Despite all the warnings about the risks associated with letters of intent (LOI), there is a time and place for them to be used on construction projects.

In an ideal world all terms of a contract would be agreed and a written contract signed by both parties before any work starts. However, in reality, that is simply not always possible.

A common situation where LOIs are useful is where a main contract has not yet been entered into but the main contractor requires a sub-contractor to procure materials with a long lead in time. A LOI can be used to create a very limited scope sub-contract for the procurement of the materials.

LOIs can, however, also be simply a letter expressing an intention to enter into a contract in the future. Alternatively, they can create a contract for the whole of the works but there can be many variations in between.

What is a letter of intent?

A LOI means only what its contents say. There is no legal definition of the expression and each LOI has to be interpreted on the basis of its wording. You are afforded no protection against liability merely by labelling a document a "letter of intent". It is the substance that counts, not the form.

What is the effect of a letter of intent?

The effect of a LOI depends entirely on its wording. There are three possible effects:

  • No effect

A letter which conveys an intention to enter into a contract in the future has no contractual effect.

  • A restitutionary remedy

Where work is carried out pursuant to a request within a LOI, there is usually an entitlement to payment on a quantum meruit basis - otherwise the recipient of the work would be unjustly enriched.

  • A contract

Generally, if you have agreed the parties, price, scope of work and time for performance the likelihood is that you will have entered into a contract. Arguably, not even express agreement of all these terms is necessary as some terms can be implied by law.

Handle with care!

There is often a general lack of certainty with letters of intent. Have the parties entered into a contract? If so, on what terms?

Solution - draft carefully!

State precisely what you mean - there is no room for error or miscommunication:

  • say whether the letter is intended to form a contract or not
  • identify the works covered by the letter
  • state what remains to be agreed
  • state what standard form or bespoke contract terms, if any, are to apply to the letter (is the letter to be self-contained or not?)
  • state when the letter will become valid/operative, and set a period for the letter's validity/operation
  • put a cap on the financial liability of the contractor
  • deal with payment and make clear there will be no entitlement to loss of profit on the remainder of any work not proceeded with
  • identify who is authorised to instruct works, certify payments, etc
  • deal with VAT
  • state whether the letter is intended to have retrospective effect
  • state whether any intended contract will also have retrospective effect when executed
  • deal with other practical issues, e.g. insurance, CDM regulations
  • deal with dispute resolution
  • make sure the letter is issued by the "employer"
  • get the letter signed by the contractor
  • remember that only a deed has a 12-year limitation period, so if the LOI creates a contract it will be a simple contract with a limitation period of six years

Warning! What happens if no contract is put in place?

If no contract is created then there is:

  • no contractual obligation on either party
  • no obligation on the contractor to complete
  • no right to liquidated damages or general damages for late performance
  • no liability for defective work (other than to reduce the quantum meruit payment to be made to the contractor)
  • however, there is an entitlement for the contractor to be paid for work carried out on a quantum meruit basis

Summary

There are two main risks associated with LOIs:

  • they are often not clearly drafted and there is a lack of certainty as to their meaning and effect. Therefore clear drafting is essential to minimise risk, and
  • once work starts focus naturally shifts to the works themselves and away from finalising the terms of the formal contract. Ensure that the LOI is followed up with a signed formal contract as soon as possible - the risks on both sides increase the longer it takes for a formal contract to be agreed.