June 2009

01 Jun 2009

It's Good To Have A Stick, But Make Sure It's Not Too Big

One of the major issues faced by the parties to an IT contract is how to deal with breaches of the contract that may have a significant impact but which may not warrant the innocent party going so far as to terminate the contract, or where termination is just not a practical solution. This may the case where a project is in midstream and for either party to stop is not a viable option.

In the absence of any tailored contractual solution, the parties often have only two options. The first is to sue for breach of contract, and the second is to withhold payment or, in the case of service providers or suppliers, withhold services or supply. These options are rarely attractive. In the case of the first, law suits are expensive undertakings, and the outcome is often uncertain. In the case of the second, the party taking retaliatory action is often technically breaching the contract themselves through such action, and thereby exposing themselves to various risks.

Further, in both cases the effect of such action is likely to signal the end of the relationship between the parties, even when the relationship is a valuable one. Suppliers and service providers rarely have so many customers that they are indifferent to losing one, and customers will often have selected their supplier or service provider on the basis of skills or pricing not easily found elsewhere.

Tailored Pre-agreed Sanctions

A potential solution is to build into the contract sanctions that can be readily applied on the occurrence of a triggering event. For example, late payments can accrue interest and performance failures can be linked to reductions in fees. Such solutions have a number of attractions.

First, if they are done properly, they can help preserve the relationship between the parties in situations where it might otherwise have broken down. A couple of key points to remember are:

1. Make sure the sanctions are reasonable. If the sanction is out of proportion with the breach, this could impact on the viability of the sanctioned party and its ability to continue with the contract and, as discussed below, it may prove to be unenforceable.
2. Make sure the triggers for when the sanction will be applied are clear. Any uncertainty could give rise to a dispute between the parties and enforcement action may even be needed which would defeat part of the purpose of agreeing the sanction upfront. In the case of late payments, the test is likely to be easily formulated, but more thought will often need to go into the triggers for failures by suppliers and service providers and the extent to which a customer may have contributed to the supplier or service provider's failure.

Secondly, from a customer point of view they can be readily applied because the sanction could be deducted from a future contractual payment without the risk that such reduction is, itself, a breach of contract. 

Thirdly, if it does become necessary to take action to enforce the sanction, the action will not be for breach of contract, but for the recovery of a debt. This avoids the need to prove the quantum of the loss and that reasonable steps were taken to mitigate that loss. This can be a significant benefit, because issues around quantum of loss and the duty to mitigate losses can create evidential difficulty and make the outcome of a claim extremely uncertain.

Fourthly, it adds certainty to the consequences of particular breaches. For example, a delay in the implementation of a system may lead to inconvenience to the customer which is very difficult to quantify in monetary terms. Neither party may be sure what the outcome of a law suit would be, so both a law suit, or the negotiations to avoid one, will be difficult. Pre-determined sanctions avoid this uncertainty by setting clear consequences for particular breaches.

Penalty Clauses

The introduction of pre-determined financial sanctions into a contract is not without risk. From a contractual point of view, the major risk is that a court will characterise the clause imposing the sanctions as a "penalty clause". The consequence of this is that the clause will be unenforceable.

The courts draw a distinction between "liquidated damages" clauses, which are enforceable and "penalty clauses", which are not. The distinction is essentially that liquidated damages are a genuine pre-estimate of the damage that would be suffered by a party to the contract if the other party was to commit the particular breach, while a penalty is "a sum fixed in terrorem". (In terrorem is a Latin term which means "in order to frighten".)

For example, if a payment is made one day late, the parties might agree that interest accrues on that payment at 10% per annum on the basis that the recipient of the payment has an overdraft facility which it will need to utilise as a result, and under which it pays 10% per annum interest. This is likely to be considered a reasonable pre-estimate of loss, and therefore enforceable.

In contrast, those same parties might agree that interest will accrue at 50% per annum on the basis that there should not be any late payments, and they should therefore be deterred by a punitive rate. This is more likely to be found to be a penalty clause and unenforceable.

Rules for Distinguishing

The basic rule set out above for distinguishing between liquidated damages and penalties was stated in an old case called Dunlop Pneumatic Tyre Co v New Garage and Motor Co ([1915] A.C. 79), which is still widely referred to in modern cases. That case set out some other rules for distinguishing between liquidated damages and penalties. These are that:

1. It does not matter whether the parties themselves label the sanction as a penalty or as liquidated damages.
2. The time at which to assess whether a sum is a reasonable pre-estimate of loss is the time at which the contract is entered into. To use the example above, if, after the contract was entered into, interest rates fell dramatically, so that the overdraft facility interest rate was only 4% per annum at the time of the relevant late payment, this would not mean the stipulated 10% per annum was a penalty.
3. A stipulated sum is a penalty if it is "extravagant and unconscionable" in comparison with the greatest loss that could conceivably be proved to have followed the breach: otherwise it is liquidated damages.

