Tuesday, August 28, 2012

Bond Amounts

In procurement there are two general types of bonds that you may encounter. One type is a bid bond that is used to ensure that the bidder stands behind their bid amount and executes an agreement at that amount. Bid Bonds should be sufficient enough to cover any excess cost of re-procurement if the low bidder is unwilling to sign the agreement. Performance bonds need to cover the amount you would need to pay to complete the work if the supplier or contractor abandoned the work, or failed to meet certain on-going obligations requiring you to hire another party to complete those obligations. Payment bonds cover any contractor non-payments to subcontractors that the buyer could be liable for under Mechanics or Materialman’s lien statutes where a subcontractor could place a lien on the property where they provided services and were not paid. Many times
Performance and payment bonds are issued as a single bond covering both issues. The cost of a bid bond is usually low, to a regular customer of the bonding company they may be provided at not cost. There is not standard cost for a performance bond and the rates will be affected by a number of factors such as:

• The amount of the bond.
• The type of contract being bonded.
• The location of the work.
• The contractor’s financial standing.
• The past job history of the contractor.
• The contractors current work on hand.

Rates usually start at one percent (1%) for low risk situations with highly qualified contractors that have the right risk factors for the bonding company and go up from there, so a contractor with credit issues or financial deficiencies will pay a significantly higher amount that will be passed on to the buyer in the contract price.

There are several factors that should drive the amount of the bonds that are required. A buyer should consider many of the same factors a bonding company would consider:
• The type of contract being bonded.
• The location of the work.
• The contractor’s financial standing.
• The past job history of the contractor.
• The contractors current work on hand.

In addition they need to consider potential inflation and increases in materials or labor costs that may occur in the interim with respect to bid bonds. For performance and payment bonds they should also consider the cost of those bonds versus the value they will provide.

Since bid bonds usually cover a very small period of time, and cover only the additional cost of re-procurement, the amount of any bid bond may be a small percentage of the bid amount. The longer it would take to re-procure something the higher you would want the percentage to be. If the contractor fails to complete the work you would have the following funds to use to pay for another party to compete the work.
• Any amounts not paid to the contractor of the original contract price.
• Any retainage held until completion of the work
• The bond amount to cover the cost.
• You would also have the right to sue the contractor for damages for any additional costs you incur in completing the work that are over and above these three previous sources.

Many times under a performance bond the bonding company may reserve the right to hire another party to complete the work. Their goal is to ensure that the full amount of the bond does not get used. If its clear that the could not be completed for the bond amount they would not exercise their right and would pay the owner the amount of the bond leaving the owner to complete the work. What this does is include another party into the relationship where their sole goal is to mitigate their costs. If you suffered any greater costs you could sue the original supplier or contractor for breach and seek to recover any added costs as damages. If the supplier or contractor had minimal assets you might recover nothing. Conversely, if you had little a highly capitalized supplier or contractor, you wouldn't need a high bond amount or might not need to require a bond. If they failed to complete the work you could sue them for breach and recover any difference in between the contract price and the actual cost to complete the work as damages. I had times where I would bid work and require a performance bond and also have the supplier identify how much they would deduct if we waived the requirement for the bond.

In private procurement where you can be selective of what companies you will allow to bid and could even control what subcontractors were acceptable or not, the decision on bonds and bond amounts becomes a cost versus risk decision. If you aggressively qualify who you allow to bid and hire only companies that have a strong track record of performance with solid financials, the need for bonds becomes less and if you do require bonds the amounts can be less because the risk is less.

In an on line forum one party commented that they preferred to use a letter of credit to cover both performance and payment risks. That’s an option that an owner may prefer as all that is needed is to show the conditions on the letter of credit have been met so the payment needs to be made. The letter of credit does not have the high cost of a bond. It also eliminates having to deal with the bonding company. Few suppliers would like this option as it ties up that portion of their available credit line for the period and would affect their ability to take on other work and finance their operations. To me it’s an option that could work for a contract of a short duration. It would also require very clear conditions that must exist both in the contract and in the letter of credit for the payment under the Letter of Credit to be paid.

Monday, August 27, 2012

Breach – When is a party in breach of contract for failing to deliver?

