Legal insight: Pros and cons of letters of intent
Jon Nash of Dentons & Co offers an expert overview of letters of intent (LOIs), and explores advantages and disadvantages within the context of construction
Historically, the concept of a letter of intent (LOI) has caused a lot of confusion and led to numerous disputes. This is because parties have had different interpretations of the concept of an LOI.
The “intent” of each party can be very different, ranging from a simple heads of terms for a proposed full contract, to a small-scope contract for limited works or to a fallback position in case a full contract is never signed.
Why would you ever want to execute an LOI?
This is a question we often pose to our employer clients because an LOI is never a permanent substitute for a formal contract. Our advice to such clients is to avoid the use of LOIs wherever possible because they can never address all of the issues covered by a full contract. That said, we recognise the commercial expediency of commencing work on the basis of an LOI and are well versed in working with our clients to ensure they have the appropriate protection when using these arrangements.
The most common reasons for our client's need to proceed on the basis of an LOI are:
• a tight construction timetable;
• optimisation of time periods needed to apply for requisite construction (or operation) permits;
• time required to obtain formal board or other internal approvals for commitment to material contract sums or liability (where LOI works may be valued under the applicable threshold); and
• to allow for the implementation of financing for the project in question.
In each case, our client will normally want to commence basic works (e.g. initial design, site clearance, permit application) and often see the placement of orders for long lead items to ensure the critical path can be maintained.
Next page: The drawbacks of an LOI
What is a "Letter of Intent" or "Letter of Award"?
An employer normally has one of two approaches:
• a non-binding LOI (also known as a comfort letter) which gives comfort to a contractor that it is likely to be formally appointed to a scope of work – the employer assumes no liability under the LOI which may be adequate to encourage the contractor to start limited works (often internal design) while a formal contract is agreed and executed. If that contract is not executed, the intent would be that the contractor does not get paid for any of its work and indeed the employer will not benefit or assume ownership of those works. Clearly the wording of such an LOI is key to ensure no liability is assumed by either party – both parties proceed at their own risk if the relationship is not formalised in due course. Employers and contractors should both be aware that UAE law can override this desire unless the situation is carefully addressed by drafting in the LOI (never assume using the words “subject to contract” avoids any ambiguity). This wording is somewhat detailed and complex but the intent can be documented – do not assume that by calling a document a “letter of intent” a court will not conclude that it represents a binding contract or allow for some payment to the contractor for work it carries out on this basis. Furthermore, some commentators recommend that such letters contain less “employer control” provisions (e.g. variation rights, LD provisions) as these indicate an employer’s intent to be in a formal binding relationship with the contractor. Normally, there is no real advantage to this type of non-binding LOI and they are often best avoided; and
• a more formal, binding LOI more of the nature of a limited notice to proceed under which the employer assumes some limited payment obligation and will benefit from the corresponding limited scope of work performed by the contractor. In such circumstances, our advice is always to call such an arrangement an “early works contract” or “pre-construction services agreement” reflecting a two-stage procurement process rather than an LOI to eliminate any confusion on whether the parties intend the document to be contractually binding and on its scope and pricing.
It is the latter form of LOI on which we are most commonly asked to advise and which will therefore form the basis of this commentary.
What are the disadvantages?
They are many (but are often outweighed by the need to proceed quickly) and include:
• transfer of significant negotiation risk in favour of the contractor who knows it will likely construct the project and so will likely play a tougher line in negotiations on the detailed terms and conditions of the contract resulting in more time commitment to finalising the final contract;
• there are limits to the scope of what any contractor will perform under an LOI – at some point, it needs to be fully mobilised under a full notice to proceed. It may be that an LOI may not be sufficient for the scope of work contemplated by an employer and contractor in advance of full contract documentation;
• it can add to the administrative burden – assuming the employer will want to take the benefit of any work performed under an LOI even if it ultimately expires without full contract being executed, an employer will likely want normal protections in place (insurance cover, bonding), much of which a contractor may want to be reduced in scale before full contract stage which can often lead to a two-step process (e.g. issue of multiple bonds);
• it adds to the negotiating process – there are many aspects of an LOI which will need to be negotiated independently of the full contract terms – for example, the timing and mechanics of payment during the LOI phase, what the consequences will be if it expires without a full contract in place and the more restricted liability of each party under the LOI; and
• the time taken to negotiate a full contract can often result in new issues arising which a contractor may then choose to resist (e.g. discovery of new ground risk conditions during site preparation performed under the LOI).
