Good intentions, bad results

Why contractors in Dubai's booming construction industry should be wary of starting a project with just a letter of intent.

COMMENT, Human Resource

All too frequently, contractors in Dubai are being asked by employers to commence works on the basis of a "letter of intent" (commonly referred to as an LOI) on the understanding that formal contract documentation will be signed by the parties at a later date. Such a trend is perhaps unsurprising in Dubai's buoyant construction industry, where development cannot start soon enough, but carries with it significant risks for contractors. In particular, many may find that the legal effect of the LOI signed by it may be entirely different from what was intended. It is important, therefore, to fully understand the legal effect of an LOI before signing it.

The LOI in its purest form is just that - a letter from an employer expressing an intention to enter into a contract with a contractor at a later date. The purpose of such a letter is to indicate to the contractor that it is the "preferred contractor" for the project and to encourage the contractor to bear the project in mind when planning its future commitments. This type of letter does not create any rights and obligations between the parties and is designed to be of no binding effect.

Without a formal contract in place the contractor will not have the benefit of the remedies that would ordinarily be available to it in the event of a dispute.

At the other extreme, a second type of LOI might contain all essential terms for the completion of the project and leave nothing further to be agreed. This type of LOI will, in certain circumstances, be construed as a binding contract between the parties. In such a case, the parties may well discover that they have inadvertently entered into an agreement that will apply for the remainder of the contract period.

A third type of LOI - a middle ground between the two extremes described above - is the most commonly used in Dubai and creates limited rights and obligations between the parties. It is this type of LOI that is the subject of the remainder of this article. It is usually typified by the following:
 

  •  a statement by the employer that it intends to enter into a contract with the contractor at a later date;

 

  •  an instruction from the employer requesting the contractor to commence mobilising on site / carry out preliminary works;

 

  •  a limited scope of work - either by way of a monetary limit on the value of work that can be carried out by the contractor, or by instructing the contractor to carry out discrete items of work;

 

  •  a date on which the letter of intent will expire.

In an ideal world, the parties would sign a contract agreement containing all essential terms before works commence. Unfortunately, this ideal situation does not always arise, with parties seemingly content to commence works on the basis of an LOI, leaving agreement of the remainder of the terms to a later date. The danger, however, is that this "later date" may never come - whether because the parties are unable to reach agreement on the essential terms or because they simply proceed with the works without ever turning their minds to the need to formalise their agreement. In either case, without a formal contract in place the contractor will not have the benefit of the remedies that would ordinarily be available to it in the event of a dispute between the parties, putting the contractor at significant risk should the employer fail to make payment to the contractor, fail to make the site available to the contractor and so on.

A pertinent UK case, Cunningham & Anor v Collett & Farmer contains a cautionary message concerning the increasing trend towards the use of LOIs and warns against their use where "inappropriate". The judgment provides a useful set of guidelines for when it will be considered appropriate to use an LOI, where:
 

  •  the contract work scope and price are agreed or there is a clear mechanism in place for the work scope and price to be agreed;

 

  •  the contract terms are (or are very likely to be) agreed;

 

  •  the start and finish dates and the programme are broadly agreed;

 

  •  there are good reasons to start work in advance of the finalisation of all the contract documents.

In addition to the factors outlined above, any contractor considering starting work on the basis of an LOI should ensure that:
 

  •  the letter contains a mechanism for claiming and recovering payment for completed works;

 

  •  the letter contains an expiry date (thereby providing an incentive to the parties to finalise a formal contract agreement);

 

  •  the letter is issued by the employer (not a third party, such as a project manager, who may not have actual authority);

 

  •  the letter states that neither party intends to be bound until the letter is executed by them;

 

  •  the letter specifies that once the contract is concluded, the contract will apply retrospectively.

While the use of an LOI might be considered "appropriate" where the circumstances outlined above exist, it is important to bear in mind that such letters are generally drafted by the employer or its consultants and might, therefore, contain any number of items that will place the contractor at risk. Contractors should, therefore, resist pressure from the employer to commence work on the basis of an LOI alone and make every effort to formalise its agreement with the employer before commencing work, if at all possible, in order to avoid the inherent risks associated with the use of an LOI.

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