While there are a number of different types of breach, having a breach requires two basic things. The first is a firm commitment to perform. The second is the failure to meet that commitment. The language that you use in establishing the commitment is the primary factor in determining whether you can claim a breach and whether you would have the right to terminate the agreement and recover damages.

As an example, if you allowed the insertion of the words “time is not of the essence” you don’t have a firm commitment. You would not be able to terminate the agreement for failing to meet a date because you have agreed that timely delivery does not go to the heart of the agreement. Failing to deliver on time would not be a material breach of the agreement that would give you cause to terminate the agreement. If you allowed the insertion of “dates for completion are only estimates, you do not have a firm commitment to meet the delivery date and the net effect would be the same as stating that time is not of the essence.

As an example if you allowed an “efforts” standard to be used in conjunction with a delivery or completion date, such as “best efforts”, “reasonable efforts” or “reasonable commercial efforts” you do not have a firm commitment to deliver by those dates. What you do have is a firm commitment to exercise the stated level of efforts to try to meet those dates. The contractor or supplier would only be in breach if they failed to exercise the specified level of effort. If they provided the specified level of effort and failed to meet the dates they would not be in breach for failing to meet the dates.

To establish a firm commitment for delivery you need to use firm language such as “will” or “shall” in establishing the commitment. That will provide you with a firm commitment where the failure to meet those dates would constitute a breach. Breaches may be either minor or major. A minor breach gives rise to a claim for damages. For example when you insert a liquidated damages provision into an agreement what you are doing is agreeing to accept only money damages for the failure to complete the work on time.

If you want to have the right to terminate the agreement and claim damages you need to establish the failure to deliver on time as a material breach of the agreement. You can do that in your termination for cause section where you specifically state that the failure to deliver on time is a material breach of the agreement. You could also include a statement in the delivery section where you would state that “time of delivery is of the essence of the agreement. That makes it clear that the failing to meet the delivery is a material breach. If you had multiple items being delivered you might also say that “time and rate of delivery are of the essence” so if they are failing to provide all the ordered items on time they would be at breach.

The rights you have under the agreement are always dependent upon the words that you use in establishing the commitment. If you need a firm commitment, use the right words and avoid the insertion of language that changes or waters down the commitment.

Wednesday, August 22, 2012

Delivery – The relation between delivery terms, liquidated damages and the limitations of liability.

If you wanted the supplier to be responsible to deliver on time, you should establish a specific schedule or date for the completion of the work or the delivery of the product or service. As part of establishing that you want to avoid the inclusion of any words that would make the on-time delivery less than absolute. For example you want to use a standard of commitment that they “will” or “shall” complete the work by that date. You want to avoid is any commitment that refers to a level of effort they will use such as reasonable, reasonable commercial, or best efforts. That is because of the fact that if they can prove they exercised the specified level of effort, they will not be liable for damages if the delivery is not on time. The second thing you want to avoid is other language that would water the commitment down. For example, it could be language that states the dates are only estimates or it could be an insertion such as “time and dates of performance are not of the essence of the agreement”. Both of those would eliminate your ability to claim damages for failing to meet the specified dates.

Once you have created a firm commitment to deliver, you next need to establish any remedies for late delivery and any damages that may be claimed. Remedies for late delivery should depend upon how much you need the supplier or contractor’s performance. For example, the following are potential remedies:
1. Cancel the order and charge them the excess costs of cover (the excess cost of re-procurement or the price difference between the amount agreed and the amount you needed to pay).
2. Require the supplier to pay for addition costs of premium freight. I once had a supplier want to place a limit on this because another customer was chartering aircraft and having it shipped and expecting the supplier to pay the cost of those charters.
If you accept a remedy you cannot claim damages for late delivery as you agreed to those remedies.

In lieu of remedies, you could consider damages for breach. There are two areas where these damages may be included in an agreement. You could establish a specific “liquidated damages” term that would establish the rate the supplier needs to pay for each agreed time interval they are late such as a cost per day. Alternatively you could also rely upon the specific limitation of liability provision in the agreement. In all jurisdictions that do not allow penalties, the liquidated damages amount needs to be a reasonable estimate of the damages the party would sustain from the delivery or performance being late. In jurisdictions that allow penalties, the liquidated damages amount could include both actual damages and penalties.