Keeping it Reasonable

The moral of the story is that any agreed financial sanctions should be reasonable, and should be calculated with regard to the loss which would actually be suffered. However, this is not the whole story.

If it is clear what loss would be suffered if a particular breach occurred, any significant deviation from this in the amount specified as liquidated damages could well lead to the clause being overturned. What is less clear is what happens in situations in which it is difficult to estimate what the loss will be for a particular breach at the outset of a contract.

The fact that a loss (such as inconvenience) cannot be quantified in monetary terms does not mean that a pre-determined sanction to compensate for that loss will not be a genuine pre-estimate. In fact there appears to be a strong presumption by the courts that a pre-determined sanction for such a loss is a genuine pre-estimate.

The approach adopted by the courts has also been to strongly presume in such cases that agreed financial sanctions are not extravagant and unconscionable, and that they are therefore enforceable liquidated damages. They have expressly recognised that one of the major benefits of having pre-determined sanctions is to avoid the difficulties caused by breach of contract claims in which losses are hard to quantify, and have looked to avoid undermining this by lightly overturning them.

Multiple Breaches

More complex issues arise where a sum is specified which will apply to multiple breaches. A basic example would be a stipulation that a party must pay $1,000 if it breaches the contract. For some breaches, such as the unauthorised copying of a supplier's software, this may be reasonable almost to the point of generosity. However, for other breaches, such as a failure to notify a change of address within 10 days, $1,000 would probably be an extravagant and unconscionable sum. In these situations, the courts have focussed on the most minor possible breach, and judged the relevant clause against that. Consequently, in our example, the clause would be overturned on the basis of its application to the notification of address changes, even though its overall effect may be largely reasonable.

The best way to deal with this issue is to make sure that a financial sanction is only payable in respect of a limited number of breaches with similar levels of seriousness. If it is desirable to capture breaches which have different levels of seriousness, there should be different sanctions corresponding to the levels of seriousness. 

An analogous issue arises with obligations which can be breached with varying degrees of seriousness. However in such cases the courts have tended to take a different approach in that they have not looked at whether a financial sanction is extravagant and unconscionable with respect to the most minor breach that can occur, but at the relevant breach as a whole. Nonetheless, it will often still be desirable to deal with this issue with a graduated scale of financial sanctions. For example, performance rebates for system outages could be calculated on the basis of a percentage of the support fees with the percentage increasing as the extent of level of system availability drops.

Rewards instead of Penalties

An alternative approach is to offer rewards for good performance rather than a "penalty" for poor performance. For example, a support provider might be paid a set fee, but receive a bonus payment if a system availability service level requirement of 98% is consistently exceeded over an agreed period of the time. The overall effect of an arrangement under which a support provider is paid a fee of $100 which is reduced to $90 if the system is down more than 2% of the time, is no different to an arrangement under which a support provider is paid a fee of $90, but receives a $10 bonus if the system is down less than 2% of the time. However, there is no sanction for breach of contract under the bonus payment arrangement, so it is unlikely such an arrangement would be found to include a penalty for this reason alone.

No Alternative Damages Remedy

One important point to bear in mind is that a liquidated damages clause is binding on both parties as an alternative to suing for damages. Consequently, while the party entitled to liquidated damages can claim them without suing for damages, the party obliged to pay them can insist that they are the contracted remedy, and that the other party is not entitled to sue for damages if the stipulated liquidated damages are inadequate. It is important, therefore, to ensure that the specified sums adequately compensate for the relevant breach.

Conclusion

There are significant benefits from using pre-determined financial sanctions in IT contracts. Utilising them is usually less damaging to a relationship than suing for breach of contract, the relevant amounts are easier to recover, and they provide the parties with increased certainty.

There is always a risk that they may be overturned as penalty clauses, but so long as they are structured properly, and there is a genuine effort to pre-estimate loss, that risk will be minimised.

Authors

Earl Gray

Partner - Intellectual Property

DDI: +64 9 977 5002

Mobile: +64 29 977 5002

Email:

View Profile

Karen Ngan

Partner - Corporate & Commercial

DDI: +64 9 977 5080

Mobile: +64 21 648 977

Email:

View Profile