Negotiating a contract

April 7, 2010

As first published on Director of Finance online (click here)

Agree first, work later
Written by Nigel Miller, commerce and technology partner at Fox Williams LLP, Wednesday, 07 April 2010

The order's won and you must start work immediately but negotiating a contract can take time.

It’s a familiar problem you’ve won the order and the customer needs you to start work immediately, but negotiating a contract can take time.

There are specifications, warranties, limitation of liability clauses, and many other clauses to agree. The pragmatic answer that is often reached is to sign up to heads of terms (also referred to as a letter of intent or memorandum of understanding or similar).

This sets out the basic terms of the understanding the parties have. It will cover the main scope of work, the price and payment terms and any other major terms.

It also normally provides that the parties will negotiate and agree the terms of a binding agreement within a timeframe after signing the heads of terms. In this sense, the heads of terms provide a useful roadmap of the steps to be taken before a formal agreement is signed.

The definitive binding contract will be much more detailed than the heads of terms. It may take many weeks to negotiate and agree all of its provisions.

Some of the terms may be contested. For example, the buyer may want the seller to pay liquidated damages for delay and the seller may not agree to this. On the other hand, the seller will want to limit its liability and the buyer may not agree to the limit which the seller seeks.

Meanwhile, in parallel with the contract negotiations, work on the contract steams ahead. This is all fine while the supplier carries on with the work to the buyer’s satisfaction, and while the buyer continues to make payments as agreed.

But what happens if the parties get to the point where they have agreed most of the essential details of the definitive agreement but then fall into dispute before it is signed?

Will the courts give effect to an agreement the terms of which were agreed or largely agreed, even though it was not actually signed? If they won’t, then does that mean the parties are operating without any contract in being, or if there is a contract what are its terms?

These were the issues that came before the court when Molkerei Alois Müller GmbH & Co KG (Müller), a well-known supplier of dairy products, engaged RTS Flexible Systems Limited (RTS), a supplier of packaging and food handling machinery, to install a new automated system for packaging yoghurt pots.

It was agreed that RTS would begin work on the basis of a four week letter of intent while the parties negotiated the terms of a final contract. The letter of intent set out the contract price for the entire project and stated the parties' intention that the final contract would incorporate a modified version of the MF/1 model form of General Conditions of Contract.

The significance of the MF/1 terms is that they contain detailed provisions on many matters, including liquidated damages and limitation of liability. A draft contract was drawn up, but was never signed.

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 July 2005 the parties had reached substantive agreement on all major points.

When the project ran into difficulties, RTS brought a claim against Müller for the outstanding balance of the contract price or alternatively damages. The first question was whether a contract had been entered into, and, if so, on what terms.

The High Court decided in favour of Müller that the parties did not intend the draft contract to have contractual effect until it was signed.

Therefore, the contract that had been negotiated and largely agreed did not apply. Instead, the Court said, some other contract terms applied which, crucially, did not contain the MF/1 terms.

The case went to the Court of Appeal, which found in favour of RTS, ruling that no contract had come into existence after the letter of intent expired.

Müller then took the matter to the Supreme Court who unanimously allowed Müller's appeal. The Supreme Court said that the parties had reached a binding agreement and had by their conduct waived the "subject to contract" provision which said that no contract would come into force until the definitive agreement was signed.

It is possible for an agreement that was "subject to contract" or "subject to written contract" to become legally binding if the parties later agree to waive that condition. Whether or not this happens will depend on the facts and circumstances of each case.

The lack of clarity surrounding the status of the contractual relationship between the parties went all the way to the Supreme Court, with each Court reaching a different decision to the one before and no doubt involved significant time and cost implications for the parties.

As Lord Clarke in the Supreme Court commented, the case demonstrates "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 to start work later".

Nigel Miller is a commerce and technology partner at Fox Williams LLP.

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