Member Article

The IT outsourcing market has matured in the past years. Many IT outsourcing relationships are fruitful and long lasting. Nevertheless international surveys continue to show that numerous outsourcing deals are untimely terminated in the first two to four years.

This paper highlights the key risk factors for failure of IT outsourcing relationships. These key risk factors will be underlined by various failed outsourcing case law. Such case law probably only represents the top of the iceberg. Most problematic outsourcing relationships are terminated under strict confidentiality in out of court "amicable" settlements. Reasons underneath are amongst others the need of IT suppliers to avoid damage of its reputation and the genuine interest of IT outsourcing clients to protect their interests and their business while the relationship is still ongoing.
Five key factors for failure of IT outsourcings are widely believed to undermine the success ratio of IT outsourcing deals.

1. Mismatch in the expectations of both parties
Most striking is the mismatch in the first two categories. 76% Of the clients say they are looking for cost reduction, whereas all suppliers believed that this is what clients are looking for. A vast majority of 70% of all clients is on the outlook for access to IT skills, whereas only 14% of the suppliers seems aware of this. As a result, already at the start of the client - supplier relationship, a fundamental misunderstanding exists about what clients want and what suppliers think that clients want.
The lesson to be learned is that both parties should, at the very first beginning of their
relationship, seriously invest in determining the real aims of the services during the term of the outsourcing relation. This should be combined with a thorough due diligence, prior to the start of the outsourcing. Such due diligence has to describe in sufficient detail the status quo of the IT environment at the start of the relationship.

2. Financial opportunism on both sides
It is said that in particular the first generation of outsourcing deals was mostly money driven, whereas the second generation outsourcing deals parties are already more quality driven. An exception is the Netherlands, which is still primarily money driven. A survey showed that price is still the most important key factor in choosing a logistic service supplier (87%). When a client is primarily cost driven, such client may be very pleased when it was able to squeeze the IT supplier at having a very attractive financial deal. However, this may backfire on the client. In the process of selecting a supplier some suppliers present themselves as real price fighters. However, once they have won a selection process, both parties fall in the financial trap that they set themselves. A striking example may be the litigation between Sprint and IBM, which was brought for a US court in May 2006. Sprint/United Management Company, plaintiff versus International Business Machines Corporation (IBM) defendant - United States District Court for the district of Kansas, complaint filed 22 May 2006.

Sprint sued IBM claiming a breach of their 2003 application development and maintenance
outsourcing deal. Sprint complained that IBM failed (i) to achieve agreed upon productivity
improvements, (ii) to adhere to the agreed methodology for measuring productivity and (iii) to provide the auditable data called for the contract to back up its productivity claims.
The basis for Sprint's complaint was that the parties according to Sprint had agreed to measure IBM's productivity using function points. The parties first established a function point baseline. IBM produced a report for the first two quarters of operations comparing its performance to the baseline. However, IBM went on to produce function points created for small projects and only estimated a number of function points created on those projects based on surveys covering a small sampling of the projects, in stead of counting the actual points. As IBM had failed to demonstrate that it had achieved a committed 6.4% productivity improvement, S print claimed to receive the equivalent number of hours at no charge, namely 119.000. The parties appear to have settled their differences, as the suit was voluntarily dismissed by the end of July 2006. There are frequent examples in the IT industry, where IT suppliers decide that they rather step out of the agreement, than continue to bear a financial loss. In the Sprint-IBM matter, IBM may have decided not to continue to live up to the applicable function points procedure, simply because it would cost IBM too much.

3. Contract successful yet client deceased
One of the most striking examples of failed outsourcing deals is the case in which the literal
language of the outsourcing contract is met, and yet the client suffers severe damage as a result of a very unsatisfactory performance of the outsourcing. An interesting example in the United Kingdom is the recent litigation between Vertex and Powergen.
Vertex Data Science Limited, claimant and Powergen Retail Ltd, defendant, May 2006 – High Court of Justice, Commercial Court Parties. Vertex is a wholly owned subsidiary of United Utilities Plc, a utility company. Vertex is the customer management outsourcing division of United Utilities. Powergen is a company which generates and supplies electricity. Powergen amongst others supplies electricity to domestic customers within the UK.
Background of the dispute In October 2002 Powergen acquired the business of TXU. Early in 2002 TXU had entered into an outsourcing contract with Vertex. Thus it was that Vertex and Powergen first came into contact with each other. Their relationship thereafter has been unhappy. Nevertheless they entered into a master services agreement (MSA) dated April 2005. The value of the agreement was around one hundred to one hundred forty million pounds per year. The MSA is a complex contract running 173 pages. It has a duration of seven years, with a provision for termination by either party after four years. This is a so called exit for convenience clause. Powergen stated that the comparison between 2005 and 2003 contracts bears out the contention of Powergen and the reduction in value of the contract reflected the seriousness of Powergen's concerns about the ability of Vertex to perform as an outsourcing partner. The services concerned in the dispute are the India services which include front- and back office customer services to be provided from Vertex's call centre facilities in India. Furthermore the services concern the Staywarm services, which needs the provision by Vertex of an end-to-end service for all Powergen customers using the Staywarm product, which is designed for elderly and vulnerable families. In 2005 meetings were held. In relation to India, Vertex accepted that more improvement was required and that the service provided to Powergen had not been satisfactory.

