Sunday, October 7, 2012

“Not to Exceed” versus “Guaranteed Maximum Sum”

In cost plus contracts,either of the above terms may used. What is the difference between the two terms?

When you write a contract that includes a not to exceed amount, the supplier or contractor is required to stop all work once that not to exceed amount has been reached. The problem is that the work itself may not be fully completed and the supplier has no obligation to complete it unless you increase the “not to exceed” amount. A “not to exceed” amount is established by the buyer. Under a not to exceed amount the supplier or contractor has no responsibility to manage the costs as they will get reimbursed for all cost and they aren’t guaranteeing the work will be completed for that amount.

When you include a guaranteed maximum sum in the contract, the supplier or contractor is required to complete the work. The agreement is still a cost plus type of agreement, but the supplier or contractor needs to manage those costs so they can complete the work at no more than the guaranteed maximum sum. Guaranteed maximum sum amounts get negotiated between the parties and may include incentives for the supplier or contractor to deliver the work for less than the guaranteed maximum sum. If the work is not completed and the guaranteed maximum sum amount has been reached, the supplier or contractor has to pay for any additional costs to complete the work.

Since in either case it’s the buyer’s money that is being spend, the decision on which approach you use will impact the amount of time you spend managing the supplier or contractor. If you select a not to exceed approach you need to spend more time managing the supplier or contractor as their performance can cause you to need to spend more money to complete the work. If you select a guaranteed maximum sum approach you can spend less time managing the supplier or contractor as you have established the total amount you will pay and if incentives were build in for a sharing of the savings you will pay less.

In some situations you could potentially use both approaches. For example if the work wasn't fully defined you could start the work on a cost plus basis and include a not to exceed amount. Once the work is fully defined you could then negotiate a guaranteed maximum sum commitment.

Limitation Of Liability - What Should Be Excluded ?

In a recent post on LinkedIn an individual asked whether warranty obligations should be included within the limitation amount, which was the value of the contract. That gave me the idea to discuss what should be excluded from the limitations. Limitation of liability traditionally consist of two limitations. The first limitation is on the types of damages that may be claimed. The second limitation is one that places a financial limit on the amount of agreed type of damages that may claimed. For example if the limitation limited recoveries to only direct damages, any financial limit would be on those direct damages.

I have a simple view of limitation of liability provisions. I believe they should only apply to claims between the parties to the contract for breaches of the contract. Based on this I have always sought to exclude costs or damages associated with any third party claims. There can be third party claims by the government for things such as not complying with applicable laws or failure to pay taxes. There may also be third party claims for personal injury, property damage, and intellectual property infringement. Even thought the buyer may not have caused the injury or damages, or been the party that infringed the third party intellectual property right, they may still be liable under the principal of agency. As a buyer you have no control over what the third party may claim as damages. Further for things like product liability claims any attempt by a seller to limit liability would probably be void as against public policy. As a buyer if you don’t exclude liability for third party claims, such as you would find in indemnifications, you can wind up in the situation where the third party can recover significant amounts from you, and you could only recover what may be remaining under the limitation of liability. That amount may have been reduced by other claims.

I also seek to exclude warranty obligations from the limitations. My argument is the limitation of liability should only apply to claims between the parties to the contract. Meeting the requirements of the warranty is an obligation, not a claim. The price you paid is based upon the commitment of the supplier that they will meet those obligations. If you included warranty obligations as part of the limitation of liability amount you would either need to have a substantially higher amount or you could have the situation where because of prior claims, there is nothing left and they could stop meeting their warranty obligations. My argument is that it’s in the supplier’s best interest to exclude warranty obligations from the limit rather than agree to a higher limit to include them. The reason is if the product has minimal failures or need for warranty repair or replacement, all they are doing is increasing the potential recovery amount for other claims.

If you provided the supplier with loaned material or equipment or shared confidential information with them I would also exclude claims for those from any limitation of liability. For loaned material or equipment the best way to manage those is by a separate agreement that would not be subject to the limitation of liability. As most limitation of liability provisions limit the types of damages that may be recovered and traditionally exclude lost profits, you need to exclude breach of any confidential information. The primary damages you sustain for the breach of a confidentiality obligations is lost profits. It’s better to manage confidential information under a separate agreement where it would not be subject to the limitation of liability provision.

As a buyer, I would never agree to a limitation of liability cap amount at the amount of the contract and have that include everything unless I had one hundred percent certainty that there would be no third party claim and the impact to me of any failure to perform and my cost to recover would be no more than what I paid. There are very few, if any, contracting situations that I’ve run into where that would apply. If you are going to agree to have a financial cap on the limitation of liability, the amount you should require should be dependent on how many things you have been able to exclude from the limitation. The more you can exclude the lower the cap can be and vice versa, Just as with liquidated damages the amount should be a reasonable estimate of what your damages could potentially be. My personal favorite approach to financial limitation is to have a minimum amount that increases as the amount of the business between the parties increases. If you agree upon a set amount and the business grows your potential risks are bigger and a fixed cap amount may not provide adequate protection.