Do you understand the legal implications of entering into a Letter of Intent?

Letters of Intent (“LOI”) are commonly used within the construction industry to enable works to commence before detailed contract terms are agreed. Whilst LOIs can be beneficial, because they allow the job to go ahead and give the contractor comfort that they will receive payment for their work, LOIs often introduce ambiguity and risk. The legal status of a LOI can be unclear and the implications of entering into a LOI are widely misunderstood. In this bulletin, we consider 5 of the most frequently asked questions about LOIs.

1) Is my LOI a binding contract?

Unfortunately, there is no easy answer to this question. A LOI could be:

• a non-binding statement of the parties‟ future intention to enter into a contract; or
• a contract which is temporarily binding until it is replaced by a comprehensive contract at a later date; or
• a fully binding contract which is deemed to incorporate the terms of the contract the parties intend to enter into in the future but have not yet signed.

Whether an LOI is binding will always depend on the circumstances of an individual case, including:

 – What does the LOI actually say?

• The words “subject to contract” are a strong indicator that no binding contract has been formed, although if there are other signs that the parties intended to be bound by the LOI, a court may overlook the “subject to contract” wording.
• If the LOI sets out the matters still to be agreed upon by the parties and makes it clear that no contract will be entered into until the outstanding matters are resolved, it is fairly likely that the LOI will not be binding.

– Has a contract been formed?

• It must be clear that the legal requirements for entering into a binding contract have been satisfied. There must be an offer from one party to enter into a contract and acceptance by the other party. Each party must be providing something and receiving something in return. It must be clear that the parties intended to be contractually bound.
• The LOI must contain sufficiently detailed terms in order for a contract to exist. However, the fact that not all contract terms have been agreed may not prevent a LOI from becoming a binding contract.

For the vast majority of construction projects, a LOI should be temporarily binding until a proper construction contract is entered into. If a non-binding LOI is entered into, the parties‟ legal positions will be very uncertain.

2) There is a financial limit in my LOI. What happens if I incur costs in excess of this limit?

It is common for LOIs to state that the contractor will only be entitled to payment up to a specified limit. This reduces the employer’ financial exposure to the contractor and provides certainty for both parties. However, it is quite common for contractors to forget about the financial limit in their eagerness to get on with the job.

Exceeding the financial limit of a LOI is extremely risky and could mean you are not paid for work carried out in excess of the limit. In Mowlem v Stena Line Ports, the contractor carried on incurring costs above the £10m limit in the LOI. The court held that the employer was correct to refuse to pay the contractor any more than £10m, because the limit was binding on the parties. This had serious financial consequences for the contractor.

3) Can I continue working past the expiry date in the LOI?

LOIs often contain an expiry date, beyond which they become invalid. This provides certainty and encourages the parties to enter into a formal contract. If the expiry date is reached and it is still not possible for the parties to enter into a formal contract, the LOI should be re-issued in writing for a further fixed period. If the LOI is allowed to expire and the parties simply continue working, this will probably result in there being no contract at all in place between the parties (although this will depend on the circumstances). In such cases, it may be that the only way of recovering payment is to bring a “quantum meruit” claim.

A claim for quantum meruit is a claim for payment of a reasonable sum for work which has been carried out when no contract has been agreed. This type of claim can be very uncertain, as it will be up to the court to determine what a “reasonable sum” is. In ERDC Group v Brunel University, the contractor made a quantum meruit claim for work carried out after a LOI had expired, arguing that it would be reasonable to be paid on a cost plus basis. The court disagreed and decided that a “reasonable sum” should be calculated by applying the tendered rates in the original LOI, which were less favourable to the contractor.

4) Can I refer a dispute under my LOI to adjudication?

Adjudication is widely seen as a quick and comparatively cheap means of resolving a dispute. The Construction Act allows the parties to a construction contract to refer a dispute to adjudication at any time. Before the introduction of the amendments to the Construction Act on 1 October 2011, it was only possible to refer a dispute arising under an LOI to adjudication if the LOI was a construction contract “in writing”. In RJT Consulting Engineers v DM Engineering, the Court held that “what has to be evidenced in writing is, literally, the agreement, which means all of it, not part of it”. This often proved problematic in LOI cases, because the informal nature of LOIs means they rarely contain all the terms of the agreement and therefore fall short of the requirement for the contract to be in writing. For example, in Hart Investments v Fidler, it was held that an adjudicator had no jurisdiction because the LOI lacked sufficient clarity to constitute a written contract.

However, when the Construction Act was amended, the requirement for contracts to be in writing was abolished. Accordingly, it is now possible to refer a dispute about a LOI to adjudication, even if all the terms of the contract have not been recorded in writing in the LOI. Nevertheless, it is still necessary for the referring party to prove that the LOI does constitute a binding construction contract and establish what the terms of that contract are. Whether this is possible will depend on the evidence available.

5) When is it appropriate to enter into a LOI?

As can be seen from the first 4 questions, LOIs are often far from straightforward, and the legal uncertainty they create can lead to costly disputes. For this reason, LOIs should only be used where there are good reasons to enter into a LOI rather than sign a proper contract. For example, a LOI may be appropriate if it is essential to commence work on a project immediately.

Nevertheless, even in cases where it is appropriate to use a LOI, the parties should strictly limit the length of time they spend working under the LOI. It is essential that the parties go on to enter into a proper contract as a matter of priority. A LOI should never be seen as a substitute for a properly drafted construction contract. A LOI is merely intended to provide basic safeguards on the parties‟ legal rights for a limited period whilst the contract is finalised.