Monday, March 25, 2013

Liquidated Damages. (Updated & Consolidated)

A Supplier may try to limit the potential liability in many different ways.
•Limits on the type of damages that may be recovered.
•Limits on the amount of damages that may be recovered.
•Limits on various types of claims.
•Limits on total liability for the contract term.
•Limits on liability for a defined period such as annual limits.
•Limits on liability per occurrence.
•Limits on the types of costs that may be recovered.
•Limits on other remedies.
•Limits on individual costs.
•Limits on periods when claims may be made.
•Limits on individual charges.
•A threshold that must be met before it triggers a right is a form of limitation.
•The standard of commitment used limits what the Supplier is responsible for.
•Refusing to accept certain terms and responsibilities limits the Supplier’s exposure.
•Any liquidated damages provisions also serve as a limitation on the Supplier's liability
For examples of each of these see the post “Limits of Liability.”

I had previously written three posts on liquidated damages and this post expands upon and will eliminate those previous posts.

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. Liquidated may also be applied in other manners. Depending upon the applicable law agreed in 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 liquidated damages amount to include 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 a reasonable estimate of the potential damages would be considered penalties and would not be recoverable. Recovery is 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.

When you have agreed liquidated damages the party does not have to prove that they sustained that level of damages. From an equitable perspective that works as there can be situations where the damages could either be far higher or far less. The party being protected against having to pay those higher amounts still has to pay the agreed liquidated damages amount even if their actual damages are less because that was what the parties agreed.

Depending upon whether you are the buyer or supplier/contractor you will have a different view of liquidated damages. In creating or negotiating liquidated damages clauses both parties need to:
1. Define them clearly at the time of contract formation:
a) What are they?
b) What is the scope they apply to?
c) What is the trigger that allows claiming them?
d) Is the trigger clearly defined?
e) If applied for failing to complete on time, is there a clear definition of what completion means?
f) What is the amount of liquidated damages?
g) What is the measurement unit?
h) What is the math used to calculate them? (If it’s not clear include an example to show the intent)?
i) If you agree to a per unit rate, is the total amount limited?
j) Are there exceptions or exclusions to payment such as delays or problems caused by the other party?
k) If there are multiple liquidated damage payments being included in a contract, you need to check a-h for each scope or deliverable that a liquidated damages payment is linked to.
l) Is the final result compatible with the limitation of liability provision in the contract or does it need to be carved out of that clause?
m) Should there be a grace period prior to collection? Normally this would be established as part of establishing the trigger.
n) Is the amount established a reasonable estimate of the potential damages?
o) Will they be enforceable under the governing law of the contract?
p) From a supplier / contractor perspective is this a risk you can manage and afford?
q) From a buyer perspective will the amount cover your damages and will it be high enough to help drive the supplier to perform as desired.
r) Does it make sense to include them or are there other remedies in the contract that can make the non-breaching party whole?
s) In conjunction with liquidated damages suppliers may propose incentives for early completion under the argument that if they will get penalized if they are late, they should be rewarded if they are early. In those situations the Buyer should determine if early completion provides a value (it may not). Another word of caution is that any time you include incentives you open yourself to potential claims for any delay or problems you cause, as the argument will be that but for your acts the supplier would have earned the incentive payment.

A supplier shouldn’t view liquidated damages as a penalty. Liquidated damages is just another form of limitation of liability in the event of a breach. Without it, if you were to breach the agreement you could be subject to all types of damages allowed under the agreement up to any financial cap on total liability. Where it’s extremely important for suppliers to want to include liquidated damages is when the potential for direct damages 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 have a lesser need to include a liquidated damages provision for their protection.

Buyers want to include liquidated damages provisions for several reasons. The first reason is to help drive the supplier to perform on time to avoid the payment of those damages. Without liquidated damages you would need to go to court to prove you actual damages, which is both time consuming and costly. With liquidated damages agreed you don’t need to prove actual damages, all you need to prove is that there was a breach of the commitment that was subject to liquidated damages. 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 usually shows me that they don’t have the confidence they will meet the schedule. If the schedule is critical I may select a different supplier as a result of their unwillingness to accept liquidated damages. If all potential suppliers were to push back on the inclusion of liquidated damages, that is normally a sign that your schedule is too aggressive and may need to be changed.

