Claire Waller, a Commercial solicitor at DWF looks at issues in commercial contracts
In tough economic times, businesses may be tempted to enter into contracts with very onerous payment provisions including fixed term prices and hefty penalties for any late delivery. A commercial decision may be taken that the benefit of the contract outweighs the risks associated with the very onerous contractual obligations. However, businesses should ensure that they have fully considered all the financial terms in the contract, particularly that fixed term price commitments allow sufficient margins to cover unexpected costs and that any penalties under the contract are proportionate to the fees which are being charged.
At the start of a contract the parties will often agree an initial period during which charges under the contract are fixed and cannot be increased. The service provider therefore benefits if it can procure any goods, labour, raw materials and fuel at a lower price, but carries the risk associated with any increases in those costs. Many businesses in the transport sector have experienced difficulties recently when the price of fuel increased significantly in a short period of time. Where transport providers have been tied into contracts with either no right or a very limited right to increase charges, this has seriously eaten into profit margins and has led in some cases to contracts becoming loss-making.
If you are in the process of negotiating contracts at present, check carefully to see what rights you have to increase prices. Look to negotiate on two levels – the frequency of any fee increase and the basis on which the fee can be increased. Most purchasers will not allow more than one price increase per year and may look to cap fee increase by reference to a maximum percentage of the current price or to the increase in the Retail Price Index. A more relevant index may be one which specifically takes into account fuel prices, such as the AA’s fuel price report. It may be possible to tie in at least a proportion of the fee increase to such an index. You may even be able to negotiate a right to increase the charges at any time if you are able to provide evidence to show there has been a material increase in costs beyond your control.
Penalties and Liquidated Damages
It is a matter of principle under English law that a penalty clause in a contract is not enforceable. Any clause whose function is simply to impose a penalty on a party and act as a deterrent – going much further than compensating the other party for the loss it is likely to have suffered – will not be allowed by the courts. Liquidated damages clauses are permitted, however, and they are a common feature in haulage contracts. A liquidated damages clause specifies that if one party to a contract breaches its terms in a particular way, it will pay to the other party an agreed fixed sum. There is no requirement for the party making the claim to actually suffer any loss or to prove the extent of the loss it has incurred – the very fact that the breach has occurred entitles that party to the money.
The amount of damages to be paid must, however, be a genuine pre-estimate of the losses which the parties agreed were likely to be suffered if that particular breach occurred. If the value in your contract appears to be excessive, then it may amount to a penalty clause meaning that the other party could never enforce it against you in court.
Liquidated damages clauses are not always a bad thing and can benefit both parties if used properly. From a customer’s perspective, such clauses may be necessary to ensure goods are delivered on time. The customer may have contracts with its own customers which contain strict deadlines and financial penalties if deliveries are not made on time. Liquidated damages provisions can also protect the haulier by capping the level of liability in the event of a delay. If a contract does not contain a liquidated damages provision, but does contain very strict and onerous KPIs and deadlines, then a breach of those service levels would entitle the customer to sue for breach of contract and recover damages to compensate it for the loss it has suffered.
The value of that loss may in fact be higher than any sum which is fixed under the contract. If the customer chose to instruct lawyers to chase payment, that adds on additional costs which the defaulting party could easily end up responsible for in court. With liquidated damages there is an element of certainty from the outset, and then can allow contractors to build a contingency fund into the pricing model and set aside sums to be paid out if required.
As well as standard financial caps on liability and exclusions of types of liability (such as indirect loss or loss of profits), one way to add protection is to make sure you have the benefit of a far-reaching force majeure clause. Force majeure clauses offer protection to a party who is in breach of a contract where the breach was caused by circumstances outside that party’s control.
In recent years various different incidents have put the focus on force majeure provisions as service providers have found their day to day operations disrupted by unexpected events:
- The bird flu epidemic attacked workforces, leaving contractors with insufficient employees to fulfil jobs.
- A volcano released a cloud of ash which disrupted air travel across the globe.
- Strikes at ports across the channel prevented vehicles crossing the sea.
- Rapidly escalating costs of fuel and raw material made it economically unviable for businesses to continue service delivery.
Which (if any) of these events would be considered a force majeure event which might release you from liability for failure to fulfil contractual obligations? The answer depends on the particular drafting of the clause in each contract. Force majeure provisions are often overlooked as being caught up in the ‘legal’ part of the contract and therefore lacking importance. It is well worth paying attention to the way this clause has been drafted and considering which risks you are required to bear even if the circumstances may be entirely out of your control. A suitable clause agreed during contract negotiations could well protect you from having to make substantial payments during the contract term.