The words “subject to contract” are often used as a catch-all phrase to avoid being tied into a legally binding agreement before you are ready to commit to a formal obligation.

As any first-year law student will tell you, a legally binding contract is created when (1) the parties have agreed all the essential terms of a contract, (2) they intend to create legal relations, and (3) there is a consideration. The use of the words “subject to contract” effectively prevents the crystallisation of an intention to create legal relations, so there is no legally binding contract.

But can use of this phrase really act as a blanket term that can be used to avoid firm contractual commitments in every case? The newly minted Supreme Court, (successor to the House of Lords as the final court of appeal in the UK for civil cases) has recently grappled with this issue in the case of RTS Flexible Systems Ltd (Respondents) v Molkerei Alois Müller GmbH & Co KG [2010].

The result makes sobering reading for those dealing with commercial contracts, with perhaps the greatest lesson to be learned: don’t start work on a contracted project until the essential terms are agreed and distilled into a signed document.

Beauty parade

In that case, Müller (renowned for its dairy products) put out to tender a contract for the supply of an automated yoghurt pot packaging system. In January 2005, RTS was successful in its tender for the £1.68 million project. Crucially, RTS agreed to begin work while the parties negotiated the terms of a final contract.

While in this case the actual words “subject to contract” were not used in written communications, the draft contract specified that it would remain “subject to contract” until the parties had signed and exchanged their parts of the contract. A letter of intent, put in place for four weeks while negotiations continued, stated the price for the whole project and confirmed the parties’ intention that the final form of contract would incorporate some model contract terms, modified as required to fit the project. A draft contract was prepared incorporating these modified terms and containing detailed provisions on many matters, but it was never signed.

The letter of intent came to an end in May 2005, but RTS continued to work on the project, and the parties continued to negotiate the terms of the draft contract. By 5 July 2005 the parties had reached agreement on nearly all of the essential points. The only other matters still outstanding either did not need to be completed before the contract was signed or were only intended to be completed during the course of the project.

Agreed variations

Throughout these negotiations RTS worked on the project. However, considerable difficulties arose with the project between June and August 2005, meaning that RTS would not be able to meet the original timetable for delivery.

Following a trail of email messages and a meeting between the parties in August 2005, they agreed to vary the project delivery plan on 25 August 2005. RTS then delivered the project equipment to Müller in early September 2005, but did not carry out the site acceptance testing provided for in its original tender document and the draft contract. Müller subsequently claimed that the equipment was defective and would only pay part of the agreed price. RTS then issued proceedings against Müller for the balance.

As stated above, a legally binding contract is created where the parties reach agreement on all the terms of the contract that they regard, or the law requires, as essential. There must also be the intention to create legal relations, and there must be a consideration involved.

Judgment day

So was there a legally binding contract in this case? The High Court answered “yes”. The Court of Appeal answered “no”. Finally, the Supreme Court answered “yes”. The Court found that the parties had reached a binding agreement in August 2005 on the 5 July terms. The Court held that, in this case, on or by 25 August 2005 the parties had, by their conduct, agreed to waive the “subject to contract” provision, and that any other conclusion would make no commercial sense.

What can be learnt from this case? Lord Clarke, who gave the judgment of the Court, commented that ‘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 to is to agree first and to start work later.’

It may not always be possible to follow this advice, but you should be aware that by beginning to carry out work on a contract before it is formally concluded you may waive the protection offered by a “subject to contract” provision.