Contracts: when actions speak louder than words

In the first of a two-part series, Matthew Bonye, Frances Edwards and Shanna Davison analyse the constraints of commonly used phrases and highlight potential pitfalls in real estate transactions. Key points Every case will turn on its own facts, but the grounds can be ripe for dispute when a party’s conduct does not accord with the label used A lack of understanding of the effect and limitations of labels such as “subject to contract” can be a costly mistake Parties who negotiate terms for an agreement require certainty to know when they have become contractually bound to those terms. Between commercial parties, a presumption usually applies that any agreement, if it is reached, is legally binding such that none of the parties can then resile from it.  Therefore, heads of terms, agreements in principle and correspondence exchanged during negotiation are commonly labelled as “subject to contract” to prevent an agreement becoming binding on the parties before they are ready. Let’s take an example of a landlord and prospective tenant who “agree” the headline commercial points of a letting (for example rent, term, permitted use). Those terms are recorded in a document headed “subject to contract” for the purpose of instructing solicitors to agree the drafting of the lease. The parties do not intend to be legally bound at that stage and so there is no binding agreement. However, let’s contrast the position where the landlord and tenant settle on the commercial points of a letting, with the landlord taking the first payment of rent and giving the tenant keys to move in without further discussion. They may well be bound by that agreement, even though the detailed terms have not been recorded in writing. This can be so despite the usual rule that real estate transactions must be formalised in writing.  There are many shades of grey in between these two examples. What if the parties have not discussed the finer points of detail and, on doing so, find they cannot reach agreement? Is there still an agreement on the headline points that can be enforced? Is it fatal if negotiations are not expressly marked subject to contract? Substance over form  The courts have a long history of determining whether a situation between parties is truly subject to contract, both with and without the use of that label. Logically, disputes only tend to arise where one party thinks that they have concluded a contract and the other does not.  In 2010, the Supreme Court in RTS Flexible Systems Ltd v Molkerei Alois Muller GmbH [2010] UKSC 14 endorsed a set of principles when applying the objective test: Look at the correspondence between the parties as a whole. Even if the parties have reached agreement on all the terms of the proposed contract, they may intend that the contract shall not become binding until some further condition has been fulfilled or further terms have been agreed. Alternatively, the parties may intend to be bound even though there are further terms to be agreed or further formality to be fulfilled. The contract will not be invalidated by a failure to reach agreement on such further terms unless that renders the contract unworkable or void for uncertainty. The parties must agree on the essential terms, and it is only matters of detail which can be left over.  The parties’ conduct and the surrounding circumstances are often more important than the label that parties give to their dealings, as demonstrated by two recent cases. In March 2022, the High Court handed down its judgment in Johnson v Spooner [2022] EWHC 735 (Ch). A business relationship, which grew from a friendship between Sally Johnson and Howard Spooner, led to Johnson owning a share of Spooner’s hotel business. The relationship broke down and protracted negotiations ensued for an exit for Johnson.  A verbal agreement was struck whereby Johnson would sell her share to Spooner, with the purchase price being paid in instalments. A few days later, emails were exchanged labelled “subject to contract” which set out the proposed agreement. The negotiations advanced further, again by exchange of correspondence labelled “without prejudice and subject to contract”. Part-payment was made by Spooner and the balance was paid to his solicitors, who were instructed to document the agreement. However, Johnson subsequently realised that she could get a better deal with a third-party investor. She delayed responding to Spooner and argued that a binding agreement had not been made.  The court did not agree, being particularly swayed by the parties’ conduct, the part-payment from Spooner and Johnson’s collection of personal items from the hotel after the exchange of emails (one of the terms of the agreement). It held that Johnson’s reluctance to sell “came about because of the sighting of money on the horizon” after both parties had an intention to be legally bound. The “subject to contract” label did not change the fact that the parties had reached a binding agreement. In contrast, in June 2022, the High Court considered Pretoria Energy Company (Chittering) Ltd v Blankney Estates Ltd [2022] EWHC 1467. The parties agreed several iterations of heads of terms for a lease of a site for an anaerobic digestion plant (ie producing biogas and electricity from organic matter).  They agreed “Heads of Terms of Proposed Agreement between Blankney Estates, Lincolnshire and Pretoria Energy Company Limited Subject to Full Planning Approval and appropriate consents and easements”. However, the subject to contract label was not used. Instead, the heads of terms recorded a proposed rent of £150,000 per annum, identified a bare land site and a term of 25 years contracted outside the Landlord and Tenant Act 1954. They included a statement that “As discussed, this is a framework proposal in how we see this project moving forward… the offer is subject to a planning permission being granted…” The parties agreed an exclusivity period for six months from signing the heads of terms. During this time, planning permission was granted, a draft lease was in circulation for the site, licences and ancillary leases were granted for neighbouring fields where maize was sown, and Pretoria Energy spent more than £500,000 investing in the project. However, the main lease was not completed and Blankney decided not to proceed with Pretoria. Pretoria issued proceedings for breach of contract, placing reliance on its vast expenditure. Interestingly, the court found that “there is a significant difference between the sale of an existing property and the creation of a new property interest in the form of a commercial lease. Terms may be readily implied into a contract for the former: in relation to the latter, it is much more difficult to know what the provisions of the lease – which the parties will have anticipated would run to many pages – must be, without express agreement.” While Pretoria may well have understood the heads of terms to be binding, that was “irrelevant” as there were clear indicators that the reasonable person would have concluded that they were not. In particular, the court was swayed by the fact that the parties had agreed the exclusivity period, which indicated that a formal agreement was to be negotiated and agreed. Further, the heads of terms provided for the lease to be contracted out of the protection of the 1954 Act, which would not have been achieved if the heads of terms themselves created legally binding obligations. Say what you really mean The subject to contract label can be helpful. But if the parties do not intend to be legally bound until they have agreed all terms which are recorded in a formal written agreement signed by both parties, they should consider bolstering this further. For example, by expressly setting this out in their heads of terms or at the start of correspondence, in addition to using the subject to contract label. Addressing this point early on clarifies the position for both parties and should prompt discussion if either party has a different agenda.  Terms such as “subject to board approval/planning permission” tend to muddy the waters and can lead to a conditional but binding agreement being inferred, rather than leaving the parties still at pre-agreement stage. It can also lead to positive obligations being implied on either party to satisfy the condition so that the agreement can become unconditional. Glossary Objective test – Would a reasonable person standing by and observing the situation understand that the parties intended for the agreement to be binding? Essential terms – This does not mean a term which is regarded as important by the parties or by the court, but one without which the contract cannot be enforced Matthew Bonye is head of real estate dispute resolution, Frances Edwards is a senior associate and Shanna Davison is a professional support lawyer at Herbert Smith Freehills Photo © Ri Butov/Pixabay