Buying Into Trouble

Taking advantage of economic and market conditions to put the squeeze...

Taking advantage of economic and market conditions to put the squeeze on your IT suppliers may seem like good business, but it could be just the opposite warns Kit Burden

In today's troubled economic climate, the temptation for suppliers is to grasp business opportunities whenever they can be found, and without regard to previous established approaches to risk, contract or bid management. While clients may perceive themselves to be benefiting in terms of their greater negotiating power and ability to beat down the supplier on costs, there is a question as to whether this will, in the long term, always be to their advantage.

Contract negotiations
IT projects are frequently complicated affairs, and as such will require detailed negotiation. Such negotiation will often relate as much to the legal terms and conditions as to the description of the services or products to be provided. In the past, many suppliers have started from the principle that work should be conducted under their standard terms of business, which invariably favour their interests. Even before the onset of the economic downturn, this approach was being challenged by the greater sophistication of in-house legal and procurement teams in IT contract matters and the greater availability of client-friendly IT contract precedents. However, the recession has undoubtedly led to a significant shift in bargaining power, such that suppliers are no longer able to insist upon using (or even starting negotiations based upon) their own standard terms, for fear of losing a potential sale to another supplier who was not so picky.

The net result is the increasing prevalence of contracts which are slanted heavily in the client's favour, particularly in one or more of the following areas:

Warranties – In the past, suppliers have been cautious as to the scope of the warranties they provide; such contractual promises do, after all, help to delineate both the scope and level of responsibility which they are to take on. Accordingly, while they would usually accept a restatement of the implied warranty in the Supply of Goods and Services Act [1982] (ie requiring the exercise of reasonable care and skill), they would fight to avoid any more explicit or wider warranties, for example, as to fitness for purpose, or suitability for a client's requirements. However, clients are now better placed to force suppliers, not merely to specify what they will deliver, but also to warrant that it will actually meet the client's business objectives. This clearly entails a higher level of risk for the supplier, as not only may such requirements be unclear, but the reasons for their not being met may actually have little to do with the quality of the supplier's goods or services.

Liability limits – Battles on liability clauses have long been a staple feature of IT contract negotiations, although, over time, a limited 'standard form' of liability provision developed. This linked the supplier's liability to the value of fees payable under the contract in question, and it expressly excluded certain categories of loss (eg indirect or consequential loss, and frequently also more specific forms of loss, such as loss of profit or loss of anticipated savings or benefits). Suppliers could take the position in negotiations that company policy would prevent them from taking a different line.

However, with increased competition for work, the approach on liability limits has become just another variable to be adjusted (albeit one which may be held back to the very end of the negotiations). Although the market has not reached (and almost certainly will not reach) the point where clients can insist on there being no limit of liability at all, the limits are creeping up (with multiples of 1.5 and 2 times fees now common). Specific exclusions of sub-categories of loss are attached and diminished, if not deleted altogether.

Price – In recessionary times, there will obviously be pressure on suppliers to slash their rates in order to win work , or agree to set fixed fees for more and more categories of work. However, just as significant are the other payment provisions which dominant client organisations may now be insisting upon, including payment plans which involve most or all of the payments being deferred to the end of the project or to the achievement of late-arising milestones (with obvious cash flow implications for the supplier) and preconditions to receiving payment, which the supplier may find difficult to satisfy. An example of the latter would be a requirement that the client is satisfied that it has obtained the envisaged benefit from the supplier's services.

Personnel – For many suppliers, their personnel are their key, if not their only, assets, and they have accordingly jealously guarded their rights to apply them to whichever project they deem appropriate, even if this meant shifting them from one client to another at short notice. However, the pressure on scarce supplier resources has now eased considerably, and suppliers are accordingly much more amenable to commitments to maintain named staff on client projects until their completion, and to give the client a right to select those supplier staff whom it wishes to work on its projects. On the flip side, this may not leave the supplier best placed to win future work by putting their best possible team forward to try to win other contracts.

Intellectual property rights – Suppliers will seek to reserve ownership of any generated IPRs to themselves, on the basis that the future development of their businesses is, in large, partly dependent upon their ability to re-assign and reuse materials from one client project to another. However, clients are now well placed to argue against this and to seek ownership rights in respect of the IT materials they have paid to have developed, whether in order themselves to seek to generate some revenue from them (which is fairly rare), or simply to prevent the supplier from swiftly re-applying the benefit of its worth and experience to the businesses of the client's competitors.

Bid and risk management processes – In an ideal world, every major bid submitted by a supplier would be subject to a rigorous internal review process, so as to ensure that it made business sense to the supplier as well as to the client (which is an essential precondition if the project in question is to be a 'win-win' for both parties). However, the pressing need to win business has resulted in many suppliers cutting short or entirely circumventing such processes, resulting in the (perhaps premature) celebration of high risk and potentially un-deliverable projects.

Future ramifications
It may be tempting for a buyer of IT goods and services to celebrate many of the wins featured above, after having been on the receiving end of many occasions when suppliers were in demand and could insist on setting their own contract terms. However, it is easy to forget that a lasting and successful deal is almost invariably one with which both parties feel comfortable. In this context it may be prudent to gaze into a crystal ball and imagine the future ramifications of the current negotiating landscape.

Setting precedents – It is only natural to refer back to points accepted or conceded in previous negotiations, when the same issue subsequently arrives in subsequent contract negotiations. However, while there is undoubtedly some need for this (for example to put the lie to an assertion that a dealbreaker provision has never, ever been accepted in the past), the reality is that every deal is a product of its individual circumstances. To rely blindly on the force of past precedent is simply to invite dispute when circumstances change. Just as suppliers have had to adjust their positions (however slowly) in the face of current market conditions, clients will in the future have to do the same. It is thus important to resist the temptation to blindly insist on the maintenance of the status quo.

