The economic crisis has led many organisations to re-evaluate their business strategies. A shift in focus towards maintaining a robust model to weather the current storm is driving new ways to save on expenditure, in areas that would never have been examined under normal circumstances. There seems little doubt that customers of IT and outsourcing agreements will be subjecting proposed new deals to greater scrutiny than before: inevitably, they will also be forced to consider what their options are under existing agreements. On the other side of the fence, supplier interests are unlikely to be aligned with this. With order books looking thinner, protecting existing sources of revenue is key.
This article looks at what might be forcing customers to take a fresh look at their existing contracts, what means they might seek to use to leverage change to (or in the worst case, exit from) existing deals and what suppliers can or should be doing to protect their own interests.
The Rules of Attraction
The genesis of every deal is, basically, that it makes (or should make) the best sense for both parties at the time it was first struck. Both parties will have, in more or less concrete terms, a business case for the deal which drives the original negotiation – they should match, or at the very least point in the same general direction. But, as with every other relationship, sometimes things change.
‘It’s not you, it’s me’
Customer business cases can be fickle: they are always sensitive to changing business requirements. No matter how far contracts try to cater for future business change on the customer side, often there will be no way around the fact that the ‘old’ contract just isn’t attractive in the new world. The deal may have been struck based on anticipated volume baselines (typical to outsourcing contracts) which now don’t match up to a reality where the customer’s business has contracted. Business consolidation may mean that there are two suppliers in the same space, when one would be more efficient. It may simply be that the customer needs to find a cost saving from somewhere, and discretionary spend is normally first in line for the chop. Plain but cheap becomes a bigger priority than glamorous but high maintenance. This is especially true where the return on investment under any particular project is longer term than current business planning allows for – often the case in complex IT procurement.
‘I’ve met someone else’
Sometimes a current deal may look tolerable in isolation, but becomes a less attractive proposition when the market for supply is changing. Other potential suitors, whose advances were less welcome before, may have improved their position to give them a competitive edge. Spreading the work on offer around may give the additional benefit of de-risking the supply chain by ensuring that there is more than one vendor in the game at all times. This may be particularly relevant to longer-term services contracts entered into during more buoyant times.
‘You’re not the person I thought you were’
Suppliers do not always execute perfectly and, as margins start to feel the strain in the IT and outsourcing sector, there may well be a need for suppliers to reduce cost – an objective which is usually inconsistent with perfect execution. It may get to a point where the customer just doesn’t feel that their contracting partner is up to the job any more, or is clearly at a high risk of financial distress or insolvency. What conclusion this leads to will depend on a number of factors, not least the key legal issues which arise when assessing options to claim financial compensation for underperformance, and/or to exit the relationship in whole or in part.
Something Has to Change
Obviously the reason a deal doesn’t look so good any more is a critical factor in assessing what can or should be done to change it. What needs to change will depend on a wide variety of commercial factors: crucially, the approach taken will depend on whether the customer believes there is a viable alternative basis for remaining in the existing relationship. This process is not simply a question of the customer assessing its legal rights under the contract and then enforcing them. It involves a holistic assessment of the nature of the commercial relationship between the parties, and options to use legal rights and bargaining power as levers to negotiate the right result.
There are three basic areas of potential change –
• value adjustment – reduction in price (potentially accompanied by reduction in scope), or increase in performance/scope for the same price
• risk adjustment – change to risk allocation provisions/provisions which tend to protect the customer in the event of supplier financial distress
• exit (complete or partial) – change of delivery to a third party (or internally), or simple cancellation because the solution/service is no longer needed
These are not mutually exclusive but it’s likely that one will form the principal driver for change. They are also likely to be fluid, since what looks like the right outcome has the potential to vary as time moves on. This is especially likely to be the case in the current environment where financial planning is more ‘day to day’, or at least ‘month to month’. Customer strategy may not always be based on an immediate and clear understanding of what it wants to achieve.
