The Commercial Toolkit (CMT) Liquidated Damages Full Guidance Last Updated 01/05/2009

Liquidated Damages (LDs) Constraints

None.

Authoritative Guidance Summary

1. In law, Liquidated Damages (LDs) or General Law damages are remedies available to any contracting party to compensate for the financial loss suffered as the result of a proven breach of contract. 2. An LDs provision quantifies in advance the amount of damages to be paid by a contractor to the Ministry of Defence (MOD) if the contractor fails to meet his contractual obligations (breach). LDs require demonstration of the breach but in the case of General Law damages it is also necessary to be able to demonstrate the loss incurred upon breach. 3. LDs are normally employed to compensate for the financial loss suffered as a result of late delivery. But they may also be contemplated for technical performance shortfalls when the Customer(s) can agree in advance of the particular shortfall occurring that it does have an unacceptable impact on military capability. 4. The decision on whether to use LDs or rely on seeking General Law damages must be considered by the whole acquisition team at the outset of a contract and must take into account all issues appertaining to the nature of the requirement and the implications of the breach. 5. The pre-estimate of the potential financial loss likely to be suffered by MOD in the event of a breach of contract need not be a precise calculation but it must be genuine and the underlying rationale clearly recorded on file. 6. LD provisions must be drafted clearly and unambiguously to avoid potential interpretation as a penalty condition. A specimen condition is provided. 7. The contractor's performance must be monitored and appropriate action taken to invoke LDs when they arise as set out in the contract. A 'period of grace' is not allowable nor should recovery be left until final delivery or completion of contract. The policy is not to trade them off against other issues.

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The Commercial Toolkit (CMT) Liquidated Damages Full Guidance Last Updated 01/05/2009

8. If a contractor disputes MOD's entitlement to LDs or General Law damages under the contract, resolution by negotiation (assisted by other methods of Dispute Resolution where appropriate) will always be MOD's preferred approach. Nevertheless, MOD may, in extreme circumstances, terminate the contract. 9. MOD will be prepared to resort to law to enforce LDs if it believes it has a winnable case, which can be pursued cost effectively. Even if the court decides the LDs provision is a penalty, MOD could still claim damages under General Law.

Authoritative Guidance
Strategy Considerations
10. LDs are set and agreed in advance in accordance with the following legal principles: a. they are an agreement, determined in advance, by the parties to the contract, and included as a provision in the contract, to pay a pre-estimated amount of damages for a particular breach; b. the party committing the breach will be liable to pay the other party a fixed or ascertainable sum; c. the party suffering from the breach only has to prove that a breach occurred, no proof of the loss is required; d. the agreed amount of damages will be payable whether the loss actually suffered is greater, smaller or even nil; and e. there is a duty on the injured party to mitigate his loss using all reasonable efforts. 11. The law on LDs and penalties is inextricably linked and the distinction between the two is of paramount importance in ensuring the successful operation of a LDs provision. The following statements on penalties must be taken into account when formulating a LDs provision. a. LDs are not enforceable under English law if the sum recoverable is a penalty (although this would not rule out a court awarding General Law damages to the claimant).

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The Commercial Toolkit (CMT) Liquidated Damages Full Guidance Last Updated 01/05/2009

b. Classification of a provision as LDs goes beyond the words and depends upon its purpose and substance, otherwise it may be interpreted as a penalty condition. c. The provision will be a penalty if the sum stipulated is extravagant and unconscionable compared with the greatest loss that could conceivably be proved to have followed from the breach. d. It is presumed that a provision is penal when a single lump sum is made payable on the occurrence of one or more or all of several events, regardless of the seriousness of the damage, but especially if the events have disproportionately different consequences. e. If the breach consists only of not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to be paid, then the provision will be held to be a penalty - this is just the situation when it is probable that pre-estimated damage is the true bargain between the parties. f. The court looks at the position at the time of making of the contract not at the time of the breach when considering whether a provision is penal. g. Although the courts will pay more attention to the substance and effect of a LDs provision rather than the language used, it would be sensible not to use the word penalty in a LDs provision.

