Part 2 of our ongoing Technology and Outsourcing Hot Spots Series discusses issues relating to the performance of technology and outsourcing contracts. It examines governance and change issues including:

• Effective service descriptions;
• Effective cooperation between parties
• Variation orders and clauses;
• Benchmarking and price review mechanisms; and
• Enforceability of agreements to agree and/or agreements to negotiate in good faith.

In Part 1 of our series, we discussed issues relating to pre-contractual negotiations and scoping of work. Even assuming that the scoping has been done properly and that the customer’s requirement was rendered in exact detail under the concluded contract, there is still a need to monitor and ensure that the scope of work is performed according to the contract. Similarly, the contract might need to be varied over time due to changing needs.

Outsourcing contracts anticipate a fairly long term relationship between the parties that is generally measured in years. Even in IT projects, these can take years depending on the complexity and size of the project. Given such lengthy time frames, change is nearly inevitable in the form of the customer’s technological and business needs. Therefore, there needs to be a system / process in place to allow parties to make periodic changes to the agreed work scope in a manner that is structured and which minimises disputes.

There is no standard outsourcing agreement that adequately suits all scenarios and business needs. Outsourcing contracts can operate in a number of forms and the customer should know what he wants from an outsourcing agreement. This can range from simple cost savings, to allowing businesses to focus on their core competencies, to obtaining real improvements (expertise and scalability) in the area outsourced.

At one end of the outsourcing spectrum, a business can simply rely on the IT vendor’s helpdesk and warranties without any formal outsourcing arrangement being entered into. At the other end of the spectrum, an outsourcing company might purchase the in-house department (personnel and assets) in order to provide that department’s service back to the company. The extent of the management and operational cooperation between parties in such circumstances can also vary dramatically. For example, a simple IT helpdesk is unlikely to require or warrant close cooperation between the customer and the vendor. Conversely, a multi-year outsourcing agreement which involves the business process outsourcing (“BPO“) company taking over all non-core and customer facing business functions will require substantial and constant cooperation.

Effective Governance

Regardless of the outsourcing arrangement entered into, effective governance is crucial. The IT Governance Institute’s Governance of Outsourcing defines the governance of outsourcing as,

“the set of responsibilities, roles, objectives, interfaces and controls required to anticipate change and manage the introduction, maintenance, performance, costs and control of third-party provided services. It is an active process that the client and service provider must adopt to provide a common, consistent and effective approach that identifies the necessary information, relationships, controls and exchanges among many stakeholders across both parties“.

(emphasis added)

The same can be safely said of the governance of IT projects as well.

The need for effective cooperation and governance

The case of Compass Group UK and Ireland Ltd (t/a Medirest) v Mid Essex Hospital Services NHS Trust, [2012] EWHC 781 (QB) provides an example of how a failure to cooperate in good faith and an overly aggressive insistence on strict contractual performance can destroy an effective business relationship.

On 1 April 2008, Medirest entered into a contact with the defendant Trust for Medirest to provide facilities management, including catering services to the hospital. Under the terms of the contract, the hospital appointed Medirest as its Contractor to perform the Services in accordance with the Service Level Specification and the Trust agreed to pay the Contract Price (on a yearly basis and subject to indexation). There was a three month “bedding-in period“, April-June 2008, when no deductions were to be made.

Clause 3.5 of the Conditions of Contract also provided for the parties to cooperate with each other in good faith and to take all reasonable action as was necessary for the efficient transmission of information and instructions and to enable the Trust or any beneficiary to derive the full benefit of the contract (see paragraph [23])..

The High Court held at [25] that such a general obligation to cooperate in good faith accorded with commercial sense,

“Medirest and the Trust had entered a long term contract for the delivery of food and other services within a hospital, the performance of which required continuous and detailed cooperation between the parties at a number of levels if it was to work smoothly. In those circumstances, it is highly likely that the parties intended that there should be a general obligation that they should cooperate in good faith with each other. The only limitation to that general obligation would be that it would be limited to the performance of the contract.”

