Letters of intent and pre-contractual risks

Letters of intent: A practical solution

In an economic climate of high and ‘sticky’ inflation, letters of intent are increasingly popular – within the construction industry and within commercial deals and developments more generally. Allowing a contractor to mobilise, or a party to commence work, before the proposed final contract is completed can often be commercially advantageous. With costs spiralling and materials scarce, securing lower costs and placing supply chain orders in advance is a necessity for developers, particularly when faced with a strict budget and an immoveable completion date. Letters of intent can play an indispensable role, and continue to be a common feature in the construction industry.

But what are the risks, and how can parties manage them?

Risks associated with letters of intent and pre-contractual communications

When a dispute arises, parties often seek to rely on pre-contractual communications as evidence of their intentions and of their interpretation of subsequent contractual provisions. However, case law provides that pre-contractual communications can be admissible for the purposes of understanding a contract’s commercial aims and its provenance; but that such communications can’t be used to aid the interpretation of specific contractual provisions. This distinction is crucial.

The rule may appear impractical and unhelpful. But the reality is that, without it, parties could continually debate and dispute the interpretation of almost any contractual provision. That would create unacceptable uncertainty, and cause significant practical difficulties.

Another key difficulty arises as to whether and/or when pre-contractual negotiations, communications and documentation themselves become contractually binding.  It’s often assumed that pre-contract negotiations aren’t legally binding. However, because (with limited exceptions) contracts can come into effect without any formality or written documentation whatsoever, if not correctly managed, pre-contractual communications or documents can result in a contract being formed inadvertently or at an earlier stage than intended.

That means parties can (and often do) become contractually bound to terms, obligations and liabilities to which they might never otherwise agree.  In Pretoria Energy v Blankney Estates [1], one party believed that a heads of terms document (often tantamount, in law, to a letter of intent) was binding.  The other did not.  A £56.4 million claim ensued, and the outcome turned solely upon which of those differing understandings was correct.

It’s therefore essential for parties to know how to conduct negotiations, and how to exchange pre-contract communications and documents, without unintentionally becoming bound to unacceptable terms. A longstanding solution has been to outline expectations in a letter of intent, but it’s vital to ensure that any such letter is properly drafted.

How risky?

The consequences of a poorly drafted letter of intent can be significant and costly.  Arcadis Consulting (UK) Ltd v AMEC BCS Ltd [2] is a prime example.  It concerned a pre-contractual agreement between a specialist concrete sub-contractor and a consultant designer in respect of two large construction projects. The parties commenced works and put into place a letter of intent while they negotiated a construction contract that never materialised.  Unfortunately, the letter of intent was not clearly drafted – neither as to its legal status and force, nor as to its terms.

A dispute arose concerning works done and as to the existence, interpretation and enforceability of terms governing the parties’ dealings.

The Court of Appeal found that the letter of intent actually constituted a contractual offer, which was then accepted by exchange of correspondence and by conduct when the works began.  Not only were the parties therefore inadvertently landed with a binding contract per se, but they were also bound by terms contained within what they had thought was merely a non-binding, pre-contractual letter of intent.  One of those terms was a liability cap of just £610,000. That proved disastrous for the party claiming damages in respect of issues with the works, as it faced a potential loss of £40 million.

Managing the risks

So, what’s the best approach for using a letter of intent?

Firstly, both parties should clarify, at the outset of negotiations, the point at which they will become contractually bound.  If discussions are never intended, by either party, to result in a binding oral contract, that should be recorded and all negotiations/discussions/communications should be marked ‘subject to contract’.

The same applies when it comes to the letter of intent itself.  Do the parties intend the letter of intent to have contractual force pending completion of the final contract, or not?  Either way, the point should be expressly confirmed, and negotiations should be conducted, and the letter should be drafted, accordingly.

