Wednesday, November 2, 2011

Terms - will they be effective. An example using liquidated damages versus bonuses

Whether a term will be effective will depend upon how you structure it and the words you use.

On a recent post on LinkedIN a writer offered his way to try to drive on-time completion. He would approach the supplier, tell the supplier that his bid or quote was ten percent (10%) too high. Then he would propose to structure the terms where if the supplier completed the work on time he would get paid the full amount. If the supplier was late, the 10% would be considered as liquidated damages and would not be paid.

I offered an alternative approach in which the contract price would be set at the 90% amount, but the supplier would be paid the additional 10% as a bonus if they completed the work by a specific date.

As you can see both approaches are intended to do the same thing. The intent is to use the 10% as leverage to drive on time performance. Both approaches can have their problems. Let's look at which will be effective.

In the bonus approach, if you were the cause of the supplier failing to meet the date they could argue that, but for that fact, they would have met the conditions of the bonus and should be paid the bonus. Most of the time if you caused a delay, the contact and the date they needed to complete the work by to collect the bonus should be extended. If this is done, claims that they should be paid if they failed to meet the extended date would not be successful.

Where the liquidated damages approach runs into problems is when a jurisdiction does not allow for the collection of penalties. Courts will uphold liquidated damages as long as the liquidated damages represent a reasonable estimate of the damages that would be incurred. If you were a supplier that was in one of those jurisdictions, you would argue that the 10% did not provide a reasonable estimate of the damages that would have been sustained. As a result a large portion of the liquidated damages represents a penalty that should not be enforced. In a suit the court would look at whether the amount establish was a reasonable estimate of the damages that would be sustained. In this example, unless you could prove that the amount of damages sustained would be the ten percent or greater, the court would allow only the actual damages. Any difference between the actual damages and the 10% would be considered a penalty that you could not collect.

If you were in a jurisdiction where penalties were allowed, the courts would not look at whether the amount was a reasonable estimate of the damages. It would simply be what the parties had agreed and that would be enforced.

The bonus approach works in both types of jurisdictions simply because the parties had agreed that the contract amount was ninety percent of the supplier’s proposal. They were given the opportunity to earn the bonus if they delivered on time. If they failed to deliver on time, they failed to meet the condition required for the payment of the bonus. The buyer would not be obligated to pay the bonus. Since the term describes a bonus rather than liquidated damaged, it would not be subject to the court determining whether the bonus was reasonable or not. It's what they agreed.

In this case what you called the 10% would impact not just what you could retain if you didn't get the performance, in jurisdictions where penalties are not allowed structuring it as a liquidated damage may not provide the leverage you want. If the supplier knows that the amount can't be justified, they will weigh what they feel would be the actual damage against any premium costs that it would take to complete the work by the required date. They would then make a business decision on which was going to cost them more. If they determined that it would cost more to take all the necessary actions to complete on time than what the real liquidated damages would be,
they won't make those additional investments to complete on time.

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