Dangerous intent — unwanted consequences of letters of intent

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Vimal Nair (left) and Callum McKenzie of Auckland legal firm Greenwood Roche outline the problems that letters of intent can cause further down the track — and how to avoid those complications.

Letters of intent are commonly used in the construction industry as a way of starting work (such as procuring materials, preparing the site and, in some cases, commencing work) before a formal construction contract is entered into.

The purpose of these letters is to enable a contractor/subcontractor to commence an aspect of the works with some assurance that they will get paid and be in line for the “formal” contract, while preserving the ability of the principal/contractor to limit its commitments early on.

Letters of intent seem like a sensible way of allowing work to commence while negotiations continue. However, there are situations where such letters can cause problems in the future.

Letters of intent do not typically have any standard format, meaning the precise effect can vary widely from a letter which expresses a party’s intention to enter into a contract but which creates no liability in regard to that future contract, to a binding contract that ends up governing the whole of the works.

Lawyers typically advise parties to enter into a formal contract rather than commence work under a letter of intent, but this is not always practical.

Letters of intent should be approached as an interim measure only, while the parties finalise the subsequent contract once all the commercial and technical details are agreed. They should not be viewed as a replacement for the main contract.

If you must use a letter of intent, try to keep in mind some of the following tips.

The perils with letters of intent

Letters of intent can create confusion about pricing and who is doing what. This was well highlighted in Electrix Ltd v The Fletcher Construction Company Ltd.

Fletcher engaged Electrix as its subcontractor for electrical services on the Christchurch Justice and Emergency Services Precinct project. To keep things moving while the contract was negotiated, the parties agreed a series of nine letters of intent.

Ultimately, however, the parties failed to agree on a contract, leaving the letters of intent as the formal record of the relationship between them.

By the time the project was finished, there were letters of intent for $14 million, Fletcher had paid $21.6 million, and Electrix had issued payment claims for $28 million.

Fletcher claimed the letters of intent formed a contract that set the price at around $14 million, and sought a refund of the difference.

Electrix argued there was no contract so it was entitled to be paid a reasonable price for the services actually provided. The court agreed with Electrix, and Fletcher was ordered to pay a further $7.4 million plus interest at 5% per annum.

In the UK case of RTS Flexible Systems Ltd v Molkerei Alois Muller GmbH & Co, KG, the employer, sent a letter of intent containing a draft contract and a clause that stated the terms would not be binding until signed by both parties.

While the formal contract was never signed, the court decided that, following the letter of intent, the actions of the parties (such as carrying out works and varying the delivery programme) created a binding contract.

This was despite the fact the letter of intent did not contain many of the detailed provisions that would be expected in a contract.

Be clear about which letter of intent applies

By their nature, letters of intent can be informal, and can arise through correspondence between the parties. Where proposals have been sent back and forth, it is vital that the parties are clear, before work starts, as to which letter is “the” letter of intent.

The UK case of Arcadis Consulting (UK) LTd v AMEC (BCS) Ltd shows the pitfalls of competing letters of intent. In that case, the court had to choose from three competing sets of terms.

One of the biggest differences between the various terms was a liability cap which, if incorporated, limited the subcontractor’s liability to £610,000 (in a claim for more than £40 million).

Have a clearly stated letter of intent

If the parties agree that a letter of intent is the only way forward then, generally speaking, it is prudent for such a letter to be prepared on the basis that a formal contract may never be finalised.

It is important to fully consider the terms of a letter of intent even though many view it as a mechanism to get things moving, and expect it to be replaced with the formal contract.

It is important to clearly define and incorporate:

• matters unique to the letter of intent, ie the parties, the scope of the works and services authorised, price or payment limits, and start and “drop-dead” dates,

• as many of the key and undisputed contract terms as possible, such as insurance, limits on liability, and payment provisions (including GST),

• matters to be resolved before the formal contract can be entered into, and record that the parties intend to immediately be bound by the letter of intent, and

• what happens if the formal contract is entered into or, alternatively, if the contract is never finalised.

It is just as important to stick to the agreed limitations (or formally record any changes) because it is easy for lines to become blurred once work has commenced.

One of the dangers of letters of intent is that work continues outside the authorised scope or expiry date in order to keep things moving while the formal contract is negotiated.

This can be problematic because if the contract is never agreed or signed, arguments arise, typically about the applicable terms and extra payment.

In those circumstances, contractors and subcontractors cannot be sure of additional payment where the expenditure cap has been exceeded, even if they have done extra work.

Takeaways

Letters of intent are commonly used in the construction industry, yet they are not always a prudent idea.

A formal contract is always a more certain way to ensure the parties receive and pay the compensation agreed, and that a contract won’t come into existence on terms some parties may not agree on.

Once works are underway, competitive tension and commercial leverage may be lost, and it can become harder to negotiate the contract if risks or problems have already arisen, as each side will attempt to contract its way out of the issues.

Therefore, you should lock in as many key terms as possible before you commit to a letter of intent.

Where possible, complete the contract rather than enter into a letter of intent.

This enables the contract to be finalised while there remains goodwill and commercial leverage, and enables a project to begin with clarity.

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