In the context of long term contracts, the High Court further held at [27] that, “any lack of cooperation in the relationship in this context could have significant ramifications for patient well-being. The duty to cooperate necessarily encompassed the duty to work together to resolve the problems which would almost certainly occur from time to time in a long term contract of this nature [citation omitted]. It also necessarily required the parties not to take unreasonable actions which might damage their working relationship“.

The Trust breached its duty to cooperate in good faith by being over zealous and unreasonable in enforcing its remedy of penalising service failure points on Medirest’s part through deductions to the Contract Price. The High Court noted the contract was barely a week old when the Trust’s commercial director requested a copy of the contract because the relationship “could get contractual“. He then instructed a colleague to “read the riot act” to Medirest (see paragraph [48]).

Interestingly enough, the High Court did note that this “challenging approach on the part of the [hospital] proved justified in the early period of the contract” (see paragraph [49]). However, by November 2008, the defective performance had generally been rectified and there were no longer complaints in respect of the services (see paragraph [59]). By the later half of January 2009, the Trust admitted the contract was essentially being performed properly and that there were no significant problems with service delivery.

Nevertheless, the Trust continued to take this “challenging” attitude when Medirest submitted a formal action plan in January 2009 as a result of a warning notice given by the Trust on 12 December 2009. An internal team within the Trust was told to review that action plan and “pull it to bits” (see paragraph [60]). Furthermore, Medirest’s attempt to seek guidance as to the issues to be rectified given the lack of specificity in the warning notice was “unhelpful[ly]” rebuffed by the Trust. Instead, the Trust chose to impose a deduction of £587,207.68 for the period of July 2008 to December 2008 which represented over half of the amount payable by the Trust for that period (see paragraph [65]) and subsequently announced its intention to make unilateral deductions of £50,000 per month (see paragraph [67]).

The High Court considered that the effect of the Trust’s conduct from the first part of 2009 was to damage, and ultimately to destroy, the working relationship with Medirest. In its view, the Trust thereby breached its duties to cooperate in good faith and to take all reasonable action so that the Trust and the beneficiaries could derive the full benefit of the contract. Furthermore, those actions also constituted “a wrongful abuse of the Trust’s powers under the contract” (see paragraph [83]).

The High Court held that important calculations rendered by the Trust in respect of the deductions “were patently absurd” and displayed a lack of “fact and common sense” (see paragraph [85]). For example, a single box of out of date ketchup attracted 30,860 service points and a deduction of £46,320 (the contract provided that service failure points of more than 1,440 justified a termination of the contract by the Trust). This was despite the fact that it was a brand not used by Medirest, the oversight was remedied immediately and the Trust was informed as such. Other examples highlighted by the High Court include the deduction of £84,540 for a one day old chocolate mousse, which was immediately removed, and £96,060 for some 3 day old bagels belonging to staff or patients, and also immediately removed!

The end result was that both parties separately terminated the contract within 18 months of its commencement in what was to have been a long term contract. The Trust’s commercial director also came in for criticism insofar as he had prime governance responsibility and had caused the breakdown of the relationship. In this respect, the High Court considered that the “challenging” approach was part of the commercial director’s mindset insofar as he had an “expectation that there would be service failure points and deductions” (see paragraph [48]) and caused the Trust to have “acted in a manner calculated, at least objectively, to impose the largest possible service failure points irrespective of the lack of justification” (see paragraph [103]).

Similarly, the case of Vertex Data Science Ltd v Powergen Retail Ltd [2006] EWHC 1340 (Comm) is a cautionary tale of how important good effective working relationships between parties are in complex contracts and how a breakdown in such relationships in one area can render an entire BPO contract unworkable.

Vertex is a wholly owned subsidiary of United Utilities plc, a utility company. It is the customer management outsourcing division of United Utilities and provides customer service activities to clients in the commercial, utilities and local and central government sectors. Powergen is a company within a group of companies which generates and supplies electricity.

