Working with a letter of intent

March 1, 2011
Show me a letter of intent and I'll show you an invitation to a dispute — typically over unpaid work.

Show me a letter of intent and I'll show you an invitation to a dispute — typically over unpaid work. A good example is a recent case involving an excavator. The general contractor directed the sub to start work before they had a contract signed. The sub performed under a letter of intent to enter a contract. The parties could never reach agreement on a written contract, the relationship deteriorated, and the general decided to give the work to another subcontractor. But by that time the sub had already incurred significant mobilization costs, and had even performed some site work. The general refused to pay, said there was no contact, and the sub was left wondering what to do with its loss.

Before I disclose what happened, let's start with some basics. A Letter of Intent (LOI) is generally an informal way of reflecting an agreement in principal between two or more parties who either haven’t worked out all the details of their relationship or aren’t legally in a position to make a commitment yet. In the construction world, they are primarily used to pin down a subcontractor or supplier to a bid or quote, even though the award to the general contractor is still not official. In this case, no contract can yet be entered with a supplier or sub. They are also used to authorize a subcontractor or supplier to begin a certain part of work that has a long lead time or is needed immediately. In this case, the general contractor simply hasn’t had the time to prepare a lengthy subcontract or purchase order, but needs to get some part of the work going.

So, why is there ever an issue? Potentially there are many reasons, including that the party that issued the LOI changes its mind and doesn’t want to go forward with the other party. The other party says it has a contract. Other reasons could be that the party that got the LOI wants to get out, but the party that issued it says they have a contract; the party that issued the LOI later finds that the party who got it won’t agree to all of the formal contract terms; and the party that got the LOI has incurred a lot of costs and made commitments in reliance on the LOI, and now the party that issued the LOI can’t or won’t pay, and so on.

How these disputes are resolved largely depends on whether the LOI is a contract. An LOI may or may not be a contract. Sometimes from its very wording, such as “I intend to enter into a contract with you in the future…,” it is saying there is no current contract, but frequently the letter says far more than that. If it contains promises or representations, such as “if you do X, I will do Y,” it can be a contract.

The most important factor in determining whether an LOI is binding or not is the intent of the parties. Where the intent of the parties is clear from the terms in the letter, the court will hold the parties to those unambiguous words. This could be the case even if the parties really didn't intend the letter to be enforced literally. For this reason, it is very important that people using LOIs draft and read them carefully and be aware that they might be stuck with the terms that are actually on that piece of paper and no others.

If the intent is not clear from the face of the document, a court can look to other circumstances surrounding the LOI to make its determination. This could include correspondence between the parties prior to issuing the LOI, testimony of the parties and outsiders about the transaction, and how the parties performed under the LOI.

If an LOI is not “the contract” or even “a contract,” the LOI still may give a party the right to recover some money. Although one party may not have intended to be bound by the LOI and wants to back out, that doesn’t mean there will be no consequences. The key here is whether the other party has relied on the representations in the letter and is entitled to compensation under a legal principle called promissory estoppel. Promissory estoppel will obligate another to perform where: (1) the promisor made a clear, unambiguous promise to the promisee; (2) the promisee relied on that promise; (3) it was foreseeable that the promisee would rely on that promise; and (4) the promisee was damaged because of his reliance on the promise.

Even without a promise, a party can end up having to pay under another principle called detrimental reliance. Detrimental reliance has most of the same elements as promissory estoppel, but you don’t even need to prove that there was a promise — only that there was action taken (or not taken) by another party that you reasonably relied on to your detriment.

In either of these situations, a party to an LOI might find itself having to reimburse the other for the expenses it reasonably incurred in reliance on the LOI. This could come in the form of re-stocking charges for materials not needed, the cost of nonreturnable materials, the cost of preparing shop drawings or processing submittals, and travel or other start-up expenses. These are all the kinds of damages the sub/supplier might incur if the contractor backs out of the deal after issuing an LOI. If the sub/supplier backs out, the damage of the contractor might be increased prices to obtain the goods or services that were to be provided under the LOI or costs of expediting to get replacement goods or services.

There are limits, however, to recovering under an LOI. As long as a court doesn’t find that the LOI rose to the level of an actual contract to perform the entire scope of work, the maximum obligation is to pay for what the LOI reasonably led the other party to spend. But because there was no contract, there can be no breach of contract damages. This means that the “non-breaching” party cannot collect lost profits from not being able to do the work, lost opportunity of work not performed because you intended to do this work, or increased cost of going to another subcontractor or supplier for the entire scope of work.

Here's what happened with our subcontractor. After politely educating the general contractor on the law, we reached a compromise entailing payment of all the direct costs the sub incurred while operating under the LOI. And both parties learned some valuable lessons about letters of intent.

Michael Callahan is a partner at Stinson Morrison Hecker LLP (the same firm as long-time columnist Susan McGreevy) where he assists clients with all aspects of their construction law needs, including litigation.

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