Contract formation - a reminder of the basics for the construction industry

United Kingdom

It is often the case that a formal construction contract will never be concluded. Care should therefore be taken to ensure that other communications passing between the parties that are intended to be legally binding are; and those that are not, are not.

The basic principles of contract formation are well known. It's all very well when one party makes an offer that is then accepted by another and the parties proceed happily with the conclusion of their contract. But in the real world, especially with building contracts, things are very rarely that simple. The question of when arrangements between two parties give rise to a binding contract regularly crop up in the construction industry. The need for a binding contract is so that the agreement can be legally enforceable in the courts. Due to a number of different factors – time constraints for one – work has often begun before a formal contract has been executed. In large projects, it is often some years after the commencement of the works before the parties' intentions are formally put into writing. So, in what circumstances will a court determine that a binding building contract exists?

The components of a binding contract

Put simplistically, there are four ingredients required to make a binding contract:

There must be an offer

An offer is a promise by one party to enter into a contract on certain terms. It must be: specific, complete, capable of acceptance, and made with the intention of being bound by acceptance i.e. that no further bargaining takes place.

An offer should be contrasted to an invitation to treat. This merely invites the other party to make an offer and does not carry the intention to be legally bound. For example, in the case of an auction sale, it is the bidder (not the seller of the property who is standing in the background) who is generally considered to be the person making the offer, so that the seller is not bound by bids and may withdraw his property from the sale without accepting an offer if the bid is below the reserve price. By entering his property into the auction catalogue, the seller is merely providing an invitation to treat, in a similar way to an employer putting work out to tender.

When drafting letters at the early stages of a construction project, the author should be careful not to use any wording which he intended to be only an invitation to treat but which the other party – and perhaps more importantly the court – could construe as an offer.

The offer must be unequivocally accepted and must not amount to a counter-offer

If an offeree (i.e. the person to whom the offer was made) purports to accept an offer but his acceptance does not match the terms of the offer – disregarding trivial variations – then no contract is deemed to have been formed. Rather than accepting the initial offer, the offeree makes a counter-offer. This amounts to a rejection of the initial offer so that no contract exists. Where a counter-offer is accepted, then its terms – rather than those of the original offer – become the terms of the contract.

There must be consideration

In addition to the necessity for an offer to be accepted, there is also a requirement that a promise – unless expressed in the form of a deed – must be supported by consideration in order for it to be enforceable. This is because the law assumes that people do not get anything for free i.e. the person giving the promise must be given something in exchange for his promise.

There is extensive case law which considers what can constitute sufficient consideration and whether it is possible to enforce a promise in the absence of consideration.

The simple message: if there are any doubts about the consideration, record the agreement in the form of a deed.

Both parties must intend to become legally bound

A contract cannot be made without the intention for the agreement to be legally binding. An objective test is used by the courts to determine the intention of the parties: it asks whether a reasonable person would regard the agreement as legally binding. In building contracts, this is rarely an issue as there is a presumption, albeit rebuttable, that the parties intend to create legal relations in commercial agreements. A party would have to produce clear evidence to the contrary if it wanted this presumption to be rebutted.

The implications of this rule should be considered carefully where parties might wish to record that the terms of their pre-contract negotiations are intended to be non-binding. For example, where there is no intention to become legally bound, this should be stated specifically rather than relying on the "Subject to Contract" label. However, bear in mind that there may be times when you want certain terms of the letter to be legally binding such as confidentiality clauses.

When a "contract" is not a contract

Poorly drafted letters of intent cause numerous problems in the construction industry. The parties can sometimes be held to have unwillingly created binding obligations where they had not actually intended to do so.  In British Steel Corporation v Cleveland Bridge and Engineering Co Ltd  [1984] 1 All ER 504, a dispute arose concerning whether a contract arises from a letter of intent. Cleveland Bridge successfully tendered for the fabrication of steel work. British Steel were iron and steel manufacturers. The court decided that the question of whether a contract to manufacture cast-steel nodes had come into existence "must depend on the true construction of the relevant communications which have passed between the parties and the effect (if any) of their actions pursuant to those communications." It was held that there was no "hard and fast rule" to answer the question of whether a letter of intent will give rise to a binding agreement. Everything should depend on the circumstances of the particular case.

