Beware letters of [inadvertent] commitment

31st August 2016

At the outset of commercial ventures, relationships are positive and parties are eager to get on with doing business together, often before full legal documentation is finalised and completed. Letters of commitment, letters of intent, comfort letters and the like, are tools which, despite their different terminology, all seek to achieve the same thing [1]: to record the key terms on which the parties have agreed to transact and to enable each party to proceed and comply with their part of the deal in some comfort that the other will do the same.  It is often (although not always) the case that parties intend that completion of full legal documentation will follow.  As the recent Commercial Court case of Novus Aviation v Alubaf Arab Int. Bank [2] highlights, however, there are some real risks associated with proceeding in this way and an understanding of some fundamental aspects of contract law is essential for managing those risks.

Formation of contracts: back to basics

A contract is formed when a person with the necessary authority to bind a party enters into an arrangement and all of the following key elements are present:

• offer;
• acceptance;
• consideration (i.e. money or money’s worth);
• intention to create legal relations; and
• certainty of terms.

It is important to remember that, with a number of specific exceptions (such as contracts for the sale of land, share transfers, assignments of certain contractual or intellectual property rights), a contract does not need to be written or indeed in any particular form.

A contract can be made orally (face-to-face or via some communication medium such as the telephone), though a party may have difficulty in proving the terms of an oral contract if they are disputed; and a contract may be made partly orally and partly in writing.

A contract may also be implied from the conduct of the parties, as offers can be made and accepted by behaviour; and a contract can be made via email, or by clicking a button on a website, provided the key elements are present.

In addition, in a commercial context, there is a rebuttable presumption of an intention to create legal relations (see below).

An enforceable contract can therefore be created more easily than one might think. All of this means that binding contracts can sometimes arise informally or inadvertently.  Disputes as to the existence or not of a binding contract or obligation arise frequently when the parties have agreed a commitment letter.

Novus Aviation – a cautionary tale

In this case the claimant company and defendant bank entered into a commitment letter and a management agreement pursuant to which the bank would provide finance for the acquisition and leasing of commercial aircraft. The bank’s representative (being its head of treasury and investment) approved the terms of the deal as set out, and signed these documents.  However, the bank’s board of directors subsequently rejected the transaction, which then never proceeded.  The company alleged that the documentation had been legally binding and sued for breach of contract.  The bank defended the claim on the basis that no contract had been formed because:

• the commitment letter had not been intended to be legally binding;
• the documentation lacked sufficient certainty to be binding because of a stated term that the bank could reject documentation if it was not “satisfactory“;
• the bank’s representative did not have authority to bind the bank to provide funding; and
• neither document had been executed according to the bank’s policy [3], nor counter-signed by the company.

The defence failed on all counts. The following key points make essential reading for all commercial parties.

• As mentioned above, the starting point in commercial cases is that there is a presumption of the requisite intention to create legal relations.
• That presumption can be displaced by express evidence to the contrary or by an objective assessment of the parties’ intentions. In assessing the parties’ objective intentions, the court will consider what was communicated between them by words or conduct and ask whether that leads objectively to a conclusion that they intended to create legal relations [4].
• In Novus the court found that it was plain from the terms of the commitment letter that it was intended to create legal relations. As well as using clear legal and mandatory language (such as “shall” and “Alubaf covenants“), the letter specified certain occurrences which would constitute breach of contract and it contained a governing law and jurisdiction clause.
• The court rejected the argument that the documentation was not sufficiently clear to have contractual force. Leggatt J commented that concluding that an arrangement is too uncertain to be enforceable should be a last resort because the courts aim to uphold and give effect to the parties’ intentions wherever possible.  He also noted that use of the word “satisfactory” merely introduced contractual discretion, which is enforceable [5].
• The court held that, as a matter of fact, the bank’s representative had actual authority to bind the bank to provide funding and that, even if it had not, by virtue of the representative’s position, the company was entitled to rely upon the representative’s apparent authority.
• It has been noted above that valid contracts can be formed without any formality whatsoever. That is the case unless the parties agree otherwise. In Novus the commitment letter was silent on execution requirements but the draft management agreement contained a proviso that it would not take effect until both parties had signed.  As neither document had been signed by the company, the court concluded that the commitment letter was binding, but the management agreement was not.

Practical guidance

• Commercial parties should review their negotiating practices and any precedent commitment letters (or similar) to ensure that they clearly record whether any agreement reached is intended to have legal effect, or whether the parties require any such agreement to be documented and signed by the parties before it has contractual force.
• Commercial parties should also be aware that the lack of any legal requirement for formality means that contracts can be formed by conduct as well as orally or in writing. It is therefore important that parties should not act in any way that is inconsistent with their contractual intentions.
• Businesses should review, and make sure that their employees understand, the scope of individual staff members’ authority to contract. In particular, where an employer does not want a member of staff to be able to legally bind the business, that should be made clear – both to the employee and to any contracting counter-parties.
• It is essential that businesses educate their staff as to the risk of informal or inadvertent contract formation and as to the fact that commitment letters and the like may or may not have legal force, depending upon both their terms and the circumstances of any given case.
• An understanding of some key contractual principles, as well as an awareness of the practical scenarios in which such risks may arise for any 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 only when that is actually required.

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[1] the term “commitment letter” will be used throughout the remainder of this briefing, although the same commentary and legal principles apply to all such purportedly ‘pre-contract’/comfort documents.
[2] Novus Aviation Ltd v Alubaf Arab International Bank BSC(C) [2016] EWHC 1575 (Comm)
[3] which, according to a document adduced by the bank required two signatures from a list of authorised signatories.
[4] 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
[5] so long as it is exercised in good faith for the purpose for which it was conferred and is not exercised arbitrarily, capriciously or unreasonably (Portsmouth City Council v Ensign Highways Ltd [2015] EWHC 1969 (TCC)).