Letters of Intent are frequently used in the construction and engineering industries and in property developments. Developers and contractors need to be clear about the nature of Letters of Intent, why they are used, and the key points typically addressed by a Letter of Intent. They, and their advisers: lawyers and professionals in the industry (e.g. project managers, costs consultants and architects) should be alive to the possible risks of proceeding solely on a Letter of Intent as a substitute for entering into the main works contract.
What is a Letter of Intent?
Although widely used there is, in fact, no fixed definition of a Letter of Intent or “standard form”. A Letter of Intent may be a binding contract or it may not. It all depends on the actual terms of the Letter of Intent.
A Letter of Intent might be:
- A pure statement of intention – the Letter of Intent might notify a contractor that the developer intends to place a contract with the contractor but that there is no contract in place or commitment until a full contract is signed for the works. This might be used in a number of situations, e.g. to give a contractor commercial comfort, so that it can start preparing for a project albeit at its own cost.
- An interim contract authorising a contractor to carry out a set scope of works for a fixed price pending conclusion of the full contract. This interim contract may incorporate certain terms of the main contract to the extent that they are agreed.
- A full contract for a project if the Letter of Intent contains all the terms required for the contractor to carry out the works and no cap on the developer’s financial liability. This carries risks for both parties (see below) and their use is not recommended.
Interim contracts are the focus of this article but parties should be clear at the outset and in the Letter of Intent how far they wish to create binding rights and obligations, and the terms and conditions that apply.
Why use a Letter of Intent in the construction industry?
The primary reason for entering into Letters of Intent is to maintain the programme, pending completion of the main works contract. A Letter of Intent allows both parties time to complete the main contract rather than hastily concluding a contract that might be inadequate, e.g. in relation to commercial, legal or technical information.
There are a number of reasons why the parties might not wish to, or be able to, sign the main works contract:
- The parties are still negotiating its terms;
- The contractor has not fully priced all elements of the works;
- The developer only has limited funds available or has not yet secured commitment from third party stakeholders in the project (e.g. tenants or funders); or
- The technical documents for the contract are not yet complete.
The Letter of Intent allows a contractor to commence authorised activities safe in the knowledge that it has a right to be paid for these activities. The Letter of Intent authority often extends to:
- Site establishment and mobilisation;
- Placing orders with suppliers and sub-contractors;
- Preparing design work;
- Carrying out limited site work e.g. demolition and other enabling works.
From the developer’s perspective a well drafted Letter of Intent will give the developer comfort that its financial exposure is limited, and a clear set of terms and conditions rather than leaving the common law to imply contractual conditions for the works.
Key terms typically included in a Letter of Intent
Common terms for Letters of Intent include:
Authorised activities and works: A Letter of Intent should clearly set out the activities and works that the contractor is instructed to carry out (see examples above). Often these works are to be carried out in accordance with tender drawings and specifications. The contractor might also be obliged to proceed in accordance with its tender programme.
Payment terms: The parties should set out the basis on which the contractor will be paid, e.g. stage payments (dates or milestones), payment periods and the documentation that must be submitted to substantiate amounts applied for. Developers and contractors should be aware that Letters of Intent are “construction contracts” for the purposes of the “Construction Act” 1996 unless one of the exceptions apply. Our recent article “Changes to the Construction Act to affect the Property Sector” provides more information on the Construction Act and its implications for the property industry.
Financial liability: The key point for a developer is to place a clear cap on the amount that it is obliged to pay for the activities and works set out in the Letter of Intent. However, developers should beware because, if further works and activities are instructed by or on behalf of the developer, then the contractor may have a common law entitlement to payment outwith the cap on liability. You might have heard of “quantum meruit” claims – this is a claim for payment of a reasonable amount for work carried out.
Contractors will also want to make sure that they are comfortable with the amount they will be paid having regard to the scope of the initial instruction. Contractors must beware because the courts will not look beyond a financial cap just because the contractor has incurred additional expense (see for example Diamond Build v Clapham Park Homes EWCH 1439(TCC)).
Termination and expiry: There is always the possibility that a developer no longer wishes to proceed with the project or cannot agree full contract terms with the contractor, and so it is common for Letters of Intent to include rights for the developer to suspend or terminate the instruction. It will be important from both parties’ point of view to make sure that the consequences of termination are spelt out. The developer will want to make sure that its liability is limited on termination to paying for the work actually carried out. The contractor will similarly wish to ensure that it has a right to payment on termination. The Letter of Intent may also place obligations on the contractor to vacate the site, hand over documents and assign sub-contracts but this very much depends on the particular Letter of Intent in question.
Liability for damage to property or injury to persons: Developers will wish to ensure that their contractors provide appropriate indemnities in relation to claims arising from property damage and death or personal injury.
Insurance: Where the Letter of Intent extends to physical work on site, parties should specify who is insuring the works and any existing structures and that any requirements for insurances to be in joint names are provided for. Developers will also often require public liability, employer’s liability and professional indemnity insurances to be in place.
Copyright licence: Developers will wish to ensure that they have the right to use documentation produced by the contractor and for which the developer has paid for the purposes of the project.
Main contract terms: Parties may wish to set out which terms for the main contract are agreed, e.g. legal conditions, total price, start and end dates, delay damages, caps on liability and technical requirements. While setting out agreed terms is extremely useful, in most cases this is simply a statement of intent and there is nothing to stop a party from re-opening negotiation on these points.
Supersession: The Letter of Intent should provide that once the main contract is signed, the main contract applies to the works and activities under the Letter of Intent and the Letter of Intent in effect “falls away”.
Parties are of course free to include any terms they wish. Other terms might include obligations to complete the work by a certain time with defined consequences for failure, provision of collateral warranties and dispute resolution.
Risks in using Letters of Intent
While Letters of Intent have an obvious use, they carry risks for both parties:
- Loss of bargaining position: If the contractor is instructed to proceed with the works, the contractor is immediately in a better bargaining position with regard to the main contract because it will be harder for the developer to stop the works and engage others. Inevitably once the contractor starts working, its focus shifts from contract discussions to getting on with the work.
- Exposure beyond the financial cap: A developer can be exposed to common law claims where additional works or activities are instructed by or on behalf the developer that fall outwith the scope of the authority provided by the Letter of Intent.
- Lack of key terms: It is unlikely that a Letter of Intent will contain all of the terms that a developer will require for the project. For example, developers will usually undertake obligations to deliver collateral warranties to lenders, purchasers and funders. If a Letter of Intent is allowed to run and the main contract is not signed, then the developer might not have a right to obtain these collateral warranties, putting its deals with third parties in jeopardy.
- Lack of protections: Often Letters of Intent will state that the contract conditions issued at tender stage will apply until the main contract is signed. Therefore if the contractor wishes to include a cap on its liability or other qualifications, then it should ensure that these matters are encapsulated in the Letter of Intent.
- Irrecoverable costs and expenses: Contractors should beware that if their costs in providing the authorised works and activities exceed the financial cap on liability, then that is their risk.
- Supply chain liability: Contractors should ensure that, if the developer can terminate the instruction at any time and for any reason, then any orders or sub-contracts which the contractor places similarly allow the contractor to terminate with limited liability.
Letters of Intent are extremely useful and widely used, but they should not be seen as replacing the need for a full contract for the project. There are numerous examples of disputes before the courts over Letters of Intent, highlighting that parties should proceed with caution. The main risks arise when the main contract is not signed and the parties proceed with the project – leaving uncertainty for both parties as to their precise rights and obligations.
Lastly, bear in mind that every Letter of Intent is different and it is dangerous to make assumptions about Letters of Intent without checking their exact terms.