Secondly, the purpose of a letter of intent must be understood. Letters of intent should always be viewed as an interim measure only; they’re not sufficient to properly engage a contractor for a project’s entirety. Their function, rather, is to serve as a ‘stopgap’, allowing work to commence whilst the parties finalise the details of the main contract. The main contract will ultimately supersede the letter of intent.

Within the construction industry specifically, it’s also worth reviewing the contractor’s proposed scope of activities, as this can determine whether a letter of intent is the right pre-contract tool in any event. It’s common practice for contractors to have much earlier engagement on a project and to advise on the design and buildability of the works as part of a ‘two-stage’ tendering/procurement process. A letter of intent is to allow works to commence whilst the building contract is formalised. So, if the design or scope of the works is still to be determined, a pre-construction services agreement is likely to be more suitable.

To avoid the mistake made in Arcadis, parties need to understand what they’re signing up to. Case law confirms that the courts will prioritise consideration of the language used (as opposed to the parties’ intentions, wider circumstances, commercial common sense, etc.) [3], and will interpret accordingly.  Clear drafting is therefore vital.

In addition, sometimes calling the letter a “letter of intent” is part of the problem. The opening paragraph typically found in such letters often also refers to future intention. This can be unhelpful, as it diverts attention away from the fact that the letter usually constitutes a contract in itself, which (subject to the drafting and the conduct of any earlier discussions!) is binding on the parties. It may, therefore, be preferable to refer to the letter as an “early engagement letter” and to include reference, in the letter, to it being a “preliminary contract”. These simple changes can help parties keep a fix on the legal status of the document and on the key issues handled within it, and to help them focus on their obligations.

In the construction-specific context, the nature and value of the works being procured through the letter should be considered, with appropriate clauses drafted into its terms. It’s necessary to distinguish between authorising £25,000 for pre-contract design and doing the same for £250,000 of on-site work. Although both fall under the Construction Act’s remit, high-value works should always include an express mechanism for valuation of the works, facilitating interim payments and the obligation to maintain relevant insurance.

Other notable key provisions which a good early engagement letter should include or take into consideration are:

• An agreed scope of the preliminary works to be carried out under the letter, with a breakdown for the costs attributed to each service/activity.
• Clarification that no other works are to be carried out until the main building contract is completed (and therefore no other payments are to be made until such time).
• A maximum expenditure cap on the amount to be paid for the preliminary works.
• Query whether the Construction (Design and Management) Regulations 2015 are engaged.
• Termination rights for the “Employer” and what happens if the building contract isn’t entered into following termination.
• Query whether ownership of advanced goods or materials need to be considered
• Confirmation that the letter is to be superseded by the final contract.

Letters of intent: A useful pre-contractual solution, but use with care

There’s ultimately no substitute for progressing works pursuant to the final [building] contract.  However, the reality is that parties will frequently wish to ‘crack on’ with works at a much earlier stage, so letters of intent are here to stay.

An understanding of how contracts can be formed, and the status and admissibility of pre-contractual communications; combined with the careful conduct of negotiations and the precise, comprehensive drafting of letters of intent, should enable developers and commercial contract negotiators to mitigate the risks associated with carrying out works prior to completion of the main contract.

Letters of intent: How we can support you

Walker Morris’ Construction & Engineering specialists can advise on all aspects of construction and development contract negotiation and dispute resolution.  We can provide legal and practical advice from the outset of any project, as well as help with the conduct of negotiations at the pre-contract stage; the preparation and completion of appropriate early engagement and contractual documents (including letters of intent); and transactional assistance throughout.  If issues, investigations or disputes do arise, we can advise on, and assist with, urgent, effective and commercial dispute resolution strategies.

For further information or training on contractual matters generally, or for tailored construction advice, please contact Inam Hasan or any member of the Construction & Engineering team.

[1] [2022] EWHC 1467 (Ch) and [2023] EWCA Civ 482

[2] [2018] EWCA Civ 2222

[3] these latter factors are generally only taken into account when there’s genuine ambiguity in the contractual wording