by Matthew Karlyn and Michael Overly

How to Protect Your Company from Vendors Who Don’t Deliver

Jun 15, 2010

Heed the warnings from recent legal cases and business scandals. Before you sign that deal with an IT vendor, make sure you know what you'll do if your supplier doesn't keep its promises.

When structuring IT transactions, CIOs and vendors frequently focus more on the positive aspects of the relationship—those areas that will help both parties achieve their business objectives—and less on what would happen if the relationship fails to meet those objectives. At the beginning of a relationship, scenarios such as the supplier going out of business or failing to perform, or your company deciding to change direction, seem so unlikely that many organizations fail to plan for them. However, economic volatility coupled with recent high-profile cases are forcing CIOs and vendors to focus more on protecting themselves through their contracts.

Consider the recent case of British Sky Broadcasting (BSkyB) v. Electronic Data Systems (EDS). In January, Britain’s high court ruled that EDS had misrepresented is capabilities as well as underestimated the time and cost to complete a customer relationship management (CRM) system. The court concluded that EDS’s representations were fraudulent and awarded BSkyB £200 million ($288 million). The judgment shows that statements by a vendor may be taken at face value.

Companies can also become victims of outright fraud, as were customers of Satyam Computer Services. In 2009, the outsourcing company admitted that it had inflated its earnings and assets for years, information which many customers relied on in entering into contracts with Satyam. In light of these cases, CIOs should consider including language in their IT contracts that protect their companies in case a vendor relationship takes an unexpected turn.

Define “service.” Most suppliers will take an exclusive and narrow approach to the term “service.” That is, if a particular service is not specifically listed in a legal document, it may be considered an extra and you may be required to pay more for it. This approach has become particularly prevalent in the past couple of years as suppliers focus heavily on revenue generation. Since your company probably doesn’t have the time or expertise to list every single element of the services to be provided, consider defining the term “services” to include not only what you’ve spelled out in your agreement but also any inherent subtasks and services. These types of clauses are frequently referred to as “sweep” clauses because they are intended to sweep in all related, but not specifically identified, tasks and activities.

Choose a time limit. Pay attention to how long you want each relationship with your suppliers to last and whether your hands are tied if you want to work with anyone else. Suppliers often offer lower pricing with longer, exclusive terms. These types of terms tend to create a supplier monopoly rather than a performance-driven relationship in which the supplier has to earn ongoing business. To keep the supplier competitive, consider contract provisions such as a short initial term, unilateral rights to renew your agreement, restrictions on the number of renewals and their length, price controls to address fee increases over time, and a clear statement that the relationship is non-exclusive.

Have a way out. Agreeing to clear termination rights at the start of a relationship can help to avoid contention if the relationship takes an unanticipated course. Each party should determine its rights and what, if any, fees or remedies are required if the relationship ends. It’s an accepted practice that suppliers will require you pay them if you want the right to terminate a contract at any time and for any reason (often referred to as “termination for convenience”). Your ability to do so may be restricted in the first few months of a relationship, and the fee associated with termination should decrease over time.

Nevertheless, suppliers shouldn’t force you to pay significant fees or penalties if your business circumstances change or you’re not satisfied with their work. As a customer you need the flexibility to expand and contract your supplier relationships in order to keep pace with the market and your business needs. One way to stay flexible is to include the right to terminate either certain services or the entire agreement. You can also incorporate provisions to ensure the relationship is neither exclusive nor dependent on a particular volume of purchases. Suppliers frequently require pricing adjustments in exchange for customer flexibility in contract and procurement terms. In order to avoid surprises later, the parties should negotiate up front how prices will be determined and, to the extent possible, the prices themselves.

Review “Entire Agreement” clauses. There’s a clause in your contract that states whether the agreement is complete as is (called the “Entire Agreement” clause, which means, simply, that the written agreement is the entire understanding between the parties and that nothing else is binding on the parties) or whether prior negotiations and pre-contractual discussions will be included as part of the contract. If you plan to rely on a supplier’s pre-contractual representations and documentation, leave out any statements renouncing them.

Keep suppliers accountable. By focusing on supplier accountability, your company can encourage its vendors to avoid problems and to detect or correct any that arise. Doing so will motivate the supplier to perform at or above the level you require.

It’s widely accepted that suppliers must bear a significant amount of responsibility for any damages that they cause your business. However, your company should have effective terms in its contracts to ensure that performance issues are solved promptly without the need to terminate the relationship. It may also be appropriate to include requirements for project team continuity, benchmarking and service levels, along with appropriate financial credits for failure to meet the service levels.

The above principles provide the foundation for drafting agreements—regardless of their size and complexity—that contain an appropriate amount of flexibility and accountability to help ensure a smooth transition should your relationship with your vendors take an unanticipated course.

Matthew Karlyn is senior counsel and Michael Overly is a partner with Foley and Lardner.