5 Practical Tips: Service-Level Agreements (III)
In the April edition of our “IT Practice Tips” on Service Level Agreements, agreement of uniform assessment procedures and the establishment of clear accompanying conditions together with the service provider were concerned. In the final article, we address the issue of possible penalties.
Tip 4: Sanctions
A service-level agreement would be incomplete without provisions on the legal consequences of the contractor’s failure to comply with previously agreed performance standards. These provisions are necessary either because the statutory defect claims do not fit the scenarios encountered in IT outsourcing, in the outsourcing of essential IT-supported business processes, or in the performance of other services in which a service level plays a key role; or because the law does not provide for any specific legal consequences. This makes it necessary to resort to the general claim for damages pursuant to Section 280ff of the German Civil Code (Bürgerliches Gesetzbuch – BGB):
1. Contractual penalty or lump-sum damages – the contractual penalty
The concept of the contractual penalty is defined in Section 339 ff of the German Civil Code as a dependent promise – made by the obligor in relation to an existing main obligation – to effect a monetary payment to the obligee in the event of the non-fulfilment or insufficient fulfilment of a contractual obligation. The contractual penalty thus achieves a twofold purpose: it ensures fulfilment of the contract by exerting appropriate financial pressure and enforces claims for payment without the need for evidence of specific loss. Under Section 341 para. 2, 340 para. 2 BGB, the obligee reserves the right to assert claims for damages exceeding the amount of the contractual penalty. The agreed amount of the contractual penalty should thus always cover the loss incurred to the obligee. Damages exceeding the amount of the contractual penalty would only be payable by the service-providing party if the obligee is able to demonstrate and prove that loss in excess of the contractual penalty was incurred by it as a result of a breach of duty by the service-providing party.
2. Contractual penalty or lump-sum damages – lump-sum damages
Lump-sum damages are the opposite of contractual penalties and are contractually agreed lump sums payable upon the failure to achieve a particular service level, irrespective of the amount of any actual loss or whether such loss can be proved by the party commissioning the services. Even if, in an exceptional case, specific loss is incurred and can be proved to exceed the amount of the lump-sum damages, the party that has commissioned the services and incurs the loss is unable to demand any compensation from the other party for loss exceeding the amount of the lump-sum damages, instead being required to bear this portion of the loss itself. Thus, lump-sum damages are the preferable sanction for the service-providing party as the precise amount payable can be determined in advance.
3. Day service credits
Day service credits are a further type of sanction. These are usually pre-defined credits on the remuneration payable by the client where performance fails to meet the defined service level. Thus, on the one hand, day service credits focus on the failure to reach the agreed service level as a result of poor performance which is thus not deserving of the full contractually agreed remuneration, whereas lump-sum damages and contractual penalties, on the other hand, tend to focus less on this aspect and more on the loss incurred to the client as a result of poor performance. The question as to which of these – either lump-sum damages or day service credits – the parties actually intended is something that has to be determined by interpretation. In dogmatic terms, the concept of day service credits as a lump-sum reduction of the remuneration payable still leaves room for damages claims to compensate the client for incurring loss that goes beyond mere poor performance. Day service credits and liability for compensation can thus exist concurrently and this is why dogmatically classifying a sanction as a day service credit or as lump-sum damages can have important legal and thus financial consequences.
4. What is the situation in practice?
Which of these sanctions should be applied in a service-level agreement depends on the interests of the parties. One aspect that is important for the client is how likely it is that greater loss might be demonstrated and proved or that a relevant basis on which to estimate this might be demonstrated. The client-friendly option would be to agree on contractual penalties as this would allow compensation to be claimed for specific loss exceeding the amount of the contractual penalty. The contractor-friendly option would be to agree on amounts for lump-sum damages as these offer the obligor the security of never having to pay more in damages than the agreed lump sum. Due to their different approaches, these two options could be combined with day service credits. In practice, the business processes involved determine whether it is more or less likely that the party commissioning the services is able to demonstrate and prove specific loss exceeding the amount of the contractual penalty. If it is less likely, then the contractual penalty is of more theoretical than practical benefit to the client.
Tip 5: Calculating sanctions – bonus-penalty systems?
Where sanctions for the failure to achieve service levels are defined, the amount of these sanctions is often determined on a staggered scale in accordance with the degree to which the work performed falls short of the service level. One frequent mistake, however, is that there is no provision for any sanctions below a particular degree of service-level shortfall deemed by the parties to be too extreme and thus unacceptable, and that the agreement otherwise contains no further instructions on the sanctions applicable in the event of total or almost total failure to meet the relevant service level. This results either in the excessive leniency of sanctions applicable in such cases or in the complete absence of any specific sanctions commensurate with the worst-case level of performance. Conceivable sanctions might be, for example, an extraordinary steering committee meeting, escalation of the issue to the service provider’s highest management level, special auditing rights, access to separate risk budgets or even an extraordinary right of termination for good cause pursuant to Section 314 BGB with total failure defined as an example of good cause.
By analogy with the sanction provisions that penalize a service provider for falling short of agreed service levels, bonus provisions are also fundamentally conceivable and are now very often called for in contractual practice on the grounds that they ensure a balance of opportunity and risk.
Bonus provisions ultimately only make sense where performance by the service provider beyond the call of duty also results in a real additional benefit for the client; otherwise, bonuses should be strictly refused. In any case, the idea that failing to meet a service level in one reference period can be offset by exceeding a service level in another reference period is actually quite absurd. Such a mechanism would also reduce the internal pressure on the contractor of actually having to pay a pecuniary sanction when it fails to achieve a service level.
For inquiries or further information: Please contact Prof. Dr. Joachim Schrey
Practice Group: IT, Outsourcing & Data Privacy
Already available: 5 Practical Tips: Service-Level Agreements (1/5)