Definition Of General Law Damages

12. Where a purchaser is unable to predict sufficiently the consequences of a breach of contract to make a reasonably well-founded genuine preestimate of any loss, the alternative is to rely on General Law to claim damages. 13. Reliance on General Law remains a relatively lengthy process, and despite recent changes in the Civil Procedure Rules (CPR) - Woolf Reforms aimed at refining and speeding up the civil claims process, it remains neither simple nor certain in operation. It is resource intensive, costly, time consuming and is uncertain in outcome. However, where LDs are unsuitable, General Law is the alternative. The inclusion of DEFCON 529 (Law (English)) or DEFCON 529A (Law (Scots)) implies that claims for damages will be sought through General Law and there is no requirement to include any supplementary conditions. 14. Pressure for an undertaking not to claim damages through General Law under a contract in which no provision is made for LDs should be
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The Commercial Toolkit (CMT) Liquidated Damages Full Guidance Last Updated 01/05/2009

resisted. Any such undertaking must be wholly exceptional and only given with the agreement of a commercial officer at Band B2 level or above. Where it is given, the contract must include DEFCON 614 (Default) and DEFCON 92 (Failure of Performance), as appropriate.

Deciding On LDs Or General Law

15. A LDs provision should be considered for every contract regardless of contract value. LDs will not, however, generally be for inclusion in Concept, Assessment or Demonstration phase contracts (the C, A and D of the CADMID cycle) unless the contract requires the delivery of goods that are critical to the achievement of the In Service Date. Its application should be considered by the whole acquisition team. The rationale for the non-inclusion of a LDs provision or the basis of the calculation of LDs should be recorded on file. 16. The breach addressed by LDs is normally, but need not exclusively be, for late delivery. LDs may be suitable for some aspects of technical performance, providing the Customer(s) confirms in advance that a reduced technical capability is acceptable. For example, where a contractor agrees to supply a ship with a speed of 20 knots LDs may be applied in the event that he supplies a ship with a 19 knot capability. This should not be confused with acceptance against the formal acceptance criteria and procedure set out in the contract. 17. The nature of the requirement and the implications of the breach need to be taken into account in deciding whether a LDs provision is suitable or not. The following questions will assist in assessing whether the contract is of an appropriate type or not: a. Is the breach readily identifiable, for example, late delivery or shortfall in performance? b. Is the method and criteria for determining whether a breach has occurred capable of being defined? c. Are the losses reasonably foreseeable and can they be quantified sufficiently to produce a genuine pre-estimate of the damages that might arise from the breach? d. Is the specification adequate and stable? (i.e. is there a likelihood of substantial change in the requirement and programme of work) e. Is it possible to set up an effective monitoring of performance and means of claiming LDs?
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The Commercial Toolkit (CMT) Liquidated Damages Full Guidance Last Updated 01/05/2009

f. Is performance of the contract by the contractor entirely within his control? (i.e. no dependencies on MOD action) g) Is the amount recoverable as damages significant enough to justify any contingency margin in the contract price or limitation of liability? 18. If, after considering the above points the answer is no, then the better option may be to rely on General Law.

Calculating The Amount Of LDs

19. The pre-estimate of the potential financial loss likely to be suffered by MOD in the event of a breach of contract is a vital element in an effective LD provision. A term can be a genuine pre-estimate of likely damage even where exact calculation is impossible but it must be reasonably well-founded with evidence of what can reasonably be expected to be the loss at the time the contract was made. 20. In calculating the potential loss account must be taken of the point in time from which it is foreseen that the loss will occur. If there is likely to be any delay between the actual breach and the actual loss, then this should be taken account of in the way in which the LDs are calculated and the date of the breach is set. 21. In the past, MOD's business sometimes made it difficult to establish a genuine pre-estimate of loss. This difficulty will ease as the full benefits of Resource Accounting and Budgeting (RAB) flow through. RAB will provide better visibility of the consequences of delay although it does not change the need for LDs to be calculated robustly so as to stand up to any challenges from contractors. 22. The utility of a LDs calculation based on a sum of money expressed as a percentage rate of the contract price per month of delay up to a maximum amount is only supportable provided that it is not applied to contracts in an arbitrary way regardless of the known consequences of breach. Such use could put MOD in a vulnerable position because it might be in danger of being a penalty. The amount of money calculated as LDs should be ascertainable and a fixed amount. Therefore, whilst it is possible for the amount to be represented as a percentage with a limit on it, it must be credible and the process used to determine it must be rigorous enough to stand up to scrutiny. 23. Further details on calculating the amount of LDs, giving examples of the wide variety of potential losses, are at Annex A.

