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Letters of intent - open to interpretation

By Chris Kirby-Turner, Solicitor in Construction. Featured in Construction Law Journal.

Letters of intent are a common, and often tempting, "short cut" for those needing to get construction works underway, without having to wait for the formal contract documents to be drawn up and finalised.

In many cases, problems will not arise and the works will be completed simply under the letter of intent, without the contract ever being completed or signed. However, the scope for protracted disputes where problems do occur is considerable.

It is no surprise that lawyers will always be uncomfortable when a client decides to proceed with often very complex and high value works on the basis of such a basic agreement. However, the client's objectives of expediency, saving costs or simply not wanting to upset hitherto strong commercial relationships means that it is almost inevitable that they will remain a feature of the industry, and therefore something that construction practitioners must grapple with as best they can.

Letters of intent - legal characteristics

As with any other contract, the basic formalities of offer, acceptance and consideration must be met, together with a sufficient degree of certainty, if the letter of intent is to be a valid contract. Thus, the effectiveness of each letter of intent must be decided on the facts.1

In older case law, the courts expressed the general rule that letters of intent are "the expression in writing of a party's present intention to enter into a contract at a future date", and that it would only be in exceptional cases that it has a binding effect.2

More recently3, the courts have recognised and confirmed that three types of letter of intent exist:

  1. "Pure" letters of intent, which do not give rise to contracts at all;
  2. Simple contracts, which contain just enough to be binding, but are entered into with the intention that they will be superseded by subsequent finalisation and execution of the formal contract; and
  3. Those that are (so far as they go) the whole contract (which may be supplemented by verbal agreements, or even need further terms implied into them), with no intention that they will be superseded by a formal contract.

Particularly where the letter of intent is a "stop gap" solution, pending formal documentation, it is understandable that the parties will become embroiled with the tangible progress of the project itself, rather than dealing with the contractual niceties of the formal contract. Frequently, even if a draft (or final draft) is circulated, the parties will not confirm it as a final version and sign the documents until very late into the project, if at all.

Moreover, if matters start to go wrong, it may become very much in one party's interests to hold off from signing up to the formal contract. By way of example:

  1. a contractor, who is in delay, may know that the formal contract negotiations will involve agreement of a liquidated damages rate which has not yet been agreed; or
  2. an employer, who decides to stop a project, may either seek to rely on a time or value cap in a letter of intent, and/or the fact that a loss of profit entitlement has yet to be formalised.

In such cases, a dispute may arise where the courts are having to interpret, as best they can, what the parties actually agreed. In those cases, the courts may well need to become involved in difficult questions of how far the courts could, or should, go in interpreting the actual words used to arrive at an outcome. They may also need to determine (as a matter of evidence) what oral terms supplement the written agreement, or imply terms to make the contact capable of performance.

Principles of interpretation

The courts have long wrangled with the issue of whether they can intervene with a poorly drafted contract. The courts will, and should, enforce the terms of the agreement in front of them. It is not for the court to try and impose a "fair" solution, if one (or both) of the parties have committed themselves to a bad (or ill thought out) bargain.

The court must give effect to the presumed intention of the parties. This is an objective test, by which the presumed intention of a reasonable person entering into that contract with that choice of words is to be ascertained. The courts cannot implement what, in effect, they think a party meant to say.

A "black letter" approach prevailed until relatively recently, whereby the words were given their plain and natural ordinary meaning. Any words or phrases with a specific trade meaning would be given the requisite technical meaning.

More recently, the courts have recognised that the background knowledge ("factual matrix") that an objective third party would have may be relevant, and can have a powerful impact on interpretation.4 This factual matrix can, in certain situations, be more important than the express wording of the agreement itself.5 However, the general presumption remains that the parties meant what they said, and the words must be constructed as they stand.6

It is now relatively settled law that the scope of the factual matrix is broad, subject to two exclusions:

1. Pre-contractual negotiations are excluded, for reasons of public policy (the so-called exclusionary principle)7. The rationale is that it would be almost impossible to distinguish between the aspirations of each party during the negotiations, and what actually reflected their final agreement.

2. What the parties actually did under the agreement is also excluded, because it reflects the subjective (rather than objective) understanding of the parties and, by definition, will have taken place after the contract was entered into, so cannot be incorporated into the contract itself.8

Chartbrook v Persimmon

Last summer's House of Lords case of Chartbrook v Persimmon9 grappled with precisely these interpretation points, in striving to give effect to an ambiguous pricing formula that had been agreed as a schedule to a development agreement. The formula was designed as a balancing payment, the amount of which would depend upon the revenue generated when the residential units on the mixed use development were sold.

Given a very literal interpretation, the figure produced was in the order of £4.5m, whereas a more purposive approach produced a figure of just £900,000, which had already been paid. Matters were made much more difficult by the fact that the adjustment was having to be applied following the dramatic fall in property prices, which had occurred on a scale which had almost certainly not been contemplated by either party at the time the contract was entered into.