Pursuant to a Master Services Agreement (“MSA“) between the two companies, Vertex was to provide very substantial BPO services. The MSA contained 9 individual transaction documents governing the individual outsourcing services to be provided by Vertex. However, the 2 key ones which accounted for 60% of the revenue and which involved Vertex facing Powergen’s customers in a representative fashion were:

1. India Services – responding to inbound customer calls and various back office activities; and
2. Staywarm (a fixed tariff service for elderly and vulnerable families) – services for handling all Staywarm customer accounts.

The MSA was to run from April 2005 till May 2012. Each party had the right to terminate the agreement after 4 years. Powergen sought to terminate the agreement after the 4 year period on the basis of material breaches of the MSA and/or such shortfalls amounting to a repudiatory breach on Vertex’s part.

The dispute between the parties centred on the India Services and the Staywarm services. In respect of the former, Powergen complained of the poor management and performance of Vertex’s Indian operations. As for the Staywarm services, Powergen complained that Vertex had failed to make any effort in collecting on bad debts.

It was clear, even before the matter reached the High Court, that the relationship between parties had deteriorated at both operational and management levels (see paragraph [5]). In the context of a complex outsourcing agreement, the fractured relationship was fatal. Even though the dispute between the parties was limited to 2 of 9 areas for which Vertex provided BPO service, the MSA was terminated as a result of the breakdown of the relationship,.

The MSA came up to 173 pages in total. Vertex called it a “very complex, multilayered commercial relationship” and noted that “[i]n such a complex project there are many hundreds of services, projects, informal requests and de facto variations going on at any one time“.

The High Court itself observed that “the relationship between Vertex and Powergen created by the MSA require[d] close and continuing cooperation at an operational level on a daily basis. Vertex [could not] perform its functions under the MSA without the continu[ed] active cooperation of Powergen” (see paragraph [5]). The learned judge concluded: “[a]lthough mutual cooperation and mutual goodwill are different concepts, I find it difficult to conceive that the cooperation required for successful performance of the MSA could be achieved without mutual goodwill“.

Lack of effective service descriptions

Compounding the problem in the Vertex case was a fundamental disagreement as to the respective parties’ obligations. This was the result of a lack of effective service level descriptions.

The core obligations which Powergen imposed on Vertex were clauses 4.1 and 4.2 of the MSA which provide:

“4.1 Vertex undertakes to Powergen at all times during the period of this Agreement that it will provide the Services and perform all of Vertex’s other obligations under this Agreement with all reasonable care and skill.

4.2 During this Agreement Vertex shall also (subject always to Clause 6.6):

4.2.1 Comply with the Transaction Documents (including any applicable SLAs), the Regulations and Good Industry Practice;

4.2.2 Comply with all statutory requirements and the requirements of all relevant statutory non-statutory bodies relating to the provision of the Services…..”

As mentioned, the dispute over the Indian Service component related to poor management and performance at the call centres in India. A customer management consultancy report commissioned by Powergen called the “customer experience” at the call centre “amongst the worst they [had] ever come across“. Powergen also complained of Vertex’s unauthorised processing of Powergen personal customer data on its Floor Manager system in India. The Staywarm dispute related to Vertex’s refusal to manage (i.e. collect) debt owing from Staywarm customers.

Parties did try to resolve their disputes. The High Court decision detailed a series of near monthly meetings, at the operations level up to management level in an attempt to resolve these disputes. However, parties were ultimately unable to resolve their differences. Throughout these meetings for example, Vertex maintained that debt collection did not form part of its service level obligation for the Staywarm service while Powergen insisted that it did.

Furthermore, in respect of the collection and processing of customer data, Vertex argued that Powergen had known for some time about its use of the Floor Manager system and made no complaint about it until 10 March 2006. Vertex also asserted that the information contained on Floor Manager could not be used to identify any particular individual. In response, Powergen said that the customer data included unique reference numbers. Furthermore, while it knew that Vertex was utilising the Floor Manager system to monitor its performance under the MSA, it did not know that Vertex was transferring data which constituted personal data within the meaning of the Data Protection Act 1998. Powergen also asserted that the dismissive attitude which Vertex had adopted to this issue was of serious concern.