On the supplier side, this may in fact represent an opportunity to take the initiative and seek pro-actively to find ways to guide the customer – identifying areas in which it can ostensibly improve the contract (which the supplier itself finds acceptable) and which it can then try to ‘sell’ to the customer. This is not to suggest that suppliers should be considering wide ranging changes to their commercial offerings ‘just in case’. But where it’s clear that a relationship has not been working as it should, suppliers may have a chance to attack the problem head on and seek to control the re-shaping of the contract, rather than simply reacting to customer demands.
Wherever the customer decides they want to go with the relationship, the key issue is how they may seek to achieve that, and what steps suppliers can take to defend their own ground. There might be said to be three angles to driving re-negotiation: let’s call them relationship pressures, win/win solutions, and threats.
Relationship Pressures – ‘let’s do it for the family’
Sometimes a more structural approach to driving change may not be needed at all. No contractual relationship exists in a vacuum: there may be other deals between the parties, there may be significant potential for securing new business in other areas, and there are strategic considerations of reputation and perception in the market at stake. These might drive a very straightforward approach from customers who want to pay less: ‘give me what I want, and in return I will be with you in the longer term, or consider you more favourably for further work’. On a more aggressive level, this might possibly be framed more as ‘give me what I want, or you will never work for us again’.
Whether this works clearly depends on the importance of the customer in question, and the position which the supplier is in at the time. Two things, though, might be borne in mind from a legal point of view. The first is that when a customer first approaches things on this basis, it may well have some effect on how a court perceives later behaviour. Where it’s clear that a customer has openly explained its need to achieve change purely from an internal business point of view, but then later switches tack to a more aggressive/legal rights approach, it may well colour the merits of that later approach. The threats themselves (rightly or wrongly) may start to have the appearance of an unscrupulous or transparently tactical approach.
The second point, and one which is a recurring theme, is that when broader relationship pressures come to be applied, some care needs to be taken to ensure that the message does not become, in legal terms, an anticipatory breach of contract. As soon as threats come to be traded, even when they have sprung from a more general discussion of the broader commercial relationship, there is a risk of unintended consequences. Customers should therefore seek carefully to control the message which they want to deliver: suppliers should be astute to any opportunity which it gives them if the messages are not carefully controlled.
Win/win Solutions – ‘I’ll meet you halfway’
In the same way that a deal may be proving unattractive to the customer in the current climate, so it might be proving less than desirable or burdensome to the supplier. The best way of ensuring a favourable outcome in any form of negotiation is if both parties receive some benefit from the proposed course of action. Admittedly finding this common ground may be difficult but, if the relationship is going to work in the longer term, it is critical. If one party comes out of a re-negotiation feeling that they simply had a gun put to their head, it’s a safe bet that this will sow the seeds for future trouble. In some cases that risk may be considered an acceptable trade-off by the customer in exchange for short-term cost savings, but it’s a consideration which should be taken into account.
(i) Less for less
In this scenario, the supplier stands to gain in some way under the current agreement from the customer’s proposal to de-scope part of the agreement. Obviously this only works if one of two situations applies – the customer doesn’t need the requirement in question, or it needs it but can get it cheaper elsewhere or internally. It will have to be a part of the contract which has historically caused the supplier excessive pain to perform, or is considered by the supplier to be high risk in the future.
Identifying areas for ‘stripping out’ will generally not be easy. However, if the contract is for the procurement of an IT solution, then there is clear potential in the current environment for customers to de-scope the ‘bells and whistles’ – areas of scope which the customer originally decided to purchase, but which in reality were ‘nice to have’ rather than genuine ‘must have’. These areas may not be the most profitable to the supplier, or may represent areas of higher risk, if they require a significant bespoke element.
Another example might be in the added service wrap elements which typically form part of a managed IT services or outsourcing relationship. Is availability really required at the level which was originally demanded? Is continuous improvement (in whatever, more or less granular form, it may take) actually needed with the benefit of experience? Will a reduction in service credits available allow the supplier to unlock some of the price? Again, the key will be to identify how supplier cost matches with customer requirements which could be stripped out.
