Letter Agreements: Risks, Purpose, and What to Include

letter agreement

In the fast-paced construction market, contractors on smaller projects, and even some contractors on bigger projects, might be asked to begin work before entering into a formal written contract.  While oral agreements can be binding and enforceable[1], they are not recommended because they leave the substantial possibility that the parties will later disagree over their respective interpretations of the agreement or whether an agreement was reached at all.  At the risk of stating the obvious – it always makes sense for construction professionals to put their agreements in writing before any work begins.

When a formal contract is not possible, parties should consider entering into a letter agreement that, at minimum, includes the essential terms of price, scope of work, and location of the project.[2]  A letter agreement reduces important business terms to writing to allow work or services to start before a more definitive agreement is signed. “Letter agreement” is not a legal term and these type of preliminary agreements go by many other names, including: Letter of Intent, Limited Authorization to Proceed, Limited Notice to Proceed, Term Sheet, and Early Start Agreement.  The important thing to consider is what is contained in the agreement, not what it is labeled.

Various reasons exist that might cause parties to enter a letter agreement before the execution of a formal contract.  First, the parties may not be able to reach agreement on all risk allocation terms of a formal contract in time for an owner to be able to meet a deadline instituted by its lender, a zoning authority, local ordinance, or some other consideration out of the owner’s control.  Second, a fast-track project in which construction and design are proceeding concurrently often results in very tight scheduling constraints for contractors that does not leave time for the parties to negotiate a formal contract.[3] Third, the owner may want the contractor to perform certain preparatory work before entering into a formal agreement.  For example, the owner might ask the contractor to mobilize at the site, begin preparing submittals, order long lead items, or lock in its subcontractor and supplier pricing before entering a formal agreement.  Finally, the parties may not be able to agree on essential elements, such as price or scope of work for the overall project.  In these instances, the parties might want to move forward with certain preliminary work using a letter agreement because they can only agree on the price for a beginning phase of the project.

All of these scenarios most often affect the first trades on a project, such as site work and utility contractors.  As a result, it is vitally important for these contractors to understand the benefits and risks associated with the use of letter agreements.  Reasons parties might not want to agree to an early start agreement include:

  • The protections of a definitive contract are not in place, which means contractors run the risk of not being paid or incurring legal fees to recover for work performed without a contract. Owners run risks when they do not have a definitive contract in place as well, including the risk of being required to pay for change orders without a signed agreement because no change order process is in place.
  • Risk that a definitive agreement may never be signed and the parties’ obligations will be governed by a letter agreement meant only for preliminary work.
  • Shifting of bargaining power. Once the parties have begun work and are invested in a project there is less willingness to compromise on contracting positions.
  • Flow down problems. For example, if a contractor is asked to lock in pricing and order long-lead items, it cannot incorporate terms and conditions of a prime contract into its subcontracts or purchase orders before the prime contract exists.

In addition to the above, when parties agree to execute a letter agreement they risk the possibility that the letter agreement will be deemed unenforceable as a mere “agreement to agree” even if one of the parties intended otherwise.[4]  An agreement to agree is an unenforceable agreement which seeks to bind two parties in order to negotiate and enter into a contract with the intent that the final agreement will be embodied in a formal written document and that neither party will be bound until the final agreement is executed.

The line between an enforceable agreement and a mere agreement to agree is a thin one based on the facts and circumstances of each case:

“Where definiteness is apparent and the parties act consistent with it, [early start agreements] may be deemed enforceable contracts.  In the construction industry, the search for definiteness invariably invokes contract construction and interpretation consistent with trade custom and practice, and with the underlying facts.  The boundary between indefiniteness that may be clarified by judicial construction and omissions resulting from outright lack of assent often is drawn between mere failure to discuss a matter as distinguished from outright discussion and failure to agree.”[5]

In Building Materials Wholesale, Inc. v. Triad Drywall, LLC[6], for example, a drywall installer brought a breach-of-contract action against its materials supplier based on a letter agreement.  After providing a letter agreement with a quoted price to the installer, the drywall supplier purchased materials and continued to negotiate contract terms, including price.  Eventually, the drywall supplier sold the materials to a different installer for substantially more money than it quoted the original drywall installer arguing that it had no contractual obligation to the original drywall installer.  The court disagreed and held that the conditional letter of intent followed by assent by conduct to a follow-on subcontract constituted a binding contract, because “assent to the terms of a contract may be given other than by signatures.”

To avoid disputes regarding the scope and enforceability of a letter agreement, the parties should be careful to include certain language in their letter agreement, including:

  • The essential elements of cost, scope of work, location, and time.
  • A provision regarding the intention of the parties for the letter to be binding, or not binding.
  • A statement that a contract is not formed for other services and work until the definitive written agreement is signed. Otherwise, there is a risk that the parties could form an oral contractor or implied in fact contract for all of the work even though they are still negotiating terms of a formal written contract.[7]
  • A statement that the formal contract will supersede the letter agreement so that the provisions in the formal contract will apply going forward and, to the extent possible, retroactively to the work performed under the letter agreement.
  • A provision regarding the right to terminate or cancel if a written formal contract is not signed within a certain amount of time. Otherwise, there is a risk that the service/work will continue indefinitely under the early start agreement.[8]

Letter agreements do not provide the specificity and clarity found in standard form agreements, which can be detrimental to both parties.  While letter agreements may be a necessary evil in some cases, the parties should ensure that the formal contract is executed as soon as possible.  A letter agreement should never be considered a substitute for a formal contract.

[1] See, e.g., Turner Broadcasting System, Inc. v. McDavid, 303 Ga. App. 593, 596, 693 S.E.2d 873 (2010) (collecting cases recognizing the validity of oral agreements).

[2] The essential terms for a construction contract are price, Jackson v. Williams, 209 Ga. App. 640, 643, 434 S.E.2d 98 (1993), scope of work, Burden v. Thomas, 104 Ga. App. 300, 121 S.E.2d 684 (1961), location, Harris v. Baker, 287 Ga. App. 814, 817, 652 S.E.2d 867 (2007), and sometimes time. See, e.g., Jackson, 209 Ga. App. at 643 (finding oral construction contract unenforceable where there was no agreement regarding the material to be used for construction, the location of the construction, the estimated cost of the project, or the time for completion).

[3] See, e.g., Marshall Contractors, Inc. v. Brown University, 692 A.2d 665 (R.I. 1997) (finding no enforceable contract where contractor was “authorized to commence site work and to relocate utilities at the building site although no formal contract had yet been executed in order to accommodate the project’s so-called fast track construction schedule plan”).

[4] Doll v. Grand Union Co., 925 F.2d 1363, 1367 (11th Cir. 1991) (finding “agreements to agree or preliminary statements of intent to contract in the future are unenforceable”).

[5] 1 Bruner & O’Connor Construction Law § 2:8, Express contracts – Definite contract or “agreement to agree” – Letters of intent (August 2017 Update).

[6] 287 Ga. App. 772, 653 S.E.2d 115 (2007).

[7] Turner Broadcasting System, Inc. v. McDavid, 303 Ga. App. 593, 693 S.E.2d 873 (2010).

[8] Other provisions that should be considered in a letter agreement are terms dealing with changes, payment, insurance, and indemnification.

For more information on this topic, contact your Construction Law counsel at Smith, Gambrell & Russell, LLP.