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The Commercial Toolkit (CMT) Liquidated Damages Full Guidance Last Updated 01/05/2009

Invitation To Tender
Drafting LDs Provisions
24. LD provisions must be clear and unambiguous. It is not practical to devise a provision to meet all possible situations, but factors that should be taken into account include: a. a clearly defined breach under the contract - what constitutes, for example, late delivery, shortfall in performance, and how will this be determined; b. a precise statement of the rate at which damages will accrue, which, unless there are good reasons for not doing so, should be expressed as a rate per day and as a sum of money; c. a separate rate of LDs for each instalment (where goods are to be delivered in instalments); d. where a breach results in a continuing loss there should almost invariably be an upper limit to the amount of LDs, set by reference to MOD's most likely response to the delay scenario, taking the effect of mitigating action into account; e. a clear statement on the periods of time to be used for the purpose of calculating the LDs, for example, whether or not weekends, public holidays, etc are included; f. that claims are made without prejudice to any other rights under the contract including DEFCON 614 (Default), DEFCON 92 (Failure of Performance); g. a statement to the effect that making interim payments does not constitute a waiver of MOD's rights to damages; h. where delivery takes place in batches, a statement that any shortfall in any one batch is firstly to be made good from items drawn from the subsequent batch, before the latter quantity is itself assessed for the purpose of calculating LDs; and i. if goods are to be delivered in one batch, do not agree to accept delivery by instalments unless a rate of LDs is agreed at the same time. 25. B. A specimen LDs provision for breach of delivery is provided at Annex
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The Commercial Toolkit (CMT) Liquidated Damages Full Guidance Last Updated 01/05/2009

26. Normally, contracts should not include a Force Majeure or Extension of Time provision because MOD expects its contractor's to abide by their contractual obligations and ensure the contract is satisfactorily performed. However, where the contract contains a LDs condition a separate Force Majeure or Extension of Time condition or a specific provision within the LDs condition must always be included. 27. The LDs provision should be included with all other contract conditions in the Invitation to Tender (ITT). However, tenderers should be encouraged to be innovative and, if they wish, propose an alternative approach.

Tendering And Contract Award

28. If a tenderer submits an alternative proposal which offers a concession or relaxation to the original terms of the LD condition and the proposal is seen to be beneficial to MOD, it must also be extended to the other tenderers. 29. However, allowing tenderers to respond in this way, enables the costs involved to be identified and a better value for money decision taken that would not discriminate against any tenderer. It means an informed decision can be made on the level of LDs (depending on what might be offered) or whether to remove them completely and rely on claiming damages under General Law.

Contract Administration
Operation Of LDs Conditions
30. Where a LDs condition is included in the contract it must be applied rigorously and consistently. Otherwise, its justification and usefulness is open to challenge. 31. Commercial officers should issue an internal notification that a contract contains a LDs condition with all copies of the contract distributed within MOD to ensure that the MOD's rights are not inadvertently prejudiced by anyone connected with the contract. (See Annex C) 32. An effective monitoring process must be set in train to ensure that no acquisition staff unwittingly prejudice MOD rights under the contract by implying acceptance of a contractor's breach. Such acceptance (e.g. encouraging the contractor to continue with the contract despite failing to meet the requirement that LDs exist to protect) may also undermine MOD's rights of termination (DEFCON 614 (Default)) under the contract.

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The Commercial Toolkit (CMT) Liquidated Damages Full Guidance Last Updated 01/05/2009

33. Any failing in the contractor's obligations should be notified to commercial and finance officers immediately there is any likelihood of a breach in delivery or performance as defined in the provisions of the contract. And, MOD acquisition teams should not impede the contractor by failing (whether actively or by omission) any of MOD's own obligations under the contract that could affect the contractor's ability to perform the work.

