A well-negotiated outsourcing agreement typically grants a customer the ability to terminate the arrangement without payment of any penalties in the event of a “material breach.” However, unless the agreement names specific events that constitute a material breach, that determination will be left to a court. While there are no “bright line” rules to assist a court in making its decision, some case law exists that offers customers guidance in navigating these murky waters.
In particular, the primary focus of a recent case, State of Indiana v. IBM,1 was whether or not the State of Indiana was properly entitled to terminate its agreement with IBM for material breach.
This article will explore some of the key points that can be gleaned from cases where material breach was a focus of the litigation and will culminate in some concepts and best practices that customers can implement to provide more predictability when evaluating whether a supplier materially breached an agreement.
What Constitutes a Material Breach?
When is a supplier in “material breach” for its failure to perform in an agreement? Law treatises offer some guidance to assist with that determination. For example, a material breach has been explained as a breach that “is so fundamental to a contract that the failure to perform … defeats the essential purpose of the contract,” “go[es] to the ‘root’ or ‘essence’ of the agreement,” or “touches the fundamental purpose of the contract and defeats the object of the parties in entering into the contract.”2 One authority, The Restatement (Second) of Contracts, recommends a multi-factor test that courts can invoke to determine whether a breach is material. Specifically, the court should consider the following factors:
- The extent to which the injured party will be deprived of the benefit that he or she reasonably expected
- The extent to which the injured party can be adequately compensated for the part of that benefit of which he or she will be deprived
- The extent to which the party failing to perform or to offer to perform will suffer forfeiture
- The likelihood that the party failing to perform or to offer to perform will cure his or her failure, taking account of all the circumstances, including any reasonable assurances
- The extent to which the behavior of the party failing to perform or to offer to perform comports with standards of good faith and fair dealing.3
Another view on materiality offers this insight: “Ordinarily the issue of materiality is a mixed question of law and fact, involving the application of a legal standard to a particular set of facts. However, if reasonable minds cannot differ on the issue of materiality, the issue may be resolved as a matter of law.”4
How have state courts interpreted the issue of material breach? In Illinois, a material breach is one that is “so substantial and fundamental as to defeat the objects of the parties in making the agreement, or whether the failure to perform renders performance of the rest of the contract different in substance from the original agreement.”5 Case law in Illinois further opines that a “breach must be so material and important to justify the injured party in regarding the whole transaction at an end.”6
In applying these concepts, Illinois courts have stated that “[t]he determination of materiality must turn on the facts of each case” and that, “to properly consider whether [a] defendant’s breach was material, it is necessary to begin by placing that breach in context.”7 An Illinois court will most likely apply the multi-factor test cited above from The Restatement (Second) of Contracts to determine the materiality of the breach. However, one Illinois court has also examined external and/or industry factors to determine whether the “custom or usage shows the breach to be material.”8
Courts in California have adopted the majority of the multi-factor test set forth in The Restatement (Second) of Contracts but have slightly modified the elements and added some additional factors to consider. In lieu of examining the extent to which an injured party will be deprived, the California test examines “[t]he extent to which the injured party will obtain the substantial benefit which he could have reasonably anticipated.” The test in California will also consider “the greater or less hardship on the party failing to perform in terminating the contract” and “the willful, negligent, or innocent behavior of the party failing to perform.”9
In New York, courts have defined a material breach as a breach “that goes to the root of the contract.”10 Moreover, a court in New York will evaluate whether a breach is material using this guidance: “A breach is material if a party fails to perform a substantial part of the contract or one or more of its essential terms or conditions, the breach substantially defeats the contract’s purpose, or the breach is such that upon a reasonable interpretation of the contract, the parties considered the breach as vital to the existence of the contract ... [or] if the promisee receives something substantially less or different from that for which he or she bargained.”11
State of Indiana v. IBM
So how will a court apply the multi-factor test to determine whether a party indeed materially breached its obligations under an outscoring agreement? There is scant case law on the topic, but an Indiana court recently provided some insights with its decision in State of Indiana v. IBM. In 2006, the State of Indiana and IBM entered into a 10-year, $1.3 billion outsourcing agreement under which IBM would transform and modernize the state’s welfare system. The project, which was intended to overhaul a welfare system that produced the worst welfare-to-work record in the country, was designed to let Indiana citizens apply for welfare benefits online or via a call center, while eligibility determinations would be made on a “centralized, statewide basis rather than in the local country welfare offices.” However, the transformed system produced high error rates and slowed the pace of eligibility determinations. In 2009, the State of Indiana terminated its contract with IBM by invoking the termination for cause provision of its master services agreement, citing that IBM was in material breach for “quality and timeliness.”12
IBM and the State of Indiana eventually found themselves in court; the state sued IBM for $1.3 billion, claiming breach of contract. IBM countersued the state for the value of equipment it was obligated to leave with the state under the terms of the agreement. The court stated that both parties were to blame, and that, consequently, “[n]either party deserves to win this case.” In its ruling, the court invoked parts of the multi-factor test from Williston on Contracts and concluded that the state failed to meet its burden to show that IBM committed a material breach, despite a record showing that “IBM did not perform well in some respects.” 13
