United States: Material Breach In Outsourcing Contracts

Keywords: outsourcing, agreement, material breach,

A well-negotiated outsourcing agreement typically grants a customer the ability to terminate the arrangement without payment of any penalties in the event of a "material breach." However, unless the agreement names specific events that constitute a material breach, that determination will be left to a court. While there are no "bright line" rules to assist a court in making its decision, some case law exists that offers customers guidance in navigating these murky waters.

In particular, the primary focus of a recent case, State of Indiana v. IBM,1 was whether or not the State of Indiana was properly entitled to terminate its agreement with IBM for material breach.

This article will explore some of the key points that can be gleaned from cases where material breach was a focus of the litigation and will culminate in some concepts and best practices that customers can implement to provide more predictability when evaluating whether a supplier materially breached an agreement.

What Constitutes a Material Breach?

When is a supplier in "material breach" for its failure to perform in an agreement? Law treatises offer some guidance to assist with that determination. For example, a material breach has been explained as a breach that "is so fundamental to a contract that the failure to perform ... defeats the essential purpose of the contract," "go[es] to the 'root' or 'essence' of the agreement," or "touches the fundamental purpose of the contract and defeats the object of the parties in entering into the contract."2 One authority, The Restatement (Second) of Contracts, recommends a multi-factor test that courts can invoke to determine whether a breach is material. Specifically, the court should consider the following factors:

  • The extent to which the injured party will be deprived of the benefit that he or she reasonably expected
  • The extent to which the injured party can be adequately compensated for the part of that benefit of which he or she will be deprived
  • The extent to which the party failing to perform or to offer to perform will suffer forfeiture
  • The likelihood that the party failing to perform or to offer to perform will cure his or her failure, taking account of all the circumstances, including any reasonable assurances
  • The extent to which the behavior of the party failing to perform or to offer to perform comports with standards of good faith and fair dealing.3

Another view on materiality offers this insight: "Ordinarily the issue of materiality is a mixed question of law and fact, involving the application of a legal standard to a particular set of facts. However, if reasonable minds cannot differ on the issue of materiality, the issue may be resolved as a matter of law."4

How have state courts interpreted the issue of material breach? In Illinois, a material breach is one that is "so substantial and fundamental as to defeat the objects of the parties in making the agreement, or whether the failure to perform renders performance of the rest of the contract different in substance from the original agreement."5 Case law in Illinois further opines that a "breach must be so material and important to justify the injured party in regarding the whole transaction at an end."6

In applying these concepts, Illinois courts have stated that "[t]he determination of materiality must turn on the facts of each case" and that, "to properly consider whether [a] defendant's breach was material, it is necessary to begin by placing that breach in context."7 An Illinois court will most likely apply the multi-factor test cited above from The Restatement (Second) of Contracts to determine the materiality of the breach. However, one Illinois court has also examined external and/or industry factors to determine whether the "custom or usage shows the breach to be material."8

Courts in California have adopted the majority of the multi-factor test set forth in The Restatement (Second) of Contracts but have slightly modified the elements and added some additional factors to consider. In lieu of examining the extent to which an injured party will be deprived, the California test examines "[t]he extent to which the injured party will obtain the substantial benefit which he could have reasonably anticipated." The test in California will also consider "the greater or less hardship on the party failing to perform in terminating the contract" and "the willful, negligent, or innocent behavior of the party failing to perform."9

In New York, courts have defined a material breach as a breach "that goes to the root of the contract."10 Moreover, a court in New York will evaluate whether a breach is material using this guidance: "A breach is material if a party fails to perform a substantial part of the contract or one or more of its essential terms or conditions, the breach substantially defeats the contract's purpose, or the breach is such that upon a reasonable interpretation of the contract, the parties considered the breach as vital to the existence of the contract ... [or] if the promisee receives something substantially less or different from that for which he or she bargained."11

