The Issue Of Penalties In Procurement

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Author: Margaret Gilbert 

It is interesting that contracts often have penalty clauses which both parties agree to. When should it be used: Penalties should be imposed when the supplier does not abide by the contractual obligations in the contract.

The purpose of penalties is to have a mechanism where it is known when a penalty will be imposed. This can either be a % or $ of the contract value.

Definition – Penalty – a punishment imposed for breaking a law or contract.

Example of penalty

‘A penalty of 10% will be imposed on the supplier if the following actions occur. In the first instance the penalty of 10% will be on the previous months invoice. For multiple situations a penalty of 105 will be based on the total contract value.’

While a penalty clause is in the contract it is often ignored which is counter-productive and sends a wrong message.  It is worrying that this clause is not used as it should be.  The reality is: if you are not going to use, then do not include in the contract.

There has to be consideration as to whether the instance is one off or whether the circumstances are ongoing. If it is one off then probably not but if ongoing then yes a penalty(ies) should be imposed.

What if’s:

  1. The penalties are imposed – then the issue will be resolved.
  2. The penalty is not imposed – the problem continues as the supplier will be aware that there is no intention to use.

Finding another way – these being:

  • Discussion (this may help)
  • Mediation
  • Arbitration

If the issue is important enough then this could be a cause for mediation which is the ‘softer’ version of arbitration. Termination is an option and can be used within the clause ‘Termination for Default’. This might be difficult to do especially if the supplier is sole source. This is where a penalty clause is an effective solution – as long as it is used.

Useful checklist:

  1. Is the penalty clause there ‘for show’?
  2. Is the issue serious or not?

Clarity is essential as is the need to communicate when penalties will be imposed and when it will not.

If the situation arises when the penalty clause is invoked then this might be a sign that things are not as they should be.

This could be about poor performance and may require a discussion on the contractual obligations. It is hoped that for the contract term that the penalty cause is not utilised. This is the hope but if necessary then it is there to use.

A penalty clause can link into (a) % of the contract, (b) a $ of the contract and (c) form part of liquidated damages.

Having but not using is pointless. Over using is ineffective. A balance has to be found that is fair but there is clarity on expectations.

There are mechanisms which should be used when appropriate. Having but not using is ineffective and adds a burden on the buyer as the supplier can see that no action will occur and will continue to act inappropriately.

It is important to take control and ensure that the contract performs to the agreed specific requirements. This has to be goal and the required outcomes – otherwise there is no gauge as to how to measure the effectiveness of a contract.

 

Margaret’s book ‘Contract Matters: A Future for Procurement’ is available through  margaret@corpcontracts.co.nz or www.contractmatters.com , $30 book, $15.00 for e-book.

 

 

 

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