There are obvious and well-documented risks associated with contracting on the basis of a letter of intent (LOI).
What is less obvious is that different forms of contract raise particular challenges when it comes to framing LOIs. This was brought home to me recently when I looked at an LOI for works to be let under an NEC3 Engineering and Construction Contract (ECC). It quickly became clear that LOIs need careful handling where the “intended” contract is an NEC contract.
This particular LOI contained (as usual) a financial cap, limiting the amount to be paid by the employer to the contractor under the LOI. Like many LOIs, it also created a binding contract, incorporating the ECC conditions.
So far, so straightforward. However, there are genuine difficulties in going down this route for NEC projects. This is because there is an inherent tension between, on the one hand, the employer’s desire to minimise its risks under the LOI and, on the other, the NEC’s focus on real-time risk and change management. If this is not recognised at the outset, there may be real difficulties in successfully managing the transition from the LOI to the final form ECC.
Take the following points:
- Compensation events
How do you deal with the compensation event mechanism under an LOI? Do you suspend it? This may be an option, but that doesn’t fit with NEC’s policy of dealing with risks as they arise.
Even if the mechanism is suspended, it is difficult to see how potential compensation events that arise under the LOI should be addressed once the full ECC is in place. You cannot readily retrofit an NEC3 contract to a project that has not previously been run along NEC lines.
Alternatively, if the compensation event procedure is operated from the outset under the LOI, how does this affect the financial cap and what does that mean for the cost certainty given to the employer by that cap?
- Programme
This is another aspect of the ECC that is difficult to retrofit if it is not put in place from the outset. So, even under an LOI the initial programme should be prepared and accepted (at the latest) soon after commencement of works under the LOI. Failure to establish a baseline programme early on will make it difficult to deal with compensation events once the full ECC is in place.
- Works information
The LOI must incorporate works information that sufficiently describes the scope of work to be carried out under the letter. Just as with the full ECC, there are risks to the employer in incorporating under-developed or sketchy works information. This is because amendments to the works information will lead to compensation events.
- Resources
It follows from all of this that the employer and the contractor need to resource the project management of an “ECC” LOI from the outset in the same way as if the full ECC was in place. An LOI is not necessarily a “management-lite” option.
How does this affect employers and contractors?
None of these points may matter hugely if the LOI operates for only a short period before the full ECC is entered into. However, if that is not the case, the employer, in issuing an LOI that incorporates a more or less complete set of ECC terms, may find that he is not only in for a penny, but in for a pound.
Despite this, an employer may well seek to avoid uncertain cost exposure under the LOI by insisting that the cap remains fixed, notwithstanding that this does not get around the issue of having to deal with compensation events and having a baseline programme. At the very least, it may be that the employer and contractor deal with compensation events on a “shadow” basis for the duration of the LOI. The events will be taken into account at the time of entering into the contract. This can either be by way of an adjusted initial contract price and “baseline” programme, or by implementing the suite of “LOI” compensation events immediately after the contract date.
An alternative for a wary employer is to offer a very limited form of LOI, setting out only essential terms (for example, scope of work, liability for design and workmanship, and a cost cap). This may be achievable if the scope of work under the LOI is a small, discrete part of the overall works. However, it is problematic if the LOI needs to be extended and still leaves open the question of how the LOI works will be integrated into the full ECC.
Also, a contractor may require some assurance that the compensation event mechanism will be operated so as to protect its interest, regardless of whether the contract is entered into, or the LOI expires or is terminated.
The overall lesson
This post perhaps raises more questions than it answers, but one thing is clear: where the “intended” contract is the ECC, an employer considering using an LOI must consider how the early works will be run and accounted for under the final form ECC.