State of Indiana v. IBM

So how will a court apply the multi-factor test to determine whether a party indeed materially breached its obligations under an outscoring agreement? There is scant case law on the topic, but an Indiana court recently provided some insights with its decision in State of Indiana v. IBM. In 2006, the State of Indiana and IBM entered into a 10-year, $1.3 billion outsourcing agreement under which IBM would transform and modernize the state's welfare system. The project, which was intended to overhaul a welfare system that produced the worst welfare-to-work record in the country, was designed to let Indiana citizens apply for welfare benefits online or via a call center, while eligibility determinations would be made on a "centralized, statewide basis rather than in the local country welfare offices." However, the transformed system produced high error rates and slowed the pace of eligibility determinations. In 2009, the State of Indiana terminated its contract with IBM by invoking the termination for cause provision of its master services agreement, citing that IBM was in material breach for "quality and timeliness."12

IBM and the State of Indiana eventually found themselves in court; the state sued IBM for $1.3 billion, claiming breach of contract. IBM countersued the state for the value of equipment it was obligated to leave with the state under the terms of the agreement. The court stated that both parties were to blame, and that, consequently, "[n]either party deserves to win this case." In its ruling, the court invoked parts of the multi-factor test from Williston on Contracts and concluded that the state failed to meet its burden to show that IBM committed a material breach, despite a record showing that "IBM did not perform well in some respects." 13

Two factors from the multi-factor test played a prominent role in the court's decision of whether IBM materially breached the agreement, namely, "the extent to which the injured party will be deprived of the benefit which he reasonably expected" and "the likelihood that the party failing to perform or to offer to perform will cure his failure." Despite a painful transformation, the court determined that the state was able to achieve a "new welfare system that works better" as a result of the modernization efforts with IBM. The court found this fact "to have great weight regarding whether there is a material breach or not." In its opinion, the court states that "[a]ll in all, the State was not deprived of benefits it reasonably expected from the contract, although some benefits were not received as smoothly as the parties would have expected."14

As to the second factor, the court acknowledged that determining IBM's performance was "premature and problematic" given the length of time the parties were bound under the agreement before the state terminated. (The final term of the agreement was 19 months—only 12 of which contained applicable performance measures.) Despite the state's claim that IBM breached the agreement for "timeliness" and the court's acknowledgement that key performance metrics for timeliness were "consistently missing the mark," the court found that IBM's performance was "steadily improving during 2009, especially in the months leading up to the October 2009 termination." Based on this, the court extrapolated IBM's performance and determined that IBM's failures had the "likelihood of being cured" and were "apparently in the process of being cured." Consequently, the court did not find that IBM materially breached the agreement under this factor and did not devote much effort to evaluating the other three factors.15

Nonetheless, the court considered another issue when determining whether there was a material breach—the extent to which the breach went "to the heart of the contract," stating that, "where a party substantially performs, there is no material breach." This finding is perhaps the most troublesome for customers of outsourced services, because the court did not grant much deference to IBM's service level performance, and, instead, determined that "these examples ... have to be balanced against the whole of the contract and IBM's whole performance showing benefits to the State and adhering to [master service agreement] policy objectives."16

As a result of the court's findings, IBM was able to avoid the material breach claim by only meeting between 50 and 80 percent of its service levels. In fact, the court minimized problems that many IT managers would find unforgiveable, such as a 48-hour call center outage under IBM's watch. The court refused to give much credence to the State of Indiana's breach claims for performance items that were not measured by service levels, but it did give strong deference to a clause in the agreement that disclaimed any warranty of "uninterrupted or error-free operation." When analyzing these performance items, the court refused to impute any additional interpretation in light of that disclaimer. The court also refused to grant much credence to the state's claim of dissatisfaction with IBM's performance as a basis for material breach and indicated that customer satisfaction was one of eight enumerated ways to judge IBM's performance.17

Uncertainty for Customers of Outsourcing and Recommendations

The ruling in State of Indiana v. IBM does not support the finding of material breach on which the state based its termination claim. While that court applied the multi-factor test to determine whether IBM materially breached its obligations, it chose to focus on two factors and view the agreement from a more holistic point of view.

As was discussed above, case law in other states suggests that all factors of the multi-factor test should be considered, and the facts of the case should be evaluated to determine if the essence of the agreement has been violated. The court in State of Indiana v. IBM took the position that performance metrics that failed to meet certain levels did not violate the main objective of that agreement—namely, to have a better welfare eligibility system. However, performance metrics are typically heavily negotiated items in an outsourcing contract; the State of Indiana was purchasing not only a welfare system that worked better than the worst system in the country, but one that met certain performance metrics for the price it agreed to pay.