How liquidated damages are structured will normally be determined by contract type and the subject matter. For example, in construction contracts with a prime contractor or between the prime contractor and the subcontractor liquidated damages may be based upon timely completion of the project. In that use it is usually structured on a day for day basis for every day the party is late. While you are limited in what you can collect per day, you are not limited in what the total amount that they can be liable for. Many times the party that could be liable for liquidated damages may want to establish a secondary limitation or cap to establish a maximum amount.

If you had a Engineer Procure Construct (EPC) contract you could have multiple liquidated damages specified - one for completion of design, another for completion of construction, another if the engineering design portion does not meet commitments such as output, etc. In those situations you could have liquidated damages for each major deliverable. The liquidated damages in that situation could also be structured differently. The design and construction milestones or completion dates could be based upon day for day amounts, where delays in the design might have a lesser amount of liquidated damages than the day for day amounts for completion of the construction. Liquidated Damages for failing to meet an agreed output might be based upon the diminished value of the work over the useful life of the constructed works. In those situations the payments could be structured as a per unit rate where the buyer or owner allows the supplier a reasonable period of time to correct the work to meet the committed output after which there would be a lump sum liquidated damages payment established on a formula of what the losses would be over the remaining period of the useful life, taking into account that
Few, if any, things will provide 100% output for the useful life as a result of shutdowns for maintenance, repairs, etc. Those types of liquidated damage provisions can be extremely complex and include a number of assumptions and formulas to establish them.

In other types of contracts you can have multiple deliverables and could have liquidated damages on each where the amount needs to tie to the damages sustained for the breach of that deliverable. For example in a purchase of electronic products I am always concerned about what’s called an “epidemic defect”. An epidemic defect exists when the defects for a specific product type or part number are in excess of an agreed quality or reliability levels. I might have a per-unit liquidated damages amount for each individual defective product that exceeds the epidemic defects threshold. In that situation the total amount of the liquidated damages could well exceed the value of the contract and suppliers will usually want to manage their total risk exposure by placing a cap on the total amount of that type of liquidated damages the buyer can collect.

Liquidated damages can further exist in a number of other areas such as services where there is a fixed amount agree either in total or by unit measure for breach of a commitment. When I did banking contracts I would include liquidated damages amounts for downtime on services in excess of what was the agreed amount of downtime for things such as transaction processing. For services that were required to be performed on a daily basis where the supplier failed to perform them, I would have liquidated damages equal to their per day compensation. For example if you had remote ATM Machine locations with contractors hired to clean them, if they failed to clean them the liquidated damages would be what they would be paid if they had cleaned them.

The constant battle in negotiating liquidated damages provisions is the goal of the supplier will always be to limit or control their potential risk and level of exposure. In contract the buyer or owner will want to ensure that the amount does not leave them with damages they will sustain that are far in excess of what the supplier is willing to assume. A key fact to remember in the negotiation is liquidated damages is a limitation of liability on both parties. For the contractor it limits the amount the owner can recover. For the owner it limits the amount they can claim. There is a balance to liquidated damages. When the owner and contractor agree upon liquidated damages the owner is giving up the right to collect more that that amount even though the actual damages could be far greater. The contractor is giving up the right to pay less than that amount if the owner incurs less. 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.
Whether liquidated damages will improve performance will always 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 damages, it won’t drive performance. If liquidated damages aren’t realistic, they will drive additional cost from the supplier that has to assume the additional risk if they are even willing to accept those risks.

Some people express concerns about whether liquidated damages would affect the relationship. The point I make is that collecting liquidated damages are a contract right, not a duty. That means the buyer doesn’t have to enforce them. They 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 liquidated damages from a buyer perspective is you never want to provide a contractor or 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. That means that you have to be very careful in agreeing to any cap that will limit the amount of liquidated damages you may collect.

There are two primary ways to collect liquidated damages. One is to use the common-law right of set-off or offset where you deduct it from any payments due to the supplier or any monies retained from the supplier. If there is not sufficient funds available to set off against or if the contract prohibits the right of set-off, to collect you would need to follow a normal collection process that could wind up in litigation.

For a contract drafting tip, always read any liquidated damages clause in conjunction with the contract’s limitation of liability provision, as that could limit what you can collect under the liquidated damages provision. For example if there was a maximum cap on the contract liability, other contract claims that are not subject to the liquidated damages provision will also be counted against that cap and that may reduce the effective amount of the coverage from your liquidated damages provision.

If you are representing a supplier in negotiations, I would expect to see you use many of the 14 ways to listed in beginning of the post to try to limit your potential liability. You may want to get the sale, but you don’t want to bet the business to get it. If you do, you may not be in business long.