Don't Forget The Computer Contract: Licensing in the Boardroom

This text first appeared in the IAM magazine supplement ‘Licensing in the Boardroom’ October 2005
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Key Licensing Issues for Senior Executives

Licensing in or purchasing a new computer system is fraught with danger if those negotiating the contract fail to ensure that certain provisions are included. Michael R Cohen, of Merchant & Gould in Minneapolis, explains what should not be left out of any systems deal

“How many disputes could have been deflated into a single paragraph if the disputants had dared to define their terms?” Aristotle

The privacy and auditing provisions of Sarbanes-Oxley, Graham-Leach-Bliley and the Health Insurance Portability and Accountability Act including new federal requirements of prompt and accurate disclosure of financial information have chief information officers and corporate boards scrambling to make sure that their computer systems are sufficient to avoid criminal and civil penalties. The potential of business disruption caused by a failed system coupled with the fear of noncompliance with federal laws has moved the acquisition and licensing of information technology from a decision left solely to the MIS department to an important matter for legal counsel and an agenda item for the board of directors.

Few businesses or organizations can survive today without effective information technology. From basic word processing and inventory management control to sales force automation, financial reporting, e-commerce, product manufacturing and delivery, technology to receive, store, manage, report and transmit information has become essential to virtually every business activity.

When the technology performs everyone is happy. When the systems crash a business can easily become crippled and finger-pointing soon begins. Is it a software problem? Is it a hardware problem? Is it a people problem? Most importantly, who will fix the problem and how soon will it be corrected? Can a lawsuit be avoided? Will the person responsible for selecting the technology solution be able to sleep well knowing that the system will meet the organization’s functional needs and requirements? Will management and shareholders feel confident that the expenditure on technology was a wise investment? Will board members be liable for inadequate computer systems that fail to comply with federal laws?

This article considers one case where implementation of a complex computer system went terribly wrong, almost destroying a business, and how effective planning for system procurement and use of written agreements and licences might have avoided some of the painful lessons learned.

A system implementation gone bad
A designer, importer and distributor of collectible giftware with annual revenues of over US$250 million hired a consulting firm to oversee the selection and implementation of a complex enterprise resource planning (ERP) computer system. When the system failed, the company sought US$1 billion in compensatory damages and an additional US$5 billion in punitive damages from the consulting firm. The dispute settled for an undisclosed amount but in the Form 10-k filed by the company with the SEC on 17th March 2004, it reported US$5.4 million of “other income” in connection with the settlement of its information systems litigation. The real costs in business disruption, lost customers and goodwill and litigation expense for both parties was enormous.

The following is a review of excerpts of the actual complaint filed by this company with some suggestions on how effective contracts and licensing may have avoided or at least mitigated some of the problems for both parties.

“[T]he engagement, which involved integration of vastly different software components, as well as extensive modifications to suit [the company’s] unique business needs, was extremely complex.”*

It is important first to analyse the particular needs of your business, the capabilities and capacities required of the contemplated system, and the ability of a proposed system to fulfil those needs. Take time to prepare a detailed written statement of the functions and performance you expect from the new system. These requirements and specifications can be written either by your own staff or by an independent consultant. Once you have documented your specific needs you can prepare a Request For Proposal (RFP) with sufficient detail to solicit vendors. These requirements and specifications should be made a part of any final written contract.

Do not forget to incorporate by reference in the final agreement not only your RFP but also any essential information contained in a vendor proposal.

“[W]hen the new system was put into operation, the business was so totally disrupted that [it] was virtually destroyed… orders could not be taken, or, if taken, were irretrievably lost; orders were not properly filled; shipments went out with no billings… [the company] was required to expend millions of dollars in an attempt to remedy the problems and lost the goodwill and continued patronage of a great number of its customers.”*

If your information technology project involves more than just off-the-shelf proprietary software that will run on proven hardware, then you should have a process in place to test and evaluate the system before you go live with fullscale implementation. The only way to assure successful implementation is to set forth clearly the process for such evaluation and testing in the agreement and use the agreed upon functional requirements as the criteria for determining acceptance and success. Such processes should benefit both parties.

In the case under examination here, appropriate system testing and other safeguards with express warranties of performance developed in accordance with agreed upon specifications would have been protective of both parties’ interests, and may have avoided the failed system and resulting litigation.

You might assume when acquiring technology that it will perform as it was demonstrated or tested and that it will meet your specific needs. However, you should not count on the technology vendor guaranteeing such performance. Forget about all those wonderful statements, whether oral or in writing, made by the sales representatives and others who are anxious for you to acquire their system. In fact, the vendor’s standard contract will most likely specifically state that any promises or assurances made by the sales representatives or others even in writing are not valid or enforceable. Read the merger or integration clause that typically appears near the end of most agreements: “This agreement sets forth the entire understanding between the parties and supersedes any prior representations, statements, proposals, negotiations, discussions, understandings or agreements regarding the same subject matter.”

It is essential to incorporate by reference in the final agreement your RFP, the vendor’s proposal in response to the RFP as well as any other significant and relevant documentation. If you are relying upon a verbal assurance make sure that it is memorialized in writing and identified as part of the final agreement.

