Liquidated Damages (LD’s) are a misunderstood and emotive concept for procurement specialists.
A starting point for clarity is the fact that in English Law a penalty clause is illegal. An LD clause is penal if it provides for payment of money stipulated as ‘in terrorem’ of the offending party to force him to perform the contract. The fact that the payment is described in the contract as a ‘penalty’ or as ‘liquidated damages’ may be relevant but not decisive. The purpose of any damages is to place the claimant in the position in which it would have been had it not sustained the wrong.
English courts have heard many cases where LD’s lie at their heart.
Such a case was Pegler Limited v Wang (UK ) Ltd (TCC) [2000] IT. CLR617.
The defendant supplier has admitted liability and the court had to assess damages. The Judge agreed that Wang’s conduct had been ‘appalling’, but stressed,
‘My task is to assess compensatory damages. It is not open to the claimants on this case to claim either aggravated or punitive damages. The purpose of compensatory damages is to compensate not punish. The question is not what Wang deserve to have to pay, but what Pegler can prove is its entitlement in compensation’.
It is always informative to scrutinise actual LD provisions as drafted in a real contract. A good example was related to a shipbuilding and ship repair contracts. It is not uncommon to see an LD clause for delay in delivery. It will be computed on a time basis (daily, weekly or monthly) e.g. £5000 per day of delays or based on a percentage of contract sum, e.g. 0.1% of the contract sum for each day of delay. There is often a cap on the amount payable, often 5% or 10%. LD clauses are negotiable, assuming the contracting strategy decrees that LD is an appropriate way forward.
If you’re reading this in the UK you should note that there is ‘custom and practice’ wherein a typical LD clause will have a deduction of 1% (0.5%) per week up to a maximum of 10% (or 5%) of the contract sum, or milestone if that is what LD’s are being applied to.
The following points are worthy of consideration:
1. There is nothing in law that decrees 1% – we’ve negotiated 7% for highly specialised courier services where prompt distribution was ‘mission critical’.
2. There is nothing in law that decrees the period of time must be a week. In an aerospace support contract we’ve negotiated ‘one hour’, where safety critical parts supply could cause an AOG (Aircraft On Ground) situation.
3. There is nothing in law that decrees 10% must be the financial cap, although it can be recognised that in practice the supplier/contractor will want the cap as low as possible to limit their liability under the contract.
4. By the way we don’t believe in granting a ‘grace period’ before the LD provision kicks in. This acquiesces in delay. If a date has been agreed by both parties, then the date should be honoured.
Returning to the consideration of a ‘penalty’, a sum will be construed as a penalty if: –
it is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breech.
Procurement should encourage a debate on what is the genuine pre-estimate of loss. It is that, that should determine the LD provision.
– if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid, and
– there is a presumption (but no more) that it is a penalty when a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others but which are minor damages.
The test as to whether a clause constitutes an LD provision or a penalty was set out back in 1914 by Lord Dunedin in
Dunlop Pneumatics Tyre Co Ltd v New Garage and Motor Co [19.5] AC79.
There are legal grounds on which LD’s can be challenged, namely:
– the provision is invalid or void for uncertainty
– on a true construction of the provision, it is not applicable to the event that has occurred
– the provision is a penalty
– the material contractual machinery is operable or broken down
– there is a condition precedent to the applicability of the LD provision e.g. a certificate of non-completion, that has not been satisfied.
Useful?
Some pointers that may help you re-appraise your organisation’s approach to LD’s. Not forgetting that LD’s are one facet of Damages and that there are very wide contractual and business considerations to be taken into account.
Thanks
Ray
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