How and when to draft an effective letter of intent

26 April 2012

In the construction industry, letters of intent are used for almost all types of projects. It is a document provided by the employer to a contractor (or by a superior contractor to its sub-contractor) to confirm the instruction for work to commence while the formal and more detailed contract document is being prepared.

One of the main purposes of a letter of intent is to provide comfort to the contractor that a binding agreement has been reached, so that work can commence immediately. This would particularly apt where, for example, there is a long lead time for ordering relatively expensive materials.

Although used widely in Hong Kong and elsewhere, there is no standard form of a letter of intent, unlike the many standard forms of formal contracts in use. This is perhaps unsurprising, given that the objective of a letter of intent is to quickly and informally give instruction to commence work, which would mandate that its use not be tied down by the rigidity that could come with a standard form.

We revisit below some matters which should be borne in mind when choosing to proceed with work and when drafting a letter of intent.

Should only be a short term solution

By its very nature, a letter of intent cannot contain all the detailed terms of the parties' agreement except in the simplest situations. This could result in problems regarding the actual agreed scope of works, payment terms and the consequences of a breach of the parties' agreement.

An unclear and under-detailed letter of intent could therefore lend itself to much uncertainty and disputes, and parties should opt to enter into a formal and detailed written contract shortly after the letter of intent, and in any event before substantial works are commenced.

What is to be included?

First and foremost, the letter of intent should expressly be stated to be legally binding on the parties pending the execution of the later detailed contract. To give added security to cover for the possibility that no formal contract would be signed at all, the letter of intent might contain wording to the effect that it would remain binding in the event that no formal contract is executed (though for the reason mentioned above it is not advisable to not sign a detailed contract).

Alternatively, the letter of intent should state what payment the contractor will be entitled to if no formal contract is executed. In such a situation, the contractor under common circumstances will be entitled to payment on a quantum meruit basis, that is, its incurred costs (plus a reasonable margin) and reasonable site withdrawal costs.

In RTS Flexible Systems Limited v Molkerei Alois Muller Gmbh & Company KG (UK Production), the United Kingdom Supreme Court held that works carried out subsequent to the expiry of the agreed validity period of the letter of intent was pursuant to a form of contract discussed, but not executed between the parties. To avoid surprises as to what was or was not agreed, the formal contract should be signed.

Although the parties desire for the letter of intent to be brief, they can still incorporate by reference detailed terms which they have agreed in advance to adopt. They may, for example, specify that the terms of a standard form of contract (such as a Standard Form of Building Contract Private Edition by the HKIA or a FIDIC form) are to be adopted. If so, it is most important to expressly spell out in the letter of intent the order of precedence in the event of inconsistency or conflict between its wording and the standard form. The letter of intent should also clearly specify which terms of the standard form of contract are not to apply (if any).

The wording of the key terms should be clear and certain, such as those relating to the scope of works, payment terms (including how payment will be calculated and timing for payment) and consequences of breach. Terms which are considerably more onerous than those in a standard form of contract should be spelt out in detail: if for example, the parties have agreed to allow termination at will (without cause) or extended suspension of work (both of which might be significantly more detrimental to a party than in a standard form), clear details will need to be contained to avoid later argument. The items which commonly give rise to disputes, such as valuation of variations (and the rates to be used) and the grounds for extension of time should be clearly stated.

To avoid argument as to whether the letter of intent was actually agreed, the document should be counter-signed by the addressee.

Other considerations

In RTS v Muller, the UK Supreme Court stated that the case 'demonstrate[d] 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.'

Letters of intent are no doubt useful, but if over or inappropriately used, can often give rise to disputes.

Although the purpose of using a letter of intent is to allow work to commence as soon as possible, there are still matters which should not be overlooked before work starts. For example, the relevant insurance policies will need to be effected, and if there is an agreement for a party to provide an advance payment or a security bond, this should be done before any work.

Despite various precautionary measures, a letter of intent will not be as safe as a detailed contract, and the parties should agree a timetable for executing the detailed contract as soon as possible. Before such time, the parties might consider holding progress meetings and preparing cost updates on a more frequent basis than otherwise to keep a close track of things.

Pending the detailed contract, the parties should pay close attention to any limitations set out in the letter of intent, such as a cap on the maximum amount payable for work carried out under the letter of intent.

Employers / superior contractors should therefore, if practicable, include a limit on the maximum amount payable for works under the letter of intent. To avoid a quantum meruit claim by a contractor, they should not permit work to continue beyond such cap, or after the expiry of the period of the letter of intent.

Contractors performing work under a letter of intent should be wary about incurring costs in excess of any stated maximum amount payable. If it is to exceed such amount, it should first obtain the employer's written instruction. Whilst a claim based on quantum meruit might be possible for work carried beyond such a cap, whether a contractor is so entitled (including whether the employer / superior contractor has in fact ordered for such work) will most likely be disputed, especially if there was no written instruction.

This article is from our April 2012 edition of Construction Law Asia newsletter.

Author(s) Steven Yip, Malcolm Chin