Renegotiations – Many IT deals are signed for relatively lengthy periods, with outsourcing deals in particular usually being intended to last for from 5 to 10 years. Clearly, much can change in this period, and we can anticipate that if one or the other party to a contract feels that market conditions have shifted in its favour, it will seek to renegotiate or amend the contract it originally entered into. Its capacity to do so will obviously depend upon a combination of its commercial bargaining power and the provisions of the contract itself (and in particular what penalties would be applicable in the event of an early termination). However, we can see an ever growing trend towards renegotiation, which will frequently end up as drawn out and expensive processes, and which will inevitably place strains on the client-supplier relationship.

Project failures – Many suppliers will assign one team to identify, bid for and negotiate business opportunities, and another to deliver the services contracted for. Such a practice, which has its drawbacks even in better economic conditions, can give risk to particular challenges when competition for the work is fierce, and the sales team has to promise or concede more and more in an effort to secure the business (and quite possibly safeguard their jobs). There will inevitably be an initial, mutual flush of success as the seller's team celebrates the sealing of the sale and the client congratulates itself on achieving such a great deal, with so many contract clauses and concessions weighted in its favour. However, once the project actually commences and the reality of what it will take to deliver it in accordance with the contractual requirements begins to dawn, it is unfortunately the case that both parties risk disappointment; the supplier as it realises that the project is likely to lead to losses if not litigation, and the client as it faces the prospect of project delay or failure, with the resulting impact on its business. All too often it will be the case that the client would actually have settled for considerably less than was promised, in exchange for an increased chance of successful delivery.

Adversarial relationships – Negotiations over large projects have an unfortunate tendency to descend into the legal equivalent of trench warfare, with teams of lawyers and negotiators trading blows (and sometimes insults) in the battle to secure favourable terms. However, where the battle is an even one and the end result is one with which both parties are broadly happy, it is more often than not the case that the resulting contract is referred to only when problems arise. On the other hand, where the end result is a contract which has left one party forced up against the wall and with little or no margin left in its pricing, the natural tendency of the party at the receiving end is to try to mitigate its position by continually poring over the contract terms, looking for ways to limit the extent of its obligations and pass the cost of responsibilities back to the other party. The result is an adversarial, contract-led relationship, characterised by frequent meetings and exchanges of contract notices and claims for 'change control' adjustments to pricing and timescales (which will frequently be denied or disputed by the client).

Stifled development – Clients will often have good reasons to insist upon being assigned ownership of the IPR in the materials which they have paid to have developed. For example, it may be that they envisage gaining some specific competitive advantage over their rivals in their market sector, which could potentially be lost or reduced, if the supplier were to be freely able to redistribute the materials once the project had been completed.

However, the flip side of this is that the attraction of the supplier to the client in the first place will frequently have been its proprietary methods and materials, which will largely have been developed via practical experience on other projects where the supplier will have preserved its IPRs in relation to its work products. If it is denied such ownership rights in respect of current projects, the supplier's future ability to extend the benefit of such materials to its wide client base (and thereby the economy as a whole) will be inhibited, and it may not be able to develop its product set as widely or as fast as would have been ideal. A short term win for the client on IPR ownership may accordingly not serve its own best interests in the long term.

Conclusion
History has a lesson for buyers of IT goods and services at the current time. At the end of World War One, the victorious Allies gathered at Versailles, determined to make the defeated Germany pay for starting the war. Many historians say that the road to World War Two began there, by creating a burden which rankled with the Germans and created the future tensions which led ultimately to war. Although the analogy is extreme, one can see how battered suppliers, sore from one-sided contract and commercial negotiations, likewise have had the seeds of dispute sown within them, both for the conduct of current projects and for future negotiations and re-negotiations. In such times, it may therefore be prudent to remember that a lasting deal is undoubtedly that which is perceived as a 'win-win' for both parties.

Kit Burden is a partner, commercial and technology group, Barlow Lyde & Gilbert, Tel: 020 7643 8056, E-mail: kburden@blg.co.uk

IT OUTLOOK IS NOT SO DIM
Prospects for the information technology industry remain strong despite the recent downturn, the latest OECD Information Technology Outlook says. New products and services will continue to drive demand from firms, households and governments, and falling costs and technological developments will help. Despite the slowdown, markets for information and communications goods and services were equivalent to 8.3% of total GDP of OECD countries in 2001, compared with less than 6% in 1992. Just as the information technology sector contributed to the current downturn, there is reason to believe it will have a significant role to play in the next recovery, the report says.

IEEE SURVEY
A survey of Fellows conducted by the Institute of Electrical and Electronics Engineers and reported in its newsletter IEEE Spectrum Opinions in January showed that respondents were equivocal when it came to assessing the health of the tech industry. For example, about the same number of respondents predicted that the telecom and semiconductor industries would recover first as said they would be last. Statistically equal shares thought that energy, telecom, or semiconductors would be the first industry to recover, with slightly smaller shares voting for computers and transportation.

Opinions also diverged on what had caused these industries to fail in the first place. Some criticised the telecom industry for overbuilding and paying too high a price for speculative assets. Others felt that energy deregulation had caused more problems than it solved. 'Deregulation of the energy industry, coupled with the alleged business ethics shortcomings of prominent players in this sector, will hamper strong recovery,' is how one respondent put it. Nor was he alone in pointing out that any tech recovery will be greatly influenced by geopolitical events. 'Recovery of the transportation industry will depend on the reduction of worldwide terrorism,' said one respondent.