Two factors from the multi-factor test played a prominent role in the court’s decision of whether IBM materially breached the agreement, namely, “the extent to which the injured party will be deprived of the benefit which he reasonably expected” and “the likelihood that the party failing to perform or to offer to perform will cure his failure.” Despite a painful transformation, the court determined that the state was able to achieve a “new welfare system that works better” as a result of the modernization efforts with IBM. The court found this fact “to have great weight regarding whether there is a material breach or not.” In its opinion, the court states that “[a]ll in all, the State was not deprived of benefits it reasonably expected from the contract, although some benefits were not received as smoothly as the parties would have expected.”14
As to the second factor, the court acknowledged that determining IBM’s performance was “premature and problematic” given the length of time the parties were bound under the agreement before the state terminated. (The final term of the agreement was 19 months—only 12 of which contained applicable performance measures.) Despite the state’s claim that IBM breached the agreement for “timeliness” and the court’s acknowledgement that key performance metrics for timeliness were “consistently missing the mark,” the court found that IBM’s performance was “steadily improving during 2009, especially in the months leading up to the October 2009 termination.” Based on this, the court extrapolated IBM’s performance and determined that IBM’s failures had the “likelihood of being cured” and were “apparently in the process of being cured.” Consequently, the court did not find that IBM materially breached the agreement under this factor and did not devote much effort to evaluating the other three factors.15
Nonetheless, the court considered another issue when determining whether there was a material breach—the extent to which the breach went “to the heart of the contract,” stating that, “where a party substantially performs, there is no material breach.” This finding is perhaps the most troublesome for customers of outsourced services, because the court did not grant much deference to IBM’s service level performance, and, instead, determined that “these examples … have to be balanced against the whole of the contract and IBM’s whole performance showing benefits to the State and adhering to [master service agreement] policy objectives.”16
As a result of the court’s findings, IBM was able to avoid the material breach claim by only meeting between 50 and 80 percent of its service levels. In fact, the court minimized problems that many IT managers would find unforgiveable, such as a 48-hour call center outage under IBM’s watch. The court refused to give much credence to the State of Indiana’s breach claims for performance items that were not measured by service levels, but it did give strong deference to a clause in the agreement that disclaimed any warranty of “uninterrupted or error-free operation.” When analyzing these performance items, the court refused to impute any additional interpretation in light of that disclaimer. The court also refused to grant much credence to the state’s claim of dissatisfaction with IBM’s performance as a basis for material breach and indicated that customer satisfaction was one of eight enumerated ways to judge IBM’s performance.17
Uncertainty for Customers of Outsourcing and Recommendations
The ruling in State of Indiana v. IBM does not support the finding of material breach on which the state based its termination claim. While that court applied the multi-factor test to determine whether IBM materially breached its obligations, it chose to focus on two factors and view the agreement from a more holistic point of view.
As was discussed above, case law in other states suggests that all factors of the multi-factor test should be considered, and the facts of the case should be evaluated to determine if the essence of the agreement has been violated. The court in State of Indiana v. IBM took the position that performance metrics that failed to meet certain levels did not violate the main objective of that agreement—namely, to have a better welfare eligibility system. However, performance metrics are typically heavily negotiated items in an outsourcing contract; the State of Indiana was purchasing not only a welfare system that worked better than the worst system in the country, but one that met certain performance metrics for the price it agreed to pay.
In light of this uncertainty, there are several measures a customer of outsourcing services can implement to minimize the chance of a similar judgment and provide more assurances that a court will support a termination for material breach:
- Memorialize specific events that the parties agree would constitute material breach, such as failure to meet a specified number of service levels or intellectual property theft, and that would allow termination without the payment of termination charges. A court will enforce these negotiated items, but, even if a breach does not meet the requirements of these “bright line” events, they can still be useful in assessing whether the breach in question is material and offering the court some guidance.
- Include a notice requirement in the agreement prior to terminating for a “bright line” material breach event and provide an opportunity to cure the defect. Notice to the supplier will reveal any arguments it may have that the conduct at issue does not meet the “bright line” test.
- In addition to memorializing specific “bright line” material breach events, ensure that the agreement has a general material breach provision. Ensure that important operational items are the subject of performance measurements. For example, the call center in the agreement between the State of Indiana and IBM did not have a service level to measure the timeliness of answering phone calls, a fairly standard call center metric.
- Define specific standards of performance and try to avoid ambiguous terms, such as “industry standards” or performance that is “appropriate,” “sufficient” or a “best practice.”
- Ensure that service levels have meaningful service level credit amounts to stress the importance of achieving those measurements. In State of Indiana v. IBM, the court commented that the service level credits were “miniscule” and consequently failed to give much weight to the importance of missed service levels.
- Try to minimize the number of service levels to avoid diluting the “At Risk Amount;” if this cannot be achieved without compromising operational performance, group service levels in a few performance categories.
- Do not position service level credits as liquidated damages. In State of Indiana v. IBM, the service level credits at issue were actually labeled “liquated damages” in the agreement, and the court viewed IBM’s payment of these “liquated damages” as an alternative means of performance. Most customers prefer to have the service levels met rather than to receive financial compensation for missed performance.
- Break up big projects into smaller deliverables with measurable results.
- Set service levels that allow for termination if performance falls below a predefined metric.