"The details are not the details. They make the design." - Charles Eames
Indiana vs. IBM
In 2006 Indiana awarded IBM a contract for more than $1 billion to modernize Indiana's welfare case management system and manage and process the State of Indiana's applications for food stamps, Medicaid and other welfare benefits for its residents. The program sought to increase efficiency and reduce fraud by moving to an automated case management process. After only 19 months into the relationship, while still in the transition period, it became clear to Indiana that the relationship was not going as planned. The expected levels of automation were not being realized. Instead, the program reverted back to a caseworker process, and performance was consistently slower than agreed to levels.
In October 2009, Indiana terminated the contract claiming that IBM committed a material breach. The claim relied primarily on a showing that the coalition of vendors led by IBM consistently missed the key performance indicators (KPIs) for Call Center abandonment rate, timely processing of applications and redeterminations, and service level metrics (SLMs) for adherence to proper processing procedures. IBM claimed that only a limited number of KPIs applied during the relevant period, and IBM already fulfilled their performance obligations by paying liquidated damages as a penalty for these KPI failures.
This case is interesting because it is rare for material breach claims such as this to be decided by a court. Typically, these cases involve messy arguments of cause and effect, and so most are settled by negotiation. Outsourcing practitioners should take this opportunity to learn from a judge's perspective on materiality and the meaning of these complicated contractual arrangements.
The court found that Indiana failed to prove that IBM materially breached its contract with the State. The Marion Superior Court in July 2012 held that widespread performance failures by IBM did not constitute a material breach when certain program objectives (e.g., increased efficiency, reduced fraud) were being realized by the State. Judge Dreyer also held that IBM's ongoing improvement precludes a finding of material breach within the short nineteen month period between service commencement and termination, and that payment of liquidated damages fulfilled IBMs performance obligations. In summary, the court found that IBM "substantially performed" its contractual obligations to the State, precluding a material breach award. IBM received a damages award of $52 million for subcontractor fees and equipment being used by the State. The State of Indiana is appealing this decision in the Indiana Court of Appeals, where various briefs by IBM and the State are due between now and the end of July 2013.
Could Indiana have avoided such heartbreak?
Including the following contractual levers and utilizing such measures in an agreement may have more adequately protected Indiana's interests:
- Provide explicit performance-based termination rights: Include in the agreement explicit grounds for termination tied to objective performance measures. For example, termination rights could be triggered when a service provider fails to achieve a service level for three consecutive months, or when the aggregate of non-material breaches constitute a material breach (the "death by 1000 cuts" approach).
- Set meaningful Service Level credit amounts or don't have them at all: Liquidated damages will only incentivize performance if they are set at levels commensurate with the importance and cost of the services. The Service Level Credits that IBM was paying amounted to $500 - $5,000 per month and in other instances they had not been yet determined. If it is cheaper to pay then perform that speaks volumes about the significance of the Service Level in question. Worse still, insignificant credits may do more harm than good -- this is not the situation where something is in fact better than nothing, because it de-values the importance of the metrics the customer is looking for the Service Provider to measure. And, while it is tempting in the negotiating process to defer setting Service Levels until after the contract commences, as was the case in Indiana, it is highly unlikely to set Service Levels that are satisfactory from the customer's perspective after an agreement is signed.
- Reserve a right of election: Reserve the right to elect alternative non-monetary relief in place of liquidated damages. This will prevent the situation found in Indiana v. IBM, where the service provider can continually cure nonperformance by paying liquidated damage amounts. While some jurisdictions (including New York) hold that liquidated damages must be the sole and exclusive monetary remedy to be valid, this does not preclude the election of non-monetary remedies, such as termination, injunctive relief, or specific performance.
- Enforce rights through proper governance: Vigilant ongoing communication and recordkeeping is required to enforce and preserve rights granted under an agreement. In other words, don't let your sourcing agreement become merely a door stop. If the best path is to grant an exception for nonperformance, do so by explicitly affirming your right to relief, and simultaneously disclaiming that right in the immediate instance. Indiana, for example, praised IBM publicly and turned a blind eye to performance failures they would later hold up as justification for termination. Conducting an outsourcing relationship inconsistent with the agreement for a long period of time can make it difficult for one party to suddenly insist on strict adherence to the agreement.