In November 2005 Powergen engaged CM Inside (CMI), a customer management consultancy. The Vertex India call center operations have been described by CMI as amongst the worst they have ever come across. On 24 March 2006 Powergen served upon Vertex a notice of termination of the MSA.
Injunctive relief seeked by Vertex to prevent Powergen from acting on the termination of the outsourcing agreement Vertex seeked for an interim injunction in court restraining Powergen from acting on its notice of termination or taking any steps to prevent or hinder Vertex from performing its functions under the MSA. The court states that this is a contractual relationship of a kind which is inherently inappropriate for injunctive relief or specific performance. The threshold question is whether Vertex has a real prospect of obtaining at trial the permanent injunction which it seeks.
The court rules on clause 19.6 of the MSA, which reads: "the parties agree that neither of them shall take any legal action against each other in relation to any matter arising from or in connection with this Agreement, safe that nothing in this Agreement shall prevent a Party from applying to the court: (i) for interim relief pending the resolution of a dispute in accordance with the provisions of this Agreement". Referred is to the arbitration clause in clause 19 of the MSA. The court concludes that parties have not, by agreeing to subject their disputes to an arbitrator whom they have expressly deprived of the power to order specific performance, make declarations and grant injunctions, agreed also that those remedies should simply be unavailable.
Subsequently the court considers whether Vertex has any realistic prospect of obtaining an
injunction at trial.

The underlying dispute
Interestingly enough the court notices that the SLA's failed to provide the yardstick against which important aspects of performance can be measured. The court claims that it is perfectly possible that the terms of the SLA permit a level of performance which is, objectively, unsatisfactory. The court foresees that a nice point may arise if litigation continues as to the inter-relationship between Vertex's obligation to perform with all reasonable care and skill and its obligation to comply with the Regulation and with Good Industry Practice, and the level of performance called for by the SLA's, particularly in the areas where the SLA's are silent. The decision Finally the court assesses the potential damage to Powergen in the event that an injunction is granted and that it is subsequently held that Powergen had in fact been entitled to terminate. The court is not convinced that the balance of convenience so strongly favours the grant of an interim-injunction that Vertex contents. The court stresses that this tentative conclusion is coloured by its believe that this is a situation in which injunctive relief is simply inappropriate and unworkable. Hence the underlying question, whether Vertex was in default on the MSA, remains undecided. Neither party filed for appeal.

The case is an example of the worst case scenario in which the IT supplier will continue to
perform, but will never deliver what the client really needs. This is what the court in the Vertex case referred to as "objectively unsatisfactory".
One should bear in mind that it is quite often the first time for a client to enter into an
outsourcing relationship, whereas IT suppliers are much more experienced. This unbalanced
relationship may result in an agreement which only requires the supplier to perform best efforts, but fails to describe any results required under the agreement. Moreover, such agreements often lack an adequate performance score card or similar price mechanisms. As a result the whole contract is frozen at the starting situation ("as is"). Services are not well described. The contract is based on the assumption that during the term of the agreement the IT environment will remain unchanged. Each change in the IT environment is then extra work, which falls out of the scope of the agreement. In other words, in addition to a fixed price, many IT activities are charged extra for.
The message to all clients and its legal advisor should be not to rely too much on the experience and reputation of the IT supplier that is selected. A good price model in combination with balanced result oriented obligations that are manageable for both sides, combined with a good change management clause should be at the backbone of each outsourcing agreement.

4. Inadequate retained organisations
It is important that clients remain in full control during the term of the outsourcing contract of its own strategic IT decision making process. Furthermore the retained organisation should be the sole vehicle within the client that should have (managerial) contact with the IT supplier, in particular with respect to any changes or elaborations of the contractual relationship. An adequate retained organisation should be able to manage its supplier to deliver the planned benefits.

5. Be very careful about the exit strategy
The exit strategy should comprise at least two components. A carefully drafted escalation and litigation clause should be agreed upon at the beginning of the relationship. It is important for the client to realise that many IT outsourcing agreements contain very complex escalation procedures, which prevent parties from any court relief unless such escalation is finished. In addition mandatory arbitration or mediation may further prevent parties from going to court. It is wise to stipulate that seeking injunctive relief at the court should be possible at all times. An interesting example in which parties contractually refrained themselves from going to court shows the case between Cable & Wireless and IBM in the United Kingdom in 2002 and 2003. Cable& Wireless PLC ("C&W"), claimant versus IBM United Kingdom Ltd ("IBM"), defendant High Court of Justice, Queen's Bench Division Commercial Court, 11 October 2002 and 27 February 2003.

