Back to basics: letters of intent

What is a letter of intent?

There is no legal definition of a letter of intent, and its legal effect will therefore be dependent on the terms which it contains and, more particularly whether it is, of itself, contractually binding or nothing more than a letter of comfort. A letter of intent generally refers to a letter given by an employer to a contractor which is: intended to be legally binding; which sets out an initial limited scope of works and/ or services; and authorises the contractor to commence those works or services, pending conclusion of a formal building contract to cover the whole of the works. Whilst the letter generally sets out an intention between the parties to enter into a formal building contract once the contract’s terms have been fully finalised, there is no binding obligation on the parties to do so.

Why use a letter of intent?

Building contracts can be incredibly technical and detailed and often require a significant amount of negotiation before a final agreement can be reached. In addition, in the case of design and build procurement, it can also take considerable time undertaking the supply chain due diligence necessary to arrive at a fixed price for the works. A letter of intent can allow certain parts of a building project to proceed whilst these details are ironed out. Matters generally instructed under letters of intent include: the procurement of long lead time goods or materials; initial design works; or preliminary enabling works. Generally, letters of intent are used where the employer’s programme constraints require works to commence without delay, before the full terms of the building contract can be finalised.

With current inflation and supply chain risks disrupting the construction industry (see our previous article here for more information), a letter of intent can also be helpful in allowing for orders to be placed early with the works supply chain to closing out price fluctuations. Without an appropriately drafted letter of intent a contractor will not want to make procurement commitments or commence works as they will have no binding obligation on the part of the employer to be paid.

Are there any risks with letter of intent?

Whilst useful, letters of intent should be approached with a high degree of caution. So far as employers are concerned, it is not uncommon for corporate governance requirements to prohibit the use of letters of intent.

Letters of intent do not represent a final and formal building contract, and many of the key commercial terms relevant to the delivery of the project as a whole are not necessarily present or adequately addressed in a letter of intent (usually because there points are still being negotiated), resulting in a significant risk of uncertainty, if it has not been carefully drafted.

These risks can include:

•  Whether or not the letter of intent is binding on the parties
•  What insurance provisions need to be maintained by either party
•  When do the works need to be finished
•  What are the liquidated damages provisions for late completion
•  How will disputes between the parties be resolved
•  What are the payment provisions and is there a cap on such payment
•  In what circumstances can the letter of intent be terminated
• Is there any incentive for the parties to enter into a formal contract

For example, some of these risks can be mitigated by including:

•  a longstop date, at which point the letter of intent will automatically terminate (subject to any terms allowing the employer to postpone the longstop date)
•  a cap on the amount of expenditure that the contractor can incur that the employer will be liable for (thereby avoiding cost overrun)
•  provisions that any sub-contractors engaged by the contractor to be assigned to the employer – thereby allowing the         employer to instruct the sub-contractors going forward (even if the contractor is not instructed going forward).

Far too often, the main risk to the employer is that a letter of intent is entered into for some initial works and then agreement cannot be reached with the contractor on the contract price, programme, or project risk allocation. The letter of intent is extended on multiple occasions because the employer wants the works to progress but, in agreeing to the extension, the pricing, programme and risk allocation issues are not closed out and therefore effectively remain with the employer – with the contractor having very little incentive to engage in negotiation to agree the final terms of the building contract.

Conclusion

Referring to a letter of intent, Lord Clarke said ‘The moral of the story is to agree first and to start work later’. Whilst this is the optimal approach in an ideal world, commercial realities are frequently far from ideal.

Getting good legal advice before entering into a letter of intent is key. It can help you:

•  decide whether the works and or services which you want to instruct are appropriate for a letter of intent
•  ensure that it is drafted correctly so as to mitigate some of the key risks associated with entering into this type of agreement.
•  to consider other options, such as direct procurement or a pre-construction services agreement (for example in the case of early design).

If you would like further advice on letters of intent, or any other construction matter, then please contact a member of our construction team.