Revisiting letters of intent

What are letters of intent?

This sounds like a simple question - after all, everyone knows letters of intent are used between employers and contractors (or contractors and subcontractors) wishing to start works early before their main contract has been finalised. Time is money and the later works start the later the revenue stream will begin for the contractor and ultimately also the employer. There may also be a risk of missing a window of opportunity, be it good weather on site or the opening of a retail centre before Christmas. These commercial considerations often outweigh any concerns about starting works before the parties have finalised their contract.

Where works are to proceed almost immediately, no one wants to spend time negotiating a letter of intent. Not infrequently a form of letter of intent used on a previous project is taken out from the bottom drawer, dusted off, the names changed and issued to the contractor for signing. Neither party is concerned about the implications of recycling in this fashion. Both are focused on the need to get works underway as quickly as possible. In any event, neither expects to have to sue on the letter – after all it is only to be in place for a few weeks while the ‘i’s are dotted and the ‘t’s are crossed.

However, all this only describes the circumstances in which a letter of intent might be used. What are the parties actually agreeing to? Is the letter of intent just a standing offer to the contractor that if he performs works he will be remunerated,
is it a ‘mini contract’ with a defined scope of works and fixed rates or is it some other arrangement?

A failure to consider the legal implications of your letter of intent can leave one or other party exposed – for example, an employer may find he is obliged to pay far more than originally anticipated whilst a contractor could find he has performed considerable works but cannot recover his full costs.

Letters of intent can be divided into two basic categories – non contractually binding and contractually binding. A
letter of intent will only be contractually binding where:

• one party has made an offer clearly stating all terms essential to the contract (for example price and basic scope of works);
• the other party has accepted this offer without qualification;
• there is ‘consideration’ (for our purposes a price); and
• both parties intend to create legal relations.

If one or more of these criteria is not fulfilled, the letter of intent will not be binding. As a matter of legal theory this all sounds very neat, but as always these things become more complicated in practice. This is particularly the case with letters of intent where the parties themselves may well not have clearly recorded or even expressly discussed whether they wanted to be contractually bound to one another.

To address this problem, the Court is increasingly taking a more pragmatic approach to the fulfilment of these criteria so that, where on the evidence the parties intended to set up a contractual relationship, the Court will try to uphold this even though on a narrow interpretation not all of the necessary criteria have been fulfilled.

Non-binding letters of intent

In the past, the view was that letters of intent are not contractually binding other than in exceptional circumstances; they have been described as merely the expression by one party of its present intention to enter into a contract at a future date.

Non-binding letters of intent may be used where an employer wishes to instruct works without committing to a contract, for example where the viability of the project is uncertain because planning permission or funding has not yet been obtained.

Such a non-binding letter of intent has advantages for both parties. Most fundamentally, it allows both parties to ‘walk away’ at any time without obligation.

From the employer’s perspective, it also has the advantage that the Housing Grants Construction and Regeneration Act 1996 (“the Act”) will not apply and so the employer will not be required to serve withholding notices required by the Act, the contractor will not have the suspension rights provided by the Act and the parties will not have the right to refer disputes to adjudication.

From the contractor’s perspective, one advantage of a non-binding letter of intent is that he cannot be liable for late completion. Another is that the contractor cannot be sued for any breach of contract, although the employer may be able to deduct from sums otherwise due to the contractor an amount to reflect defective work.

This leads to the question of how sums due to a contractor acting under a non-binding letter of intent are assessed. In general a contractor working under a non-binding letter of intent will be entitled to receive a quantum meruit or reasonable remuneration for the work performed.

This puts a label on the issue, but does not provide much guidance as to the mechanics of valuation. In some cases the contractor has only received the amount by which the employer’s property increased in value as a result of the works. However, a more common approach is to award the contractor’s costs with an allowance for profit (although whether this should be limited by any rates and prices for the anticipated main contract which are referred to in the letter of intent is unclear).