In most cases, where work is carried out on the basis of a request in a letter of intent, it will not matter whether a contract did or did not come into existence because the other party – who is simply claiming payment – will simply be claiming on a quantum meruit basis (i.e. the claim is one for reasonable remuneration as opposed to an award of damages).

When a "contract" is a contract

ACT Construction Ltd v E Clarke & Sons (Coaches) Ltd [2002] EWCA Civ 972 is a recent case where the courts have held that a contract, and therefore an implied obligation to pay a reasonable sum for the works, existed. The claimant contractor was instructed by the defendant to embark on the necessary design work for a substantial redevelopment. A dispute concerning payment arose. The judge decided to determine, amongst other things, whether there had been a contract between the parties. He held that as neither the scope of work nor the price had been defined with any precision in the communications passing between the parties, there could be no contract. On appeal, the Court of Appeal stated that as long as there was an instruction to do work and an acceptance of that instruction, there was a contract. Their decision was based on the fact that in the absence of a formal contract, there was "contractual quantum meruit" whereby there was an agreement to carry out the works despite the fact that all of the terms, including their scope and price, had not been agreed.

The difference between the British Steel case (where the court decided that there wasn't a contract) and the ACT Construction case (where the court decided that there was a contract) seems to be that where the parties are still discussing fundamental terms, there will be no contract. Whereas, where the meat of the contract has been agreed but negotiations are still progressing concerning other – although not necessarily insignificant – issues, there will be a contract.

The latest guidance on this subject comes from the Court of Appeal in their judgment in Harvey Shopfitters Ltd v ADI Ltd [2004] 2 All ER 982. Harvey were engaged to refurbish a number of flats that were owned by ADI. A letter of intent was issued to enable the works to start early. The letter was issued by ADI's architect and confirmed ADI's intention to "enter into a contract with [Harvey] on the basis of the tender sum of £339,895.34". The letter also stated that the main contract documents were being prepared for signature and would be in the form of the JCT Intermediate Form of Building Contract 1994 Edition (IFC84). Harvey were asked to sign and return a copy of the letter if they were in agreement with the terms set out in it. Harvey did this. No formal contract was ever signed. A dispute concerning the terms of the letter of intent then arose. ADI contended that the parties' contract was on the IFC84 conditions whereas Harvey argued that it was merely a "simple" contract. Harvey pointed to some wording in the letter which read: "if…the [IFC 84] should fail to proceed and be formalised, then any reasonable expenditure incurred by you in connection with the above will be reimbursed on a quantum meruit basis". The Court of Appeal held that the quantum meruit principle would only apply if the IFC84 both "failed to proceed" and "failed to materialise". The judge said that the court was entitled to "look behind the apparent or literal meaning of the words of a letter…to determine the true intent of the parties". Having done this, the Court of Appeal  held that the judge at first instance was right to conclude that the parties had agreed to a fixed-sum contract under the IFC 84 conditions. In other words, the only circumstance in which Harvey would be entitled to quantum meruit was if the contract did not proceed and was not finalised.

Steps to consider if you wish there to be a binding and enforceable contract

As the distinction between when the court will conclude that a contract exists and when one doesn't is very fine, a number of factors can usefully be taken into account when drafting what is intended to be a legally binding document:

  • Clearly state that the document is intended to be legally binding. If not all parts of it are, state those that are.
  • Ensure that there is sufficient consideration – for more see above.
  • Make certain that all of the essential terms of the contract are in clear and precise language.
  • State that the terms of the letter of intent shall apply for the course of the project, providing that a formal contract is not subsequently entered into. Alternatively, specify a time limit if it is not intended to continue indefinitely.

Of course, if the document is not intended to become legally binding, this should be made equally clear.

For further information please contact Adrian Bell at adrian.bell@cms-cmck.com or on +44 (0)20 7367 3558