What makes a contract legally binding?

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As a matter of general law there must be certainty as to the terms of the contract, an intention by the parties to create legal relations and what the law calls “consideration”; namely the value promised to another when a contract is made. There must also be an acceptance of the contractual terms offered.

Certain contracts, such as contracts for the sale of land, must comply with specific legal formalities in order to be legally enforceable. In the case of land, this means the contract must be in writing and incorporate all the terms the parties have agreed.

However, for other types of commercial contracts, the question of exactly when a contract has been formed by the acceptance of the terms under discussion can be uncertain, particularly where there has been a course of both oral and written negotiations. Accordingly, to avoid the risk that a contract might be created inadvertently or prematurely during the course of a negotiation, parties will often use the words “Subject to Contract”.

This phrase indicates that until a formal written contract is signed the parties do not intend to enter into binding contractual obligations. “Subject to Contract” is commonly used during commercial negotiations but also in conjunction with the words “Without Prejudice” when attempts are being made to settle a dispute.

The courts will uphold the non-binding status of “Subject to Contract” negotiations except in very strong and exceptional cases where the parties have taken steps from which the court will infer that an implied binding agreement has been reached. For example, by acting in accordance with the terms of the proposed contract as set out in correspondence or a ‘Heads of Terms’ document, even though a contract has not been signed.

Not surprisingly, when things go wrong, these cases are likely to become the subject of litigation, particularly where one party has incurred significant costs in the belief that it has won a contract and the parties’ conduct is arguably consistent with a contract having been formed.

This litigation risk can be mitigated by making it explicitly clear that negotiations are not only “Subject to Contract” but also that there is no intention to create legal relations until a written contract is signed. That said, the safest course of action is to not only use clear wording but also to avoid taking steps to implement or encourage the performance of the proposed contractual obligations in advance of the signature of the written contract.