Formation of contract and enforcement of terms: What negotiators need to know

16th October 2019

Gwendoline Davies, Head of Commercial Dispute Resolution, and James Crayton, a partner in the Commercial Contracts Team, offer practical advice arising from the recent case of Volumatic v Ideas for Life [1], which highlights the risks of doing business in the absence of a concluded contract.

Why is this case of interest?

In the commercial world, so much is about contacts, communication and keeping up with changes, competition and advances in products and technology. As such, at the outset of many ventures, relationships are positive and parties are eager to get on with doing business together, often before legal documentation is put in place.  As this recent case demonstrates, however, there are some real risks associated with proceeding in this way – even in the context of long-standing commercial relationships.

What practical advice arises?

• Key risks are that, without a concluded contract, parties lack certainty or common understanding as to the terms which govern their business relationship. As happened in this case, significant problems can also arise when a party seeks to actually enforce what it believes to be binding contractual terms.
• An understanding of the basics of commercial contract law is crucial for managing those risks (as to which, see below). In addition, an awareness of the likely practical scenarios in which informal commercial discussions may arise for a particular business will be key to getting the balance right between being able to quickly obtain sufficient comfort to enable parties to proceed with their plans, and becoming legally bound when that is actually required.
• Commercial parties should review their negotiating practices and be aware of the risks associated with informality. On the one hand, the lack of any specific requirement for formality and/or documentation means that contracts can be formed orally and by conduct as well as in writing; and it is therefore important that parties should not discuss terms or act in any way that is inconsistent with their contractual intentions in case a contract comes into effect prematurely, inadvertently or on unsuitable terms.  On the other, and as shown by this case, the fact that an intention to create legal relations is a necessary component of any valid contract can mean that, depending upon the particular circumstances, it can be a costly mistake to assume that a contract has come into being at all.
• For large organisations, it can be important to ensure that different teams are aligned to the same position – so that, for example, operational teams behave consistently with the procurement teams if a contract is not yet meant to be binding. Equally, before committing resources and expenditure to perform a particular transaction, businesses should be clear that any counterparties have actually committed to their side of the bargain.
• Ideally, parties should communicate their intentions clearly when negotiating. If you do not intend to be bound until a formal document is signed or further terms are agreed, the relevant party would be best advised to expressly and prominently label correspondence and draft agreements as “subject to contract”. This includes email correspondence. Even stronger disclaimer language could be used when appropriate, for example “we have no intention to enter into a binding agreement until both parties sign an agreement in writing”.
• “Subject to contract” or equivalent language is a strong indicator that parties do not intend to be legally bound, but it is not conclusive. A court will look at all of the parties’ words – and conduct – when deciding whether or not a contract has been formed in any particular case.
• It is essential that businesses educate their staff as to the risks of both inadvertent contract formation and of conducting business (and therefore going on to incur expenses and responsibilities) on the assumption that contractual backing exists when in fact it may not.

Formation of contracts: back to basics

A contract is formed when all of the following key elements are present: offer; acceptance; consideration (that is, money or money’s worth); certainty of terms; and intention to create legal relations.

In a commercial context there is a rebuttable presumption of an intention to create legal relations and the burden is on the party claiming that a binding contract has been made to prove the intention to create legal relations. That can be evidentially difficult in the absence of any express agreement. Equally, however, where there is any express agreement, the burden of proving that there is no contractual intention is a heavy one [2].

Contracts can be made orally (face-to-face or via some communication medium such as the telephone); via an exchange of e-mails or other correspondence; or they can even arise by virtue of the parties’ conduct. Crucially therefore (with some limited exceptions) contracts can be formed without any written documentation or other formality whatsoever.

A lack of understanding about the formation of contracts can have devastating consequences. For example, a party may have invested significant time and money in a project on the understanding that its opposite number was contractually bound to the scheme, only to find that no binding obligations are actually in effect and that its opposite number can walk away scot-free, leaving the project to collapse, at any time.  Similarly, a party may be operating under the assumption that key terms (say, as to price, limitation of liability or termination options) are still to be agreed, only to find that their conduct, or something they said to their opposite number several weeks ago, has committed them contractually to what is now an unfavourable deal.

