Outsourcing Disputes: Time for a Different Approach

March 24, 2014

It is hardly surprising that issues and disputes commonly arise under IT outsourcing contracts. They are often complex, cover a wide range of services, and create a close relationship between suppliers and customers with different motivations and objectives.

In challenging times for the IT industry, it’s important for those involved in large outsourcing agreements – particularly complex multi-party deals – to ensure they understand each other’s objectives and the commercial realities, not just the fine print of the contract. Without that understanding, , an outsourcing engagement can become problematic for everyone.

For the customer, the benefits of outsourcing include access to lower cost technology services, specialised capabilities, new technologies, and global practices that would be more difficult, and certainly more expensive, to obtain independently.

In return for those benefits, suppliers – unlikely to know with certainty what the costs will be over the contract – hope to deliver services profitably. They also hope that, by implementing smarter technologies and processes, they can obtain operational efficiencies in the delivery of these services. However, their often paper-thin margins are likely to be squeezed further as the already competitive IT outsourcing market matures and other options (infrastructure as-a-service, and other cloud-based variants) become more acceptable to more organisations.  It is likely that more and more loss-making deals will be signed in the expectation either that things will improve given time, or that higher-margin services will be sold to the customer over the life of the engagement.

The contract negotiation is usually a difficult and prolonged process, for both parties. The proposed engagement is usually intended to be substantial and long-term, and includes a large number of variables, obligations and inter-dependencies that need to be considered and documented.

The negotiation often becomes adversarial. The client invariably strives to obtain the best possible commercial and legal terms, knowing that the supplier is likely to be under considerable pressure to achieve its signing targets for the period.

Typically, the supplier is much more familiar with the technology and service delivery model than the customer; equally, the customer knows its business and processes much better than the supplier ever will. It is easy in that environment for some mistrust, battle-weariness and even outright cynicism to develop.

As a result, when the deal is eventually signed, and the parties are left with a heavily negotiated legal document that they hope will be a reliable framework for the years ahead, the relationship between the parties is likely to have deteriorated to some extent. Against this backdrop, issues and disputes are likely to arise in every large outsourcing engagement. After all, every serious relationship has its ups and downs.

Commonly, there will be disagreement about the scope of the services provided under the contract. Significant scrutiny will be placed on the detail of the technical and financial responsibility documents contained within each Statement of Work, with contract managers and lawyers often hotly debating the meaning of now pivotal words and phrases.

Service delivery and the contractual performance targets are often another common area for dispute. Whilst the fault for those issues can of course rest solely with the supplier, the situation will be much more difficult to untangle if the customer or one of its other vendors has done (or failed to do) something that may have contributed to the problem.

In many contracts, dissatisfied customers have the ability to take matters into their own hands by withholding payment. In most cases, those mechanisms are used to gain the supplier’s attention or apply pressure in commercial discussions, but they can also be misused by customers, sometimes to devastating effect.  

Disputes and engagement 

Left unresolved, minor and major disputes can cause significant damage to the relationship, leading to long-term discord and discontent on both sides.

For the customer, discontent in the vendor management team can seep through to the rest of the organisation over time. It can result in a reluctance to engage the supplier for the kinds of higher-margin projects that it may have come to rely upon to wring profit from the deal. Left unchecked, it could also damage the supplier’s prospects of winning an extension or longer term re-appointment at the end of the contract term.

For the supplier, disputes can dramatically reduce the profitability of the deal and may even impact the regional and global performance of its business. This is likely to have several unintended repercussions for the customer.

The supplier will undoubtedly look for ways to remove cost from its delivery of the services, perhaps at the expense of the quality and reliability of those services. In these cases, what may have started as an initiative led by the customer’s vendor management team to reduce cost can soon impact the everyday user in the customer’s business, with negative consequences for all.

There is also an important human aspect that is often overlooked. Supplier personnel, especially those critical to the engagement, will often be remunerated according to the underlying financial performance of the account. Strong performers are always in high demand and it may be difficult for a troubled account to hold on to them when it cannot afford to reward them for their hard work. It may also be difficult to persuade replacements of a similar calibre to join the account. 

Dispute resolution 

So how do organisations deal with all these variables in their outsourcing arrangements? Unfortunately, many deals do not cope well with the almost inevitable disagreements that will occur during the course of the engagement.

Typically, dispute resolution mechanisms in an IT outsourcing agreement do little more than require the parties to follow a convoluted series of escalation meetings before litigation (or arbitration) can be started. Structured resolution processes like mediation, which could provide some real benefit, are rarely mandatory in outsourcing contracts and seldom used.

Arbitration may promise a more flexible and confidential process, but is not favoured by many parties and, in any event, arbitral proceedings are likely to have the same negative impact on the relationship as court action.

Litigation is often (rightly) seen as a ‘nuclear option’ – one that will destroy the relationship. In all but the most extreme cases, for example where termination has already occurred and disengagement has been completed, it may not be an appropriate option.  By its nature, IT litigation is distracting and expensive. It requires parties to deal with complex technical and evidential issues in a forum that is likely to be alien to them, turn over many hundreds of thousands of documents to the other side, and tie up important figures in the business for many months or even years.

Litigation of matters of this nature will also inevitably bring with it considerable uncertainty. What is certain, however, is that the litigation process itself is unlikely to be a quick or easy one. 

Stomach for the fight 

Total legal costs for both parties in BSkyB v EDS have been reported to be around $80 million. The case commenced in August 2004 and a decision wasn’t handed down until 2010. Few organisations will have the stomach for that kind of fight, even if they are prepared to end the relationship with their IT supplier in dramatic fashion.

