Is your Letter of Intent a binding contract?

It is an all too familiar scenario. A company has a project that needs to be completed by a particular date and in order to achieve that target, they need the contractor to commence work as soon as possible. The contractor, being eager to secure additional work, indicates that it is able to commence work immediately and is not overly concerned about the form of agreement that it enters into with the company. The result is often that the parties enter into a letter of intent (“LOI”) which may provide for the following:

• An abbreviated scope of works which the parties indicate they will set out in detail in the fully termed contract;
• A price for the work which may be stated to be fixed even though the scope of works is not fully detailed;
• A commitment by the parties to use their best commercial endeavours or, to work in good faith, to execute a fully termed contract by a particular date. The parties may even provide that the fully termed contract will be based on a form of contract which is annexed to the LOI;
• A provision that there is no binding agreement between the parties until they execute a fully termed contract; and
• The company has the right to terminate the LOI with an undertaking to pay the contractor for the work done to date.

With the LOI in place the parties commence work on the project. More often than not they commence negotiations on the fully termed contract however, it is not an uncommon occurrence where, for one reason or another, negotiations are not completed and a fully termed contract is never executed.

Provisions in an LOI that it is not binding until a contract is executed may not be effective to prevent the formation of a contract where work has actually been carried out under the LOI.

It is not surprising that where an LOI is quickly put in place and the scope and terms of the contract are not fully agreed, the parties often find themselves disagreeing on aspects of the project which can ultimately develop into lengthy and costly disputes. In such a situation a court or arbitration panel will seek to determine whether, based on the evidence before it, a contract exists between the parties. The court or arbitration panel will not be seeking to figure out the intention of each party rather, it will examine all of the circumstances of the particular case including the stage at which negotiations ended between the parties and the actual work done under the LOI; all with a view of determining whether there was an intention between the parties to create legal relations and if so upon what terms. Where work has been performed, it is more likely than not that the decision will be that there is a binding contract between the parties and in the absence of agreed terms the court or arbitration panel may be forced to put in place the terms that it believes should govern the conduct of the parties which may be quite different from the actual intention of the parties.

It goes without saying that best practice would dictate that no work should commence under an LOI and that it should only be used to give the parties time to complete negotiations and enter into a fully termed contract. The commercial realities however are that this may not be possible thus the parties should consider the following:

• Parties may not be able to rely on provisions in an LOI which state that no binding contract exists until a fully termed contract is executed where significant work is done under the LOI;
• Parties should set out a realistic timeframe in the LOI within which negotiations are to be completed and the contract executed;
• The LOI should clearly set out what occurs in the event that the contract is not executed by the agreed date which should include the stoppage of work on the project and a detailed mechanism to calculate the amount due to the contractor for the work done to date;
• The parties may consider setting a limit on the amount of work and on the amount that may be spent under the LOI so that they are incentivized to complete the negotiations before that limit is reached; and
• Each party should establish systems within their organizations to track LOIs under which work has commenced so as to ensure that sufficient focus is placed on finalizing and executing the relevant contract.

When work has commenced under an LOI, it is not uncommon for circumstances to develop where the negotiating power shifts in favour of one of the parties and the other is forced to accept terms that they may not have accepted if the contract was negotiated and executed prior to the commencement of work. In an effort to avoid sub-optimal contracting terms and possible disputes and litigation, it would be in the best interests of both parties to avoid relying on the LOI and to promptly proceed with the negotiation and execution of the fully termed contract.