Tuesday, June 28, 2011

Do Penalties, Liquidated Damages and Remedies Drive Performance

In a recent discussion on linkedin.com someone asked the question of whether or not penalties drive performance.  The responses were varied but I would like to share mine and summarize an observation made of the responses.
Many people kept putting penalties and liquidated damages into the same bucket when they are different. A penalty is an amount that is over and above the actual loss of the party. In many locations penalties are not enforceable.  Liquidated damages can be viewed several ways. A supplier may look upon liquidated damages as a form of limitation of their liability not a form of penalty. If a supplier breaches their agreement the buyer could sue and recover all actual damages they incur as a result of the breach. That amount could be much more than the liquidated damages amount. In that case a liquidated damages provision represents a sharing of the risk.
A buyer should look upon liquidated damages as a way to recover some but maybe not all of losses they sustain from the suppliers non-performance. Remedies are an obligation of a breaching party for failing to meet a specific term.
Whether penalties, liquidated damages or remedies will improve performance will depend the investment trade-off the supplier will make. They will weigh what they would need to invest to perform as agreed against what it will cost them in penalties, liquidated damages, or remedies. If it will cost less to correct the problem they will make the investment and you will get performance. If it would cost them more to correct the problem than to pay the penalty, damages or provide the remedy, it won’t drive performance. If whatever the penalty, liquidated damages or remedy is based upon isn’t realistic, they will drive cost. For a material breach of a contract since you could recover the actual costs you incur, the only thing a liquidated damages provision does is avoid the need to go to court to prove the damages, as the damages were agreed in advance. Some people expressed concern about whether liquidated damages would affect the relationship.  The point I made is that liquidated are a contract right, not a duty. That means the buyer doesn’t have to enforce them or can choose when to enforce them. How they impact a relationship will depend upon how you enforce them. If every time there is even the slightest problem you bring a claim that will clearly impact the relationship. If you enforce them only when there is a significant problem it probably won’t impact the relationship. What they do is allow you to recover incremental costs that the buyer incurs as a result of the suppliers substandard performance that they could also recover as damages in court for breach of the agreement.
The key in structuring penalties, liquidated damaged or other remedies is you never want to provide a supplier with a cheap way to walk away from a problem or to allow problems to continue where you are bearing the majority of the cost of the problems they create.

Liquidated Damages

Liquidated Damages is an amount that is pre-agreed by the parties to the contract on the amount of damages that will be paid in the event there is a specific type of default. Normally liquidated damages are applied when a party fails to perform within the contract period and the amount is established on a time measurement – it could be an amount per hour, per day, etc. 

Depending upon the law is applied to the contract, what you include in the liquidated damage amount could be different.  Under non-English Law based legal systems, the law may allow a damages amount that includes both the expected damages and a penalty.  Under English Law based legal systems, the law of equity was a main principal in the creation of common law. Under the principle of equity you would not be allowed to make a profit on someone’s shortcomings. As such amounts that would exceed the actual damages would be considered penalties and would not be recoverable.  Recovery would be limited to a reasonable approximation of what your damages would be.

Even if there is language in an agreement that said that the amount was liquidated damages and not a penalty, a Court may still look at the amount to determine whether that amount reasonably approximated the damages that would be sustained.  If the court determines that the amount was excessive, that excess amount would not be awarded. Depending upon whether you are the buyer or supplier/contractor you will have a different view of liquidated damages. 

As a supplier you view liquidated damages is another form of limitation of liability in the event of a breach.  Where it’s extremely important for suppliers to want to include liquidated damages would be when the potential for direct damages could that could be recovered without and liquidated damages specified could be substantial. In that case you would want either liquidated damages or a cap on overall contract liability for certain breaches.

If the limitation of liability either had a cap on liability or limited recovery on certain breaches to only direct damages, the contractor might not need a liquidated damages provision for their protection.

Buyers may include liquidated damages provisions for several reasons.

Help drive the supplier to perform on time so as to avoid the payment of those damages.

With liquidated damages the amount is fixed and would be deducted from final payments. Without liquidated damages you would need to go to court to prove you actual damages, which is both time consuming and costly.

Since liquidated damages clauses would be read with any limitation of liability provision, before a Buyer would want to insert a liquidated damages clause into their agreement or agree to a supplier or contractor proposed clause, you should consider it in conjunction with the limitation of liability provision.
What type of damages does the limitation of liability allow you to collect?
If the supplier or contractor failed to perform, what would be the potential amounts and types of damages you will sustain?
What, if any, cap is there on the supplier’s liability?
You would then compare the potential recovery under the liquidated damages versus what you could recover without it to determine if the amount is reasonable.

When I did construction contracting I would ask suppliers to give me two prices, one with liquidated damages and one without. It would do two things. First I could see if a premium was included and second it would provide a good gauge about how confident the contractor was in being able to meet the schedule. If there was a substantial difference between the two prices, I would divide that by the per day liquidated damages amount and that would tell when the contractor really thought the work would be completed.  As schedule or need may be flexible with that information you could work with the business team and identify any premium costs that are associated with the schedule. With that you could potentially negotiate the lower price based upon an extended schedule and still have liquidated damages apply or you could take the deduct and remove the liquidated damages provision. Removing the liquidated damages provision doesn’t mean that you couldn’t claim damages if they were late, it only means that you would have to prove your damages
in court to collect them.

Many people don’t like liquidated damages and argue that they make the relationship adversarial.  I like to deal with suppliers that have a high confidence that they will meet the schedule.  When a supplier strongly pushes back on the inclusion of a liquidated damages amount that is fair and reasonable it shows me that they don’t have the confidence they will meet the schedule and if the schedule is critical I may select a different supplier as a result.