The recent case of Volumatic v Ideas for Life covers many of the issues that can arise, and is a cautionary tale for all commercial contracting parties.

What happened in this case?

The claimant manufactured a product, a component part of which had been provided, for several years, by the defendant. When the claimant wanted to upgrade its product in 2004, it required a new and improved component from the defendant, and the parties commenced negotiations accordingly.

Various draft contracts were sent between the parties, but nothing was signed or completed. In 2005 the parties reached agreement in a meeting about the way forward. Neither party asserted that a binding contract had come into being at that meeting. Following the meeting, the parties drafted and signed an agreement (the agreement) which related to the design and production of the new component and which provided for various stages of works and payments. The agreement also provided that, subject to certain conditions being satisfied, the defendant would transfer intellectual property rights (IP) to the claimant. The agreement also stated that a formal legal document would be drafted in due course. The parties proceeded to do business together.

It was not until 2016 that the claimant sought to enforce the term of the agreement that the defendant would transfer the IP to it. The dispute then arose as to whether the agreement amounted to a legally binding contract.

The High Court held that there was no intention to create legal relations and that, in the absence of that essential element, the agreement was not an enforceable contract.

The following key points arise:

…on the issue of intention to create legal relations

• Whilst the starting point in commercial cases is that there is a presumption of the requisite intention to create legal relations, the presumption can be displaced either by express evidence to the contrary or by an objective assessment of the parties’ intentions.
• In making that assessment, the court will consider not the parties’ subjective intentions, but rather what was communicated between them by words or conduct and whether that leads objectively to a conclusion that they intended to create legal relations [3].
• A relevant factor is likely to be the degree of precision with which the alleged agreement is expressed. Vagueness and uncertainty may be grounds for concluding that there was no intention to create legal relations and, as mentioned above, the existence of an express agreement will make it more difficult for a party to prove that there was no such intention.
• In this case the judge placed emphasis on the facts that both parties had confirmed that no contract came into being at the 2005 meeting, and that the agreement merely recorded the consensus reached at that meeting. The detail in the agreement, and the fact that the parties had had input from legal representatives were not sufficient to establish a finding of intention to create legal relations.

…and on the issue of the parties’ conduct over time

• The judge decided that, even if the agreement had been binding, the claimant would be estopped from relying on it in 2016 by the parties’ conduct in circumstances where both parties had acted as though the agreement were not contractually binding for some 11 years. The judge considered that it would be unjust or unconscionable for the claimant to renege on that position now.
• The judge also explained that, even if the agreement had been binding, he would have refused to make an order for specific performance of the IP transfer term. Specific performance is an equitable remedy. That means that it is a remedy underpinned by fundamental fairness and awarded by the court at its discretion (as opposed to a legal remedy that is available as of right to a successful claimant). When exercising its discretion, the court will apply certain key principles of equity, including: the maxim of ‘clean hands’ (that is, anyone looking to equity for a remedy must be free of wrong doing him/herself); that equity will not suffer a wrong to be without a remedy (where fairness requires, a remedy will be provided even if one does not exist by right at law); and – as was relevant here – the doctrine of ‘laches’ (delay), which is predicated on the fact that delay can cause detriment and unfairness in itself, and so an equitable claim may be barred if it is not brought within a timely manner.
• For all these reasons, therefore, and despite many years working together productively, the claimant could simply not require the defendant to transfer the IP to it as it had hoped.

Further advice or assistance

In the vast majority of commercial cases, the best advice will be for parties to wait until a formal written contract has been completed before they start work or otherwise invest any significant time or money. In today’s fast-paced business world that is not always possible or practicable, however, and so for further advice, or assistance in relation to any of the issues covered in this article, please do not hesitate to contact Gwendoline Davies or James Crayton. If you think training would benefit your organisation, please contact Gwen or James, who would be happy to assist.

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[1] [2019] EWHC 2273 (IPEC)
[2] Edge Tools & Equipment Ltd v Greatstar Europe Ltd [2018] EWHC 170 (QB)
[3] as per the test set out in the leading case of RTS Flexible Systems Ltd v Molkerei Alois Muller GmbH & Co KG [2010] UKSC 14