The purpose of, in general, liquidated damages in procurement contract is to increase certainty and avoid the legal costs of determining actual damages later if the contract is breached. But what is Liquidated damages in procurement contract, when should the clause be used and what can we expect to achieve?
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Remedies available and Liquidated damages.
If the supplier is unable to perform its obligation according to contract, there is a range of remedies available. In most cases buyer wants to the supplier to preform according to contract, for example repair of a product which is damaged at delivery.
In parallell to the remedies related to the goods, buyer should always have the possibility to be reimbursed due to damages caused by the suppliers inability to perform according to contract. These costs could be direct and indirect.
If the costs due to supplier’s non-performance is pre-defined in the contract, it is called liquidated damages.
One very common variant of reimbursement is cost incurred due to supplier delay and is defined in relation to the value of the Purchase order.
If you would go to the Supplier portal of a buying company, that publish their General Terms of Purchase, you can probably find examples of this type of clause. Here is one example from Hexatronic.
“If the Products are not delivered within the agreed time due to circumstances for which Supplier is liable, Purchaser shall, for each commenced week of delay, be entitled to liquidated damages amounting to one (1) percent of the relevant Purchase Order price. The liquidated damages shall however not exceed fifteen (15) percent of said price. If the delay is material, Purchaser shall be entitled to cancel the Purchase Order and to terminate the Agreement. If the Purchase Order and/or Agreement is cancelled, Purchaser shall be entitled to additional compensation, in case the actual damage exceeds the liquidated damages.”
Two perspectives on Liquidated damages in procurement contract.
Incentive
Liquidated damages in procurement contract is also called LD.
The purpose of the clause, from buyer side, is not to make money on supplier delay, but to create an incentive for the supplier to perform according to contract and delivery on time. 1% of the Purchase order price per week, as in the example above, is a significant share of supplier’s profit margin and the cap (15% in above example) should be set to completely remove any supplier profit.
If of the liquidated damage per week is set too high, the supplier will include the potential extra cost in its price and buying side have created a less cost efficient supply chain.
Risk Mitigation
The buyer certainly have costs due to supplier delay and want to share this cost with supplier and distribute risk among the parties in the supply chain. There are multiple ways to mitigate risk of supplier non performance (having extra quantities in stock or dual source to name a few examples).
In general all procurement contracts shall have a LD clause. And most important is that the buyer negotiating the contract are comfortable in not only explaining (to the supplier) the LD clause in it self, but also the risks being addressed.
Learn more about Liquidated damages in procurement contract
Learn more in Jon Kihlmans course International Sales Law: Remedies for breaches of contract which provide an understanding of remedies for breach of contract in International Sales Law
It is crucial to understand the remedies available to buyers in the event of a breach of contract. International sales contracts, often governed by frameworks like the United Nations Convention on Contracts for the International Sale of Goods (CISG), provide specific remedies for buyers to ensure fair dealing and compensation.
Direct and indirect damages
In procurement contracts, the distinction between direct and indirect damages is crucial for understanding the extent of liability and potential compensation in case of a breach or failure to meet contract terms. Here’s a breakdown of the differences:
Direct Damages
- Definition: Direct damages are those losses that arise naturally from a breach of contract. They are the immediate and foreseeable consequences of the breach.
- Examples: If a supplier fails to deliver goods on time, direct damages could include the cost of purchasing the goods at a higher price from another supplier, or the lost profits from sales that could not be completed due to the lack of goods.
- Characteristics: Direct damages are usually easier to prove and quantify because they have a clear and direct link to the breach of contract.
Indirect Damages
- Also Known As: Sometimes referred to as consequential damages, special damages, or secondary damages.
- Definition: Indirect damages are losses that do not flow directly from the breach but are a secondary result of the situation created by the breach. These damages were not necessarily foreseeable as a probable result of the breach at the time the contract was made.
- Examples: If a business had to cancel a promotional campaign because of delayed delivery of goods, any resulting loss of reputation or future sales could be considered indirect damages.
- Characteristics: Indirect damages can be more challenging to predict, prove, and quantify, as they require establishing a causal link between the breach and the damages claimed, which is not immediately obvious.
Understanding the distinction between direct and indirect damages is essential in procurement and contract management. It helps parties in a contract to anticipate potential risks, liabilities, and financial implications of breaches. Additionally, contracts often include clauses that limit or exclude liability for indirect or consequential damages, making it important for both parties to negotiate and understand these terms clearly.
Note: Illustration to the blogpost “Liquidated damages in procurement contract” is a screenshot from Jon Kihlmans course. Remedies for breaches of contract.
Extra: Liquidated Damages Clause (Illustrative example)
Liquidated damages in procurement contract sample clause. Always adapt to your conditions and consult legal advice.
Clause: Liquidated Damages
- Purpose:
The parties acknowledge that in the event of a delay or breach by the Supplier in the performance of its obligations under this Agreement, the Buyer will suffer damages that are difficult to ascertain with reasonable certainty. Therefore, the parties agree that the Supplier shall pay liquidated damages as a reasonable estimate of such damages and not as a penalty. - Trigger for Liquidated Damages:
Liquidated damages shall be applicable in the following events:- Failure to deliver goods or services by the agreed delivery date.
- Failure to meet specified performance or quality standards as outlined in this Agreement.
- Any other breach of obligations as specifically identified in this Agreement.
- Amount of Liquidated Damages:
In the event of a delay or breach, the Supplier shall pay the Buyer liquidated damages at a rate of $500 per calendar day for each day of delay or non-compliance, up to a maximum of 12%. This amount shall be the sole and exclusive remedy for the delay or non-compliance specified herein. - Assessment and Payment:
- The Buyer shall provide written notice to the Supplier specifying the nature of the delay or breach and the amount of liquidated damages assessed.
- The Supplier shall pay the assessed liquidated damages within thirty (30) days of receipt of the notice.
- If the Supplier fails to pay the liquidated damages within the specified time, the Buyer shall have the right to deduct the amount from any outstanding payments due to the Supplier under this Agreement or any other agreement between the parties.
- No Waiver of Other Rights:
The imposition of liquidated damages under this clause shall not preclude the Buyer from pursuing any other remedies available to it under this Agreement or applicable law, except that the Buyer shall not be entitled to recover damages in excess of the liquidated damages specified herein for the specific delay or breach. - Mitigation:
Both parties agree to use reasonable efforts to mitigate the effects and extent of any delay or breach, including taking prompt and appropriate corrective actions. - Force Majeure:
Liquidated damages shall not apply if the delay or breach is due to a force majeure event as defined in this Agreement, provided that the Supplier has complied with the notification and mitigation requirements associated with such force majeure event. - Termination:
If the Supplier fails to remedy the delay or breach within a reasonable period after the imposition of liquidated damages, the Buyer reserves the right to terminate this Agreement in accordance with the termination provisions herein, without prejudice to any other rights or remedies available to the Buyer.
By agreeing to this clause, both parties confirm that the liquidated damages represent a fair and reasonable estimate of the Buyer’s damages in the event of a delay or breach and are not intended to serve as a penalty.
This liquidated damages clause is designed to provide a clear and enforceable mechanism for compensating the Buyer for delays or breaches by the Supplier, while also ensuring fairness and clarity in its application.