Should Customers Include Liquidated Damages Clauses?

When was the last time your Liquidated Damages clauses provided a genuine remedy for a supplier’s poor performance? Even if a supplier paid service credits did the money resolve the problem? And, how many times did a supplier pay Liquidated Damages and continue not to perform?

These are the questions we ask clients when they want to include Liquidated Damages in their contracts. Our philosophy is that the customer wants performance, not spare change from their supplier’s pockets. Suppliers want to perform and not pay Liquidated Damages. However, we’ve yet to meet a customer stakeholder—whether in legal or in finance—who truly understood the limitations of Liquidated Damages or the superior contract mechanisms for driving performance. Should customers include liquidated damages clauses or is there a better way to drive supplier performance?

This article will provide contract professionals on both the buy-side and sell-side with an understanding of the limitations of Liquidated Damages and provide two contract mechanisms that will do a better job of assuring performance.

Three Reasons Liquidated Damages Don’t Work as Intended

#1 LDs need to be defensible

Liquidated damages are meant to make the non-breaching party whole after the breaching party misses a critical obligation. To avoid being interpreted as a penalty, which is not permissible in U.S. law, the parties (1) have to calculate the anticipated damages in advance of the breach, (2) the amount of anticipated damages must be reasonable vis-à-vis the harm, and (3) the imposition of Liquidated Damages must be justifiable for the lack of performance.

In our experience, each of these elements can be attacked by the breaching party. The breaching party can assert that the non-breaching party cannot prove that the calculations were based on data or facts which can be tied to a financial loss. Many finance departments don’t have enough data to defend the amounts they require. So, the Liquidated Damages can be interpreted as overpayments of actual damages. Finally, rarely is non-performance solely one party’s fault, which leads to the next reason why Liquidated Damages are good in theory but often don’t work in real life.

#2 LDs “penalize” partial offenders

If the breaching party is not in total control of the situation that causes harm, the threat of Liquidated Damages simply acts to inflate what the customer must pay for goods or services. Delivering products in today’s market requires so many supply chain interfaces that holding one party accountable does little to assure performance. It simply drives risk premiums which inflate overall costs.

#3 LDs Are a Spreadsheet Shell Game

Truth be told, both parties use spreadsheet shell games. For example, Jeanette was involved in a post-award dispute where the buying organization failed to include $60,000 of necessary services in the master contract, while the same supplier told the buying company it would miss a key delivery deadline triggering a $50,000 payment in the form of Liquidated Damages. One senior leader wanted to propose that the supplier perform the services instead of paying the Liquidated Damages. That solution was not reasonable, but to add insult to injury the missed deadline impacted the delivery of goods and the Director of Operations was not aware of this scheme! It was all a numbers game. Ultimately the supplier found a way to deliver on time and the senior leader “found the budget” for the missing services.

So, what can you propose to your organization to drive supplier performance?

Two Ways to Drive Performance

Metrics Matter

Many buying organizations use the same metrics over and over without considering if what is being measured will actually track, let alone, drive performance. If performance is an issue, then the two organizations will have to customize their metrics. Drafting metrics is not hard, but it does require knowledge about the work being performed, the party’s capabilities to objectively measure that work, and the ability to spot problems before they cause damage. And that leads to the second way to drive performance.

Governance, Governance, and More Governance

Contractual governance mechanisms provide a basis for making future decisions, a process for resolving issues, and removes the need for a charismatic character to drive performance. But, for governance to work the parties need meaningful metrics, and a business case and baseline to measure against.

Many buying organizations drop the post-award contract management ball. The lack of meaningful conversations and oversight leads to the kind of problems that cause customers to levy Liquidated Damages. In some organizations, this is seen as a badge of honor, rather than as a failure of effective governance.  

If performance is your goal, by far the best way to incent supplier behavior is to measure and manage for performance. For example, safety is priority number one at a public utility client of Jeanette’s. They know that levying Liquidated Damages for safety violations does not keep people safe, so they flow down their safety culture in their contracts instead. And, it works! Very few suppliers report preventable injuries. Safety training and programs, stop work provisions empowering every person on the job site, daily tailboard meetings, and other mechanisms proactively prevent injuries.

I foresee a future in which companies collaborate frequently with their supply base and with intentionality to achieve business goals. The old school method for shifting risk from one party to the other through Liquidated Damages will not—and probably never did—drive performance. Shifting to proactively monitoring performance with meaningful metrics rather than ad hoc levying damages after the fact creates best-in-class contracts that deliver results.