At present, no set rules have been established and so the remuneration owed to the contractor will be uncertain.

A further uncertainty facing non-binding letters of intent is the recent trend towards letters of intent being held to be binding rather than non-binding. This can be the case even where the letter of intent is phrased as an intention to enter into a main contract at some future date. The Courts will take a practical approach to whether and on what terms a contract has been entered into. A failure to observe ‘niceties’ will only be fatal to a contract where essential items have not been dealt with and, in a commercial relationship, the Court will try to establish the existence of a contract because that is the presumed intention of such parties.

As a result, if the parties intend not to be contractually bound, very clear wording will be necessary (although this still may not be sufficient, particularly if inconsistent with the parties’ subsequent conduct).

Binding letters of intent

Binding letters of intent may be used where the parties want to regulate their relationship with greater certainty, for example to avoid the risks inherent in a claim for quantum meruit or because the employer wants to hold the contractor to a particular completion date.

As a corollary of non-binding letters of intent, both parties to a binding letter of intent will be obliged to perform their obligations fully, the Act will apply and the contractor can be sued for breach of contract and will be bound to complete within a reasonable time (or the date specified in the letter, subject to appropriate extensions of time).

There may also be terms implied into the contract. In the case of the supply of goods, obligations as to fitness for purpose and satisfactory quality will be implied. In addition, there may be an implied term that the contractor is entitled to receive reasonable remuneration for work performed.

However, where these matters are dealt with in the letter of intent, such implied terms may be excluded. This will generally be the case with the obligation to pay reasonable remuneration. The usual approach has been for binding letters of intent to provide that the contractor is authorised to work only up to a maximum figure; any work the contractor performs over and above this value is at his own risk. Until recently, this has given the employer certainty but left the contractor exposed should he be unable to assess the value of the works performed at any given moment in time. However, following a recent case, it seems that in certain circumstances a maximum sum provision may not cap the contractor’s recovery but instead act as a ‘code’ indicating when the employer can terminate the letter of intent.

Accordingly, if the parties still wish to use a maximum price mechanism they should specifically address the issues raised by the case in their contract. This could be done by inserting mechanisms to enable the parties to know when the maximum sum has been reached and providing for what is to happen when this occurs (for example termination or extension of the maximum sum). The maximum sum should also be realistic to reduce the risk that it is interpreted as an irrelevance (e.g. because it has already been exceeded prior to the date of the letter of intent).

As an alternative to using a maximum sum mechanism, the letter of intent could be drafted as a ‘mini contract’ whereby the contractor is to perform fixed works for a fixed price. Whilst having the advantage of certainty, in practice such an approach may cause further delay as the parties negotiate an appropriate price for the works.

Other key terms

Regardless of whether your letter of intent is binding or non-binding, it should address the following issues:

• Price;
• Scope of works;
• Termination (including payment and other consequences);
• Copyright and other intellectual property rights as necessary;
• If a time for completing the initial works is specified, an extension of time clause will also be necessary;
• How works performed under the letter of intent are to be reconciled with the full contract once entered into (typically payments made under the letter of intent are stated to be payments on account of the final contract price under the full contract and the terms of the full contract are deemed to apply as of the date when works under the letter of intent were begun);
• Finally, for good housekeeping, list the documents to form the final contract and identify all outstanding issues, including whether or not they are considered essential to the final contract.

Minimising your risk

No lawyer is ever likely to recommend the use of letters of intent in place of a full contract. However, the nature of the commercial imperatives in the construction industry is such that letters of intent are often used, frequently at short notice.

Given this, it is worth developing standard form(s) of letter of intent which address relevant case law and protect your company’s interests. Having done this, remember that the law is not static and it may be worth giving the letter to your lawyer for a quick once over before issuing it on a particular project. After all, as the cases show, the costs down the line can be considerable, particularly if you become embroiled in a lengthy dispute.

For further information please contact Alex Cunliffe at [email protected] or on +44 (0)20 7367 2670