(ii) Same for less
Clearly this is less likely to be attractive to suppliers, and is likely to be the result of a more ‘threat’ based approach. It requires both customer and supplier to think creatively about whether anything can be changed about the method of delivery or performance, which allows output to remain the same. In the outsourcing context, however, there is more obvious potential for it to work, as there may be clear means by which the supplier can reduce the end-to-end cost if it can change the delivery method – typically, by using more leveraged (ie less dedicated) resource or by off-shoring elements of service.
(iii) More for same
Sometimes a customer may be willing to add something to the deal as a means of creating more efficiency. One obvious potential is to extend the term of the existing agreement (or abandon termination for convenience rights) in exchange for a short-term price reduction. It may be that there is a consolidation opportunity which will give the supplier greater volumes, in exchange for lower prices. While, for suppliers, securing a customer for a longer period through the downturn might be appealing on the face of it, it is going to depend very largely on its ability to finance the deal. Suppliers will also want to take care not to mortgage their ability to profit from the (hoped for) upturn by fixing lower prices for a long period.
Threats – ‘sorry, but I just don’t think I can do this any more’
In reality there may be a number of mechanisms available to customers under the contract to try and ‘force’ improvement which fall significantly short of terminate and sue/be sued. The effectiveness of any particular type of threat is heavily dependent on two key factors: (i) the robustness of the contract itself and how well the facts support the position which the customer might seek to adopt and (ii) the credibility of the threat, usually itself dependent on the creation by the customer of valid alternatives. None can be exercised in isolation: in all cases the use of a more aggressive strategy is likely to change the dynamic of the relationship. Suppliers will inevitably start to explore any opportunity which they have to bring pressure to bear on the customer in return (see Assertive Defence below).
What types of mechanism might be available to the customer, and what position may this lead suppliers to adopt in response?
Benchmarking is more or less accepted as a fact of life in the negotiation of long-term IT services or outsourcing agreements. The customer’s decision to use it is going to depend on three key factors: (i) how certain the customer is of the outcome, (ii) the cost and disruption associated with executing it and (iii) the effectiveness of any remedy which it may lead to.
The experience of using benchmarking as a means of achieving price adjustment is now considerable, but as a lever it may be more valuable in the threat itself than in the execution. To begin with, it is hard in all circumstances to be sure at the outset that the outcome will be to the customer’s clear advantage. True, general market testing and even ‘mock’ re-procurement can improve the level of information available and enable greater confidence, but even then general market testing will be potentially skewed by comparison with deals which have actually been entered into – especially in an environment where other suppliers are aggressively seeking new business.
Benchmarking also takes considerable time and has a high cost. It is therefore unlikely to bring a quick solution. Suppliers will also be astute to use any rights which they may have to influence, delay or challenge the process; in most circumstances there will be some opportunity to do so, and little prospect for the customer to, say, obtain injunctive relief to force participation in such a flexible process. Suppliers will understand all these issues and may be keen gently to point them out in the event that benchmarking is genuinely threatened.
Finally, the contractual consequence associated with the outcome may not be especially favourable to the customer – or there may be rights for the supplier to challenge (and challenge again) to delay the impact. We have seen a trend in recent years for failure to implement benchmarking results to lead to a right to terminate for ‘quasi convenience’: this may be the opposite of what the customer really wants, and may not even represent much of a threat against the supplier if the termination payments due are generous (see Terminate for convenience below).
Right to adjust pricing triggered by events
Outsourcing contracts, which tend to be dominated by volume based pricing mechanisms, often identify rights for the customer in some circumstances to re-negotiate the pricing in the event that volumes stray a set margin from an agreed baseline. Typically, however, the basis for such re-negotiation is not strictly set – there is unlikely to be a formula which gives robust certainty to customers. They may simply be reliant on bringing broader commercial pressure to bear to try to get the best deal. Alternatively, if there is a formula in the contract, it may actually be rather generous to the supplier in any event. Even if an adjustment is agreed, the customer will have to bear in mind that the baseline is clearly subject to future business change – should volumes start to rise again as business hits an upturn, how good any adjustment is will depend on how the new pricing reacts to such a reverse in fortunes.
