract would not become binding or effective. The Court of Appeal considered that it would need a clear express variation of clause 48 before it could be said that a contract was concluded between them. However, the Supreme Court was of the view that it was possible for the waiver to be inferred from communications between the parties and the conduct of one party to the other. On the facts, the Supreme Court held that the parties had agreed to waive the requirement of clause 48: the circumstances pointed to the fact that there was a binding agreement and that it was not on the limited terms held by the judge; final agreement of the essential terms had been reached by 5 July 2005; the subsequent agreement to vary the contract was reached without any suggestion that the variation was agreed subject to written contract; it was possible to draw a clear inference that the parties agreed to waive the express requirement in clause 48 any other conclusion did not make commercial sense; a reasonable, honest businessman would have concluded that the parties intended that the work should be carried out for the agreed price on the agreed terms, including the terms as varied by the agreement of 25 August 2005, without the necessity for a formal written agreement, which had been overtaken by events; and the parties had chosen to let sleeping dogs lie rather than signing the contract as neither party wanted the negotiations to get in the way of the project. The only reasonable inference was that by or before 25 August they had waived the subject to contract provision of condition 48. Conclusion The Supreme Court reached a different conclusion from both the judge and the Court of Appeal. The judge s decision that there was a contract between the parties resulted in the contractor s potential liability to the employer Construction Law International Volume 5 Issue 3 August 2010 37

being far greater than it was prepared to undertake during negotiations between the parties. This was an extraordinary result which highlighted the dangers to a contractor proceeding under an expired LOI. The Court of Appeal s decision that there was no contract between the parties resulted in the contractor undertaking no contractual liability whatsoever to the employer arguably, also an extraordinary result which highlighted the dangers to an employer of proceeding under an expired LOI. The Supreme Court s finding that a contract had come into being that incorporated the MF/1 terms accords with the sensible view that it would be almost inconceivable that the parties would have entered into an agreement for the performance of the whole project which was not based on detailed terms. However, parties need to be aware that acting as if the terms are agreed may lead the court to conclude that contract terms are agreed, even if there is a requirement that the contract be signed and counterparts exchanged before the contract comes into effect. If employers and contractors wish to preserve the term subject to written contract then they must ensure that no inference from either their conduct or communications can be drawn to waive such a requirement. Chris Hill, Partner and Jo Kern, Senior Associate, Norton Rose, London. This case review was previously published in the Construction and Infrastructure Updater by Norton Rose Group. Reproduced by permission. For enquiries related to this review please contact joanna.kern@nortontrose.com. Pay-when-paid clauses - William Hare v Shepherd Construction Limited and others [2010] EWCA Civ 283 Chris Hill and Rona Westgate Norton Rose, London As Mr Justice Coulson accepted in the first instance decision in this case, pay-when-paid clauses in construction contracts in England have been a relatively rare sight in the construction industry for the last fifteen years. This is largely due to section 113 of the Housing Grants, Construction and Regeneration Act 1996 (the Construction Act) which outlawed pay-when-paid clauses, except in cases where the employer had become insolvent in one of the ways provided for in section 113. Both the court at first instance and the Court of Appeal had to consider the effectiveness of a paywhen-paid clause in a sub-contract. At issue was whether the contractor (Shepherd Construction) could refuse payment to its sub-contractor (William Hare) of approximately 1,000,000 in reliance on a paywhen-paid clause following the administration of the employer, Trinity Wakefield Limited. The trial judge decided that the contractor could not refuse payment to the sub-contractor and the contractor appealed to the Court of Appeal. The background Section 113 (1) of the Construction Act prohibits pay-when-paid clauses in the construction industry unless it can be shown that the third party employer is insolvent. Subsection (2) of the Construction Act sets out four situations which can constitute insolvency. The relevant ground in this case was the making of an administration order against it under Part II of the Insolvency Act 1986. By the Enterprise Act 2002, the Insolvency Act 1986 (the Insolvency Act) was amended, adding administration without court order, described as self certifying administration. That led to an amendment in 2002 to section 113 of the Construction Act to clearly include both administration through court order and self certifying administrations. Facts The sub-contract between the parties drafted in 2008 contained an express pay-when-paid clause (clause 32) drafted by the contractor which entitled the contractor to withhold sums of money otherwise due to the sub-contractor in the event of the employer s insolvency. The subcontract set out the grounds which would constitute insolvency. These grounds followed the grounds set out in the Construction Act but did not reflect the revised amendments made to section 113 of the Construction Act. The contractor withheld approximately 1,000,000 from the sub-contractor pursuant