Recovery Of LDs
34. LDs should be recovered as soon as they fall due - as soon as the losses are incurred. A 'period of grace' is not allowable nor can recovery be left until final delivery or completion of contract. 35. In anticipation of a breach occurring, MOD should remind the contractor of his contractual duties and advise him of the intention to invoke LDs in accordance with the contract without prejudice to any other rights and remedies. When the breach occurs, the contractor should be informed by letter of the amount claimed according to the LDs provision. The claim should be presented in instalments where damages are separately assessed for each of a series of deliveries. A specimen letter to the contractor claiming LDs is attached at Annex D. 36. At the same time the claim is forwarded to the contractor, a letter accompanied by a copy of the letter to the contractor and a DAB1 Form should be sent to the Financial Management Shared Service Centre (FMSSC) to notify them of the claim. The DAB1 Form enables FMSSC to issue an invoice to the contractor in order to seek recovery of the amount due. FMSSC should also be asked to confirm when the specified amount has been recovered. A specimen notification to FMSSC of a LDs claim is attached at Annex E. 37. If the contractor contests the claim he should be advised that contractually MOD is entitled to claim and he is obliged to pay the LDs. Any disputes arising should be dealt with in the manner stipulated in the contract. Where the contractor wishes to contest the claim the matter should immediately be brought to the attention of the acquisition team leader and the relevant commercial officer who will, as necessary, consult. If the contractor asserts that the sums claimed are a penalty and not LDs, it is important to establish the legal position quickly to preserve MOD's rights. In such cases legal advice must be sought. 38. If the contractor has not paid in a reasonable time, FMSSC will automatically take action under DEFCON 509 (Recovery of Sums Due) to Set off the sum against the payments due.

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The Commercial Toolkit (CMT) Liquidated Damages Full Guidance Last Updated 01/05/2009

39. The rules relating to treatment of recovered sums are complex and it is vital that finance officers are fully aware of the proposed recovery so that appropriate accounting action can be taken. Attribution of recovered LDs is an accounting matter to be determined between Customer 1 and Customer 2, as appropriate. Similarly, any consideration of either deferment of recovery or waiver of MOD's rights raises important Government Accounting issues and finance officers must be involved from the outset.

Trading LDs Against Other Claims Or Offers

40. Any proposal to draw LDs into a negotiation on general claims and counter claims, or into any other general negotiations on trade offs, may result in MOD inadvertently foregoing other rights and remedies available under the contract. 41. Claims for LDs must therefore be kept separate from general claims for damages that have to be dealt with on their particular merits and those other claims settled, preferably, by negotiation or by dispute resolution and ultimately litigation. 42. Equally, whilst there is no reason why MOD should not discuss trade off options with a contractor (without commitment) to better understand any potential benefits, any consequent agreement must be made on the basis that the LD provision in the contract is totally unaffected in terms of operation or value. Any proposal to trade-off LDs must be discussed with Finance colleagues as early as possible as any agreement will require approval at the appropriate level.

Court Action And LDs

43. If a contractor threatens court action, for whatever reason in relation to a LDs claim, acquisition teams through the commercial officers are responsible for ensuring that there is good evidence of: a. the existence and scope of the contract - full documentation of both original contract and of any agreed amendments; b. the breach of that contract; and

c. if LDs are payable, of the basis on which they were calculated and of any relevant discussions or agreements with the contractor. 44. If it is not possible to enforce a LDs provision because the courts judge it to be a penalty, for example, the MOD may still be able to claim damages under General Law.

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The Commercial Toolkit (CMT) Liquidated Damages Full Guidance Last Updated 01/05/2009

Claiming Damages Under General Law

45. Commercial officers will handle claims for damages under General Law. The decision whether it is worthwhile to pursue a particular claim for such damages is a matter of judgement. The aim should be to agree a negotiated settlement in the first instance, but where this is not possible follow the guidelines on Dispute Resolution to reach agreement. However, it is important that legal advice is sought if there is any possibility of pursuing a claim.

Associated Documents
Annex A - Calculating LDs Annex B - Specimen LDs Provision For Breach Of Delivery Annex C - Internal Notification That A Contract Contains A LDs Clause Annex D - Letter To Contractor Claiming LDs Annex E - Notification To FMSSC Of A LDs Claim

Further Reading

Force Majeure topic Termination Of Contract topic Dispute Resolution topic Limiting/Excluding Liability For Risk topic Pricing - CAAS Estimates topic Claims topic Contract Amendments topic Requests For Contract Action topic JSP 472 Resource Accounting Policy Manual for information on Resource Accounting and Budgeting (RAB) MOD/Industry Commercial Policy Steering Group Guideline No 2 Incentivisation of Contractor Performance

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