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Letters of Intent - Who Needs Them?

What happens when you give a letter of intent to a lawyer? Bad jokes aside, the first thing he or she will consider is whether or not the parties intended to be contractually bound by it and, more often than not, the answer to that question will not be clear.

The procurement process for construction projects can become prolonged and complex. It is not uncommon for the building contractor to be ready to start working on site long before the contract terms have been finalised. It is one of the ironies of the industry that developers put enormous effort into ensuring that the contract terms are satisfactory but are often willing (or forced) to allow contractors to start work on the basis of a mere letter of intent.

What is a letter of intent?

A letter of intent ordinarily expresses an intention to enter into a contract in the future but creates no liability with regard to that future contract. They are often issued by developers to contractors and contain wording such as:

"Our negotiations are not yet complete, therefore the formal contract documents are not yet complete";

The parties concerned may take comfort from such a letter, not least because they feel that they are one step closer to agreeing the final contract. This is why letters of intent are sometimes known as "comfort" letters. How much comfort each party can really take though will depend on the legal status of the letter.

In Monk Construction Ltd v Norwich Union Life Assurance Society (1992) the Court of Appeal found that letters of intent give rise to three possible situations:

"We intend to complete our negotiations and sign a contract soon"; or

"Please proceed with mobilisation and ordering of materials up to a maximum expenditure of £X".
  • there may be no contract at all (Le. a "pure" letter of intent);
  • there may be an ordinary contract; or
  • there may be an 'if' contract (Le. the developer asks the contractor to carry out work and promises that, if he does so, he will be paid).

When a letter of intent is a contract

When used in the context of business negotiations, the words "subject to contract" will generally lead the courts to the conclusion that the parties did not intend to be bound by the letter of intent.

However, that is not the end of the story. In Harvey Shopfitters Ltd v ADI Ltd (2003) the Court of Appeal found that the court is entitled to look behind the apparent or literal meaning of the words of a letter to determine the parties' true intention. The courts will analyse each letter of intent as a whole. As a consequence, even express wording, such as "we do not intend to create legal relations", may not be sufficient to avoid the courts finding that a letter of intent is in fact a binding contract.

A substantial part of the lengthy judgment in Tesco Stores Limited v Costain Construction Limited (2003) was devoted to deciding whether a letter of intent did in fact impose contractually binding terms on the parties.

In that case, the judge - emphasising the importance of the intention of the parties to be legally bound - found that a letter of intent issued by the developer, a copy of which had been signed and returned by the contractor, did amount to a simple contract. Moreover, there were terms implied into the contract such that the contractor would perform any construction work in a good and workmanlike manner, and that any design element would be reasonably fit for its intended purpose.

Even if a letter of intent is in fact a contract, it may only cover part of the works. Certain enabling or advance works may be covered (often up to a specified cap on expenditure) but the main works may not be covered. What is the position, then, if the contractor carries on working after such enabling works are finished? This can lead to uncertainty as the developer will often try to argue that he only has to pay the contractor up to the amount specified in the letter of intent whilst the contractor may argue he should be paid for the extra work as well.

When a letter of intent is not a contract

If a contractor carries out work under a pure letter of intent, he will usually be entitled to be paid on a "quantum meruit" basis. This amounts to a reasonable payment plus profit for the work carried out. The contractor will normally be under an obligation to carry out the work with reasonable care and to undertake work within a reasonable time but what is reasonable will depend on the facts in each case.

Further, there will be no entitlement for the developer to make variations, no set date for completion, no right to deduct liquidated damages and, perhaps most alarmingly, following Murphy v Brentwood District Council (1990), in the absence of a contractual relationship, the contractor probably has no liability in negligence for defects in the building itself.

In the UK, the Housing Grants, Construction and Regeneration Act 1996 does not apply to pure letters of intent. As such, a contractor will not be entitled to the rights this Act affords (such as the right to receive interim payments, the right to statutory adjudication and the right to suspend work for non-payment). Whether a letter of intent is in fact a binding contract has huge implications in the context of this Act alone.

Conclusion

Before issuing a letter of intent, the first question to ask is whether the parties wish to be contractually bound by it. If they do, lawyers will ask why they cannot agree the final contract terms. If they do not, lawyers will ask the point of issuing a letter at all.

If it is simply not possible for the full contract terms to be concluded before the contractor starts work, it is advisable for the developer to document the deal as fully as possible in the letter of intent.

Provisions limiting the developer's obligation to pay (e.g. by placing caps on total expenditure) or ensuring the authority given by the letter of intent lasts for a limited period are advisable. Due consideration should also be given to the position if either party wants to walk away from the deal or the formal contract documents are never signed.

It may be argued that there is simply not enough time to document the deal fully in a letter of intent. However, the counter argument is that it is inadvisable to allow a contractor to commence work on site in the absence of full agreement as to the contractual terms.

This in turn begs the question of whether the industry should bother with letters of intent at all.

Ian Fairclough, Clifford Chance
International Construction Newsletter
Summer 2004

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