“[The consulting firm] represented that the total cost of the implementation project would be $2.9 to $3.3 million, including [their] fee of $600,000 to $700,000. When [their] implementation attempt was complete, [the company] had paid over $12 million for the implementation.”*

You can quickly lose control over costs for such projects if you fail to have a process in place to manage change orders and scope of the project. Performance milestones set forth in the agreement with relevant checkpoints to assure progress towards successful implementation will allow both parties to monitor progress and address problems early on. Payments for achievement of certain milestones or withholding money if milestones are not achieved are effective incentives to assure performance. A reasonable amount of the total purchase price or licence fee might be withheld until after final acceptance testing of the system. A progressive payment schedule allows you to make sure the technology performs as expected in your workplace, using real data, consistent with the mutually agreed upon functional requirements and specifications. The length and degree of acceptance testing can be negotiated so that it is fair to the vendor and allows you an opportunity to make sure that all critical business functions are met before a final payment is made.

“[The consulting firm] led [the company] to scrap its existing system in favor of a new and as yet incomplete ERP System which [the developer] was just bringing on the market.”* “Weeks before the start date [the consulting firm] advised [the company] that, since [the consulting firm] had not devised any contingency plans, [the company] had no choice but to shut down the old system and start up the new system.”*

Don’t be a pioneer. This is a cardinal rule in any major system acquisition. It is also important to consider the feasibility of how, and the specific manner in which, your existing procedures and information will be transferred from manual or automated systems to any new replacement system, and at what cost. You should have a clear understanding of precisely how and when this conversion will be done and by whom. The time and expense involved in the conversion process to new technology is frequently overlooked and should be considered when preparing the relevant milestones to include in the final agreement. It might be appropriate to have parallel systems operational at least until the new system proves that it can operate successfully. You should also consider what backup system and disaster recovery options are available from the vendor and cover such options in the agreement. Early testing and evaluation of the system as part of the performance milestones should prevent any surprises.

“The engagement leader was so busy selling [their] services to other potential clients that he virtually ignored the needs of [the company].”*

Vendors will be most attentive and responsive to your needs just before the deal is consummated. You will probably have already been introduced to their best and brightest employees. If you have selected the vendor based on specific individuals then you should include a key personnel provision in the agreement identifying such persons. If not you may never see or hear from them again after the agreement is signed.

“[The company] signed an engagement letter, prepared by [the consulting firm], for the implementation and testing phases of the project. The engagement letter provided that [the consulting firm] would invoice [the company] monthly for hours worked plus out of- pocket expenses. The agreement also provided that work would be performed “in a professional and workmanlike manner in accordance with professional standards”.”*

The warranty that the work will be performed in a “professional and workmanlike manner” suggests that the company was not acquiring a fully functional computer system but merely engaging the consultant to supply services. The written agreement should make it absolutely clear that the primary purpose of the agreement is the delivery and completion of a system that conforms to and performs in accordance with the agreed upon specifications. In similar cases, the vendor has argued that they were simply hired to provide services on an hourly basis and should therefore not be held responsible for the failure to deliver a fully functional computer system. Since a contract for services may have different legal consequences than a contract for the delivery of goods under the Uniform Commercial Code it is important to make it clear that the agreement is not a services agreement.

Standard vendor contracts will probably disclaim all implied warranties, including any warranty that the technology or system will be suitable for any particular purpose. It is essential, therefore, to have relevant and appropriate express warranties. For example, the vendor should expressly warrant that the technology will conform to and perform in accordance with the functional requirements and specifications set forth in an exhibit to the agreement or as contained in the RFP and the vendor’s proposal.

Additional warranties set forth in the agreement might require a prompt response time, limited downtime, sufficient capacity or other performance features. If the system must generate timely reports, make sure these requirements are clearly identified. If you are concerned about compliance with federal or state laws or some other special needs, make sure that appropriate warranties of performance are included in the agreement.

The process of negotiating express warranties can prove invaluable in analysing potential risks and concerns. If these issues are identified early in the procurement process, they can be more easily and less expensively resolved. A vendor’s reluctance to provide reasonable warranty protection might be an indicator of the vendor’s own lack of confidence in the technology as a solution to the needs of your business.

Don’t treat the contract or technology licence as an afterthought
Your information technology is a vital corporate asset capable of providing a significant competitive advantage in the marketplace. It has now also become critical to your compliance with certain federal laws.

The agreements covering such technology should therefore be treated with the highest level of care and concern. The scope of use permitted by any software licence grant, rights and ability to modify the system, ongoing system support and maintenance and related costs, training, remedies for failed performance and ownership of intellectual property rights in any newly developed technology are additional key elements in these projects and not to be ignored when negotiating these agreements.

A clearly written and reasonable agreement may not guarantee success but can serve as an effective tool to ensure a smooth implementation. The agreement should however be considered as more than an enforcement tool in the event of litigation. Make use of the agreement early in the acquisition process as an opportunity to enhance a relationship based on trust and as a means to encourage communication and reward achievement.

“Nobody can really guarantee the future. The best we can do is size up the changes, calculate the risks involved, estimate our ability to deal with them, and then make our plans with confidence.” Henry Ford, II

*Excerpts taken from the actual complaint filed by the company and available at www.2001law.com/article_589.pdf