Consider this common scenario. After a lengthy tender process, a preferred tenderer has been selected. The terms of the contract are being negotiated, but the principal is eager for the construction works to begin. It does not want negotiation of the formal contract to slow this down. The contractor is instructed to begin the works under the terms of a letter of intent, perhaps attaching a draft of the formal contract to be negotiated. The principal intends for the parties to sign the formal construction contract as soon as it is negotiated.

Fast forward a few months. The parties are in dispute. The parties never signed the formal construction contract. What legal terms does a court consider when determining the dispute?

Binding v non-binding

When a project goes pear shaped, a party might seek to rely on the terms of the letter of intent to either bring or defend a claim for payment. At this time the court may be asked to decide whether or not the letter of intent is binding on the parties, or whether it is merely a guide and subject to further negotiation and agreement – in other words an “agreement to agree” in the future.

First ask: were the terms of the letter of intent binding? Consider whether the requirements of a binding contract have been met (offer, acceptance, consideration, and intention to create legal relations). Are the terms of the letter of intent sufficiently certain so as to bind the parties? If so, on what terms?

If the letter of intent expressly states that its terms are non-binding, then unless there is other evidence to counter this, the terms of the letter of intent might not apply.

Courts will generally need to consider the terms of the letter of intent, the subject matter of the agreement, the conduct of the parties and the surrounding factual circumstances to decide which of the following 4 categories the letter of intent falls into:

  1. A document containing all the terms of the agreement (binding).
  2. A document setting out all key terms of the agreement but where performance of certain terms is conditional upon the execution of a formal contract (binding).
  3. A document entirely subject to a formal contract (not binding).
  4. A document immediately binding the parties but where the parties have agreed to execute a formal contract at a later date (binding).

What terms should a letter of intent include?

Instructing or carrying out works under a letter of intent may present commercial and legal risks for both principals and contractors. However, the greater risks generally fall with the principal. 

Principal’s perspective

The courts have described letters of intent as being “...of a skeletal nature whose classic use is for restricted purposes that do not protect the [principal’s] interests in the same manner as would the formal contract.”1

As a general rule, it is in the principal’s best interest to include as many operative (principal favoured) clauses in a binding letter of intent as possible. This should include, for instance:

  • a clearly defined scope of work;
  • the price (usually a “price cap”) or method of calculating price;
  • payment terms (including content and timing of payment claims);
  • a limit on amount payable under letter of intent;
  • a variation clause (process and calculation);
  • insurance obligations;
  • the contractor's standard of care;
  • right of set off; and
  • termination / expiry of agreement.

A letter of intent, by its nature, cannot govern the parties’ rights and obligations in the same way as a formal construction contract.

Consider the experience of the principal in the case of The Trustees of Ampleforth Abbey Trust v Turner & Townsend Project Management Limited [2012] EWHC 2137:

In that case, works on a project were progressed through the continual issuing of (binding) letters of intent, with each one covering more of the works than the last. Despite good intentions, the formal contract (which contained the liquidated damages provision) was never signed by the parties. The works were completed significantly behind schedule and the principal sought to claim liquidated damages against the contractor. Unfortunately for the principal, as the letters of intent did not provide for liquidated damages the principal was prevented from making the claim. The principal successfully sued its project manager (Turner & Townsend) for failing to exercise reasonable care and skill to ensure the builder executed the contract. The court also found that Turner & Townsend failed to properly advise the principal about the risks of continually using letters of intent for the delivery of the project.

Contractor’s perspective

When considering the proposed letter of intent, a contractor will need to carefully consider the terms to determine what risks may result in signing and / or carrying out the works under the letter of intent.

There will be a number of provisions the contractor should seek to have included in its letter of intent. These include (but may not be limited to) the price or calculation of payment, appropriate limitation of liability and exclusion of consequential loss clauses.

Be careful of your conduct during period of letter of intent

Parties need to be aware that conduct during the project can undo terms in a letter of intent.

For example, the parties may either expressly or by their conduct abandon the application of the letter of intent.

If the principal instructs works to be carried out which exceed the “payment cap” agreed under the letter of intent, a court may nevertheless find that the terms of the letter of intent, and not any unsigned formal contract, applies (see for example Diamond Build Ltd v Clapham Park Homes Ltd [2008] EWHC 1439).

If principals want to reduce the risk of this occurring, they may wish to include a formal sunset clause which stipulates a date on which the letter of intent ceases to apply irrespective of whether the formal contract has been agreed.

What happens when the complete contract is signed?

What happens when the formal contract is eventually signed? Do its terms apply to the work carried out prior to signing?

To avoid any doubt on this issue, the principal should seek to include a provision in the formal contract making it clear that the terms of the formal contract retrospectively apply to the works carried out pursuant to the letter of intent.

So that there is mutual recognition between the documents, principals may also wish to include a term in the letter of intent stating that it is the parties’ intention that once signed, any formal contract terms will apply to the works carried out pursuant to the letter of intent.

Interplay with the BCIPA

Principals must be careful as a letter of intent may be found to be a contract, agreement or “other arrangement” under the Building and Construction Industry Payments Act 2004 (Qld) (BCIPA).

You will recall that BCIPA applies to the carrying out of construction work or the supply of related goods and services under a contract, agreement or other arrangement.

If the BCIPA applies, the contractor may be able to refer the payment dispute to adjudication.

To determine if the BCIPA applies to the letter of intent, ask yourself: does the letter of intent instruct the contractor to carry out construction works or the supply of related goods or services, and has the contractor carried out the work or supply in accordance with the letter of intent?

Even a non-binding letter of intent could be an “arrangement” under the BCIPA and thus potentially expose the principal to a BCIPA claim by the contractor.

Lessons learnt

All parties involved or who advise on construction projects need to know the risks of using letters of intent, and act or advise appropriately.

For principals: note the shortcomings of a letter of intent and wherever possible do not allow a contractor to begin works until a formal contract has been negotiated. If that is not possible, a principal should ensure that after issuing the letter of intent, it drives the parties to negotiate and agree the terms of the final construction contract as quickly as possible. It has been our experience that the longer the works are carried out under the letter of intent, the less likely the contractor will agree to the formal terms.

For contractors: assess the project and legal risks, and ensure you seek to include those clauses which are required to ensure you are properly paid and that you sufficiently limit your liability.

For advisors, including project managers or superintendents engaged by the principal, be sure to advise your clients of the risks of using a letter of intent. Be sure to also take all reasonable steps to ensure the parties agree the formal construction contract as soon as possible.