When there is a liquidated damages amount for late delivery, that liquidated damages amount also serves to limit the supplier or contractor’s liability to that amount for the breach of the delivery. If there was no liquidated damages provision, the buyer or client would have the ability to pursue all types of damages that they are allowed to claim under the limitation of liability provision. There is a separate post on “Damages” that you should read that identifies the types of damages that may be included or excluded in a limitation of liability section.

As the limitation of liability provision applies to the entire agreement, it’s important to consider the types of damages that are allowed as that could impact your ability to collect under liquidated damages. For example, if your liquidated damages amount included what would be considered to be consequential damages or loss of profits, and the limitation of liability precluded the payment of consequential damages or lost profits, that would limit the types of damages you could collect under the liquidated damages provision. The best way to manage against this would be to specifically carve the liquidated damages provision out of the limitation of liability section. A “carve out” could be something as simple as: “Except for damages under Section ___ Liquidated Damages, in no event will either party be liable for …...”. By doing that the Liquidated Damages section would be excluded from the Limitation of Liability. If there was a monetary liability cap in the limitation of liability section, you would need to establish whether the liquidated damages payments will count against that cap, or whether they will be in addition to that cap. If you want them to be in addition to the cap, once again you would need to carve those payments out of that cap or make it clear that those payments would be in addition to any amounts recoverable under the limitation of liability.

When you draft contracts you need to read it as the whole document to ensure that each of the individual sections are compatible with the other sections and one section doesn’t serve to restrict or limit what you can recover unless that was specifically your intent.

Thursday, August 16, 2012

As a supplier should you avoid liquidate damages provisions?

If you have ever heard about Yin-Yang you would know that things may be described as positive or negative. Liquidated damages are one of those issues that fall into this. The negative view would see them as a charge you would have to pay if you were late in delivering. The positive view is that liquidated damages serves as a cap on liability for damages. When there is a liquidated damages provision you cannot be charged more than that amount if you are late. If you exclude the clause you could still be liable for damages. The only difference is the other party would need to prove the amount. In the end those damages could be more than the proposed liquidated damages amount.

Whether you should accept liquidated damages or not depends upon several factors:
1. Is the schedule for performance something you can reasonably meet?
2. Do you have the resources to manage and document all the activities that impact the delivery? These could be changes to the scope of work. They could be delays buy the owner or a party working for the owner. It could include force majeure events.
3. Is it a reasonable estimate of the direct damages that they will sustain?

I'm personally more inclined to try to negotiate a lower amount so you cap your liability and push to have a threshold of a number of days late before it triggers the need to pay liquidated damages. If what you sell is a piece of equipment that needs to be shipped and then installed, I would separate the two factors and have two performance measurements. I would make the customer responsible for shipment and import so the on-time measurement for delivery of the product is when it leaves your dock. That way any delays that occur in transit or with the import process don't impact you your performing. For the second deliverable, I would want that schedule to start only after the equipment is at the site and you have bee able to inspect it to ensure that it wasn't damaged in transit. You don’t want the clock for liquidated damages to be ticking if the item was damaged and needs to be replaced!

Tuesday, August 14, 2012

Contract Signatures

Over time requirements for signatures for contracts have evolved as technology has evolved. Each new technology has required that the laws or courts approve the validity of the use of that technology as a signature. The process started with the invention of telegraphs and the use of the Morse code. The next new technology was the invention of fax machines where if a document that was faxed contained a signature the laws or courts needed to accept those as being equivalent to an original signed copy. With the invention of the Internet and establishment of Electronic Data Interchange definitions for sending data between companies the parties needed to agree that transactions that were made using that also were considered be original signed copies of documents. It took the position that the person who claims to have written the message is in fact the one who sent it and the individual that received the message is the one the message was intended to be sent to, making theses electronic messages electronic signatures. To add additional protection, companies have moved to digitally encrypted signatures that are unique to each individual. In all these cases the goal of these different forms of signatures is to show that individual agrees to the contents of the document. For example when you download software via the Internet one of the step in the process is the requirement that you click on accepting the terms of the license agreement. That click is just another form of electronic signature.

