Contract formation and the dangers of letters of intent

What you need to know

Letters of intent can serve a useful purpose, as a sign of commitment to a project. They may also be the basis for some initial work to be done, such as ordering long-lead items. There is a risk, however, that they may be more than the parties had bargained for: if in the end the final contract is not signed, a court or an arbitral tribunal might conclude that the letter of intent was binding after all. This can mean that a simple contract may have been formed that is unsuitable for the project.

Like all transactional documents, parties need to be careful that a letter of intent has a clearly defined scope and purpose. In particular, it should state that it is not intended to be binding, if that is what the parties mean. The parties must then behave consistently with that statement.

The cases

Arcadis Consulting (UK) Ltd (Formerly Hyder Consulting (UK) Ltd) v AMEC (BCS) Ltd (Formerly CV Buchan)¹ related to the construction of a car park at a shopping centre in Bournemouth, UK. The defendant, Buchan, was the specialist concrete sub-contractor. It engaged the claimant, Hyder, to carry out design works. The car park developed serious faults: cracks appeared in the concrete, and some concrete fell off. The car park may need to be rebuilt at the cost of tens of millions of pounds. The contractor blamed Buchan, which in turn blamed Hyder.

Hyder argued it was not liable for the defects; but if it was, its liability was limited to around £600,000. For this limitation of liability it pointed to various contract documents which passed between Buchan and Hyder but were never signed. In fact, while Buchan had issued a letter of intent instructing Hyder to start work, no formal contract was ever executed. Buchan argued that no contract was formed at all. The judge rejected that submission, and concluded that, as the work had been carried out and completed, a contract had been formed. However, he also concluded that, since the limitation of liability proposed by Hyder had not been accepted by Buchan, the contract did not contain such a term. Buchan could therefore pursue Hyder for the full amount of the loss.

Spartafield Ltd v Penten Group Ltd² concerned an extension to a building in east London, to add eight new flats. Spartafield was the developer and Penten was the contractor. A letter of intent was issued: it was originally supposed to just cover the cost of design and pre-construction activities, but eventually covered all work up to the cost of £ 1 million. Again, however, no final contract was ever executed. The work proceeded, and, towards the end of the project, various claims for additional costs were made by Penten. An adjudicator decided that Spartafield had to make a payment to Penten, by reference to the terms of the letter of intent. Spartafield sought to have that decision set aside because, it submitted, the letter of intent had in fact been replaced, through the conduct of the parties, by a main contract based on the standard terms of the JCT Intermediate Contract with Contractor's Design 2011.

The judge reviewed all the relevant documents that passed between the parties. He concluded that everything had been agreed for the main contract, apart from a few minor details: for example, the parties had agreed on a scope of work, a date for completion, and a contract price. This meant that, although the main contract had not been signed, it had in fact been formed, replacing the letter of intent.

Why are these cases of interest to the energy sector?

These two cases highlight the potential risks involved in carrying work out before a formal agreement containing all the terms agreed by the parties has been finalised and executed. Although both cases are fact-specific and concern the UK construction industry, they are of wider application.

Letters of intent or memorandums of understanding are frequently used in the energy sector, with finalised contracts to be agreed upon after further negotiations. Parties may be under internal or external pressure to start work before they have signed the contract, so they sign a letter of intent in order to get work underway.

These can give rise to binding obligations – and in some cases that is what is intended. For example, there might be a mobilisation of drilling equipment to a drill site while the full terms of the project documents are being negotiated. The letter of intent may cover the mobilisation of the equipment and payment for it.

However, in some situations, there may be unintended consequences flowing from letters of intent, particularly when a party thinks that a contract has not yet been formed.