Whilst it did not have to come to a decision, the High Court noted that there was “a fundamental question whether Powergen [could] legitimately complain about, or regard as non-contractual, a level of service which, whilst not in accordance with the Regulations and Good Industry Practice to which, by clause 4.2.1 of the MSA, Vertex must adhere, [was] nonetheless not actually in breach of a Service Level Agreement (“SLA”) because the SLA lack[ed a criterion which measure[d] the relevant shortcoming in performance“.

The High Court also noted that, “[i]t [wa]s perfectly possible that the terms of the SLAs permit[ed] a level of performance which [wa]s, objectively, unsatisfactory“.

Failure is costly

A badly drafted contract and/or one with poor governance can cause business, reputation and other losses to both the customer and the vendor above and beyond the mere fact that parties had not obtained what they had bargained for.

In the Vertex case, the High Court considered that Powergen could well have embarked upon a new strategy of dealing with clients directly (contrary to the entire point of the outsourcing contract) on the basis that the existing arrangements between the parties were hurting Powergen’s reputation and business. The judge also thought it “also not inconceivable that Vertex’s performance may in fact be damaging to Powergen’s reputation and business without amounting to a breach of Vertex’s contractual obligations” (see paragraph [37]).

In turn, Vertex claimed that Powergen’s issuance of the notice of termination would jeopardise their ongoing pitches for work. Vertex claimed that it would have to disclose Powergen’s termination as part of the standard disclosure questions and which in turn would prevent them from winning such business. They claimed that such reputation losses could not be compensated in damages as the basis for seeking an injunction (see paragraph [51]).

In the BSkyB v HP case discussed previously [hyperlink], the High Court agreed that the delay in getting the CRM system up and running due to the misrepresentations on the part of the vendor’s representative caused loss of business benefits like reduced churn of customers and reduced calls to the BSkyB’s call centres. There were also losses in the form of BSkyB having to step into the shoes of the vendor to do the work of a systems integrator as well as reducing the scope of what their integrated CRM system was supposed to do in an attempt to salvage the delays that had accrued. As a result, HP faced an interim damages award of £270 million and eventually settled at £318 million inclusive of legal costs.

Change control procedure – Catering for business and technological change

As mentioned, a customer’s requirements, however well specified, will likely evolve over time. In those circumstances, it is important that the contract provides for a framework and mechanisms that would allow parties to determine and effect the necessary changes whether to the design, quality, quantity or costs of the project. For example, in cases of long term IT projects and outsourcing contracts, issues of technology replacement and technology refresh might arise which affect all four criteria.

One important mechanism is benchmarking provisions, which can have the dual benefit of keeping pricing and performance competitive. It is axiomatic in management that a firm cannot manage what it cannot measure. Depending on how commoditised the outsourced services are and whether comparable services are readily available in the market, benchmarking can be a simple exercise of getting quotes from the markets and pegging any revision in fees and charges incurred to those quotes. As such, benchmarks can also be useful in monitoring and maintaining efficiency, performance and even as part of gain sharing i.e. where the vendor gets a share of any cost savings as a result of improvements or gains on a particular matrix.

Conversely, in a complex outsourcing agreement, benchmarking itself could become a costly endeavour with the result that the cost outweighs its benefits. For example, when performance targets run into the hundreds, gathering and analysing the data to determine if such targets have been met will inevitably be costly. In such circumstances, parties might wish to consider either reducing the number of performance targets or committing to review such targets on a sample basis.

It is also important for both parties to have mechanisms in place that would allow changes to the scope of work. In the absence of a contract change (or variation order) clause, a vendor is only obliged to perform what is stipulated in the contract. The customer is not entitled as of right to direct variations, whether to amend or increase or decrease the scope of work. Conversely, a proper clause will ensure that the vendor is paid the agreed contractual price as opposed to a fair market value (or quantum meruit basis) for a properly directed variation. Similarly, a proper variation order clause should provide for attendant effects like delay.

A variation order clause could also break a deadlock as to the pricing of the variation as between the vendor and customer by spelling out the measurement and valuation of variations. It is important to note that unlike a construction project, technology and outsourcing projects do not have the equivalent of an independent surveyor or engineer who can be relied upon to decide rates and prices.

