Update | Construction: letters of intent

Letters of intent are very common in the construction industry. They are used to enable materials to be ordered or even work to be started, before the full building contract has been settled and signed. Why are they used and are ?they safe?

Building contracts are big, complex documents running to many hundreds of pages. As well as containing legal and commercial terms they also include drawings, specifications, and other technical documents, prepared by various members of the project team - the employer, the contractor, architects, engineers, project managers and other specialists.

This means that the input of many people has to be finalised before the building contract can be bound and signed (to say nothing of agreeing the price and programme once all of the design information is settled). This takes time.

Combine this with the generally immovable deadlines applicable to construction contracts, and you can see ?why many employers feel they have no choice but to let work start before the contract is signed. Employers are eased towards this conclusion by the thoughts that the contract is nearly agreed, they are happy with the contractor, and what remains to be settled is usually fairly minor.

Why, then, are the construction law reports so full of cases about letters of intent? More to the point for practitioners, how should we respond when asked to advise clients who are between a rock and a hard place and are insisting that a letter of intent is the only option to avoid delaying the project?

The client needs to be told that letters of intent are bad news, that the law reports are full of examples of them going wrong, and that safety is not an option without a proper, signed building contract. If a letter of intent is to be used, then we have to consider what is an acceptable balance ?of risk.

What can we do?

Solicitors can certainly do something ?about the legal risks. Letters of intent are often drafted by project managers who ?have no understanding of what they are creating in law. They leave uncertainty about whether the letter creates a contract on the terms of the draft building contract or on some other more limited basis, whether all works are to be started or just some limited packages of works, whether a financial cap applies and what the legal effect is to be if the employer subsequently authorises or acquiesces in works being done beyond any cap.

Solicitors know to incorporate the building contract terms in so far as they have been agreed, but to limit the letter of intent contract to particular works and a particular value cap. As to the design and commercial terms, this is best covered by referring to the tender documents and subsequent correspondence between the parties, so as to clarify (and incorporate into the letter of intent) everything which has in fact been agreed, but subject to the limited scope and financial cap. What remains outstanding may not affect the work to be done under the letter of intent and, if it does, the legal fudges of "reasonable" and "appropriate to the works" are significantly better than nothing.

Other risks to be considered by anyone drafting or using a letter of intent, are best considered separately from the different points of view of the employer and the contractor separately.

For the employer, the major risk of a letter of intent is that:

1. the contractor starts work under it;

2. then refuses to sign the contract unless the price is increased or other concessions are made to him; and

3. the employer has to concede, because by that stage threats to get another contractor in to replace the one who is already there doing the work are not realistic and therefore not believable.

This situation does not require an unreasonable contractor or a prior breakdown in the employer/contractor relationship. The contractor may consider himself perfectly reasonable in behaving in this way. For example he may have started work under the letter of intent and found unexpected soft spots in the ground or more asbestos in the existing building than anyone expected. Even if the proposed contract put those risks onto him, he is not going to sign the proposed contract now, for the original price, in the certain knowledge that he will lose money.

In such a case the contractor will demand more. He will not see himself as profiteering, he will probably only demand enough to cover the additional cost, leaving him with no greater profit than originally expected. However for the employer the price has gone up.

The employer can very easily get into the position noted at point three above because once a contractor has been paid to mobilise, any replacement contractor would also have to be paid to mobilise. Therefore if mobilisation costs £50k the contractor, who has been paid that under a letter of intent, can easily say he will not sign the contract unless the price goes up by £50k - because he knows that any replacement would have to charge that sum too.

Another reason the employer may find himself in position three above is that once a contractor has done real work, for example foundations, it is almost impossible to find a replacement contractor willing to take on full responsibility for the building. Any replacement contractor would have to build on someone else's foundations, which he has not designed or seen poured. The lack of a contractor's warranty covering the whole building can affect funding and saleability. More reasons why the employer has to pay what the contractor asks.

Moreover it is not just payment - in these circumstances the employer's negotiating position is lost and he will often have to give way on the other points which had not been agreed before the contractor was allowed to start work.

Another risk for the employer is that the letter of intent is not restricted to particular works and/or does not include a financial cap. This can result in the contractor doing the whole job under the letter of intent and the contract itself never gets signed, thus leaving the employer with uncertain and inadequate rights in the event of any delays, defects or cost overruns.

Therefore if a letter of intent covers:

? initial ordering of materials, the risk is very low;

? construction mobilisation costs, there is a real risk;

? strip-out or demolition work, there is a serious risk if the intention was to put the risk of the unexpected onto the contractor; and

? new building work, the risk is ?again serious.

Game of chicken

For the contractor, the main risk of a letter of intent is that the contractor starts work, commits to subcontracts and contracts with suppliers (even informal ones), and then finds that while the financial cap in the letter is enough to cover the work done up to a certain point, it is not enough to cover the cancellation costs if the job were ?to be stopped.

The contractor is thus trapped into continuing to work, knowing that if the job is stopped the letter of intent will not cover both the work done and his cancellation costs. Even when the cap in the letter of intent is reached, does the contractor dare stop work? To do so might prejudice signature of the contract and leave the contractor with a loss, but if he doesn't stop work he knows he is really working entirely at risk. This makes value engineering workshops with the employer something of a game of chicken - the contractor is participating in them in the knowledge that if he can't deliver the savings the employer wants, the project may be stopped for redesign and the contractor be left with ?a big loss.

Therefore a contractor needs to ensure that a letter of intent covers demobilisation and cancellation costs, as well as the work he is being asked to do.

If, for commercial reasons, a letter of intent really has to be given or accepted, then the following points should reduce the inherent risks, but the client should be made aware that risks remain. The letter of intent:

? should be produced by lawyers and define what sort of contract the letter is creating (i.e., a limited one, not the whole building contract);

? be for a limited scope of works, clearly defined as regards scope, standards, timescales, etc;

? specify what is to be paid and when;

? deal with what happens if the deal goes off and the main contract is never signed (e.g., assignment of orders for materials, copyright licences for designs produced under the letter of intent, warranties of work carried out under the letter of intent); and

? provide for the scope of works and ?the financial limit to be extended in ?a specific, controlled way.

?There are, of course, other things to be covered in letters of intent, but these are the critical ones. The bigger point is, however, to use them only as a last resort and only in circumstances where the risks are clearly understood by the client.