IBM Beats Indiana in Outsourcing Case No One ‘Deserves to Win’

“Neither party deserves to win this case.”

So begins the judge’s order in the legal outsourcing battle between the state of Indiana and its former IT service provider IBM. While deciding last week that Indiana failed to prove that IBM materially breached its 2006 $1.6 billion contract with the state, Marion County Judge David Dreyer wrote: “This story represents a ‘perfect storm’ of misguided government policy and overzealous corporate ambition. Overall, both parties are to blame and Indiana’s taxpayers are left as apparent losers.”

Indiana initially sued IBM for the $437 million it paid the provider for what it said was a failed welfare system overhaul, an amount that was later reduced to approximately $170 million. IBM countersued for $100 million that it claimed it was owed by the state. Judge Dreyer awarded Big Blue $12 million for the equipment retained by the state.

“[It is] surprising that the court found a pox on both houses,” says Lawrence J. Bracken II, partner in the commercial litigation practice of law firm Hunton & Williams. “This decision demonstrates these are cases that are very difficult to resolve in court. Not only are the matters and contracts very complex and the evidence comprised of millions of documents and data points, but typically each party shares some of the fault when these projects go off the rails.”

It was a rare judgment in favor of an outsourcing provider that should serve as a wakeup call for all IT leaders. “Buyers have a tendency to select big-box service providers, because they feel more secure operating under the notion that if something goes wrong they can always sue [them] and recoup their losses,” says Paul Pinto, managing partner at outsourcing consultancy Sylvan Advisory. “Buyers believe that the larger service providers will not be willing to endure the bad publicity associated with a law suit. The result of this case clearly displays the contrary.”

More specifically, “the case is a bit discouraging if you write careful contracts hoping that they’ll be enforced as written,” says Randall Parks, co-chair of the global technology, outsourcing and privacy practice at Hunton & Williams. The court took IBM’s achievement of a limited set of service levels metrics along with its delivery of some unexpected benefits–supporting Indiana flood relief in 2008 and a “plan B” welfare system to replace the one that did not work–as evidence of acceptable contract performance, Parks says. “For providers, it is apparently still possible to get an ‘A’ for effort. In the end, the decision seems to represent rough justice in a complex case.”

Pinto isn’t surprised that IBM walked away unscathed. “IBM prides itself on its ability to write and negotiate onerous contract terms. They have developed this skill through many years of experience, and wield it artfully,” he says. ” Even though IBM did not perform in alignment with the intent of the agreement, they were deemed to have satisfied the letter of the law.”

IBM was able to avoid material breach of the contract by meeting somewhere between 50 and 80 percent of its service levels. “Surprisingly, the court minimized problems that many IT managers would find unforgiveable, including a 48 hour call center outage, and readily gave IBM a pass for the difficult and politicized environment in which it was working,” Parks says.

Big government IT outsourcing deals have a poor track record for success. Indeed, they may be doomed to fail from the start, says Adam Strichman, founder of outsourcing consultancy Sanda Partners, who says IBM actually made a valiant effort with this deal.

“What is hiding between the lines here is that the state wanted to change it’s culture by outsourcing–always a difficult move, but almost impossible for a government organization. [Indiana wanted to] shift the [welfare] eligibility determination [process] from the state offices to a centralized call center.” says Strichman. “Guess what–when they did that, the old organization magically still had control, and [then they were] paying for two organizations. State organizations are masters at never giving up control. This is a textbook case of why outsourcing often fails at the government level.”

Political rhetoric also made Indiana’s assertions against IBM difficult to prove. “Public-sector outsourcing is complicated by politicians’ desire to claim success right up to the moment when they are forced to confess to a problem,” says Parks. “In this case, the repeated ‘thumbs up’ from various state officials were impossible to reconcile with the later claim of material breach. In government, line management often has very little ability to influence this sort of activity, even when the realities don’t match the sound bites.”

Public sector IT organizations might far better if they adopted a more incremental outsourcing approach, says Strichman. “Set up a shop that doesn’t interfere with state jobs and fiefdoms. Roll out a high tech alternative in parallel with the status quo. Test it, work out the bugs, and roll it out selectively,” says Strichman. “A tiny contract would not have had so much riding on it, and could be tested until they got it without colossal budget pressures and bad press. It can work, if states stop biting off more than they can chew, and outsourcers and consultants stop serving it up that way with a smile.”

There are lessons in the case for IT leaders outside of government organizations, as well. At a time when outsourcing customers have been negotiating IT services contracts with fewer, more targeted service levels, “this case says that more performance measures that might reduce a judge’s discretion are worth the investment,” says Parks. “Customers can’t count on the judge or soft concepts like ‘material breach’ to protect them. There is no substitute for precise performance definitions and careful, prompt management of departures on both sides.”

The Indiana-IBM fight also underscores the value of recent shifts in IT outsourcing philosophy–the importance of breaking up big projects into smaller deliverables with measurable results, the appeal of spreading risk across multiple providers, and the importance of robust outsourcing governance.

“Outsourcing is still a hit or miss proposition. The only way to increase the chance of success is to become a truly informed buyer,” says Pinto. “This case sends a clear message to the Buyers of outsourced services, that they cannot outsource their responsibility along with the engagement.”

Stephanie Overby is regular contributor to CIO.com’s IT Outsourcing section. Follow everything from CIO.com on Twitter @CIOonline, on Facebook, and on Google +.