Author: Tim Wright
Tim Wright, Partner, Fladgate LLP (firstname.lastname@example.org)
Another outsourcer is reported to be facing problems, with reports in the media stating that Amey has been hit with a £48.5 million ‘penalty fine’ for failing to replace two sets of damaged roadside bollards. The sum is said to have been imposed by Birmingham City Council under its troubled 25-year PFI highways services contract which Amey successfully tendered for in 2010, then worth a reported £2.7 billion.
This is not the first time that the contract has run into trouble, with a series of court hearings starting in 2014 and ending with a settlement agreement reached between the parties in 2017. That settlement saw Amey repay £54.95 million to the council and agree to a £1.3 million reduction in the monthly payments made by the council to Amey for its services.
It was also reported that, on another occasion, the council issued a notice under the contract fining Amey £14 million because it took too long to remove three cable ties left by workers around a lamppost – deemed by the contract to constitute unnecessary “cosmetics”.
Not surprisingly, the relationship between Amey and the council is described as “difficult”. Amey is said to want to withdraw from the contract.
The bollards in question were located in a parking strip on one side of the road adjacent to a set of speed humps – the idea being to stop motorists swerving to one side to avoid having to slow down for the humps as well as preventing cars from being parked adjacent to the humps. Amey did not replace the bollards within an hour of their damage being reported – the time permitted by the contract for an “emergency” incident requiring a category 1 response. This lead to an initial £250 penalty. By the time that the work was completed, some months later, with the penalty doubling every hour, the total due for one set of bollards was £31 million; and £17.5 million for the other.
Amey argued that the incident should have been classed as a non-urgent category 2 incident, which would have given them 28 days to complete the repair, and would have resulted in a penalty fine under the contract of £2,500.
English law permits the parties to a contract a fair degree of latitude when agreeing specific remedies which are to apply in the event of a contractual breach, such as liquidated damages, forfeiture of deposits/advance payments, or demurrage in a shipping time charter. There is, however, a general rule that if a clause is a penalty then that clause will not be enforced beyond the actual loss of the innocent party (i.e. the clause remains but cannot be enforced beyond the actual loss suffered). The rule is one of public policy and accordingly will only be exercised sparingly since the courts will not ordinarily interfere with the parties’ freedom of contract.
Whilst there have been a number of cases on this point, a good rule of thumb is that a clause is likely to be found to be a penalty where it cannot be commercially justified, i.e. where the detriment imposed on the breaching party is completely disproportionate to the legitimate interest of the innocent party. Of course, it doesn’t matter whether or not the clause uses the term “penalty”, although it is usually best avoided.
Liquidated damages clauses are often used in outsourcing agreements such as a delay payment or deduction where the supplier fails to meet a contractual milestone within an agreed timeline. Great care needs to be taken with the drafting of a liquidated damages clause. Including language to the effect that the clause represents the parties’ genuine pre-estimate of the likely losses which the customer will incur as a result of the delay will be persuasive but not necessarily determinative. The clause must be capable of being justified as a genuine pre-estimate of loss and should not provide for excessive payment on breach. Otherwise it may fall foul of the rule against penalties.
Apart from this, there will be other considerations, such as whether the liquidated damages are the customer’s only remedy or whether general damages are also available. A middle ground is for the liquidated damages to be the sole remedy up to a point in time after which the customer has the right to claim additional damages.
Service credits are another remedy typically found in outsourcing agreements. Usually service credits are triggered by the supplier’s failure to meet a particular service level. Service levels and service credits are typically designed as a tool to “encourage” the supplier to perform the services in a manner which meets or exceeds the required performance metrics rather than trying to fully compensate the customer for its actual losses, and they certainly shouldn’t be used to penalise or fine the supplier.
For this reason, service credits are often described as effecting a price adjustment because of the poor service received, as opposed to trying to estimate the customer’s loss. With this approach, the need to avoid the rule against penalties is not such an issue, although in the Amey/Birmingham CC case, one wonders whether those involved in crafting the “penalty fine” regime were aware of the rule. It is hard to see how, in the examples reported, a penalty in the tens of millions of pounds might be considered commercially justifiable, nor why Amey would have agreed to this in the first place.
One-sided, heavy-handed performance management regimes are unlikely to contribute to a long-term sustainable and mutually beneficial customer/supplier relationship. Although risk and reward will often mean different things to suppliers and their customers, it is important that any performance management system is fair and balanced, with opportunities for suppliers to be rewarded for over-performance (as well as compensating their customer’s where they under-perform); alternatively suppliers could be given the ability to earn-back previously incurred service credits. However, it is important to ensure that an earn-back does not have unwanted consequences which can happen where the supplier’s account manager is rewarded against his/her ability to minimise the amount of service credits suffered by a supplier rather than focussing on overall service performance and sustainable improvements.