Are you working at risk?

In the current times of grave uncertainty surrounding material prices and lead times, initially prompted in early 2020 by numerous events including covid and more recently being fuelled by the Russian invasion of Ukraine, the use of letters of intent (or LOIs) is becoming increasingly popular. However, it’s important to be aware of the risks involved for both contractors and employers working under them.

What is a Letter of Intent (LOI)?

An LOI is typically a letter from an employer to a contractor that expresses an intention to enter into a formal contract at a later date, and in the meantime requests that the contractor carry out certain works before the finalisation of that contract.

Why are LOIs used?

LOIs are generally used as a stop gap, to enable contractors to commence some works whilst the technical and practical elements of the full construction contract are being negotiated.

It is normally cheaper and logistically more efficient for parties to organise supply chains, procure materials, and commence site preparations as soon as possible.

LOIs can give comfort to contractors that they will be paid for preliminary works prior to entering into a full contract, while offering flexibility to employers who may not yet have finalised the full scope of the project.

In recent months the use of LOIs has become increasingly prevalent due to material price increases. Employers are desperate to get contractors to make a start on procuring materials and setting up supply chains as early as possible in an attempt to fix prices for certain elements of the works at an early stage.

Are LOIs binding?

Whether or not a LOI is binding is a matter of interpretation and every case will turn on its facts. Courts will look at whether parties intended to create legal relations. It is therefore important when seeking to create a binding LOI to ensure that the LOI is signed by both parties, provides for consideration (i.e. payment in return for services carried out) and sets out a clear arrangement as to the ultimate aim of the LOI.

The general principle is that provided there is agreement over the essential terms and that it is acted out by the performance of the parties, the LOI will be a binding contract. Conversely a lack of agreement over terms essential to the operation of a basic interim contract will normally be fatal to the characterisation of a LOI as a binding agreement.

What if the LOI isn’t binding?

Where a LOI is found to be non-binding but work has still been started, there will often be uncertainty around some fundamental matters, such as time to complete the works, site access, control over materials and relationships with third parties, which is likely to lead to disputes.

A non-binding LOI is not always bad news though. While it will ordinarily be preferable to have a clear and binding LOI for both parties to rely on, a non-binding LOI does not leave the contractor with no rights. Often works carried out under a non-binding LOI will be payable on a ‘quantum meruit’ basis, so that contractors are paid a reasonable sum for the works completed. And counterintuitively, in certain circumstances that is the best position to be in…

Watch out for the cap

It has long been the case that if there is a cap within a LOI (be that financial, scope of time related) and the contractor exceeds that cap, they will be legally exposed. This is important: often contractors believe they will be paid a reasonable sum for any works undertaken over and above the cap, but that is not the case.

There are two main exceptions to this rule. First, contractors will be entitled to payment on a quantum meruit basis if no binding contractual relationship ever existed (as mentioned above).

Second, contractors may be entitled to payment on a quantum meruit basis over the cap if it is held that the parties have impliedly agreed a variation to the LOI so as to increase the cap, without actually entering into a formal contract. However, this is notoriously hard to prove and so it is always recommended that contractors agree to increase the cap before reaching the limit, or in the absence of such agreement that works cease (or at least pause) once the cap is reached.

How does an LOI end?

In an ideal world, a LOI will come to an end once a formal contract is entered into. It is preferable for LOIs to expressly set out that any contract (once executed) will supersede the terms of the LOI, and also that the contract will apply retrospectively to all works carried out under the LOI.

However it is not unheard of for LOIs to run for the entirety of projects, with the parties never agreeing a formal contract and consistently increasing any caps (or LOIs being uncapped in the first place).

Further, especially in the current market, there will be situations where one or both parties may not wish to enter into a formal contract. Whilst LOIs will not place an obligation on either party to enter into a formal contract, often LOIs do not clearly deal with termination of the LOI itself. It is therefore also advisable to include provisions which enable either party to terminate the LOI in certain pre-agreed circumstances.

If a LOI sets out an expiry date, the same principle applies as with a cap: contractors should stop works on that date unless an extension to the LOI is agreed in writing.

If the parties continue to carry out works following the expiry of a LOI but before a contract is finalised the legal position can be very difficult to predict. The Courts may hold that no contract exists, that the terms of the (not yet executed) contract apply, or that different terms entirely apply. This difficulty was demonstrated in RTS Flexible Systems v. Molkerei [2010] where the Court at first instance, the Court of Appeal and then the Supreme Court all reached three completely different decisions on what the applicable contract terms were.

The moral of the story?

Lord Clarke of the Supreme Court put it quite well in that Molkerei case: “the different decisions in the courts below and the arguments in this court demonstrate the perils of beginning work without agreeing the precise basis upon which it is to be done. The moral of the story to is to agree first and to start work later”.

This article is from May 2022’s edition of Aggregate. To read the complete newsletter as a PDF click here.