How Much is Enough?

When developing a Performance Based Contract (PBC) one of the questions consistently asked is, “so how much should be put at risk?”. Notwithstanding the fact that highly successful PBCs use a combination of both financial and non-financial rewards and remedies, this specific question simply refers to what percentage of the contract price is placed at risk based on seller (or contractor) performance.

The key here, like a lot of the elements in a Performance Management Framework (PMF), is the balance between:

the desire of the buyer to have sufficient money “at risk” to ensure the seller is motivated to perform, the classic sufficient “skin in the game”; vs.
the desire of the seller to limit their exposure to ensure their likely financial return is sufficient for the risk of delivering the outcome of the contract.

So in practicality what does this usually mean? In my observation what appears to be agreeable to both buyer and seller is only exposing the sellers profit to the PMF; that is, only the profit is “at risk”. This approach protects the sellers costs from the PMF while ensuring there is sufficient “skin in the game” with 100% of the profit at risk, since most seller don’t work for cost alone.

Importantly, too much at risk may result in either a seller solution that is unaffordable or an adversarial relationship between the parties. Alternatively, too little at risk may result in the seller not being motivated to deliver the buyers outcome. While I acknowledge there are a few highly successful PBCs that don’t follow this rule, in my observation they are exceptions rather than the rule.

Of note, in Australia, a 2012 High Court decision in Andrews v ANZ has implications on the application of the penalties doctrine to performance based contracts. Key points are as follows:

  • Abatements or deductions used in PBC may now be subject to the legal doctrine of penalties;
  • Abatements or deductions may be set aside if they are unconscionable having regard to the loss likely to be suffered or represent an extravagant attempt to secure a level of performance;
  • The buyer may have some protection in respect of certain types of loss that are extremely difficult, expensive and complex to calculate precisely, although this is unlikely to protect against amounts that are clearly unconscionable;
  • If the abatements or deductions are deemed to be a penalty, it is necessary to prove actual loss for breach of contract, which can be difficult for Defence applications which are measured in “capability effects”; and
  • The decision applies to existing and future contract, including those entered into prior to the date of the decision.

That said, in my opinion, it is unlikely that abatements or deductions equalling the level of profit on a contract would be deemed a penalty and set aside. Accordingly, in your specific application and legal jurisdiction, it may be worthwhile getting your local legal advisor to provide advice on your specific PMF. A full copy of the Australian judgement is available at http://www.austlii.edu.au/au/cases/cth/HCA/2012/30.html.

So where does this leave us? Noting that financial rewards and remedies are only one part of the PMF, in setting the amount at risk we need to be like Goldilocks in choosing her bed. It needs to balance the need to be big enough to motivate the seller to deliver and small enough to make the solution affordable and have a reasonable relationship. In other words, it needs to be “just right”.

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