The lower courts adopted a predominantly "black letter" approach, which was backed by the majority of the Court of Appeal (Lawrence Collins LJ dissenting). However, the House of Lords unanimously allowed Persimmon's appeal, and overturned the Court of Appeal's decision, being satisfied that the "black letter" result was commercially nonsensical, given the clear purpose of the formula.

In delivering judgment, the five Law Lords (and in particular Lord Hoffmann, in his last judgment before retirement from the House of Lords) took the opportunity to give a detailed summary of the legal principles which will govern determination of such a dispute.

(1) Construction of the contract

Lord Hoffmann confirmed that whilst generally the court will not easily accept that people have made linguistic mistakes in formal documents10, in some cases the context and background will lead the court to conclude that something has gone wrong with the language. In this case, the factual matrix meant that simply applying the ordinary rules of syntax produced a result that was of no commercial sense.

Lord Hoffmann went on to emphasise that there is no "limit to the amount of red ink or verbal rearrangement which the court is allowed", where it is clear that something has gone wrong with the language of the contract and what was meant is clear.

(2) Admissibility of pre-contract negotiations

Persimmon had sought to rely upon evidence of the parties' negotiations, and the court was invited to depart from the long established exclusionary rule.

The court confirmed it would not depart from this rule, and Lord Hoffmann stated that in the rare cases that such negotiations are relevant, the rule can be justified on pragmatic grounds, in that to allow such matters to be considered would greatly increase the uncertainty of the outcome of any litigation, and its costs. The court was satisfied that any such change to this principle would be a matter for investigation by the Law Commission and legislation, and not something that should be developed by case law.

Lord Hoffmann also emphasised that the inadmissibility of pre-contract negotiations when constructing the contract does not, of course, exclude the use of such evidence in the context of a claim for rectification or estoppel.  

Lord Hoffmann also made some significant obiter comments, when considering Chartbrook's alternative claim for rectification (which, because Chartbrook's construction case had succeeded, did not fall to be determined by the courts). In making a claim for rectification (that is, a claim whereby the court amends the terms of a written document where it is satisfied that it does not accurately reflect the terms that the parties agreed), Lord Hoffmann accepted Persimmon's argument that the court should read the documents surrounding the pre-contract negotiations objectively, rather than weighing up the parties' subjective accounts of their understanding at the time.

Implications for letters of intent

The principles of contractual interpretation that were reiterated in the Chartbrook case will clearly be relevant to parties involved in a dispute arising from a letter of intent, given their inherent qualities of incompleteness and ambiguity. This will be the case particularly in cases where the letter of intent was intended to be a precursor to the "proper" contract, which has never actually been drawn up or finalised.

In other cases, where a contract has been drawn up and superseded the letter of intent, there may be inconsistencies between the two, where what is stated in the letter of intent is said by one party to more accurately reflect the parties' intentions. In such cases, the Chartbrook case confirms that the courts will not allow the letter of intent to be used in interpreting the contract, but it may well be persuasive evidence in a claim for rectification.

Ultimately, all the court can do is to use these well developed principles to try and achieve a result, based on their assessment of what an objective third party bystander would view as being the agreement actually reached between the parties.

It is inevitable that the outcome of such a process will always be influenced by the views of the particular judge (or judges) who are undertaking that exercise, and so it will be almost impossible in finely balanced litigation to predict the outcome. Therefore, the only sure way of mitigating these risks is to make the letter of intent a well thought out and detailed document, dealing precisely with all eventualities. Of course, that will rarely be likely to happen, as it raises the entirely natural (and largely unanswerable) question of why, if such attention to detail is to be expended, the parties do not enter into a "proper" contract in the first place.

The underlying uncertainties and risks of letters of intent will always remain, as too will the propensity of those in the industry to use them. The above principles of interpretation will often be called upon in trying to resolve a dispute, and are worthy of inclusion on the list of "health warnings" to any party operating in the industry.

 


1 Twintec Ltd v GSE Buliding & Civil Engineering Ltd (2003), per Kirkham J 

2 Turriff Construction Ltd v Regalia Knitting Mils (1971)

3 Diamond Build Ltd v Clapham Homes Ltd [2008]

4 Investors Compensation Scheme Ltd v West Bromwich Building Society [1988]; Mannai Investment Co Ltd v Eagle Start Life Assurance Co Ltd [1997]

5 Antaios Compania Naviera SA v Salen Rederierna AB [1985]

6 IRC v Raphael [1935]

7 Prenn v Simmonds [1971]

8 Union Insurance Society of Canton Ltd v George Wills & Co [1916]

9 Chartbrook Ltd v Permsimmon Homes Ltd and another [2009]

10 Investors Compensation Scheme Ltd v West Bromwich Building Society [1988]