Friday, January 28, 2011

Penalties versus Liquidated Damages

Penalty clauses are terms of contracts that seek to impose an obligation to pay a sum of money in the event that the contract has been breached. A traditional penalty clause amount would include an amount the far exceeds the amount of damages that would be sustained. In many jurisdictions penalty clauses are not enforceable as a matter of public policy. The rationale is that contract terms should not be used for party to profit from the breach of a contract by the other party. 

Penalty clauses are different than clauses for liquidated damages. Liquidated damages clauses also imposes an obligation to pay a sum in the event of a Breach, however with liquidated damages the intent is to only recover the amount of the damages you sustain. So the real difference between the two is whether you are trying to profit from the breach.

Calling a clause “liquidated damages” does not make it a true liquidated damages provision. In interpreting it a court would apply several tests to determine whether it is a penalty or a liquidated damage. It would be considered a penalty if:
1. The amount payable is excessive when compared to loss*.
2. The amount payable is greater than what should have been paid
3. The amount payable would apply to minor versus major breaches.

*Liquidated damages clauses must be a genuine estimate of the loss to be suffered by the party in the event of a breach. Whether the term is a penalty clause or not is determined as of the time the contract was formed. The amount only needs to be a genuine estimate of the loss at that time.  This means that irrespective of whether the loss would have been greater or smaller at the time of the actual breach does not apply as the parties agreed to establish that as the amount. Where a non-breaching party made a genuine effort to determine their loss and has acted in good faith, the clause will not be classified as a penalty.

To avoid having a liquidated damages term from being considered a penalty the amount needs to be a reasonable reflection of the non-breaching party’s expected loss for the breach. That means that a single liquidated damages amount should not be applied to all breaches. If the intent is to apply liquidated damages to multiple different types of breaches, you should tailor the amount of the liquidated damages for each different breach so each represents a reasonable reflection of the loss for that breach. Most of the time liquidated damages is applied only to the failure to deliver on time.
Amounts payable for performance are not penalty clauses if the performance is not met. For example if you included a bonus for early completion of work and the Supplier failed to complete the work early, the failure to pay the bonus would not be a penalty or liquidated damage as they are not connected with a breach.

The value of liquidated damages provisions is the parties agree on the amount in advance and it relieves the non-breaching party from having to prove their damage in court. The only thing that the breaching party can challenge is whether there was a breach. They could challenge that amount as representing a penalty, but if the amount was properly established as a reasonable reflection of the damage and was agreed by the parties, courts would most likely will not view it as a penalty.

Point in Time or Auto Updating Documents

Many times a contract will incorporate other agreements or documents into it.  For example, you may negotiate a Master Agreement and then incorporate that into Statements of Work negotiated for individual purchases. You may incorporate specifications and other documents into your contract.

When you incorporate a document or another agreement by reference into your Agreement, that document will be what I call a point in time document. Without expressing language to the contrary, the document you incorporate will be as it existed as of the date you incorporated it into your agreement, effectively being frozen at that point in time.  Sometimes that may work, other times it can require a huge number of contract amendments to constantly update your agreement.

When incorporating a document by reference into a contract you need to decide if a point in time incorporation works or if you want your agreement to change every time the incorporated document changes. If you want it to change, you also need to decide upon the extent it will be changed or updated.

If you wanted all the changes that were made to be included, at the point where you incorporate the document or agreement by reference you could, include  “as may be amended from time to time by the parties”. This shows the intent of the parties for it to automatically update within your agreement each time the referenced document changes.

You could also agree to limit the scope of the auto updating. For example if you had a strategy where Subsidiaries wrote their own agreements and incorporated their Parent Company’s agreement with the Supplier, there could be a number of reasons why they would want to separately review and agree what terms get incorporated into their agreement. They may want to take advantage of addition of new Products or Services that are added to the referenced document so they don’t have to amend their agreement every time a new product or service is added. They may also want to take advantage of any price changes that get negotiated. To do something like that you might say, “This agreement automatically incorporates any changes to the Products, Services and Prices included in the Referenced Agreement. All other changes to the Referenced Agreement shall require written agreement by the parties to this Agreement before incorporation into this agreement”.

Let me give you an example.

You have a Master Agreement. Over time you have written 20 statements of work that each incorporate the terms of the Master Agreement.  Each statement of work is still in effect. Over time the master agreement was amended 10 times.  You encounter a problem with the Supplier that could potentially affect all your statements of work. You want to determine what contract protection you have against this problem. To do that you would first look to see whether the incorporation was point in time or auto updating.  If all the incorporations were point in time, to understand your contract rights, you first need to review all amendments to the statement of work to see if any of them incorporated changes made to the Master Agreement. If they didn’t you then would need to understand what the Master Agreement terms were at the time it was incorporated into each statement of work.  To do that you would review the Master Agreement and any amendments executed prior to the date it was incorporated into the Statement of Work for to understand each statement of work's full terms. Depending on when they were written you could have up to 10 different versions of terms in effect for the SOW’s.

Auto updating works when the document being auto updated requires mutual agreement by the parties.  You would never use auto updating when the Supplier alone controls the document.

If you consider using auto updating, contact your legal support to see if Auto Updating provisions may be used in that jurisdiction and what they would recommend.