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Although we all recognise that the heart and soul of an outsourcing transaction lies in issues of service, price and governance, it has always been the case that an inordinate amount of time in outsourcing negotiations gets taken up with legal issues. And of those legal issues, the one that tends to absorb the most time is the Liability Clause. By this, I mean the clause that stipulates who pays what if something goes wrong, what types of loss can and can’t be recovered and, most controversially, the maximum liability of either party in the event that something goes wrong which causes a loss.

In many ways, perhaps it’s understandable that this particular topic causes angst and leads to a ritual dance around some fairly well-rehearsed issues. But it is frustrating – even to a jaded outsourcing lawyer like me - that every negotiation seems to start from square one without there being a recognition by either the Customer or Service Provider of some of the realities of the situation in which they find themselves.

Too often, I seem to find myself faced with 2 positions that I find equally untenable – the Customer who expects a Service Provider to pick up uncapped liability; and the Service Provider who refuses to accept responsibility for seemingly obvious potential losses – financial loss, for example, in a financial services sector BPO where the very nature of the services provided inherently involves exactly that type of risk.

Typical principles

There ought to be a few clear points of agreement around the topic of Liability Clauses. For example:

• For the most part, a Liability Clause is no more than an acceptance that, subject to various exceptions, where a party is in default it picks up the tab – which should be Motherhood and Apple Pie to both sides. The difficult bit is what those exceptions should be.
  
• Customers will usually want some form of enhanced protection around certain types of loss – traditionally, indemnities against loss to third party software owners whose rights may be infringed. But as outsourcing has moved gradually closer to Customer’s core functions – and especially in the BPO sector – Customers are now increasingly worried about enhancing protection against exposure to external third parties such as the Customer’s own clients. More on this below.
  
• In strict numerical terms, it is now universally accepted (I hope) that across-the-board unlimited liability clauses are not realistic. This took some time to permeate to certain sectors – especially the public sector. But it is now common practice that the exposure of a defaulting party under contract ought to be financially limited in some way. Having said that, there are still certain areas where uncapped (i.e., unlimited) liability is routinely negotiated – for example in relation to IPR infringement (or other) indemnities, or in relation to liability based upon fraud. The other area that often is discussed in this context is unlimited liability for what lawyers call "wilful abandonment" – the argument here being that it should not be cheaper for a Service Provider to "walk away" from a poorly performing contract than to continue to perform it – and therefore if a Service Provider does seek simply to abandon a contract then its liability ought to be uncapped.
  
• A typical starting point for negotiations on financial limits is often an annual cap of 100% of annual contract value – and the parties then negotiate up or down from there. Having said that, if one thinks about it there is simply no logical connection between the size of a contract and the scale of potential loss: on some large contracts, the potential exposure to loss can be minimal; whereas, conversely, even on contracts that have a relatively small value, if the services are of the right kind, then the scale of loss can be enormous. But "proportion of contract value" has come to be recognised as a handy yard-stick for assessing and determining caps on liability and most Service Providers cling to that yard-stick as if to a life-belt.
  
• Generally, it will suit an outsourcing Customer to have a single cap on liability: whereas it will tend to suit a Service Provider to have as many as possible (and as small as possible) sub-divided "pots" of liability, with each pot being set against a particular type or cause of loss. The reason for this is simple; the more a liability exposure is sub-divided, the more likely it is that significant losses are likely to be cut-off by the pre-agreed cap on liability.

Bigger Contracts, Bigger Caps?

One fact that emerges from recent negotiations is that, as outsourcing contracts have got bigger over the past decade, even though the scale of potential losses is higher, the average cap on financial liability has not kept pace with the increased size of contracts. It has become more common to impose both an annual cap on liability as well as an overriding "contract life" cap. And this is probably correct, because one ought to recognise that while it is certainly possible that an outsourcing relationship could survive one significant default that leads to a liability payment by the Service Provider, that relationship is unlikely to survive a second large claim and, therefore, providing for a cap large enough to cover multiple significant claims over the contract duration is probably unrealistic.

The Balancing Act

The whole issue of Liability Clauses and their negotiation is, in fact, no more than a reflection of one of the central tenets of outsourcing negotiations – which is that the right solution is likely to be a balance between the two parties’ interests which enables them both to feel as if they have got a fair deal.

Much can be done if each party can recognise the concerns of the person on the other side of the table. Too often, negotiations on this particular issue become bogged down because parties are blinkered and don’t recognise the potential exposures on the other side of the negotiating table. So, for example, Customers often over-egg their demands for liability protection and seek to set liability clauses against the worst case, even though in reality the effects of mitigation (which will be legally required anyway) may bring the maximum possible claims down to a more moderate level.

Likewise, Service Providers are routinely disingenuous about potential exposure. They spend considerable amounts of time and effort selling their way into lucrative, high-value contracts. As noted above, the current generation of BPO contracts has moved ever closer to the core of Customers’ businesses – and Service Providers are as responsible for that as anyone as they vie for bigger and better contracts with a wider scope of services.

Especially in relation to banking and other financial services clients, those outsourcing contracts are increasingly central to Customers’ operations on which large amounts of Customers’ own clients’ money depends. But Service Providers cling to old norms on Liability Clauses that were developed when potential exposures were much different. It therefore seems unfair to seek to apply "old" expectations of low caps on liability to the current generation of increasingly high-value, lucrative contracts.

To use the example I started with, one Tier 1 Service Provider even today steadfastly refuses to accept that it might be liable for any form of financial or economic loss suffered by its Customers or its Customers’ clients – even on BPO contracts where it loudly touts its skills but which are all about handling (and running the risk of mis-handling) clients’ money.

Conclusion

As with so many aspects of outsourcing, a successful Liability Clause is about striking the right balance. Those protracted negotiations around Liability Clauses could be an awful lot shorter if Customers stopped setting liability expectations against the worst case; and if Service Providers were prepared to accept the downside of liability exposures relevant to the current generation of outsourcing contracts commensurate with the upside of the profits available from the services that they now provide.

 

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This article was first published by Alsbridge in Outsourcing Leadership News August 2006 and is reprinted with permission. For more information see http://www.outsourcingleadership.com/ or http://www.alsbridge.com/.