While litigation may not be a viable option in many cases, there is often little thought given as to what other dispute resolution options may assist the parties to resolve disagreements in a structured, amiable and efficient way.

Some observers have explained this as a reluctance by the parties to provide an easy route to pursue potentially expensive or disruptive claims. The theory goes that, if the ‘nuclear option’ of litigation is all there is, then the parties are less likely to go to war.

Instead, efforts can be made to resolve the dispute in other ways, perhaps by the customer taking other services and products from the supplier at a discount. In that scenario, everyone is happy.

While this approach may have worked historically, it has only papered over the cracks in many cases. It may well have encouraged aggressive or dominant parties to push for outcomes that they would not have achieved had the dispute been dealt with in a more structured way.

In any event, the ability for parties to negotiate resolutions in this way appears to have receded significantly in the current economic climate. There are fewer viable options in this market to ‘sell to solve’ issues that may arise under large outsourcing engagements, and seemingly a diminishing ability for the parties to trade their way out of their problems.

Resolution options 

Given these challenges, suppliers and customers should give more thought to an appropriate dispute resolution structure to deal with issues that arise under IT outsourcing contracts.

Experience shows that those parties that undertake thorough preparation will be in a far better place to achieve a favourable resolution. Time and again, parties that start on the back foot find it difficult to recover, forced to take defensive positions that are unlikely to assist when a dispute escalates.

Parties should identify and begin to build a capable team to manage a dispute as soon as it has been raised. That team should include internal and/or external legal advisers from the outset, who can provide the necessary legal and strategic guidance and advice, and drive the matter towards an outcome.

In all likelihood, the other party will already have involved its lawyers, whether or not it openly admits to having done so.

Once the core team is in place, there should be a detailed assessment of the issues raised in the dispute. There is no better foundation for the successful resolution of a technical dispute than a thorough, accurate and objective legal assessment of the issues and how they might be resolved.

Trying to do this on the fly during the negotiation, or adopting a reactive approach to the other party’s arguments will, inevitably, make it significantly harder to achieve a happy outcome.

Only when the team is in place and has completed this assessment should discussions about a suitable framework for the resolution of the dispute take place. Parties should avoid the temptation to keep things casual or ad-hoc, unless the objective is to prolong the discussions for as long as possible (rarely a good idea in the long term).

Thought should be given as to what dispute resolution mechanism might assist the parties to work through their issues more successfully.

Parties should cast from their mind any pre-conceived prejudices that they might have against these methods – they can be combined and tailored to meet any situation, and experience strongly suggests that disputes are more likely to be amicably resolved when those methods are employed.

The customer and supplier can employ several options, such as mediation (mentioned earlier), expert appraisal and expert determination, to help resolve a dispute.

A mediation is a non-binding and consensual process in which a neutral third party (often a senior lawyer or retired judge) assists the parties to resolve the dispute.

An expert appraisal is a process by which parties appoint an independent expert to investigate the issues in dispute and provide a non-binding opinion. Often the issues in dispute are legal in nature, and the expert appointed will be an independent senior barrister, rather than someone with technical IT experience. An expert determination is similar to an appraisal but the expert typically makes a binding determination of one or more issues in dispute.

It is possible to combine one or more alternative processes within a single process. This could occur in a fluid or staged way. For example, expert appraisal or determination could be incorporated for certain issues as part of a wider mediation process.

In practice, IT outsourcing engagements work well only where the primary objectives of both the supplier and the customer are met. If the deal becomes unprofitable or unappealing for either party, it is likely to be unsuccessful for both.

When these kinds of deals are the subject of increased scrutiny, it is all the more important for the parties to work together to find a sensible, commercial structure to resolve disputes as and when they arise.

I have set out my tips for resolving an IT outsourcing dispute below. 

Dominic Keegan is a lawyer at Maddocks: http://www.maddocks.com.au.


Tips for resolving an IT outsourcing dispute 

Build the right core team. Having the right mix of commercial, technical and legal people involved in understanding the issues and shaping the resolution is vital. Ensure that those people have the capacity to be fully engaged with the team and the process to completion.

Form a robust internal view. Document the team’s view of the dispute and resolution options early. Obtain internal support for the recommended resolution strategy and ensure that the core team has authority to settle the dispute at the relevant time.

Protect sensitive communications. Ensure that all communications relating to the merits of the dispute and its resolution are protected by legal privilege, in case litigation ensues.

Structure the process. Meet with the other party’s core team at the outset of the dispute and agree an appropriate structure for discussions. The agreed structure should be clearly documented, so that it can be used as an effective roadmap for the process.

Identify and narrow the issues. Meet with the other party to agree which issues are going to be dealt with in the process. If some issues are more straightforward than others, then consider removing them from the main discussions to streamline the process.

Tailor the approach. In disputes involving a wide range of issues, it may be appropriate to  deal with their resolution in different ways. For example, technical issues could be referred to the parties’ relevant SMEs for a joint recommendation to the wider group.

Select a strong mediator. In most cases, mediation will offer an invaluable framework for the broader discussions. Ensure that an experienced and respected mediator, acceptable to both parties, is selected early. Meet with them to discuss the process and timetable.

Consider the impact. The financial and operational impact of any outcome will be key to ensuring an ongoing healthy relationship. Both parties should be encouraged to brief the mediator in strict confidence as to their underlying commercial objectives or constraints.

Document the outcome. When an agreement has been reached, it should be documented and any consequential contract changes effected. Where numerous issues are being discussed, establish a process to document their resolution in a non-binding way.