Monday, April 11, 2011

Breach & Remedies

A breach is the non-performance of a contract or a provision in the Contract. There are two types of breaches, minor and material.
  • A minor breach is usually a cause for the collection of nominal damages.
  • A material breach is a failure to perform that goes to the heart of the Contract and may be cause for both termination of the Contract and damages.
For example if your Contract had language that said that the “time for performance of the Contract is of the essence of the Contract”, what you are saying is that the failure to meet the time for performance is at the heart of the contract and the failure to meet it would be a material breach.  Most contracts would require that there be notification of the breach to the other party and a period of time in which to correct or “cure” the breach.

Remedies In General
In the breach of the Contract the non-breaching party would have what is called “remedies”. The typical remedies that may be available to the parties are:
  • Expectation damages (benefit of the bargain)
  • Reliance damages (recovery of costs reasonably incurred in reasonable reliance of a contract that was breached).
  • Restitution (recovery of the value provided by the non-breaching party)
  • Stipulated or Liquidated damages – (A fixed sum or formula that has been agreed will be paid in the event of a material breach. For example a per day amount for each day a project is late in delivery)
  • Interest
  • Special or Punitive damages (Damages that are designed to punish the party. For example, willful Intellectual Property infringement in the US is subject to treble damages that would be considered to be punitive damages.
  • Contract agreed remedies, (If the Supplier is late in making delivery, and the delivery term requires them to ship it by express freight with the Supplier paying the incremental cost, that is an example of a contract agreed remedy.
  • Specific Enforcement / Specific Performance (Ordering the party to perform)
  • Cover (Being able to charge the reasonable cost of excess re-procurement)
  • Incidental and consequential damages (recovery of costs that are not the direct result of the breach, but would be incidental to or a consequence of the breach
For all remedies, the non-breaching party has the responsibility to mitigate damages with reasonable effort and without undue risk. The types of remedies that you may recover may be limited in what is called a “limitation of liability” provision.

In the Contract you may also include specific remedies in many of the clauses that would be in addition to the remedies you have retained elsewhere. For example, if a Supplier fails to deliver a Product on time, your contract could provide the right to cancel the individual order without charge; it could require Supplier to deliver Products using priority freight with any difference in cost at Supplier’s expense. If there were on-going performance problems you may have remedies that require the Supplier to take additional actions to mitigate the potential impact to you. These remedies can be used to improve performance or reduce your costs associated with their performance problems or provide additional remedies for the breach. For example, a source code license or manufacturing rights license may be additional remedies you may need if the Supplier breached the Contract and you needed to continue to use and support the Product.

Most contracts will provide catch all language where if there were a breach in addition to any contract remedies that you may have spelled out, you would have the ability to exercise all other remedies provided at law, or equity. Most of those remedies would allow you to collect certain damages you incurred. Equitable remedies go beyond just collecting damages.

As one of the main remedies for Breach of a Contract is damages, you should understand the different types of damages that could possible be claimed. There are a number of different types of damages that you should understand, as frequently both the types and amounts of the damages will be negotiated.
  • Direct damages are caused immediately and directly from the breach of the contract. An example of a direct damage would be the cost of “cover” which is the excess cost of re-procuring the item from another Supplier.
  • Incidental damages are damages that are paid to reimburse the cost of mitigating the damages sustained.
  • Consequential damages are damages that may include lost profits and other indirect injuries caused by the breach of the contract provided the such damages were foreseeable and can be determined with certainty
  • Special damages are damages that are peculiar to the situation.
  • Liquidated damages are damages that are specified in the contract and agreed to by the parties that will be upheld if they are reasonable.

For example, if a Supplier had a major quality problem, the Buyer could be incurring everything but direct damages.  The cost of replacing the item would be the direct damage. The cost of replacing it in the field or reworking the item could be an incidental damage. If a customer canceled their order and returned the product as a result, the Buyer could have consequential damages such as lost revenue or profits. If the Buyer incurred damaged with their customer for failing to perform, they would be sustaining special damages. As you can imagine, in any negotiation one of the goals of the Supplier would be to limit their potential liability, which is done by limiting both the types of damages that may be claimed, and the amount of their liability.

The damages you may claim may be limited in the contract either in a specific section of the Contract by words that limit the amount of liability such as describing a remedy as the sole and exclusive remedy for the breach of that item, and by limitation of liability provision.  For example if you had a warranty provision where the replacement of a defective product was identified as the sole and exclusive remedy for defective products, you would not have access to any other remedies. The limitation of liability provision is a key term in every contract as it can limit both the types of damages that you may claim or the amount of damages you may claim. For example if you had the following limitation of liability provision
“In no event will either party be liable to the other for any lost revenues, lost profits, incidental, indirect, consequential, special or punitive damages.” 
By agreeing to that, you would be limited to recover only direct damages that occur as a result of the breach.

