Performance guarantees, performance bonds and liquidated damages

In another forum an individual asked whether you could do away with a performance guarantee if you had liquidated damages. I thought I would discuss it here and the relationship between them and their relationship to limitations of liability.

A performance guarantee is usually provided by the contract party where within the contract they commit or guarantee to a specific level of performance for the item they delivered or constructed. If they fail to meet that committed performance the remedy available to the buyer would depend upon what the guarantee language says. For example it could provide the buyer the right to return the item and be refunded any payments made. There could be a credit to the price for the reduced value of the purchase. If the contract was silent as to remedies, the failing to meet the performance guarantee would be a breach and the buyer could pursue damages.

A performance bonds is issued by a bank or insurance company. As mentioned in a prior post, bonds may be conditional or on demand. A fairly common performance bond would be for completing the work. Those bonds are intended to protect against damages you incur if the party fails to perform, and they would include the costs to complete the work. For example if a contractor walked away from a job, you would go against the performance bond to recover costs to complete the work. The bond may allow the bond issuer to complete the work or they may simply pay the bond holder. It all depends upon what the bond says.

Liquidated damages are an amount that is pre-agreed by the parties to cover damages for work not being completed on time. The liquidated damages amount has to be a reasonable estimate of the damages you would incur. Any more than that a portion of the liquidated damages could be disallowed as a "penalty". In jurisdictions that allow for penalties, the liquidated damages amount could include penalties as part of the liquidated damages.

The bond issuer is only liable for the damages they commit to cover. Most performance bonds would not cover either performance guarantees made by the supplier or liquidated damages the supplier agree upon unless those are specifically committed in the bond. There liability is up to the amount of the bond. As they are not a party to the contract, their liability would not be impacted by a limitation of liability in the agreement. They limit their liability through the terms of the bond they issue.

The supplier or contractor could be liable for the performance guarantee breach damages. They could be liable for liquidated damages. If the performance bond didn’t cover all the costs to complete the work, the supplier or contractor could also be liable for any excess costs to complete the work as damages for their breach of the agreement. A limitation of liability section could limit those damages.

As liquidated damages are a form of limitation of liability it's important that they
be drafted correctly. You want the language to make it clear that the liquidated damages solely apply to the failure of the supplier or contractor to complete the work on time. They should not impact what the buyer or owner may claim as damages from the bond issuer. They should not limit what they would be liable for if there was a failure to meet the performance guarantee, or any additional costs not covered by the Bond.

In contracts that include performance guarantees you also need to carefully draft any limitation of liability provisions. Traditional limitations of liability try to limit damages to only direct damages. When you require a performance guarantee most of the time it is to ensure that you get the promised output as having less than the promised output impacts operating costs, revenue, and profit. If you limited their liability to only direct damages, you would not be able to recover those losses. My opinion is that it's best to carve any performance guarantees out of a general limitation of liability clause and deal with any limitations to the Supplier or Contractor's liability for breach of the performance guarantee in the performance guarantee language.