For the above reasons, open-ended commitments are ill advised, both legally and commercially. Work should not be allowed to proceed for a material time period under an LOI as it does not provide the certainty of full contract terms, and will not likely afford the parties the necessary degree of protection.
Next page: What should the ideal LOI comprise?
Key mitigants that an LOI must contain
In an ideal world, any tender documentation issued by an employer should contain full contract documentation so agreement should not be delayed. Even if works must be commenced, that form can be attached to any LOI as a basis of proceeding (perhaps recognising that a certain defined number of issues are not agreed). To address some of the key risks associated with the use of an LOI, we also recommend that it contain clear terms relating to:
• the method and timing of payment;
• a cap on the employer’s liability for payments to the contractor and a clear statement that the parties intend this to override any other interpretation of payment terms (e.g. on a quantum meruit basis); it is also advisable to require the contractor to notify the employer if it is reaching or could be required to perform work in excess of that cap due to reasons outside its control (i.e. change order relief);
• a statement that the LOI works will be subsumed into the formal contract when executed and payments made under the LOI will be treated as payments under the full contract (a corresponding provision should be included in the full contract);
• termination and suspension at the employer’s convenience (and consequential payment entitlement for the contractor if any) – this is important should a contractor attempt to argue any quantum meruit claims for works performed outside the authorised scope;
• the definition of the scope of work authorised under the LOI (this should not be general in nature; specify the exact nature of survey, design, etc.) This is important for a contractor as well as the employer. A contractor needs to avoid a situation where its works have not been authorised and be able to stop work once that scope is completed (avoiding any suggestion that it must continue with the works indefinitely once it starts);
• the project’s target completion date including any phases (and the consequences of missing it – see below);
• the transfer to the employer of supply contracts let by the contractor in the event of termination of the LOI without finalisation of a full contract;
• a clear date for execution of the full contract; and
• expiry of the LOI (including consequences of expiry) – this is important as a contractor’s incentive to finalise full terms will diminish over time. However, parties should consider whether this is necessary in all cases. If the scope of work and payment for that scope are clearly defined (or the LOI is drafted as an early works contract), an expiry date may not be necessary and its absence will reduce the chances of any claim for payment by a contractor on a quantum meruit basis.
Other key terms
The need for these will depend to some degree on the scope authorised by the LOI (LOI works involving site access need extra provisions). The parties should consider whether an LOI should contain provisions addressing the following:
• method of communication and issue of notices by the parties;
• a right to vary the scope;
• the required standard of care to be adopted in performing the work;
• the obligation to comply with the terms of a draft contract attached to the LOI (this may not always be possible even with an agreed list of excluded clauses/issues not yet agreed and yet to be finalised between the parties);
• the requirement for bonding or other security in respect of the LOI works;
• the requirement for appropriate insurance cover to be in place;
• access to site (on a licence basis only);
• an appropriate licence to use any intellectual property in the LOI works (drawings, calculations etc);
• indemnities for property damage and personal injury/death (where site access is contemplated); and
• appropriate disputes resolution clause.
Any LOI should be issued by the employer and not by any other party (such as the contractor or any consultant or project manager of the employer).
Next page: Should you consider an LOI?
Other points to consider
Due to the inherent increased uncertainty over scope and timing at the LOI stage, our clients often seek to build in as much flexibility as possible into the terms of an LOI. We tend to counsel against this. Payment and liability caps, scope and expiry dates can always be tweaked if at any stage an LOI needs to be extended or renewed. Many of the LOI disputes on which we advise relate to the lack of certainty arising from vague and general commercial terms like these which come from a genuine desire to make the LOI process easier but which often ultimately backfire.