For some breaches direct damages may not adequately cover the types of damages you may sustain. So the key in negotiating any limitation of liability is to understand the nature of the damages that you would sustain in the event there was a breach of that specific provision. For example, direct damages for a defective part is the cost of “cover” (the cost to acquire a replacement). That may be acceptable if you had a limited number of failures, but what if the number of failures reached epidemic proportions?  If you wanted to claim costs of having to pull the product that contains the defect from the field or the cost to re-work the product to replace the defective item, those costs would be considered to be incidental or consequential in nature, not direct. Even if you listed those types of costs in a clause on defects, if you didn’t specifically exclude that clause from the limitation of liability section, the limitation of liability provision could limit your recover of costs to only direct damages. It’s important to remember that a contract will be interpreted as complimentary with all terms having equal weight so even if a warranty or defects clause said that you could recover certain types of costs, the limitation of liability could limit that recovery.

Another example of this is third party claims that would be covered under a general indemnification or intellectual property indemnification. If you sustained these costs they are not a direct damages, so to fully recover any costs you sustain as a result of those, you would want to exclude those sections from the limitation of liability. For example, to do that you would add the following to the above limitation:
“This mutual Limitation of Liability does not limit the obligations and liability of Supplier provided in the Section entitled “Indemnification”.
This would exclude the named section Indemnification from the limitation and would allow you to recover all types of remedies for a breach of that section.

Here’s an example of why this is important. Under certain statutes, a party that has been wronged may sue for punitive damages. In the U.S. if there was a willful infringement of another party’s intellectual property rights, the wronged party may sue for treble (3X) damages that would be considered as special damages. If you didn’t exclude the Intellectual Property Indemnification from the Limitation of Liability, you might have to pay the plaintiff the treble damages but only be able to collect 1X the damages from the Supplier.

With the exception of “liquidated damages”, there is a requirement of certainty with respect to damages. Damages are not what you anticipate; they are what you actually sustain, so you would need to be able to prove those damages. Liquidated damages are pre-agreed by the parties, so there is not a requirement of certainty. Liquidated damages only are required to be reasonable. The most common type of liquidated damages involves the failure to deliver a product or service on time where the Buyer will sustain extra costs or damages as a result. In that case liquidated damages could be a rate per a unit of measurement (such as hour, day, week) for each unit of measurement that the Supplier is late.
Equitable Remedies
Equity principles are based on the concept of fairness. If you reserve equitable remedies in your contract, the non-breaching party could seek the equitable remedies of injunctive relief, specific performance or contract modification to prevent unjust enrichment of the other parties or if money damages were inadequate to the harm that could be sustained.
  • Injunctive relief is a court ordering the party to not do something. For example, if a Supplier breached a Non-Disclosure Contract, the collection of damages may be inadequate so the non-breaching party may seek an injunction preventing further breach, disclosure, or use of the information.
  • In Specific Performance a court could order the breaching party to perform and meet their obligations. A common example of specific performance could be you have a purchase and sale Contract to purchase a house and the builder or owner refuses to sell the house. If a court ordered specific performance they would be obligated to sell the house or be in contempt of court until they do.

As the goal of negotiating a contract is to make sure that you have promises that you can enforce and that provide you remedies or damages if they are breached, you need to understand what can make a contract voidable and what can excuse performance.

Claiming a Breach and Terminating the Contract

If you have properly established the commitments that the Supplier is required to meet and they fail to meet them it’s a breach.  If it is a material breach, then you may want to terminate the contract. There a process that you must follow and in most Contracts the breaching party is allowed time to rectify or “cure” the breach, so what happens is:
  • There is a breach by a party
  • The non-breaching party sends a “cure notice” to the breaching party to correct the breach.
  • If the breaching party corrects the breach within the agreed period the non-breaching party can neither collect damages nor can they terminate the Contract.
  • If the breaching party fails to cure the breach within the agreed period, the non-breaching party has the right, but not the obligation to terminate the Contract.
  • If they elect to terminate the Contract they would send a termination notice stating when the termination is effective.
  • They may proceed against the breaching party for damages irrespective of whether they terminate the Contract or not.
  • The non-breaching party’s obligation is to “mitigate” the damages that they sustain (take reasonable actions to minimize the damages sustained).

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