No matter how forcefully lawyers may counsel against them, Letters of Intent have an established position in the commercial and administrative landscape of the construction industry in the UK. Julie Stagg in an extract from a paper given at the 14th Fenwick Elliott Construction Update Seminar held in April 2008 discusses some of the ways to avoid the perils and pitfalls that may be faced when negotiating or proceeding to work under a Letter of Intent.

There is, to a certain extent, good reason for the use of letters of intent. In the real world where deals are struck and offices, schools, hospitals and homes, etc. are built, factors such as materials shortages, stakeholder expectations and aggressive programmes can trigger a need to “get on with the job” long before contract negotiations have come to an end and the lawyers have finished playing with words. Authorising activities under a Letter of Intent (“LOI”) has practical advantages for employers and contractors alike.

The LOI can alleviate programme constraints by enabling certain activities to be progressed pre-contract, such as: 

  1.  off-site pre-construction activities; 
  1. the instruction of subcontractors and suppliers; and/or 
  1. the instruction of site remediation (in advance of full planning permission), enabling works and other (limited) on-site activities.

Open-ended commitments are, however, extremely unwise, both legally and commercially. Work should not be allowed to continue in perpetuity under an LOI as it is no substitute for formal contract terms, and will not (unless carefully drafted and administered) afford the parties a satisfactory degree of protection. This paper highlights many of the common problems with the drafting and general use of LOIs with reference to some of the more recent judicial decisions on the subject and offers some practical advice to those using LOIs on a regular basis.

If an LOI must be issued, there are several ways in which the parties can ensure that the document is legally binding. A binding LOI has essentially three fundamental elements: 

  1. intention to enter into a binding agreement;
  1. certainty of terms and of dealings; and 
  1. consideration.

Identity and intention of the parties

It would seem self-evident that the parties must be known to each other and have reached a consensus as to the purpose of the correspondence between them. Yet even these basic principles appear to present a challenge for certain parties engaged in activities pre-contract. Care should always be taken to ensure that each party understands the purpose of the proposed LOI and that each party intends it to be binding until superseded by a formal contract (subject to agreement of satisfactory terms).

LOIs are frequently issued by surveyors and project managers on behalf of their clients for expediency; however, this practice is best avoided whenever practicable. A contractor would not accept a JCT contract executed by any party other than the contractor’s ultimate employer; therefore the same discipline should apply to the signature and issue of a LOI.

Scope and duration of instruction

The instruction should clearly identify the activities authorised under the LOI either by reference to a schedule of activities or by incorporating specific activities in the main body of the letter. Where a Programme has been agreed, appending a copy may also assist in defining the scope and duration of the authorised activities. A clear start date, and preferably an expiry date or specific event triggering expiry, is also recommended. An express expiry date imposes a certain amount of discipline on the parties to finalise their contract negotiations in a timely manner following signature of the LOI.

Monitoring expiry dates is perhaps an administrative burden, however we are of the view that it is better to invest time in doing so, and in issuing supplementary agreements extending the instruction, than to permit the letter to operate on an indefinite basis. The risk of the terms being varied by conduct and maximum financial commitments being exceeded without such changes being addressed contractually is much greater in LOIs unlimited in scope and/or duration.

From an employer’s perspective, express termination and suspension provisions are recommended, particularly in the context of LOIs authorising on-site activities. As an interim contract, employers are advised to seek to ensure that an LOI is always capable of termination at any time at the employer’s discretion and that loss of profit/loss of contract claims are excluded. Contractors will understandably hope for a more balanced approach to termination and/or suspension, and are advised to seek terms permitting recovery of cancellation costs and any costs associated with demobilisation and remobilisation.

Price and payment

Price can be one of the most contentious aspects of a contract negotiation, so it may not be possible to confirm even the estimated contract sum in an LOI at the time of issue. The parties should nevertheless be in a position to price specific activities or to refer to an appropriate schedule of rates. The employer will be reassured by any measure of cost control that can be introduced into the LOI, whereas the contractor may prefer to leave prices undefined.

Where activities authorised under an LOI are for 45 days or more, a payment mechanism compliant with the HGCRA will be implied if no express reference is made to payment terms. The parties may alternatively elect to apply the payment terms of the proposed contract.

Whilst the payment mechanism was not central to the discussion in Allen Wilson and Buckingham2, the judgment did touch on the complications that can arise over payment when an LOI has been allowed to lapse.

The claimant contractor seemed unsure how to claim its “perceived financial entitlement” for the valuations falling outside the only signed LOI for the works. Previously AWS had applied the payment mechanism of the proposed form of contract, but during the adjudication sought to rely on the Scheme for Construction Contracts in the Act. The adjudicator relied on the terms of the contract referred to in the LOI and the court was persuaded that (on the particular facts) this reasoning was sound. The defendant had sacked his surveyor but was, by his own admissions, administering the contract himself, therefore the payment mechanism remained in place and was unaffected by the change of administration.

Limitations on liability

Well-advised employers generally cap their financial and legal liabilities to a contractor or consultant under an LOI to a specific amount. This is usually equivalent to the value of the activities to be instructed, however if the scope of the instruction is uncertain when an LOI is issued, the parties may agree a cap on a more general basis. The cap should be substantial enough not to stifle activity under the letter, but ought not to be so generous as to obviate the need for the parties, more particularly the contractor, to settle the formal contract terms. Financial caps, like expiry dates, can always be revisited if at any stage an LOI needs to be renewed.

Some contractors are now paying closer attention to their own liabilities under an LOI, for example in the context of LOIs used to instruct pre-construction phase activities in two-stage procurement. Unless an employer is prepared to concede similar limitations in the proposed contract, concessions to the contractor in the LOI are best avoided unless the limitation can be ring-fenced to apply to professional and/or off-site activities only.