to the paywhen-paid clause in the sub-contract when the employer went into administration. The sub-contractor challenged the withholding on the basis that the employer was not insolvent within the meaning of clause 32 because the employer had not had a court administrative order made against it. The problem for the contractor was that the employer s insolvency arose as a result of a self-certifying administration (without the need for a court order). As set out above, self-certifying administrations were not referred to in clause 32. Was the employer insolvent within the meaning of clause 32? The contractor s arguments The contractor argued that it would be absurd if clause 32 of the sub-contract was construed without taking into account the subsequent amendments to the Insolvency Act and that this was one of those cases where it was so clear that something had gone wrong with the drafting that the 38 Construction Law International Volume 5 Issue 3 August 2010

court should construe the clause as covering all routes to administration. In particular, the contractor relied on the following cases: The House of Lords decision in Investors Compensation Scheme v West Bromwich Building Society [1998] 1 WLR 896 - interpretation of a contract depended on what a reasonable person having all the background knowledge which would have been available to the parties would have understood the words to mean Lord Diplock LJ in Antaios Compania Naviera SA v Salen Rederierna AB [1985] AC 191, 201 if detailed semantic and syntactical analysis of words in a commercial contract is going to lead to a conclusion that flouts business commonsense, it must be made to yield to business commonsense Chartbrook Limited and Another v Persimmon Homes Limited and Another [2009] 1 AC 1101 - words themselves could be altered, if the court was compelled to the view that the parties simply could not have meant what the words said (Lord Hoffmann). Was the employer insolvent within the meaning of clause 32? The Court of Appeal s view The Court of Appeal dismissed the contractor s case and gave strong support to the first instance decision. Waller LJ said of the first instance decision that: the judgment is a model of clarity and I would like at the outset to pay tribute to it, and indeed reveal a strong inclination simply to say that for the reasons the judge gives the appeal should be dismissed The Court of Appeal confirmed that the starting point for the principles of contract interpretation in English law are those in Investors Compensation Scheme but that there must be a strong case to persuade the court that something must have gone wrong with the language used in a contract (it should not easily be accepted that people have made linguistic mistakes, particularly in formal documents... ). However, in cases of exclusion of liability, such as this case, the Court of Appeal was very doubtful that the usual principles of contract interpretation set out above would apply at all. In the court s view: Pay-when-paid clauses were generally ineffective except in cases of third party insolvency as set out in section 113 of the Construction Act. If the contractor wanted to rely on a pay-when-paid provision in a sub-contract, the pay-when-paid provision would need to cover an event of employer s insolvency as defined in the Construction Act. If the contractor mis-drafted the pay-when-pay provision so that the ground of insolvency was not in accordance with the Construction Act, there was no reason why, however obvious it was that the contractor had mis-drafted the provision, the court would come to the rescue. If the contractor had drafted the pay-when-paid provision in a way which actually worked (as the clause did in this case), even if a reasonable person would guess that there had been an error, there was even less reason for the court to come the rescue. The clause as drafted was still workable but just not wide enough to cover the scenario the contractor would have wanted it to ie, selfcertifying administrations. In this case, the pay-when-paid provision had the effect of relieving the contractor of a liability to pay and it was for the contractor to get a clause of this nature right if they wished to rely on it. The Court of Appeal considered that the dominant principle to be applied was that set out by Lord Bingham in Dairy Containers Ltd v Tasman Orient Line CV [2005] 1 WLR 215: The general rule should be applied that, if a party otherwise liable is to exclude or limit his liability... he must do so in clear words; unclear words do not suffice; any ambiguity or lack of clarity must be resolved against that party. As a result, it was not open for the contractor to argue that there was a lack of clarity in a provision that they had drafted so as to relieve themselves from liability, and the court should not use the principles identified by Lord Hoffmann in Chartbrook to help the contractor. Clear words should have been used. Accordingly, the Court of Appeal confirmed that the pay-when-paid provision was not effective. Conclusion This case illustrates the importance of clear drafting. Had clause 32 of the sub-contract been amended to refer to any amendment reenactment of the legislation which entitled an administrator to be appointed without a court order, then the result would have been different and the contractor could have relied on the pay-when-paid provision. The decision also confirms that contract clauses which seek to exclude or limit liability are likely to be strictly enforced against the party seeking to rely on them. Chris Hill, Partner and Rona Westgate, Know How Lawyer, Norton Rose, London. This case review was previously published in the Construction and Infrastructure Updater by Norton Rose Group. Reproduced by permission. For enquiries related to this review please contact rona.westgate@nortonrose.com. Construction Law International Volume 5 Issue 3 August 2010 39