Project Delivery - Part 3: Pre-Construction Documentation – Contractual and commercial issues to consider

Welcome once again to our Project Delivery article series, designed to provide practical assistance to cover all the key stages of the delivery of projects in the built environment, from inception to handover. We started our journey with a practical introduction to public sector contracting and the legal procurement regime, followed by challenging a public sector award decision. This month, we move on to the pre-construction phase and look at some of the contractual and commercial issues to consider. In our next instalment we will reflect on key pre-construction considerations in light of the new building control regime under the Building Safety Act 2022.

Pre-construction documentation has always been a feature of construction projects and, due to the current economic climate and increased project risk putting parties under greater commercial pressure on parties to meet certain milestones and adhere to an agreed construction programme, its use is more popular than ever. To keep a project moving or to develop a project further, a Letter of Intent (LOI) or a Pre-Construction Services Agreement (PCSA) can be used to allow the contractor to commence an agreed scope of works and/or services before the main works contract has been signed. That said, neither of these agreements should be used to put off the negotiation of challenging commercial points and should only be used if the circumstances are fitting. 

What is an LOI and when should they be used?

An LOI is a letter of agreement between an employer and its selected contractor expressing an intention to enter into a main works contract at a future date and instructing the contractor to carry out certain works while that contract is being finalised. The scope of works forms part of and is not separate to the main works. The main works contract will often be close to agreed form with the exact scope and/or fee to be negotiated. LOIs should be used as a temporary measure so that preparatory works and works on site can commence. Entering into an LOI allows the contractor to procure materials, organise its supply chain and commence site preparations and works on site with the knowledge that they will receive payment for the agreed scope of works under that LOI.

Whilst an employer’s use of an LOI is largely to ensure the project does not fall behind its programme, by allowing the contractor to commence works, if an employer requires the contractor’s advice on the design, buildability and/or cost of the works to be able to get to stage two of a tender process, it is likely a PCSA will be more suitable than an LOI.

What should an LOI include?

Given the temporary nature of an LOI, parties often adopt a relaxed approach to the drafting, which can lead to uncertainty for both parties. There have been several examples of LOIs coming before the courts and, due to inadequate drafting, the contractual position is often not as envisaged by the parties.

Contrary to what is often said about LOIs, a comprehensive and correctly drafted LOI will be binding upon the parties. Whilst the enforceability of an LOI depends on its form and content, and will be considered on a case by case basis, if the courts find there is an intention to create legal relations they will likely find that a contract has been formed. If the LOI is silent on certain terms it will find a basis on which to imply those terms whether that be the terms of the draft or form of main works contract, the Scheme for Construction Contracts (England and Wales) Regulations 1998 or the Housing Grants, Construction and Regeneration Act 1996 (the Construction Act) or other common law implied terms.

Taking the recent case of CLS Civil Engineering v WJG Evans and Sons [2024] as an illustration of both these points, the employer and contractor failed to reach agreement on the main works contract and the employer terminated the contractor’s appointment. The court found that the LoI was binding (and had not been superseded by terms of the JCT the parties had been negotiating, because they were still negotiating) and with that the £1.1m cap on liability also applied despite the contractor claiming entitlement to payments in excess of £1.4m.

The inclusion of the attributes set out below will increase the likelihood of an LOI being considered binding and create certainty for both parties:

• the four essential elements required for a contract – offer, acceptance, consideration and intention to create legal relations;
• a clear statement that it is the intention of the parties to enter into the main works contract on the terms of the draft contract appended to the LOI (subject to agreed amendments);
• a clearly defined scope of works detailing the limited services that the contractor has the authority to perform under the LOI;
• an expiry date until which the contractor has the authority to proceed, which can be extended by way of a written extension letter;
• a clearly defined payment mechanism with due dates and final dates for payment, which comply with the Housing Grants, Construction and Regeneration Act 1996 – this can either be done by reference to the terms of the draft main works contract or by including an activity and payment schedule within the LOI;
• a maximum sum that is payable by the employer to the contractor, with the contractor being required to obtain written authorisation from the employer before it commits to any further expenditure;
• grounds on which the LOI can be terminated;
• a statement confirming that, once the main works contract is signed, its terms will supersede the terms of the LOI; and
• a statement confirming that in the event that no main works contract is signed, the terms of the LOI together with the relevant agreed terms of the draft main contract will apply to the works carried out by the contractor to date.

A further point to note is that it is also possible for pre-contract negotiations between parties to inadvertently lead to a contract being formed orally, by exchanges of communication or by clear conduct. In order to avoid being bound by a contract with unacceptable and/or unfavourable terms in the long term, if pre-contract negotiations are not intended to result in a binding contract, parties should be clear that any discussions in relation to the project are 'subject to contract'.

What is a PCSA and when should they be used?

