Letters of Intent: principles and pitfalls

Letters of intent will always be a topic of interest to the construction industry. There are times when you cannot avoid them. Indeed, they have been described by some as a necessary evil.

In a recent case,[1] HHJ Coulson QC indicated that a letter of intent could be appropriate when:

• the contract scope and price were either agreed or there was a clear mechanism in place for the scope and price to be agreed;

• the contract terms were, or were very likely to be, agreed;

• the start and finish dates and the contract programme were broadly agreed; and

• there were good reasons to start work in advance of the finalisation of all the contract documents.

In an article explaining some of the pitfalls concerning letters of intent, Matthew Needham-Laing starts by considering the key points everyone should consider before signing a letter of intent.

It can take a long time for the formalities of a professional appointment, building contract or subcontract to be concluded, and time is money for all parties involved in construction. Employers and contractors want to get started on a project as soon as possible, consequently they frequently resort to sending letters expressing their intention to enter into a formal contract for the entirety of the works in due course. There are a variety of reasons why such letters are resorted to, and why both parties to a contract find them acceptable for their respective purposes.

In the case of the employer, they may wish to get the development started early to reduce the borrowing costs or bring forward the date when the development produces an income, rather than delay the design or commencement of construction until the formal contract has been signed.

In the case of the contractor or subcontractor, frequently they want some form of letter before commencing work so they have some comfort, whether it is illusory or real, that they will be paid for the work they are about to embark upon.

It therefore suits both parties to send or receive a letter expressing their intention to enter into a formal contract in due course. Letters of intent come in a variety of forms, but generally they can be categorised into three main types:

1. The most common arrangement is that where the contractor agrees to start work without any agreement to do the whole works. The contractor can thus call a halt at any time to the works. The arrangement is simple and contractual. Usually the letter is sent from the employer, and is either countersigned or accepted by conduct by the contractor. There is usually (but not always) a payment on a cost reimbursement basis, and sometimes employers seek to put a limit on their liability to pay the contractor, by expressly stating that the letter only authorises expenditure up to a certain amount. The contractor may not be obliged to complete the work at all, and may not be required to complete it by any particular time, but there will be an implied term as to the quality of whatever work the contractor does. This type of letter of intent is frequently described as “an if contract” following the case of British Steel Corporation v Cleveland Bridge Engineering Company Limited ([1983] BLR 95).
2. Alternatively, and less frequently, the letter of intent is expressed as the contract for the whole of the works, frequently referring to the terms and conditions, and the various contract documents which are to be incorporated into the formal contract once signed.
3. Finally, there is a “Letter of Comfort” which is no more than an expression of the parties’ intentions and creates no legal relationship at all. If a contractor or consultant carries out work pursuant to this letter, then any entitlement to payment for what he does would be on a restitutionary, quantum meruit basis.

In the majority of cases where parties have resorted to issuing a letter of intent, they subsequently finalise their negotiations for the entire contract, and the letter of intent arrangements are superseded by execution of the contract, which then governs all the works being carried out. It is only when those negotiations fail to conclude a formal contract, that letters of intent are exposed to judicial scrutiny. The optimism with which the parties agree to carry out the works pursuant to the letter of intent is exposed to the uncompromising law of contract formation as formulated by the courts over a century ago.

In order to determine whether a contract has been concluded in the course of correspondence, one must look at the correspondence as a whole.

Even if the parties have reached agreement on the terms of the proposed contract, nevertheless they may intend that the contract shall not become binding until some further condition has been fulfilled.

Alternatively, they may intend that the contract shall not become binding until some further term(s) have been agreed.

Conversely, the parties may intend to be bound forthwith even though there are further terms still to be agreed or some further formality to be fulfilled.

If the parties fail to reach agreement on such further terms, the existing contract is not invalidated unless the failure to reach agreement on such further terms renders the contract as a whole unworkable or void for uncertainty.

Parties often enter into letters of intent without fully appreciating what their rights and liabilities are. As a minimum, the following three points should be considered before signing a letter of intent:

Is the letter of intent to form a binding contract? Whether it does or does not depends on the construction of the communications which have passed between the parties and the effect, if any, of their actions pursuant to such communications.

If a contract is found to exist, then it will determine the parties’ obligations or, alternatively, if no contract is found to exist, the letter of intent will have no contractual effect.

In drafting letters of intent, it is therefore vital for the parties to state clearly whether or not the letter of intent is to form a binding contract. If work is done pursuant to a contract, then the contractor will have obligations as regards the workmanship and time for completion. Conversely, if there is no comprehensive contract, then there can be no such contractual obligations, although there may be obligations for negligence as regards workmanship.

If materials are purchased or bought pursuant to the letter of intent, how are these to be paid for?

Whether or not the letter of intent is legally binding on the person carrying out work under it, they will almost certainly be entitled to be paid for their work. The letter of intent should therefore state the basis of such payments. If the letter of intent is to be contractually binding, then payment schedules should be inserted. If no provisions are inserted, then a reasonable rate will be implied.

If a letter of intent is not legally binding, the contractor will almost certainly be entitled to payment on a quantum meruit basis, i.e. the contractor is entitled to be paid a reasonable sum for the labour and materials supplied by him.

The letter of intent should state that if a contract is subsequently entered into between the parties, then any payments made under the letter of intent form part of the Contract Sum, thus avoiding potential overpayment problems (see Boomer v Muir [1933] 24 P.2d 570).

Of course, in an ideal world there would be no letters of intent. All parties would agree the terms of their contracts and execute formal contract documentation before commencing work.

There have been two recent cases which demonstrate some of the pitfalls discussed above.

[1] Cunningham & Others v Collett & Farmer [2006] EWHC 1771 (TCC).