Letters of Intent - Getting Them Right

What Is a Letter of Intent?

Letters of intent, commonly referred to as 'heads of agreement', are used to indicate the terms under which two or more people intend to enter into a contractual relationship when doing business together.

The term 'letter of intent' has no legal significance. However, the courts have often treated so-called letters of intent as contracts capable of being enforced, so care must be taken when drafting them.

One legally binding clause that is normally included in a letter of intent is the confidentiality clause in which it is agreed that confidential information acquired during negotiations will not be disclosed to any third party or otherwise used.

Why Use Letters of Intent?

Many letters of intent are really a mechanism by which the parties to a deal give each other reassurance of their intentions. They provide strategic guidance as to how a deal is to be done. They are also useful when outsiders need to be brought into the picture. For example, a takeover deal may need to be financed by institutional investors. The letter of intent is a valuable tool for them in their decision-making.

A letter of intent can be submitted to the relevant authorities in order to obtain a clearance that a particular way of structuring a deal will not cause problems: for example, obtaining a tax clearance from the Inland Revenue.

What Problems Might Arise?

Letters of intent can present problems. Unless drafted carefully, a letter of intent can create a contract, enforceable in the courts. For example, the use of the words 'subject to contract', which normally operate to show that contractual relations will be created later, are not always effective in this regard. Similarly, the courts have ruled on several occasions that work done following agreement of a letter of intent should be paid for at a reasonable rate, when the anticipated contract did not materialise.

If negotiations fail, there may be a damaging 'loss of face' if details have been disclosed to third parties.

In addition, UK tax law will often catch 'arrangements' in which a series of predetermined steps is carried out with the effect that tax payable is reduced. The existence of a letter of intent could justify the tax authorities arguing that an arrangement was in effect. This can be of particular importance in management buyouts, sales of businesses and similar deals.

What Should be Included?

Normally, letters of intent should contain the following clauses:

• a statement of the law under which the letters are drafted;
• a statement that they are not binding, or clear identification of any parts that are intended to be contractually binding;
• any provisions for non-completion (e.g. where one side must do work to progress the deal, and whether they will be compensated for this);
• a 'lock out' clause is common, in which the parties agree not to have negotiations with competitors for a period;
• a non-disclosure ('confidentiality') clause defining to whom (if anyone) disclosure of terms can be made.

Recently, the court issued guidance regarding when letters of intent might most usefully be used in construction agreements. In the court's view, letters of intent are most suitable for use when the following are agreed or there is little chance of dispute regarding them:

• the scope of the works;
• the price of the works;
• the date of completion of the works and any ‘milestones’ prior to final completion; and
• the main contract terms.

The use of letters of intent is also most appropriate when there are good reasons to commence the works prior to the formal contract documents being in place.