In several cases, after discussions with our clients, we have helped them to understand that they actually wished to execute a series of small limited contracts for early works (e.g. demolition, site surveys, preliminary design) rather than have a one-stop LOI. If this is a workable approach for a project, it is distinctly preferable. These contracts can often be easily subsumed into any full contract in due course.
The nature of an LOI is temporary so parties often make the mistake of not contemplating many of the issues associated with underperformance by a contractor (assuming a full contract will be put in place in due course to address these matters). These mostly relate to delay caused by a contractor. Employers expect to include delay liquidated damage provisions in construction contracts but often do not consider whether any specific delay protections for the employer should be included in an LOI. Ultimately the employer may need to benefit from the work done under an LOI but its delayed delivery may have very significant knock-on effects if a full contract does not materialise. Employers would be well advised to be more definitive in an LOI on the contractor’s liability in the case of its underperformance. We have also seen many cases where parties have failed to finalise a full construction contract and kept extending the scope of an LOI until or nearly until completion of the project. In this context, you can appreciate why the LOI should address issues of, and liability for, underperformance.
The full contract should contain provisions addressing how work performed and payments made under the LOI will be treated under the full contract and that the LOI is superseded and no longer has legal effect (a well-drafted and bespoke “entire agreement” clause should address this). It should also contain an appropriate declaration by the contractor that it has no grounds for any claims for time or cost relief as of the date of the execution of the full contract.
A well-drafted LOI is only as effective as the team implementing it. Once the LOI is signed and the lawyers have departed, project managers must ensure that the parties adhere to its terms:
• For an employer, it is essential not to allow work to continue outside the authorised scope of work under an LOI – this will avoid any potential for a contractor to claim for payment on a quantum meruit basis or indeed that a full contract has come into effect on the basis of the conduct of the parties over a significant period of time;
• Ensure any extensions of the LOI are properly documented and that work does not continue in a vacuum. The risks assumed by both parties by conduct are much greater in such circumstances;
• Diarise expiry dates and ensure valuation of work is addressed properly at any progress meetings so both parties are aware of the impact of financial caps in the LOI; and
• Discuss any extensions/modifications to an LOI well in advance of its expiry to avoid the cliff edge scenario which leads to a legal vacuum and the inevitable disputes associated with it.
Employers should also recognise that it may be the case that a new contractor may be required to take over the project if a full contract cannot be agreed. In this case, it is normally workable if the original contractor has performed limited works such as demolition, site clearance, limited design or let supply contracts. If, however, these extend to new permanent works (e.g. foundations), a replacement contractor may be reluctant to assume liability for them in its scope.
We will continue to challenge our clients on whether they should be adopting LOIs, not to dissuade them from using them at all but to ensure that they have thought through all the advantages and disadvantages carefully. Once that is done, it is likely that the need to use an LOI will become clear. In our experience, an LOI is a commercially sensible approach to take where:
• there are compelling commercial or technical drivers to proceed in advance of finalising the full contract terms and conditions;
• the programme, commencement and completion dates are agreed;
• the contract price, scope of work, performance standards and other key commercial terms are agreed or there is a clear path to agreement; and
• the remaining contract terms and conditions are close to being (or very likely to be) agreed (if parties are struggling to agree key terms of a full contract then this is a good indication that the LOI may not be a sensible approach to adopt).
If these tests remain true, and provided the LOI is carefully drafted to address the inherent risks of an LOI approach, a satisfactory outcome for both employer and contractor is achievable. However, parties should be wary that the need for speed in commencing work does not lead to a rushed job in formulating terms of an LOI. If you wish to avoid joining the huge number of parties disputing the meaning or intent of an LOI (often at a time when you are trying to finalise the full contract), it is worth spending the necessary time upfront to get it right. Good legal advice can implement the necessary protections quickly so it need not get in the way of the commencement of early works.
This commentary is for information purposes only. It should not be relied upon or construed as advice or applied to any particular case or set of facts. If you are facing similar issues, please seek separate legal advice.
Jon Nash is a partner in the energy, transport, and infrastructure practice at Dentons & Co.