“Liquidated damages are damages whose amount the parties designate during the formation of a contract for the injured party to collect as compensation upon a specific breach (e.g. late performance).”
Liquidated damages clauses are frequently incorporated into contracts as a method to incentivize performance and an efficient way for the injured party to achieve compensation. They are intended to represent a reasonable estimate of the financial harm that will occur as a result of a specific shortfall in performance and hence tend to have application to particular issues, such as late delivery or failure to meet a specified level of performance. In that limited context, they represent an alternative to contractual provisions such as the Liabilities clause, but do not replace it.
There are several factors to take into account when considering the use of a liquidated damages provision.
- The criticality of supply.
- The extent to which it is possible to pre-estimate damages.
- The impact on price and behavior.
- The possibility of alternatives that may be either more appropriate or more effective.
Not all acquisitions are equal and your ability to deal with supply delays or disruptions will vary. A liquidated damages provision is a relatively blunt instrument, and it is wise to think strategically before it is included in the contract. Some years ago, IACCM undertook research that showed 96% of organizations made regular or occasional use of LD clauses, but at that time only half accurately monitored performance and less than 25% invoked their right to collect damages.1 A major reason that buyers gave for not pursuing their rights was that ‘collecting LDs will damage the relationship’. Although automated performance monitoring is likely to have increased since that survey, there is little reason to believe the overall picture has significantly changed.2
Therefore, we suggest that LD provisions should be viewed as one option in the armory of contract terms and before deployment, it is smart to ask the question ‘Given the nature of this acquisition or the nature of our supply relationship, is this something we would impose?’ If the answer is no, then think of alternatives.
As a general principle, care must be taken to ensure that the liquidated damages are a genuine pre-estimate of the loss that would be suffered on the occurrence of a particular event. If they are not, and the court views them as a penalty, they will not be enforceable. This again points to the need for thought, both in terms of whether it is possible to make an accurate pre-estimate and therefore whether it makes sense to include an LD clause. This works both ways in that if your estimate can be challenged, the LDs may not be enforceable, but also if you make a significant under-estimate, you may have limited your ability to recover.
Impact on price and behavior
Rather like imposing a requirement for an insurance policy, an LD clause may carry an incremental cost. At an IACCM executive roundtable conducted in 2015, a group of suppliers admitted that they include provision for paying LDs in their price. The possibility to do this naturally varies depending in large part on levels of market competition. But in environments where there is extensive competition, LDs may in any case serve limited purpose since you may be able to rapidly shift the source of supply. So if their use is typically when you are buying more complicated or specialist products, there is a greater chance that you are in fact paying for your own LDs! An interesting way to test this is to include an LD clause and then ask what discount you can have if it is removed.
One of the biggest factors to consider is the impact an LD clause will have on counter-party behavior. It is important to remember that your purpose is not to collect LDs, it is to incent delivery and avoid direct and consequential losses. A key factor in avoiding loss is the ability to mitigate and the ability to mitigate is on large part determined by open communication and joint problem solving. The earlier your supplier provides warning of a problem and the more they collaborate in providing a solution, the better the chances that you can limit or eliminate the problem.
So what is the impact of an LD clause? It constrains the flow of information. By providing early warning or being transparent, a supplier essentially acknowledges fault and renders itself liable for the LDs.
Therefore, when it first becomes aware of a likely default, the typical behavior within a supplier organization is a) to withhold that information and b) start compiling evidence or reasons why it can apportion blame onto the customer.
Hence the earlier point that collecting LDs is often at the expense of the relationship.
As previously stated, LD provisions have a role in encouraging performance, but should not be used without careful thought. So are there other ways to incentivize suppliers?
- Consider the possibility of a graduated form of LDs. If you are in fact trying to avoid problems and recognize that this is more likely to be achieved if you are given advance notice, consider a form of ‘graduated LDs’. For example, if I am alerted at least 90 days before the event, you require the supplier to work with you to identify a solution and impose a charge of (say) 1%; at 60 days, perhaps that becomes 2% …. And so on, until if you are given no warning it becomes 8%.
- Consider the impact of reputation risk. Given the humanitarian purpose of ARC, suppliers are unlikely to want the publicity associated with letting you down. Might you leverage this by a clause that enables publicity in the event of a supplier’s non-performance, perhaps even requiring that they join in that public acknowledgement.
- Can you be more precise and targeted in your compensation? For example, rather than a generic LD clause, might you instead require the supplier to recompense you for any additional price you have to pay when securing supplies from an alternative source.
- Consider a positive incentive, rather than a ‘punishment’. For example, perhaps offer a performance bonus for consistent on-time delivery. This could be in addition to the contract price, or it could be as some form of withheld percentage of the price. Think through other incentives – for example, a supplier endorsement or willingness to give references; the prospect of additional business.
Ultimately, contracts and their terms should be designed to ensure clarity of rights and obligations and structured in such a way that we optimize the likelihood of those rights and obligations being fulfilled. The various provisions relating to indemnities and damages have an important role to play, but they should be viewed as providing a ‘last resort’. Our goal is to avoid the need to invoke them.
As the previously cited IACCM research report concluded: ‘Where such clauses may retain their value is in more transactional situations, where the prospect or value of a long-term relationship is less significant or non-existent. Certainly the ‘pain' of perceived penalties may induce performance - if, of course, the offended party takes steps to enforce them and the offender actually pays. Again, experience suggests that the result is often a dispute and finger pointing - so lack of ambiguity and good contract management records are critical to success.’
Therefore, we recommend that Liquidated Damages be used thoughtfully and with caution. This paper suggests the points that should be considered and possible alternatives to their use.
- IACCM research report ‘Contract Performance Incentives’ available in the World Commerce & Contracting content hub at https://www.worldcc.com/Resources/Content-Hub/View/ArticleID/6409
- It should be noted that this percentage is much higher in the context of service level credits, which are administratively much easier to manage.
Copyright World Commerce & Contracting 2020.
Disclaimer The content of this article does not, and is not intended to, constitute legal advice; instead it is provided as general information only.
Content reflects views and opinions of the author and do not necessarily reflect the views and opinions of World Commerce & Contracting.