Top Ten Tips - Liability and Risk



Kit Burden
01/10/2012

IT and outsourcing contracts are primarily concerned with liability and risk, as well as the assignment of responsibility for each between the customer and the supplier. With technology and outsourcing projects having an unfortunate propensity to go wrong/not deliver according to the parties' expectation, the corresponding contractual provisions are accordingly of vital importance! What then are the most common and/or significant risk and liability issues, and how might they be addressed?

1. Misrepresentations and overselling

It is important to note at the outset that this is a two-way street; just as a supplier may oversell itself in an effort to win business, so might a customer misrepresent the true nature of its operations and service levels etc, when trying to convince a supplier to "step up to the mark" in terms of desired service level agreements (SLAs) and levels of pricing.

Customers should be wary of provisions in a contract that state the "entire agreement" between the parties supersedes all previous understandings or documents; the actual effect of this may be to prevent the customer from ever being able to point back to the original proposal documents upon which it relied in seeking to engage the relevant supplier in the first place. At the very least, it should ensure that any key representations or promises made by the supplier in such pre-contract documentation are fully reflected in the contract itself.

From a supplier perspective, they should ensure that when they are expressly relying upon information provided by the customer, they will at least have the option to re-evaluate the fees in the event that such information is found to be materially inaccurate.

2. Project delays

Estimating the time it will take to complete large-scale and complex activities (such as an outsourcing-related transition or transformation programme) can be extremely difficult, and yet customers may face significant adverse consequences in the event of delays. Many of the provisions of contracts for IT and outsourcing projects are accordingly focussed upon both incentivising on-time delivery, and "punishing" the party who is guilty of delays. A very common tool used in this regard is the liquidated damages provision, which stipulates that the supplier will have its charges reduced by preset amounts for each day, week, etc. it goes beyond the agreed delivery/commencement date.

It is important to remember, however, that there may be opportunity to use a carrot as well as a stick; for example, if the customer gets a demonstrable financial benefit by reason of an early delivery (as for example, would be the case if the customer could stop paying for an existing/legacy service or stop incurring some other form of expense), there may be scope to offer a supplier a bonus for early/on-time delivery, which may in turn make it more amenable to take on more risk/liability in the event of late delivery.

3. Non-functioning systems

Once a customer has paid a lot of money for a system or service, it will expect that it work as planned. However, this will unfortunately not always turn out to be the reality. The question then arises as to what must be done. In this regard, customers need to be wary of warranty clauses, which appear at first blush to be promises from suppliers to come back and fix any problems that may arise during a certain period (e.g 90 days). Although this may sound positive, on closer examination it may turn out to be an effective limitation of the supplier's liability, such that if problems arise after this warranty period, no matter how serious they may be, the supplier may have no liability at all!

You must accordingly be very careful to specify in your contracts not only what you expect your services/system to do, but also exactly what the consequences will be in the event that things don't turn out as planned.

4. Service quality problems

Many contracts (including support/maintenance and outsourcing contracts) involve ongoing services which – even if not quite being provided as was envisaged or hoped for – are nonetheless not so bad as to justify the costs and hassle of a contract termination.

Issues of risk and liability in these circumstances are best addressed through a service level regime, whereby the parties effectively quantify the level of service that is required (e.g in terms of a maximum period that it should take a supplier to resolve a particular type of problem etc), and agree upon a mechanism for reducing the amounts payable to the supplier in the event that these levels of service are not achieved. Key issues to be negotiated in this regard are (obviously!) the setting of the required service levels themselves, how quickly fee reductions (usually called service credits) will accrue if they are not met, and whether such reductions are subject to a cap (e.g 15% of monthly fees, or whatever the parties can agree).

5. Staffing issues

No matter what the contract says, the actual performance of the services and the ultimate success of the project is likely to be largely dependant upon the individuals engaged upon it. The customer will accordingly have a vested interest in the actual personnel engaged in providing the services. Specific personnel-related risks that the contract should address may include staff attrition levels (as a project with high rates of turnover will be unlikely to be working efficiently), the movement of key personnel off the account, compliance with customer policies, and staff vetting and checking processes.

6. Lack of governance

Although most lawyers would inevitably say that the contract is the foundation of the relationship of the parties, it is equally true to emphasise that it is a "relationship"; a good relationship between the parties can achieve success even if the contract itself is flawed.

The key to this is governance. The contract can and should set out a detailed governance structure which will have as its watchwords transparency and openness (on the principle that if issues can be highlighted early enough and without "surprises", they are far more likely to be capable of resolution).

7. Financial instability

In these more financially challenging times, a key risk faced by the parties is financial stability. From a customer perspective, will the supplier still be around so as to be able to provide the services as required (particularly if the customer will have a heavy reliance upon such services)? The current situation with Satyam is an obvious case in point; what will happen with the customers whose outsourced operations are effectively dependant upon Satyam, if that company ceases to exist or it ceases to be able to pay its staff and they stop turning up for work? On the flip side, the supplier will want to feel comfortable that the customer will in fact be able to keep on paying its bills!

The contract can contain various forms of safeguards in this regard in the form of escrow rights, rights of notification of deterioration of financial condition, and associated termination rights, etc, but ultimately there is no substitute for undertaking a thorough due diligence exercise at the outset.

8. IPR claims

It will always be an unpleasant surprise to receive a claim saying that you do not in fact have the right to use a product or service that you thought you had paid good money to have the benefit of, and hence intellectual property right infringement claims can be emotive matters. Indeed, it is partially because of this "fundamental" expectation (and because of their potential impact upon the business) that such claims are usually excluded from the effect of any limitation of liability provisions (see below).

It is however worth noting in the context of allocation of risk as between customer and supplier that there are some forms of IPR claim that may be more difficult for either party to predict. In the case of patent claims, because they are territorial in nature, it is possible for a supplier to quite innocently develop a product for a client in one country, and for the client to then find itself on the receiving end of a patent claim when it – equally innocently – tries to then utilise that produce in another country. This will often be a difficult point of negotiation for the parties to address.

9. Liability limits

If all else fails and the parties end up in a serious dispute, the question will arise as to how much needs to be paid out in compensation.

In IT and outsourcing contracts there will invariably be a limitation of liability clause, as the supplier will argue that – bearing in mind its profit margin on any given contract – it cannot take on unlimited risk associated with it. The setting of the level of this limitation is the first key point of negotiation in terms of the allocation of risk, but the parties must also go on to carefully consider whether any forms of loss should be completely excluded (e.g loss of profit) or indeed made expressly claimable in any event (e.g fines or official sanctions).

10. Dispute resolution processes

Any consideration of risk and liability would be incomplete without also considering how the disputes dealing with such matters could or should be resolved. It is far too simplistic to be silent and leave matters to the court. There are in fact a range of other potential dispute resolution tools and processes, including management-level escalation, mediation, expert determination and arbitration. The parties should carefully consider which mechanisms would be right for their contract, and in relation to which kinds of loss or dispute.

Conclusion

Issues of risk and liability are multifaceted and touch upon many different aspects of both the contract and the parties' wider relationship. They must, however, be addressed openly and honestly between the parties, and in doing so they may actually increase the chances that the relevant project will proceed more smoothly, and to ultimate success.