Letters of intent – a potential recipe for disaster

United Kingdom

Letters of intent are often used where negotiations are not keeping pace with programme. Emcor Drake and Scull v Sir Robert McAlpine reminds us that a Letter of Intent can be a recipe for disaster

How about this? Start negotiating sub-contract terms. Do so for about a year. Realise programme constraints mean works must start immediately. Start the sub-contract works using an unsigned letter of intent with a maximum sum of £1,000,000. Continue under an unsigned letter of intent with the same maximum sum but different terms. Carry on negotiating the sub-contract – carry on a bit more. About six months later realise you're still not getting very far. Increase the maximum sum to £3,000,000. Continue sub-contract negotiations. After a further six months, increase the maximum sum again (to £8,000,000). Carry on sub-contract negotiations. A few months later, increase the maximum sum yet again (now to £14,000,000). All the while, continue full sub-contract negotiations. After nearly a year and a half of works realise you're getting nowhere and call it a day. Argue over whether you have a contract for the whole of the works, just part of the works, or something else altogether.

Appetising? OK, maybe not appetising, but a familiar flavour? The facts are essentially those of Emcor Drake and Scull Limited v Sir Robert McAlpine Limited [2004] EWHC 1017 (TCC) and the decision in that case was recently upheld in the court of appeal.

Letters of intent ("LoIs") are often used where negotiations are not keeping pace with programme. Their familiarity can make parties feel quite comfortable with them; after all, nothing has gone wrong before. However, EDS v SRM reminds us that an LoI is a recipe for disaster: if you don't replace it with a full contract quickly you could end up with a nasty taste in the mouth.

The project involved new building and refurbishment of the existing Russells Hall Hospital and the construction of day centres at Corbett and Guest Hospitals. The Dudley Group of Hospitals NHS Trust signed a project agreement with Summit Healthcare (Dudley) Limited under the private finance initiative. Summit in turn signed a main contract with SRM. SRM wished to appoint EDS as mechanical and electrical sub-contractor. EDS worked for SRM for about eighteen months until their relationship broke down and EDS left the site.

EDS sued for work done but not paid for. SRM (amongst other things) wanted a declaration that it was entitled to an indemnity for EDS's fundamental breach of contract. SRM said it had a full sub-contract with EDS for the whole of the works. Accordingly, by leaving the site before completing the whole of the works, EDS had fundamentally breached that contract. On the other side, EDS said the parties were working under an LoI, not a full sub-contract. EDS said it had performed in accordance with the LoI, which allowed only the performance of certain works up to a specified maximum sum. EDS said that it had therefore not committed a fundamental breach of contract. The court's job was to decide (as a preliminary issue) whether EDS and SRM had a contract for the whole of the works or something else.

The court said there was no contract for the whole of the works. The parties acted as though they expected a full sub-contract would be signed. This suggested they did not think a full sub-contract was already in place. They were also still negotiating how to transfer material clauses from the main contract into the sub-contract. Accordingly, the court would most likely say a contract for the whole of the works was void because its terms were too uncertain.

Alternatively, if the contract was not void, EDS had not made an offer to perform the whole of the works that was capable of acceptance by SRM. This was because EDS and SRM had still not agreed a position on yet more key points: design risk, completion dates and liquidated damages.

Instead the court held SRM and EDS had a contract only for the works specified in the LoI and only up to the maximum sum set out in the LoI.

The easy moral of the tale is that you should 'just say no' to an LoI. If you did this, you would avoid a costly dispute as to whether a contract exists and its basic terms. However, this is sometimes not realistic and an LoI is the only commercial solution. If you find a letter of intent is necessary, make sure your LoI addresses the issues arising in EDS v SRM.

First, consider whether you want a commitment to sign the full contract included in the LoI. The LoI in EDS v SRM listed out the terms which would form the eventual sub-contract. It also said that, upon SRM's request, EDS had to sign the sub-contract. The court said SRM could have made EDS sign the sub-contract if SRM had given EDS drafts which contained the terms listed in the LoI (in the event SRM failed to do this). So, at least where the LoI sets out the full contract's terms, an obligation to sign a compliant contract will be upheld. Think carefully about whether you are willing to make a commitment to sign the full contract; if you have not yet finalised your own position, better to steer clear.

Second, think about how you will use the letter of intent and ensure the letter reflects this. For example, in practice will you use the payment, variation or dispute clauses set out in the full contract drafts? If so, and they are agreed, consider incorporating these clauses by reference. If a different mechanism is to be used, specify this (note the Scheme for Construction Contracts may apply if you remain silent). If you use clauses from the full sub-contract which are not incorporated into the LoI, the other party may say you have agreed the full contract terms.

This is what happened in EDS v SRM. SRM pointed out that EDS's applications for payment dealt with retention and included amounts for variations and claims. The full sub-contract terms referred to these, but the LoI did not. Accordingly, SRM argued, the full sub-contract must be in place. In the event, the court decided against this. However, the court accepted these points were 'some evidence of a common assumption that a full sub-contract existed'. This is consistent with the approach taken in an earlier case. In that case, the parties to an LoI performed their obligations as though the full contract terms had been agreed. The court said this meant one party was prevented from denying that the full terms applied.

Ensure your LoI is consistent with your intended actions.

Third, beware any maximum sums. EDS exceeded the maximum sum it could recover under the letter of intent several times. SRM could have successfully argued that EDM was not entitled to be paid anything above the maximum sum. EDS acknowledged this risk in correspondence with SRM. Luckily for EDS, SRM increased the maximum sum several times (except for the final payment application). However, it would have been better for EDS if it had agreed such increases with SRM before the maximum sum was reached.

As an aside, note the present case was unusual in that the contractor needed to argue the maximum sum did not apply. More commonly the contractor needs to argue a maximum sum does apply so that it can avoid paying a higher sum to the sub-contractor. In this latter scenario, there is case law suggesting a contractor's liability to a sub-contractor can exceed the maximum sum in certain situations.

Maximum sums are useful mechanisms, but should be drafted and used carefully.

Fourth, whilst lawyers get worked up about the inadequacies of letters of intent, it's still worth making sure the thing is actually signed by both parties. Correspondence flying about with signatures on letters containing different terms only invites argument. In EDS v SRM, SRM's initial draft letter of intent was followed by an amended version produced by EDS which was never signed by SRM. This lack of clear documentation worsened the confusion and no doubt increased legal costs.

Fifth and finally, there is no substitute for getting the full contract signed. Don't give in to the temptation of letting negotiations slip whilst energy is focused on the works – dedicate someone to finalising full contract terms at the earliest opportunity.

For further information please contact Alex Cunliffe on +44(0)20 7367 2670 or at alexandra.cunliffe@cmck.com