Finally, it should be recalled that changes can be good, neutral or even detrimental to the project. It is advisable for all stakeholders to have an opportunity to participate in the control of any changes. A change control procedure should therefore anticipate the possibility that a change is rejected. In this respect, what might be necessary are processes to identify reasons for the changes, an investigation into the impact of such changes (including attendant costs and delays) and for reviewing those changes in light of the likely impact of such changes.

A contractual provision that occasionally finds its way into such contacts is an agreement to negotiate certain changes in good faith. This is despite the fact that such provisions are generally unenforceable under English law as per the House of Lords decision in Walford and Others v Miles and Another [1992] 2 AC 128. Such agreements, like agreements to agree, are unenforceable because they lack the necessary certainty as to their terms.

Nevertheless, a number of commonwealth jurisdictions (New South Wales and Canada) have departed from that strict position to give some effect to such provisions in certain circumstances. The recent Singapore Court of Appeal decision of HSBC Institutional Trust Services (Singapore) Ltd (trustee of Starhill Global Real Estate Investment Trust) v Toshin Development Singapore Pte Ltd, [2012] SGCA 48 clarifies that where parties are already in a contractual relationship the court will not simply render such a clause unenforceable. More details of this case can be found in a previous post. However this does not mean that the courts can be called upon to ensure that parties actually come to a result. Instead, the role of the courts is simply to ensure that parties abide by their contractual obligations. If there is an unremedied breach of an obligation to negotiate in good faith and parties come to a negotiated result, then the prejudiced party may seek the court’s assistance in voiding that result.

Thus for example, in the case of HSBC v Toshin, if Toshin had failed to disclose and provide all the valuation reports it had surreptitiously commissioned and both parties had negotiated a new rent, then HSBC would be entitled to void the new rent on the basis that Toshin had failed to negotiate in good faith. The avoidance would have been done on the basis that the obligation to negotiate in good faith encompasses reasonable commercial standards of fair dealing. This necessarily includes the disclosure of all material information which could have an impact on the negotiations and/or the ultimate result.

The Singapore Court of Appeal held at [45] that the concept of good faith had a core meaning,

“At its core, the concept of good faith encompasses the threshold subjective requirement of acting honestly, as well as the objective requirement of observing accepted commercial standards of fair dealing in the performance of the identified obligations. This encompasses a duty to act fairly, having regard to the legitimate interests of the other party.”

In the context of negotiations, the Court of Appeal held that “[f]aithfulness to the common purpose incorporates an obligation during the course of negotiations not to attempt to unfairly profit from the known ignorance of the other” (see paragraph [50]). A party should not take action or a course of action which would give it an “unfair advantage“.

More importantly, the Court of Appeal held that despite parties not having identical interests in a negotiation exercise, such an exercise “envisages not an adversarial process but joint action and collaboration by the Parties, either by genuinely endeavouring to agree on the new rent [or failing which] by jointly appointing the three valuation firms…” (see paragraph [50]).

Nevertheless, there are real limitations to this process oriented approach. In the event that parties are unable to come to a negotiated position despite having negotiated in good faith, the court will not determine that dispute for them and impose a result on parties. In the event that parties prefer the business relationship to continue, they would be well advised to have some binding mechanism that is capable of breaking the deadlock.

Conclusion

The execution of technology and outsourcing contracts presents a host of interesting issues by virtue of the length of their tenure and the extent of cooperation required between the parties. Compounding the problem is the tension between the specificity of service level obligations (or benchmarking provisions) to ensure that the customer gets what it actually wants and the costs of monitoring and enforcing those provisions in large and complex contracts.

The importance of effective governance cannot be overstated. Effective governance structures allow parties to highlight, ventilate and escalate issues and problems before those become intractable and jeopardise the entire agreement. Nonetheless, such structures and processes cannot be panaceas. Having the right people in those governance structures “deploy[ing] fact and common sense” is ultimately key to ensuring a successful business relationship.