Long-term services agreements frequently include some means of adjustment for indexation, usually put in place to protect suppliers against an increasing cost base. Few would ever have expected customers to be assessing their own rights under them, but a potential period of deflation (in the UK, at least) may mean that customers are at least dusting off that section of the contract. Customers will want to determine whether such terms lead to any right of price reduction. Whether they assist the customer will be very much driven by the precise drafting (and the index used), but suppliers will no doubt argue that the clear intent of such provisions was to protect them only (even if the drafting does not say so explicitly), and to imply the same from the context of those provisions where there is any ambiguity.
Audit is not usually thought of as anything other than a means to a specific end, and is not normally considered to be of any real significance outside the context of ‘open book’ provisions, and rights to audit for regulatory compliance purposes. It is, however, another potential tool in the customer’s box in seeking to leverage change. There may be clear limitations as to scope but, particularly in the context of an outsourcing agreement where the pricing structure is complex and dependent on information which the supplier controls in practice, it may represent an opportunity to verify historic payment and unearth potential claims. Naturally, such an investigation could cut both ways, and may result (although it’s rather less likely) in the unpleasant discovery that significant undercharging has taken place. It would be as well to be certain before embarking on such an exercise whether historic undercharging is recoverable under the contract terms.
Claim financial compensation for breach
I am not going to discuss in detail the considerations which go into assessing the merits of any claim for breach, but a couple of observations can be made about the value of this as a customer threat. First and foremost, in complex IT transactions, there is rarely any such thing as an ‘open goal’ when it comes to proving breach. It may be possible to generate a degree of confidence in the final outcome, but doing so tends to require a significant amount of effort, and is disruptive to operating the contract on the customer side. Second, the process is unlikely to be quick and easy. True, some contracts and issues in dispute will lead quickly to expert determination or to mandatory mediation, both of which can produce a swift result, but often this will not be the case. A lengthy dispute tends to lead to bitterness and disappointment on all sides: in practice it is very difficult to continue to operate the contract. Finally, the effectiveness of this strategy will be closely tied to the availability of set-off under the contract (or generally, if the contract does not exclude it). If wide rights of set-off are available, or supplier remedies in the face of non payment are very limited, this can considerably change the dynamic. Suppliers will then be forced to consider carefully their own rights to bring the dispute to resolution quickly.
Terminate for convenience
It scarcely needs to be said, but any purported action to terminate takes the customer into a higher risk area, where even the threat itself (if improper) could lead to a risk of repudiation, and a supplier claim. Even procedural defects of the purported termination may have a significant potential risk associated with them.
Timing for exercising such rights may be constrained to certain windows: termination for convenience may not be available at all times, or it may make little economic sense at particular times due to the schedule of termination payments. It may not be clear what the impact of a termination in part for convenience is on the remainder of the contract: even heavily negotiated contracts tend to leave open the question of how pricing for the retained element is re-set when one aspect of a contract is terminated.
Finally, actual termination lays bare the issue of what the customer is going to do as an alternative, and how viable that solution really is. If the service in question is going to be continued internally or by another supplier, there will be the question of transition, the steps required from the existing supplier to ensure effective transition, and the cost and disruption which this entails: there will also, in a partial termination scenario, be the key question of how manageable the interfaces in the new multi-sourced solution are. The contract, drafted in anticipation that partial severance was unlikely, may address this in only very high level terms.
Terminate for cause
Threatening a termination for cause as a means of bringing a supplier to the negotiating table is clearly a game of higher stakes. It is only likely to be a viable approach where the customer is genuinely serious about exiting the contract, and has a viable alternative in the offing. There are several reasons for this.