In light of this uncertainty, there are several measures a customer of outsourcing services can implement to minimize the chance of a similar judgment and provide more assurances that a court will support a termination for material breach:

  • Memorialize specific events that the parties agree would constitute material breach, such as failure to meet a specified number of service levels or intellectual property theft, and that would allow termination without the payment of termination charges. A court will enforce these negotiated items, but, even if a breach does not meet the requirements of these "bright line" events, they can still be useful in assessing whether the breach in question is material and offering the court some guidance.
  • Include a notice requirement in the agreement prior to terminating for a "bright line" material breach event and provide an opportunity to cure the defect. Notice to the supplier will reveal any arguments it may have that the conduct at issue does not meet the "bright line" test.
  • In addition to memorializing specific "bright line" material breach events, ensure that the agreement has a general material breach provision. Ensure that important operational items are the subject of performance measurements. For example, the call center in the agreement between the State of Indiana and IBM did not have a service level to measure the timeliness of answering phone calls, a fairly standard call center metric.
  • Define specific standards of performance and try to avoid ambiguous terms, such as "industry standards" or performance that is "appropriate," "sufficient" or a "best practice."
  • Ensure that service levels have meaningful service level credit amounts to stress the importance of achieving those measurements. In State of Indiana v. IBM, the court commented that the service level credits were "miniscule" and consequently failed to give much weight to the importance of missed service levels.
  • Try to minimize the number of service levels to avoid diluting the "At Risk Amount;" if this cannot be achieved without compromising operational performance, group service levels in a few performance categories.
  • Do not position service level credits as liquidated damages. In State of Indiana v. IBM, the service level credits at issue were actually labeled "liquated damages" in the agreement, and the court viewed IBM's payment of these "liquated damages" as an alternative means of performance. Most customers prefer to have the service levels met rather than to receive financial compensation for missed performance.
  • Break up big projects into smaller deliverables with measurable results.
  • Set service levels that allow for termination if performance falls below a predefined metric.

Footnotes

1 State of Indiana, et al., v. International Business Machines Corporation (Marion Superior Court, Cause No. 49D10-1005-PL-021451).

2 23 Williston on Contracts § 63:3 (4th ed.).

3 Restatement (Second) of Contracts § 241 (1981).

4 23 Williston on Contracts § 63:3 (4th ed.).

5 Village of Fox Lake v. Aetna Casualty & Surety Co., 178 Ill.App.3d 887, 900–01, 128 Ill.Dec. 113, 534 N.E.2d 133 (1989).

6 Id., at 901.

7 Machesney v. World Novelties, Inc., 363 Ill.App.3d 558, 844 N.E.2d 462, 300 Ill.Dec. 464.

8 McBride v. Pennant Supply Corporation, 253 Ill.App.3d 363, 623 N.E.2d 1047, 191 Ill. Dec. 461.

9 Sackett v. Spindler (1967) 248 Cal.App.2d 220, 229.

10 Department of Economic Development v. Arthur Andersen & Co., 924 F.Supp 449, 483.

11 Viacom Outdoor, Inc., v. Wixon Jewelers, Inc., 25 Misc.3d 1230(A), 2009 WL 4016654 (N.Y.Sup.), citing 23 Williston on Contracts § 63:3 (4th ed.).

12 State of Indiana, et al., v. International Business Machines Corporation, at. 9, 3-4, 36.

13 Id., at 1, 38 [citing 23 Williston on Contracts § 63:3 (4th ed.)], 2.

14 Id., at 40, 41, 46.

15 Id., at 46, 47.

16 Id., at 38, 47.

17 Id., at 49, 51.

Originally published on 19 December 2012

Visit us at mayerbrown.com

Mayer Brown is a global legal services provider comprising legal practices that are separate entities (the "Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP and Mayer Brown Europe – Brussels LLP, both limited liability partnerships established in Illinois USA; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales (authorized and regulated by the Solicitors Regulation Authority and registered in England and Wales number OC 303359); Mayer Brown, a SELAS established in France; Mayer Brown JSM, a Hong Kong partnership and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions.

© Copyright 2013. The Mayer Brown Practices. All rights reserved.

This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions