Taking Out a Contract

Open the bottom drawer, blow the dust from those IT contracts and go searching for the demons and the diamonds that lurk within.

The health insurance commission recently renegotiaated a contract; and got access to software running on up to 1200 more Mips for $1.6 million less that it used to pay.

Canon has a team working its way through a 40-page contract, dense with an array of demands from the prospect (a division of one of the big four banks), which even if it wins will net just $200,000 revenues for the printer supplier.

St George Bank has renegotiated its volume licensing contracts for open systems software and brought down its annual charge from $6.5 million to $5 million.

Welcome to the wild world of modern IT contract negotiations.

Time was when an IT contract was drawn up, looked over, signed and put in the bottom drawer. Today IT contracts - whether for software, hardware, peripherals, communications or services - are more lively documents, and in best practice situations perform as an active management tool by clearly defining the outcomes expected from the supply of goods or services.

Best practice contracts also keep the parties out of court if something goes wrong. Dr Gordon Hughes, a partner with Blake Dawson Waldron, says by incorporating performance measures, defining the means of monitoring performance and also nominating performance level rebates, a good contract has "both the offence and penalty pre-prescribed".

It does not always work that way, though. IT litigation is rare in Australia, but according to some lawyers it is on the rise.

One high-profile dispute in negotiation at time of writing is between the building supply company Crane Group and PeopleSoft. In July Crane revealed the extent to which an IT project using JD Edwards software (now owned by PeopleSoft) had blown out. The system was installed after four years, but Crane took a $28.7 million pre-tax write-down on the software in its 2004 annual results.

After disclosing the problem in July, Crane clammed up, refusing to discuss how the dispute negotiations are proceeding. All a spokesperson for the firm would say is that there has been no court action at time of writing.

Another lawsuit, dating back to 1996, was finally put to bed this year. In 2001 Justice Hansen in the Supreme Court of Victoria ruled on a claim by RACV Insurance and RACV Group Services against Unisys Australia regarding a failed IT project for the design, supply and installation of a work flow management system based on the imaging of documents. The judge found in favour of RACV and awarded damages in the order of $4 million for expense wasted on the contract. Unisys appealed the decision but in May, the Full Court of the Supreme Court of Victoria unanimously dismissed the appeal.

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Court action is costly for all parties, so not surprisingly CIOs are getting smarter about contract management. Sydney Airport Corporation Limited (SACL), for example, has had a database of contract precedents under development for the past two years. Expected to be completed in 2005, the database will steer the organization through all of its IT contract negotiations, ensuring that the correct procedures are followed, and where it makes sense, make use of tried-and-tested contract components. According to SACL CIO David Luong, this will help ensure that nothing is overlooked during negotiations.

Issues such as intellectual property access and ownership are addressed by the precedents, along with the use of escrow to guarantee access to source code, and the precedents ensure commercial liabilities of the parties are properly explored for each contract. "Over the last year or two that library of contracts has been built up and developed in partnership with our in-house lawyers and procurement specialists," says Luong.

Acknowledging that there can be no single contract precedent for IT products and services because of the fast changing nature of the beast, Luong nevertheless believes it is possible to define a precedent-based framework that can be harnessed for any contract negotiation. An important element of that framework, he says, is the technique to identify and quantify risk. "Say it was an implementation project, we would look at the timing risks: What are the likely effects of being late? What are the cost risks of the project? What happens if it's running late - are there any holding costs and who is liable? What are the quality risks - how well does the contract capture the responsibility of our suppliers and ourselves?"

If the risks are not appropriately identified and accounted for in a standard contract, then a team made up of procurement specialists, project managers, technologists and lawyers needs to analyze them and ensure that any newly developed contract does account for them. Again, by following the framework for contract negotiations, the chance that any risks may be overlooked is reduced.

Luong says he has noticed that in the past five years suppliers are a great deal more risk averse, which has tended to make contract negotiations more complex and lengthy. "They are increasingly asking more questions such as: 'Is what we are asking for fair and reasonable?' You can try and offload all the commercial risk onto the supplier, but suppliers are now prepared to walk.

"I remember a time when supply outstripped demand and customers had more clout. Certainly around 2001 - customers had more leverage then."

He says there is still some leverage to be had when doing deals with tier-two suppliers who tend to be more innovative and less risk averse. "Perhaps they are driven by the need to win market share," says Luong. "There have been times when with larger suppliers we have felt we weren't really the customer. We felt we had no leverage. That is something that the larger suppliers need to be aware of."

Larger customers meanwhile enjoy more clout. Michael Jamieson, director of Nike's supply chain in the Pacific, says his company's global brand delivers him a strong bargaining position. "With rapid application and infrastructure development, vendors are very keen to get the latest tools into businesses like ours, therefore providing an increasingly negotiable contract environment."

Management of IT contracts at Nike is quite devolved at present. So, for example, the country manager with responsibility for network support manages the network contracts, the manager with responsibility for application development manages contracts related to that function, and so forth. Shortly this will change, as Nike is about to move all component applications and supporting hardware to the US where they will be managed and supported.

For the moment, however, Jamieson says accountability for contract management, in totality, lies with the relevant senior managers. "Strategic direction and consultative input and final approval is always given by the CIO," he says, "but the autonomous model of contract renewal and renegotiation by senior managers is preferred. Adherence to activity, financial, and support and maintenance-related milestones and KPIs, driven by a regular functional performance management process, provide the visibility the CIO requires from month to month."

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Those KPIs are also set out in contracts, but Jamieson points out that Nike does not overplay its bargaining hand. "We are as careful as possible to ensure that the scope of developmental works, or infrastructure KPIs, are realistic, which at the end of the day limits risk to both parties and the likelihood of an issue related to underperformance in the first place. Fortunately, we have not experienced any local non-performance contract issues in the IT arena for many years."

Very much a believer that litigation should only ever be a measure of last resort, SACL's Luong says he views all contracts as the blueprint for a partnership between supplier and user where both parties use the contract as a framework to achieve what was intended. Contracts are not something signed and shelved but exist as a living document that should provide the framework for progress, he says.

It is an important point. Organizations that do not review their contracts on a regular basis may lose out.

It is a lesson learned by the Canberra-based Health Insurance Commission (HIC). HIC outsources its hardware requirements to IBM GSA. It retains, however, a significant investment in internally generated software and third-party software. Vipan Nahajan is the manager of capability development and projects for HIC, reporting to Lyn O'Connell, HIC's CIO.

Over the past 18 months Nahajan has been overseeing a software audit - identifying what HIC owns, pulling out of the bottom drawers the contracts associated with the software, and then identifying the liabilities associated with what it owns. What he has uncovered in the jumble of contracts is "a number of hidden horrors".

"For example, there is ambiguity in terms of the annual maintenance costs, and you can fall into the trap," Nahajan says. "Say you are paying a percentage of the list price of the software for your maintenance. Well, 20 years ago it may have had a list price of $1000. But the software vendor can turn around and say: 'Well, the list price today is $50,000.'"

Nahajan may have found himself scared half to death with what he has found in some of the contracts, but he turned the potential horror into an opportunity. He has created a timetable noting when the contracts come up for review, and carefully logged what aspects of the contract need to be negotiated.

"A number of vendors have said that they would never license software according to a logical partition of the mainframe," says Nahajan. "In the past vendors were unwilling to negotiate that." But he says increased IT market competition now means that where there might have been only one supplier able to meet the organization's needs in the past, there is now a flurry of possibilities.

"The leverage we have been using is that there are now a number of equivalent products. We do realize there are risks involved if we did move. But we tell the vendors that if their costings don't improve we might be willing to make the change. We have done that with one of the big vendors."

HIC had been paying $4.6 million for software to run on an 1800 Mips mainframe. When it renegotiated the supply it got the price down to $3 million, and also the flexibility to run the software on 2000-3000 Mips as demand required. That the industry is prepared to negotiate afresh is, according to Nahajan, in part a reflection of its growing maturity and a recognition that users are under greater financial constraints.

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As well as renegotiating supply contracts, organizations are also revisiting the early rounds of outsourcing contracts - and users are demanding more for less. The Commonwealth Bank renegotiated IT supply contracts recently and, according to one report, its mainframe costs fell $17 million in 2004 and its desktop computing costs dropped $19 million.

When you are under pressure to cut costs, HIC's Nahajan says there are two options: reduce staff or reduce the costs of your suppliers. "My preference is not to touch staffing. The implication for the vendors is that I'm hoping they make a little less money.

"The IT shops are constrained but IT is growing overall, and that's where they [the vendors] are looking for broader market share. With the new generation of contracts, we are looking for more flexibility and lower costs," Nahajan says.

The new generation of contracts that Andrew Newman is going to have to manage was thrust upon him when JP Morgan announced it was abandoning outsourcing and moving 4000 staff out of IBM and back in-house. Part of the deal with the $US5 billion outsourcing deal with IBM was that IBM had managed all the contracts with the subcontractors.

Now Newman, the vice president and regional sourcing manager for JP Morgan in the Asia Pacific, is going to have to start looking after those contracts himself. The way in which JP Morgan is structured means that Newman in his dedicated regional sourcing role is responsible for all contract management - not the individual business managers, and that includes the regional technology managers.

To better serve the needs of the IT division, a specialist technology sourcing group has been established in the strategic sourcing group. When CIOs or business units decide that they need new technology they forward the request to this group, which then manages the request, issues a request for proposals to the market and conducts any negotiations in alliance with JP Morgan's legal team.

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