Defining Damages

Author(s): Leslie S. Marell Leslie S. Marell, attorney at law in Hermosa Beach, California. January 1999, Purchasing Today Vol. 10, No. 1, page 18 An effective supply contract will use liquidated damages clauses to set the stage for consequences of nonperformance.

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You've written up a contract for services to be performed by a given supplier. Unfortunately, a contract is no guarantee of performance. Ideally, the payment to a supplier is reason enough to perform, but in some cases, a purchasing and supply professional needs more protection in the contract. What compensation should you receive if a supplier fails to perform? How much is a particular service worth? These issues are often addressed through liquidated damages clauses. Liquidated means "agreed upon." The concept is that before you and your supplier sign the contract, you both fix the damages (or "penalty") that the supplier will incur if he or she fails to perform his or her obligations according to the contract. Liquidated damages clauses can serve as a good incentive for the supplier to perform services on time. In maintenance contracts, these types of clauses often are structured such that the purchaser deducts a certain amount of money from the monthly maintenance fee depending on the equipment downtime. One cautionary note: damages in contract law are intended to compensate the injured party and not penalize the breaching party. A clause which fixes unreasonably large liquidated

damages will be viewed as a penalty and considered void. You should justify (and keep on file) how you arrived at these amounts of money. Also, avoid using the word "penalty" in your contract. Tips for Negotiating Clauses You will have a difficult, if not impossible time convincing your supplier to agree to penalties of an extensive magnitude. For example, if a piece of equipment fails due to a supplier's failure to perform maintenance, your organization may incur revenue losses of $10,000 per hour. However, it is fair to say that no supplier would agree to a contract that contains liquidated damages clauses requiring him or her to pay that amount for every hour that the equipment is not running. Also, in the unlikely event that you actually ended up in court over such a dispute, that amount of money might be considered excessive, designed to penalize, and, therefore, void. It's more realistic to fix liquidated damages to be an amount proportionate to the service fee you will pay. Other analogous concepts include (a) an extended period of maintenance at no charge, (b) rebate of a certain portion of fees previously paid, or (c) termination of the maintenance agreement. See the box below for more information on sample clauses. Where you end up, of course, will depend on your leverage. In that regard, don't forget to negotiate when your leverage is the highest. If you are purchasing the equipment from the supplier who will maintain it, make sure you negotiate the maintenance contract at the same time that you negotiate the acquisition of the equipment. The Best Offense... Given the option of resorting to the liquidated damages clauses in the contract, or never having to refer to them in the first place, most purchasing and supply professionals would choose the latter. While liquidated damages clauses can serve as incentives to timely performance, your real goal is not to deduct for late service; rather, your goal is to receive good maintenance and eliminate downtime. Whether you need a core piece of capital equipment repaired, the copier down the hall serviced, or the plumbing leak fixed on the spot, a supplier's failure to perform can be costly but avoided. To that end, you should understand and address the following "up front" issues in your contract:
1. Preventative Maintenance: What type will be performed, how often, by whom, and when (during or after business hours)? 2. Spare Parts: What are the critical units of equipment and what are their mean times between failure (MTBF)? What is the minimum type and quantity of spare parts that should be maintained? Where should they be stored (at the purchaser's facility on a consignment basis or at the supplier's facility)? Have you predetermined the price of these parts? 3. Preventative and Remedial Maintenance: Have these terms been clearly defined in the contract? Does the contract specifically state the responsibilities of the maintenance provider and the purchaser?

4. Response Times: What is the MTBF and the mean time to repair (MTTR) key equipment? Response time, while important, is only a means to an end. What you want is a short downtime. The MTBF and MTTR figures can be used in the liquidated damages clause if the number of repairs is greater than would be predicted by the MTBF or if the equipment is down for more than a specified time. 5. Back-Up System: Is it possible or realistic to require the maintenance provider to provide a back-up system if the equipment exceeds a certain downtime? These terms and conditions, when agreed upon during the initial contract negotiations, can ease the road to satisfactory performance by suppliers, and hopefully reduce the need to act upon liquidated damages clauses.

Check out some Sample Clauses If a contract stipulates the following: Maintainor will respond to all requests for Services within twenty-four (24) hours of each request by Customer. Maintainor will remedy any defect in the Software or Equipment within forty-eight (48) hours after the initial request for Services by Customer and, if necessary and within such time frame, either replace any defective module or swap the entire defective unit. The following liquidated damages might be appropriate to include as well: Either ... If Maintainor fails to remedy any such defect within forty-eight (48) hours of the Customer request, Customer shall be entitled to a one (1) month maintenance credit for each additional twenty-four (24) hour period during which any such defect remains unresolved. In the event any such defect remains unresolved for more than one (1) week, Customer may, in its sole discretion, elect to terminate this Agreement and receive a refund of any fees that were paid in advance by the Customer. Or... If Maintainor does not respond and remedy the failure, malfunction, defect or nonconformity within forty-eight (48) hours of receipt of Customer's request, Customer shall be entitled to a credit against future maintenance costs of (dollar amount) for every hour or part thereof that Maintainor fails to remedy the failure, malfunction, defect or nonconformity. Monies becoming due to the Customer shall be applied as a credit against future maintenance invoices submitted by Maintainor hereunder.