I have a nagging question which I cannot answer. Why do some Owners (including Government institutions) insist on including LDs (liquidated damages) in contracts? Based on my experience and on informal surveys I have taken, LDs, in general, DO NOT work. They make no sense from an economic viewpoint. Incentives make much more sense. Here’s my rationale –
1. LDs raise costs for the owner. The purpose of well prepared and properly adminstered contracts is to increase value, not raise costs. LDs run contrary to common sense and do not stand up to the rigor of analysis.
– Bidders have to factor in the risk of LDs. That’s the first layer of added cost.
– LDs create an adversarial relationship wherein the contractor and owner jockey for position to “manage” the LD process. The focus of the contractor is on defending against potential LD claims. So naturally, the contractor diverts attention and resources to establish claims which counteract potential LDs. This “contractual behavior” adds cost to all parties.
– It is VERY difficult for an Owner to successfully extract LDs. The burden of proof weighs heavily in the favor of the contractor. A savvy contractor is usually able to assert counterclaims against the owner, especially on a complex project.
– Adversarial relationships undermine the spirit of cooperation, knowledge sharing, communication and transparency that are essential on large and complex projects.
2. Incentives work much better because they appeal to stronger, commonly shared economic interests.
– The owner gains economically when a project is successful. Incentives are a vehicle to share in these gains.
– Incentives are a net positive for bidders, therefore, they do not drive up the cost of bids. If anything, they should drive bids down for confident bidders.
– The opportunity to earn an incentive or bonus can be shared by the contractor with the project team and subcontractors. This creates a solid potential to align interests. When the owner’s interests are aligned with the project team, good things happen.
3. Common Sense.
– Would you tell an employee that if their performance was low, they would have to return money at the end of the year? Or would you establish performance-driven bonus targets?
I’d like to hear your opinions in this matter. What experiences have you had which either support or refute my arguments?