One of the problems that you have in contracting is the law on electronic signatures varies by location so there is no consistent law worldwide. Even in the U.S. different states there own laws. If you are contracting with a party in another country, you should always find out what that country requires for enforceable electronic signatures. Even when I use an electronic version of a signature such as sending or receiving a fax or scanned version of a signed copy to expedite the signing, I still want individually signed copy for my files.

My preference is also to use electronic signatures primarily to conduct transactions under the agreement or to perform actions under the agreement. For example, in one company we established a system where authorized personnel of suppliers could log into the system to do certain make certain changes like adding a new part number or change a price where if we accepted that by electronic signatures it would constitute an amendment to the agreement. When I want to use any form of electronic transaction, it’s important to both describe the process that the companies will follow and include a clear statement of intent that the parties agree that electronic signatures and electronic copies provided by any reliable method shall be deemed to be an original.

The last thing I check is whether the individual signing the agreement has the authority to sign it. For example for the process we used to make changes to the agreement electronically. I made sure that access to the system was limited to only those people that had the authority to make those changes for their company and the acceptance of those changes by our company needed approved by individuals that had the authority to make those changes. (See also the blog post on Authority).

Monday, August 13, 2012

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.

Thursday, August 9, 2012

What documents do you put into an agreement?

In a traditional negotiation you may have the Buyer’s bid documents or request for proposals, the supplier’s proposal, with exceptions or assumptions, minutes of each negotiation meeting, etc. While available time is clearly a driver, my preference is to create a clean document that reflects the final agreement. To do that, I put each of the documents under revision control. As items are agreed or taken off the table,
I produce a red-line of each the documents that change as a result of the agreement between the parties. I keeping the originals, and each revision update so I have a record of what was agreed at each point in the process. In the final agreement I include a what’s called a “merger clause” that states that the agreement represents the entire understanding of the parties an super-cedes all prior communications.

The wrong way to do it is to simply incorporate all documents, and rely upon an order of precedence to establish the priority. Using the order of precedence approach only addresses the priority if terms conflict. It doesn’t eliminate additional or different items that are not in conflict. For example, a supplier’s response to a RFP or Bid may have included a number of exceptions, assumptions or addition proposed terms or requirements. The order of precedence will only deal with them if they conflict with a term that has a higher priority. If there is no conflict they become part of the agreement. To eliminate those, you would need to either:
1). Go through all documents to strike out all terms that were not agreed and have all those changes initialed by both parties, or
2) You would need to create a new document that references document and location within the document where it is found and lists what being excluded. That new document needs to be a higher priority that those other documents whose content it is excluding.

Monday, August 6, 2012

Construction Performance Bonds

On my linkedIN group (Contracts Questions and Answers) an individual asked whether the principal can seek to recover any money in case of an on demand performance bond being cashed by the beneficiary? Can the payment be commensurate to the actual loss/damage? I thought I would post and expand upon my answer here.

A performance bond is a financial guarantee that performance will be completed and they are traditionally issued by banks or insurance companies. There are two types of performance bonds. Conditional bonds require the party to provide that the conditions have been satisfied for the issuer to make payment to the beneficiary of the bond. An “on-demand” performance bond does not need to prove that the bonded company was in breach.

There are several factors that will determine whether you could seek to recover monies. The first factor is the actual language that you use to establish an "On-demand performance bond". If you used language to the effect that the on-demand performance bond covers the actual and reasonable damages the other party sustained, up to the amount of the bond, the other party would only be allowed to collect their actual damages, and you could pursue an amount over that amount.

The second factor will be whether the jurisdiction allows or doesn't allow penalties. If there was no limiting statement, and the law allowed penalties, the beneficiary could collect the full amount of the bond even if that exceeded the actual damages. If the jurisdiction didn't allow penalties, their demand against the bond should be based upon their actual damages. If their demand exceeded their actual damages, you could seek to recover excess amounts, claiming that there demand for monies in excess of their damages constituted a penalty that would not be allowed by law.

It's always best to make the intent clear. For example if you contracted in a location that allowed penalties and you only wanted the proceeds of the bond to cover actual damages whether if you used either type of a bond you would want to make it clear that proceeds from the bond can only be used to pay actual damages sustained for breach of the committed performance. Further, if you have a limitation of liability provision that limited the types of damages that could be recovered you would want to make it clear that those same limitations apply any claims made under the performance bonds.