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.