First, it is usually hard to create absolute confidence that a right to terminate for breach (or a common law repudiation of the contract) has arisen. This is in part due to the nebulous concepts of material or persistent breach which tend to underpin termination rights: and in part due to the complex factual (and technical) matrix which will have to be assessed in detail, including the impact of customer dependencies. However, this assessment is absolutely necessary because a purported termination wrongly exercised will almost certainly be a repudiation of the contract, which then gives the supplier rights to claim damages (potentially considerable if at that point in time it has incurred large costs for little return). A repudiation may also raise a question around the ability to enforce exit provisions in the contract: it is likely that many suppliers will, for reputational reasons, seek to comply with their exit obligations in any event, but the cost of obtaining that co-operation may be greater than expected.
Secondly, the exercise of the right to terminate is sensitive to ongoing behaviour and communication. There have been several examples in recent years of parties to long-term services agreements failing to preserve (and losing) their rights to terminate, by failing to raise issues quickly enough or, having raised them, then acting inconsistently with the intention to terminate. It is unlikely to be possible to preserve termination rights on a long-term basis, even if the contract does not have any express ‘use it or lose it’ provision in relation to termination rights, which the more supplier-friendly agreements do. As a result, it is difficult to leverage a threat to terminate for cause purely as a tactical means of driving a better deal with an existing supplier.
Assertive Defence – ‘two can play that game’
Faced with a potentially contentious approach from a customer, the supplier itself is unlikely simply to stand still. There are likely to be several key aspects to the supplier response, and customers should consider the potential ramifications of supplier changes in behaviour before deciding on a course of action.
Positioning in relation to breach
Faced with a potential allegation of breach to support a customer position, the supplier will quickly wish to get to grips with contractual compliance and process compliance to ensure that the situation does not deteriorate further. This will include making a conscious decision as to how to react to the alleged underperformance: is the approach simply to deny the breach/deny the obligation? Or will the supplier try to fix the underlying perceived problem? If the second route is taken, the supplier will wish to take some care to preserve the underlying position (since the action would otherwise be inconsistent with denying liability).
Hard as it is to achieve in practice, some efforts should be made to get a grip on communications with the customer to ensure that a consistent message is being delivered in the face of the claims made. A level of pragmatism is needed here: delivery must still remain key, and operational staff cannot be expected to shoulder the burden of commercial positioning, but they should understand that it is critical for them not to comment on certain issues, and to follow the clear directions which they are given by commercial colleagues.
Work to rule
Suppliers will almost certainly start assessing what their own collateral leverage may be. Have they been over-performing in some areas? Are they working ‘off contract’ through additional activities for which the customer has not agreed a contract variation? Are there ambiguities in the requirements which, in less troubled times, were not truly examined? Two particular possibilities come to mind here. First, there may be opportunities to ‘filibuster’ future change by strict operation of the change control mechanism (which, in almost all cases, will not have been followed to the letter up to that point). Many contracts will have aspects of future change which are considered to be ‘mandatory’ but there may be considerable grey areas as to what falls within and outside that regime. Secondly, there may be opportunities to position matters in relation to exit: whether by tightening up exit plans, or relying strictly on aspects of the exit schedule which will cause the customer some difficulty (and are typically not as detailed as might be desirable).
As acknowledged above, many suppliers will not wish to take quite such a robust approach, and indeed all potential ‘work to rule’ regimes carry with them the potential to repudiate the contract inadvertently – not ‘crossing the line’ into breach requires a degree of commercial awareness at all levels of the organisation which is hard to achieve.
Before the downturn, the accepted wisdom was almost certainly that IT and outsourcing contracts were difficult to exit without considerable operational and legal risk. Now, organisations, especially where unsatisfied with existing relationships, may be starting to challenge that accepted wisdom as they are driven harder to cut costs. They will want to have an early view of the ‘bottom line’ legal options as a means of ensuring that any re-negotiation they achieve is the best value outcome. Legal advisers will have to be more robust and more creative in their assessment of the potential outcomes as they are asked to consider the future of the relationship – and whether sticking together really is the right answer.
David Halliday is a Senior Associate in the IT/Commercial department of Baker & McKenzie LLP’s London office, specialising in dispute resolution in technology and outsourcing contracts.