In an ideal world, each party to a commercial contract would perform its obligations faultlessly at the first time of asking. However, the reality is that like all relationships, the parties are likely to go through some sticky patches. The customer’s primary obligation is to pay the fee for the goods and services. The supplier’s primary obligation is to deliver.
In most cases, the customer will want the services performed or the goods delivered, rather than compensation, and as such, incentives in the contract to ensure supplier performance should be engineered to do two things: (a) drive the right behaviors, and (b) provide an avenue for compensation or rectification if things go drastically wrong.
Liquidated Damages (or LDs)
LDs are a genuine pre-estimate of a party’s loss for a breach of contract. Under contract law, there are generally two types of breach – those that go to the heart of the contract and give the innocent party a right to terminate and claim damages, and those that are “run-of-the-mill” breaches, which only allow a damages claim. Damages can be difficult to quantify, prove and recover.
LDs, which the parties agree between them, take the hassle out of the process by stipulating an agreed sum that the customer can claim if there is a breach. For example, if the parties have agreed a specific time for delivery, there may be an LD attached which states that a certain percentage of the order value will be refunded for each day that the delivery is late (up to a certain point).
They main issue to remember with LDs is that they must be a genuine, fair and reasonable pre-estimate of loss, otherwise they risk being struck out as a penalty. An innocent party can’t make a profit from a breach, so any excessive amounts charged are unlikely to be enforceable. In addition, the same amount should not be charged for every breach, as it may not be fair or proportionate.
Parties may have multiple contracts, or may have an obligation to pay each other under a single contract. Using LDs as an example, if the supplier owes the customer damages, and the customer is due to pay the supplier for the service, then a right of set-off allows the customer to deduct what the supplier owes in LDs from the amount the customer owes the supplier.
Taking this a step further, if the parties have more than once contract, allowing the right of set-off across all of them allows the customer to set-off any amount owed under other contracts against what he owes. This ensures that the supplier is incentivised to pay any amounts owing to the customer in a timely fashion, as well as encouraging contractual performance to avoid accruing LDs.
If a supplier is unable, unwilling or otherwise prevented from performing the services, the customer may ask for a right to “step-in” and ask a third party (or by itself) perform the services to ensure there is no loss of continuity. Any payment obligations to the supplier are suspended. If invoked, the supplier runs the risk that the customer will not “step-out” and/or they will lose the business to a competitor.
If the contract is for a long period, the customer will want to ensure that the prices charged remain competitive. Apart from regular reviews, or index-linking the charges so that they move with the market, the customer can ask for a benchmarking clause. This would allow the customer to compare the prices being charged with comparables across the same industry for the same or similar services, and if there is a reasonable discrepancy, insist that prices are lowered in the contract to account for the difference. These clauses usually only operate in a downwards direction and are best used when there are sufficient comparables (such as in the delivery of goods).
There are many other forms of incentive to keep suppliers honest – such as escrow clauses which allow the customer access to the software if there is a material breach, and dispute resolution clauses which escalate issues to senior management, but the key is the same – driving performance of contractual obligations rather than compensation.