Scope/duration unclear

As lawyers we are frequently asked to review LOIs expressed to authorise the contractor or consultant to proceed with the whole of the works or services for an indefinite period and either for full value or an unconfirmed sum. On such terms, there is very little incentive for the contractor or consultant concerned to cooperate with the employer so as to conclude a formal contract.

Uncertain status of adjudication

The questionable status of LOIs as creatures of contract can also cause procedural problems when disputes arise during the course of authorised works. Bennett v Inviron3 was an application to enforce an adjudicator’s award. The dispute involved work undertaken by Bennett under an LOI with Inviron during the course of electrical installations at a project in Wimbledon. Bennett referred the matter to adjudication in 2005. Inviron asserted that the adjudicator had no jurisdiction as there was no binding contract between the parties necessary to comply with s107 of the Act.

The adjudicator agreed and declined to make any determination, therefore Bennett referred the matter to a second adjudicator. That adjudicator concluded that he did in fact have jurisdiction and found in favour of Bennett, but Inviron refused to pay. Inviron raised several jurisdictional challenges, including the submission that as there was no contract (simply an LOI), any remedy that Bennett might have was restitutionary and so outside the scope of s107 of the Act.

In considering the adjudicator’s award, the court had regard to various matters of fact: whilst the terms of Inviron’s own contract and the proposed form of subcontract with Bennett were mentioned, the LOI was clearly identified as an LOI and headed “subject to contract”; the letter also referred to a meeting between the parties but did not elaborate as to the significance of the meeting or the terms agreed at it; and although a price for Bennett’s work was confirmed, subsequent valuations well exceeded that price and the scope of work was varied. Wilcox J concluded that the parties did not intend that the LOI should have contractual effect, as express and material terms were not specifically recorded in it or incorporated by reference in a manner satisfying s107. Therefore even if the LOI had not been subject to contract the agreement between the parties as evidenced by the letter had to comply with the Act. The adjudicator had no jurisdiction and Bennett’s application for summary judgment was dismissed.

Contractual uncertainty was again an impediment to proper interpretation and thus a bar to adjudication. In other cases, however, the courts have found enough in the terms of agreement and in the conduct of the parties to conclude that the adjudicator did have the necessary jurisdiction to reach a decision on an LOI. Therefore the factual background to a dispute under an LOI assumes greater importance for the party wishing to rely on adjudication as a means of dispute resolution.

Monetary limits exceeded

Financial thresholds may be exceeded in a number of ways. Most commonly, authorised expenditure is exceeded and goes unchecked when a limited LOI expires and is not renewed, or agreement as to renewal cannot be reached. Similarly, an employer’s maximum aggregate liability cap, which was in all probability hard won in negotiations, may be waived by conduct if the employer continues to pay out sums in excess of the cap, whether or not the general authority conferred by the LOI has expired. In the Buckingham case, much of the work carried out by AWS was not included within the two lump sum items referred to in the letter of intent and certainly not the work carried out in the two contested valuations. The court nevertheless found that, as it was work that the supervising officer had authorised on behalf of the defendant, AWS was entitled to be paid in accordance with the terms of the proposed contract. Employers should, accordingly, always have an eye on the budget and be wary of issuing or permitting the issue of instruction to a party under an LOI which pushes the boundaries of the sums authorised under it.

Terms insufficient for on-site activities

A common pitfall for many employers is the use of LOIs intended only for off-site activities in a physical works context. The complexity of on-site activities from a liability perspective means that the parties are best advised to confine activities under an LOI to off-site works and/or services wherever possible. It can be helpful to use express terms to prohibit on-site activities so that the parties are compelled to vary the scope of the instruction formally before on-site works can commence.

LOIs authorising on-site activities are very different documents from those serving a more limited purpose. A limited letter will therefore be deficient in a number of fundamental ways if relevant terms of the proposed contract are not incorporated by reference and the LOI is silent on matters such as: 

  • works insurance and insurance for public/third-party property liability; 
  • indemnities for personal injury and/or death; 
  • site establishment and health and safety requirements such as CDM Regulations compliance; 
  • nuisance trespass in relation to adjoining owners and occupiers; 
  • (where appropriate) a duty of reasonable skill and care of a competent designer and professional indemnity insurance requirements; 
  • subcontracting arrangements (including a right for the employer to take over a subcontract or supply contract in the event of termination of the instruction).

Conclusions

The practical issues surrounding and the judicial opinion flowing from disputes generated or exacerbated by the use of LOIs clearly demonstrate that LOIs are documents requiring serious consideration and, as such, should not be entered into lightly. Parties are best advised to put formal contract negotiations first so that the contract is not treated as an afterthought and, where possible, to seek other means of managing their commercial arrangements, such as placing smaller more limited contracts for early works if there are particular pressures to begin work in advance of agreeing the main contract. Where the parties have no alternative but to proceed on the basis of an LOI, its terms demand equivalent time and attention as formal contract terms (particularly where on-site activities are being authorised).

Avoid ambiguity, as neither party may benefit from it in the long term if the LOI is tested in an adjudication or in court proceedings. Have a positive eye to the future and to the successful conclusion of contract negotiations by including a clear statement in the LOI that the terms of the contract will take precedence and have retrospective effect. Finally, make sure that you do your housekeeping: a well-drafted LOI is only as good as those who manage it. Ensure that renewal dates are documented, reviewed and met, and that authorised expenditure is not exceeded, if there is really no alternative but to issue a supplemental LOI. The terms of any supplemental letter should be discussed well in advance of the expiry of the earlier LOI so neither party is facing a “showdown” over the drafting which might lead to a legal vacuum where an instruction has expired and there is no contract in its place.