A version of this article was published in Construction News on 16 February 2015
Service credits have long been a fundamental part of performance management in facilities management contracts. However, a recent decision has shed new light on the importance of keeping service credits updated as the service requirement evolves to ensure they remain enforceable.
The commercial principle of service credits is sound. With agreements covering an intricate range of services, demonstrating losses caused by specific failures is a complex process often involving effort disproportionate to the problem itself. Instead FM contracts usually include a series of fixed (or ‘liquidated’) sums payable if certain failures occur meaning that clients can more easily recover their losses and suppliers understand their risk upfront. Without such arrangements, performance management would become unworkable.
Setting the value of service credits has always been a commercial challenge. Whilst the practical effect may well be to provide a ‘carrot and stick’ to incentivise performance, that should not be the primary objective. As with any form of ‘liquidated’ damages, to be enforceable they must not be a penalty but rather a genuine estimate of the loss likely to be suffered as a result of the failure. The point should be to compensate the client for the financial consequences of the failure, not just to punish the supplier.
In determining whether a sum is a penalty there have traditionally been two well-established principles:
Given the second of those points, the recent decision in Unaoil v Leighton Offshore perhaps came as a surprise when a liquidated damages sum, which was at least theoretically enforceable at the time the contract was entered into, was held to be unenforceable because of a later variation which significantly reduced the size and value of the project. In the court’s view, such a major variation should have caused the liquidated damages to also be reconsidered. The judge said: “So far as I am aware, there is no authority to such effect but it seems to me that this is consistent with general principle.”
The Unaoil case concerned an infrastructure project but the message is even more relevant to FM contracts. With typically longer term agreements and client requirements inherently more changing in nature, FM contracts are more prone to major change during their lifespan. Yet standard forms such as the NEC3 Term Service Contract and many bespoke FM contracts make no mention of reviewing service credits as part of the assessment of change. Given the principle now set down in Unaoil, those involved in rebaselining or change management in FM projects should take note and consider whether service credits are still fulfilling their legitimate commercial purpose rather than simply taking comfort from the carrot and the stick in contractual armoury.
David Weare, Partner, Fladgate LLP (firstname.lastname@example.org)