Benchmarking
Parties entered into a global framework agreement ("the GFA") on 20 December 2000.
According to the GFA IBM would supply to C&W information technology services throughout the world. An important feature of the GFA was a series of provisions designed to maximise and monitor the quality and price competitiveness of the services provided by IBM. This process is well known as benchmarking. It was to be conducted by a qualified, independent third party selected from an agreed list of suitable bench markers. The GFA was to remain in force for twelve years and the benchmarking would be required by C&W no more frequently than annually. The objective of the benchmarking was defined thus, that IBM would provide C&W with technology, service levels and charges which are equal to or better than that received by the top ten percent after transformation of other organisations similarly reliant on and receiving similar services.

Dispute
By an agreement dated 28 February 2002 IBM and C&W engaged Compass Management
Consulting ("Compass") to carry out a benchmarking process. A report was produced by
Compass which in substance indicated that IBM's charges were above those of the comparators. IBM challenged the validity of the Compass reports and asserted that they were so fundamentally flawed as not to amount to "Benchmark Results" as defined by the GFA. IBM therefore declined to produce a "Benchmark Plan" until that dispute had been determined. C&W, however, claimed compensation in the range 31,5 million to 45 million UK pounds. This amount was calculated, going back to the start of the GFA, that being the actual loss which C&W had suffered as a result of IBM's failure to meet the objective of GFA.

Litigation versus mediation
Clause 41.2 of the GFA provides as follows: "If the matter is not resolved through negotiation, the Parties shall attempt in good faith to resolve the dispute or claim through an Alternative Dispute Resolution (ADR)procedure as recommended to the Parties by the Centre for Disputes Resolution. However, an ADR procedure which is being followed shall not prevent any Party or Local Party from issuing proceedings."

The court rules on 11 October 2002 that the mere issue of proceedings is not inconsistent with the simultaneous conduct of an ADR-procedure, such as mediation, or with mutual intention to have the issue finally decided by the court only if the ADR-procedure fails. The court rules that there can be no doubt that C&W has declined to participate in any ADR exercise. As such C & W is in breach of clause 41.2 of the GFA. The court then in details discusses the discretionary nature of ADR.
Apart from this discussion about ADR the court raises another very relevant consideration. The court points out that IBM disputes the fundamental validity of the Compass Benchmarking Report. If IBM is right, the issue of construction which C&W wished the Court to resolve would not arise. Therefore the court decides that there are extremely strong case management grounds for allowing the reference to ADR to proceed, for it will necessarily be brought to bear on both disputes and could not sensibly leave out of account IBM's position on the validity of the Benchmarking Report. The court estimates that those ADR-procedures would be completed in a few weeks. Therefore the court comes to the practical solution that the appropriate course in the present case should be for the hearing of the claim for declaratory relieve to be adjourned to after the parties had referred all there outstanding disputes to ADR. In the event that this reference would be unfruitful, the parties could reinstate their claim. After an inconclusive Court-order mediation that took place in December 2002, the court ordered an expedited trial of all matters and issues between the parties. Full pleadings were then exchanged. Cable & Wireless seeked a declaration as to the meaning of certain overcharging related provisions of the GFA in compensation for overcharging by IBM. The claim in the UK amounted to approximately 115 million UK pounds and approximately 22 million US dollars in respect of the United States.
On 8 September 2003, an "amicable resolution" of the matters in dispute was agreed upon by Cable & Wireless and IBM - the terms of which are confidential - following which, by consent, Cable & Wireless and IBM entered a Tomlin Order at the House of Courts of Engeland and Whales. The effect of that order was to stay the legal proceedings, which existed between Cable & Wireless and IBM in relation to the disputes. On 31 December 2003, the terms of the GFA expired (Cable & Wireless having given notice to terminate the same in June 2003) and in January 2004, all services previously provided by IBM under the terms of the GFA were insourced back to Cable & Wireless.
A second important feature of an adequate exit strategy is to already agree upon the insourcing at the outset of the relationship. It is too often that at the end of a quite successful outsourcing relationship problems occur. All of a sudden the IT supplier requests that, in order to cooperate with the insourcing of the IT activities or cooperating with the outsourcing to another third party supplier, the original IT supplier demands major payments for for instance know how, tailormade software or licenses on their own generic software. Disputes about insourcing can be easily be avoided by negotiating the insourcing term at the outset of the relationship, when such relationship is still in safe water.

CONCLUSION
Five key factors to poorly performed outsourcing relationships are:
1. mismatch of expectations of both parties;
2. too much emphasis on financial gain, and too little emphasis on IT quality;
3. unbalanced contractual obligations between the parties resulting in good performance on
the contract, but malperformance on the outsourcing;
4. inadequate retained organisations;
5. inadequate exit strategy in the outsourcing agreement.