Liqduiated damages: incentives and motivation in IT contracts
What do liquidated damages have to do with incentives? All economists love to talk about incentives. Incentives are simply a way of explaining why people do what they do. For example, why do people (usually) pay their taxes? In other words what are the incentives for individuals to paying a large chunk of your hard earned money to the government where it may not even directly benefit them? It could be for moral reasons because they are honest and don’t want to break the law, or because they feel a social obligation to help others in society, or because of self-interest to avoid punishment as they don’t want to go to jail (remember the IRS caught Al Capone not the police). This two part article will explore how customers can use the basic economic theory of incentives to help ensure a supplier is motivated to perform its obligations under an IT contract on time and to the required standard.
How can a customer use incentives to ensure a supplier performs?
If you are a customer engaging a supplier to provider almost any type of technology or construction project the perennial problem is trying to ensure that the supplier completes the project on time, within budget to to the agreed specifications (ie. the iron triangle of avoiding project delay, cost overrun and poor quality of service). Incentives should be at the heart of a well drafted and structured commercial contract and the contract should contain provisions rewarding good performance and discouraging bad performance by the parties. Taking the example of an IT software development contract, how can a customer use incentives to ensure that the project to implement and maintain customised software is delivered on time, meets the customer’s specifications, and the supplier stays within budget? One common way of achieving this is for a customer to insert a liquidated damages (LDs) clause into the contract. If the incentives in the contract are thought of as the ‘carrot and stick’, liquidated damages are the ‘stick’ as they compensate the customer and financially punish the supplier if the supplier does not perform to the metrics specified in the contract.
Liquidated damages are a pre-agreed amount for default or late delivery
The usual position is that damages are unspecified or ‘un-liquidated’ in a contract and in the event of a claim the parties leave it up to the court to assess the amount of damages. On the other hand, if the parties specify an amount to be paid if there is a breach (or some other specified event or default occurs) during the term of the contract then the damages amount is a called liquidated damages. Liquidated damages are a useful method of motivating the supplier to deliver each of the agreed milestones of the software development project on time or if the actual damages for late delivery are difficult or impossible to calculate accurately before the project has even begun..
Liquidated damages can help both parties
Liquidated damages provide a clear monetary incentive for the supplier to perform certain contractual obligations, for example delivering a project (or certain project milestones) on time, as the supplier will be financially punished if they do not. However, including a liquidated damages clause can actually help both parties. For example:
- The customer does not have the difficulty and expense of proving the actual damages it has suffered as a result of the supplier’s delay or failure to meet a service requirement.
- The supplier has more certainty regarding its commercial risk profile in relation to performing the project, including its exposure if something goes wrong. Moreover, before signing the contract the supplier will normally have a chance to negotiate the actual amount of the liquidated damages rather than leaving this up to the court if there is a claim at the end of the project.
Ensure liquidated damages are not a penalty
The courts will generally try to uphold provisions in commercial contracts that have been freely entered into by parties of comparable bargaining power. However, when drafting a liquidated damages a customer must be careful to ensure that the provision is not deemed to be a ‘penalty’. If a liquidated damages clause is found to be a penalty the provision will be unenforceable or void. Very broadly, a penalty is a financial obligation that has been held to be a punishment, unconscionable, or manifestly excessive. A court will not uphold a liquidated damages that unless it is a genuine pre-estimate at the time of making the contract of the anticipated loss that the innocent party will suffer if the other party is in default. It can therefore persuad a court that the amount is not a penalty if the parties include drafting in the contract stating that “both parties agree that the liquidated damages are a genuine pre-estimate of the likely loss to the customer arising as a result of the breach and are not a penalty“.
Stating liquidated damages are ‘sole and exclusive remedy’
English case law suggests that a simple liquidated damages clause in a contract is evidence of the parties intention to limit the damages recoverable for the stated event to the specified liquidated damages. However, in the event the contract contains a more complicated liquidated damages regime, a useful approach is to include a clause stating that payment of liquidated damages is the customer’s sole and exclusive remedy for the supplier’s failure to meet a milestone or complete the project and other remedies or payment of damages are excluded.
Interaction with the liability cap
To assist with commercial certainty nearly all suppliers try to limit or cap their liability for causes of action such as negligence and breach of contract to an amount commonly known as the liability cap. From a supplier’s perspective it is important that the drafting of a liquidated damages clause clearly states that any liquidated damages that the supplier pays to the customer will be subtracted from the overall liability cap. This helps provides the supplier with certainty regarding its total financial exposure to the customer under the contract and stops the customer trying to ‘double-dip’.
Negative aspects of liquidated damages for customers
Supplier will increase price and cap LDs
If you are reviewing a contract on behalf of a customer you will often find that the supplier’s standard-form contract does not contain a liquidated damages clauses. During the negotiations stage a customer can propose including liquidated damages in the contract. However, in my experience suppliers will argue that the supplier’s quoted price for the project does not take into account the risk of the supplier incurring liquidated damages for delay. Accordingly, in return for including liquidated damages, the supplier will often request an increase in the total project charges and cap the total amount of liquidated damages that it is liable for.
Extension of time / customer dependencies
The supplier will also claim that there are usually certain inputs and deliverable that the customer will be responsible for providing in respect of the project (sometimes known as ‘customer dependencies’). If the customer does not provide a customer dependency on time or to the required standard the supplier will usually insist that the contract provides the supplier with a right to:
- an extension of time;
- the payment of additional costs by the customer; and
- relief from liability to pay liquidated damages.
Alternative to liquidated damages: KPIs and bonus incentives
Despite their benefits shown above, liquidated damages clauses can be time consuming, expensive, and difficult to enforce. As suppliers generally feel that a liquidated damages regime is a negative approach and they are being penalised they will also vociferously argue for the customer to remove any liquidated damages provisions from the contract. However, there is another group of positive incentives that can motivate the supplier and reward good performance, which I will discuss in Part 2…
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