Wednesday, July 18, 2012

Enforceability of side letters - a postscript

In an earlier post, we had discussed the decision of the English High Court in Barbudev v Eurocom on the issue of the enforceability of side letters. In April this year, the Court of Appeal upheld the ultimate decision of the High Court, departing however, from the reasoning adopted.

As discussed in the earlier post, the key issue in the case was whether a side letter signed by the parties could be enforced by the claimant. The judge at first instance concluded that the side letter was a mere 'agreement to agree', and was hence unenforceable in English law. Since the side letter was unenforceable, the judge also concluded that the letter was not intended to create any legal relation between the parties. This connection between the two issues formed an important part of the judge's reasoning, and was based on dicta of an earlier decision of the High Court in Dhanani v Crasnianski [2011] EWHC 926 (Comm), where the Court had observed, "the circumstance that an agreement is no more than [an] agreement to negotiate and agree may show objectively that the parties to it cannot objectively have intended it to be legally binding, notwithstanding that it had certain characteristics which otherwise might have evinced an intention to agree". On that basis, Blair J in the High Court in Barbudev found it difficult to see how "an agreement can be intended to create legal relations if it is unenforceable in its entirety" (paragraph 96). In addition, slightly confusing observations by the High Court relating to whether this inquiry was subjective or objective (paragraphs 91 and 93) created some further cause for discomfort.

The claimant appealed to the Court of Appeal on the primary bases (amongst others) that (1) the parties did intend to create legal relations; and that (2) the side letter was more than an agreement to agree, and hence, enforceable.

On the first of these questions, the Court concluded that when considering a wholly written contract, "the court must consider the language used and ascertain what a reasonable person … would have understood the parties to have meant. The court must have regard to all the relevant circumstances and, in a business context, it should prefer the construction that is more consistent with business common sense" (paragraph 31). It further reiterated that this test was an objective one. However, in the Court's view, even without resorting to the surrounding circumstances, the side letter was clearly intended to create legal relations. This was because (a) it was drafted by external legal advisers (Freshfields); (b) it contained language which was "that of legal relations" ('in consideration of …'); (c) the reference to an English statute and a provision that the contract was governed by English law; and (d) a clear intention that the confidentiality clause in the side letter was intended to be legally binding. On that basis, the Court of Appeal concluded that the High Court had erred in holding that the side letter was not intended to create legal relations.

However, having decided that the side letter was intended to create legal relations, the Court of Appeal then moved on to the independent question of whether these intended legal relations were enforceable. On a review of the side letter, the Court concluded that it amounted to no more than an 'agreement to agree', by which the respondents had agreed to negotiate with the claimant in good faith. Based on the concession of the claimant's counsel, and the decision of the House of Lords in Walford v Miles [1992] 2 AC 128, this necessarily meant that the side letter, though intended to create legal relations, was unenforceable.

Therefore, the Court of Appeal ultimately agreed with the High Court that the side letter in question here was unenforceable, since it was no more than an 'agreement to agree'. However, what is significant is that the Court of Appeal divorced this question of enforceability from the independent question of whether the side letter was intended to create legal relations. Although the outcome remained the same on facts, the decision is a useful clarification of the two step process involved in determining the binding nature of an agreement between parties: focussing, first on the intention of the parties (as objectively evidenced by the terms of the agreement and the communication between them), and only later on the second question of whether this intention to create legal relations had been successfully implemented through an enforceable contract.


Badrinath Srinivasan said...

A small point: Just because an instrument is drafted by a law firm does not mean that there was an intent to create legal relations. Aterm-sheet (non-binding) or a MoU (non-binding may also be drafted by a law firm. In practise, a company outsources several of such functions (of drafting non-binding instruments) to law firms.

DigitalAsian said...

What is the purpose then of the parties in putting something down in writing and signing it if not to be bound by that document?

Anonymous said...

Practically speaking, "side letters" are nothing but a "psychological comfort" and an "ego satisfaction" exercise. For law firms, another source of revenue. As long as everything goes fine, no one reads anything. But when things are not as per the expectations, everyone starts reading everything including the "side letters". Even the person trying to enforce a "side letter" perhaps knows that his argument of relying on the "side letter" will not any serve any purpose but he just does it for the sake of it.

To sum up "side letters" serve no purpose.

Siddharth R said...

A side letter (or a more accurate description would be a letter of intent) is a document of great commercial value. Whether the law of contract accords legal effect will alter the incentives of contractual parties ex ante. The court of appeals decision perfectly balances the conflicting incentives of reliance in contract and the potential for contractual abuse by a party. Although, one of the factors that the letter was drafted by a law firm is quite irrelevant. A side letter of the nature described merely imposes an obligation on the parties to negotiate in good faith and nothing more, the interesting part being the precise contours of the phrase "negotiating in good faith". This seems to be the default rule left to the parties to contract out in express terms.