A PCSA is a stand-alone agreement, separate to the main works contract and with a separate scope of works. It is an interim contract, usually for the provision of services, before the main works contract is entered into. A PCSA is typically used as part of a two-stage tendering process for projects, usually for larger, more complex projects, where the design, price and/or programme require further development before the main works contract can be tendered, or perhaps where, for other reasons, the employer is not in a position to appoint the main works contractor.

For projects outside formal procurement processes, in stage one, a preferred contractor is selected and appointed to carry out pre-construction services (under a PCSA), often following a competitive tender process run on a limited design basis. In the run up to stage two, and in tandem with performance of the pre-construction services, the employer and contractor negotiate the terms of the building contract for the main works to be entered into in respect of stage two, once the design has been more fully developed.

PCSA arrangements allow for the involvement of a contractor in the design development phase of a project so that the employer and the project team can benefit from the contractor’s expertise at an early stage in the project. The contractor can advise on buildability and programming, the construction risk profile, works packages and interface issues, and value engineering solutions and/or innovative solutions. At the same time, the contractor can prepare an informed, properly priced and correctly programmed tender, creating greater cost certainty for the employer (and hopefully some costs savings), as well as reducing the risk of delays to the project during the construction phase. This potentially early selection of a contractor can encourage greater collaboration between the project teams.

A PCSA also allows more time to procure subcontract packages, a plus for both contractor and employer in terms of the selection of subcontractor. If commercially agreed, this may be done on an ‘open-book’ basis, providing greater transparency for the employer but less room for manoeuvre for the contractor. A PCSA can also be used to procure early preparatory works and order long lead items to lock in the cost of certain materials.

What should a PCSA include?

Given the interim, stand-alone nature of PCSAs, a properly drafted PCSA should include:

• the scope of services, including the extent of the design work to be carried out, the design liability to be taken on by the contractor, including if it is not appointed under the main works contract;
• clearly drafted payment provisions - the approach to these provisions can vary considerably depending on the commercial arrangements but both parties will want to make sure there is no ambiguous drafting that could lead to disputes over fees due to the contractor;
• the granting of an intellectual property licence to the employer to copy and use the contractor’s design;
• even though the PCSA is a stand-alone contract, confirmation that the services will be subsumed into the main works contract so that all the rights and obligations are ultimately governed by the same terms and to facilitate the granting of third party rights or collateral warranties in respect of the whole works;
• provision by the contractor of collateral warranties / third party rights in respect of the pre-construction services and works;
• termination grounds, which will often include termination at will by the employer; and
• other provisions common to construction contracts, including insurance and dispute resolution.

What are the key commercial considerations when entering into LOI and PCSA arrangements?

LOIs and PCSAs are used in different circumstances and have different commercial considerations. For example, contractors engaged under a PCSA and who as a result are embedded in the project end up in a good bargaining position - a position made all the stronger if the employer is working to a tight programme as is often the case - and this may impact the parties’ commercial positions when it comes to pricing the main works. Incentive arrangements can be used to encourage a contractor to provide the pre-construction services to a high level and not take advantage of its involvement and position, including fixing certain elements of the contract price such as overheads, profits, risk mark-ups and certain packages or making part of the fee conditional upon the contractor being appointed the main works contract.

Under both arrangements, it is not unusual for contractors to continue to carry out works once the LOI has expired or once the services under the PCSA have been completed. However, if the parties cannot agree the terms of the main contract, the contractor’s involvement in the project may end once the LOI expires or once the services under the PCSA have been carried out. From a contractor’s perspective, it should ensure that it only performs the agreed scope of works or agrees an additional scope of works and related additional sum. If the parties continue to require or perform work outside the express scope of a LOI or PCSA then there is a real risk to both parties that they will be exposed to risk, liabilities or irrecoverable expenditure. There are many examples of both contractors and employers alike suffering harsh or unexpected outcomes as a result of working without the protection of commercial arrangements that have been expressly agreed and properly recorded.

Contractors are also well advised not to make any presumptions or over-commit resources and should make adequate contingencies to deal with unforeseen circumstances (ie the LOI/PCSA being terminated or a main contract not being agreed), and to take the time to make a fully informed assessment of the contractual and commercial risks it is prepared to take on in terms of risk allocation, pricing and programme.

LOIs and PCSAs should only be used in the limited circumstances they are intended for because they create uncertainty for all parties involved. LOIs in particular should be avoided where possible and parties should aim to go straight to the main works contract. If it cannot be avoided, contractors should focus on finalising the main works contract as soon as possible. This is not as straight forward with PCSAs due to their nature and the circumstances in which they are used and, in practice, two-stage tendering is becoming increasingly popular. This ‘popularity’, and the risks involved, may increase further where the project involves higher-risk buildings following the introduction of the new gateway regime under the Building Safety Act and the frontloading of design and programming it necessitates, a topic we will revisit in our next article.

That being said, if correctly drafted and used in appropriate circumstances, rather than create ambiguity or risk for the parties involved, these agreements are useful tools that allow projects to progress and better adhere to cost and programme pressures, and can play a crucial role in the success of a project.