Terms - will they be effective. An example using liquidated damages versus bonuses

Whether a term will be effective will depend upon how you structure it and the words you use.

On a recent post on LinkedIN a writer offered his way to try to drive on-time completion. He would approach the supplier, tell the supplier that his bid or quote was ten percent (10%) too high. Then he would propose to structure the terms where if the supplier completed the work on time he would get paid the full amount. If the supplier was late, the 10% would be considered as liquidated damages and would not be paid.

I offered an alternative approach in which the contract price would be set at the 90% amount, but the supplier would be paid the additional 10% as a bonus if they completed the work by a specific date.

As you can see both approaches are intended to do the same thing. The intent is to use the 10% as leverage to drive on time performance. Both approaches can have their problems. Let's look at which will be effective.

In the bonus approach, if you were the cause of the supplier failing to meet the date they could argue that, but for that fact, they would have met the conditions of the bonus and should be paid the bonus. Most of the time if you caused a delay, the contact and the date they needed to complete the work by to collect the bonus should be extended. If this is done, claims that they should be paid if they failed to meet the extended date would not be successful.

Where the liquidated damages approach runs into problems is when a jurisdiction does not allow for the collection of penalties. Courts will uphold liquidated damages as long as the liquidated damages represent a reasonable estimate of the damages that would be incurred. If you were a supplier that was in one of those jurisdictions, you would argue that the 10% did not provide a reasonable estimate of the damages that would have been sustained. As a result a large portion of the liquidated damages represents a penalty that should not be enforced. In a suit the court would look at whether the amount establish was a reasonable estimate of the damages that would be sustained. In this example, unless you could prove that the amount of damages sustained would be the ten percent or greater, the court would allow only the actual damages. Any difference between the actual damages and the 10% would be considered a penalty that you could not collect.

If you were in a jurisdiction where penalties were allowed, the courts would not look at whether the amount was a reasonable estimate of the damages. It would simply be what the parties had agreed and that would be enforced.

The bonus approach works in both types of jurisdictions simply because the parties had agreed that the contract amount was ninety percent of the supplier’s proposal. They were given the opportunity to earn the bonus if they delivered on time. If they failed to deliver on time, they failed to meet the condition required for the payment of the bonus. The buyer would not be obligated to pay the bonus. Since the term describes a bonus rather than liquidated damaged, it would not be subject to the court determining whether the bonus was reasonable or not. It's what they agreed.

In this case what you called the 10% would impact not just what you could retain if you didn't get the performance, in jurisdictions where penalties are not allowed structuring it as a liquidated damage may not provide the leverage you want. If the supplier knows that the amount can't be justified, they will weigh what they feel would be the actual damage against any premium costs that it would take to complete the work by the required date. They would then make a business decision on which was going to cost them more. If they determined that it would cost more to take all the necessary actions to complete on time than what the real liquidated damages would be,
they won't make those additional investments to complete on time.


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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.