3 top mistakes in negotiating SLA & penalties of an outsourcing agreement

What mistakes you cannot afford to make in negotiating SLAs and penalties or liquidated damages of an outsourcing agreement?

SLAs schedules and penalties/liquidated damages clauses are usually the core of an outsourcing agreement. Below is an outline of some of the most relevant issues and mistakes to avoid, also taking into account the current digital transformation. This is first in Italian as part of my videoblog Diritto al Digitale and in English in the article

1. Don’t start drafting the first version of the SLAs alone

One of the first issues that arise in drafting an outsourcing agreement is who has to draft the service level agreements (SLAs). The battle is between lawyers and the IT team of the supplier and of the recipient of the service to take the lead.

My experience is that a considerable team-working activity is required. Lawyers need to make an effort to speak the same language as engineers. It will be difficult otherwise to reach a result that adequately protects the parties and meets the needs of the recipient of the service.

And indeed, for SLAs it is quite rare that is possible to rely on previously drafted agreements. They have to be arranged taking into account the peculiarities of the business of the recipient of the service, including for instance some statutory or market driven levels of service. The review and the understanding (or at least a high level review and understanding) by lawyers of technical documents and a very deep knowledge of the business of the recipient of the service considerably help on the drafting of the SLAs. But this rule is valid for the drafting of the entire outsourcing agreement.

Also, for this reason, it is often mentioned that outsourcing agreements are close to joint venture arrangements. Both parties work together for a common result that in most of the cases means the success for both of them and such cooperative approach starts from the negotiation of the agreement and continues for its entire term.

2. Don’t be unfair in negotiating liquidated damages or penalties in an outsourcing agreement

The above is valid also to determine the amount of liquidated damages or penalties of an outsourcing agreement triggered as a consequence of the breach of SLAs. The drafting of such clauses needs to take into account that punitive damages are prohibited under the laws of several jurisdictions, including Italy.

Likewise, in countries like Italy, if the amount of contractually agreed liquidated damages is excessive compared to the actual damages suffered as a consequence of a breach, the value of such liquidated damages might be reduced by courts despite of the wording of the clause so vanishing the efforts of long negotiations on the matter.

On the contrary – depending on the wording of the clauses – they might operate as a liability cap preventing to seek additional damages in case of breach even if adequately proven in a dispute. Therefore, they might represent a risk for the recipient of the service.

Finally, the reference to such clauses as liquidated damages or penalties is linked to the applicable law. Liquidated damages as predetermined amounts of damages is the term used in common law countries which refer to penalties as punitive damages. On the contrary, civil law countries refer to predetermined amounts of damages as penalties and ban punitive damages.

3. Don’t forget an enforcement clause

The above clauses might not be effective in absence of a detailed enforcement proceeding contractually agreed. For instance, the setting up of an internal committee made of representatives of both parties in charge of reviewing a potential breach and identifying the party responsible for that, ensuring that any action aimed at limiting the potential damages suffered and, if necessary, enforcing the liquidated damages is often extremely important.

All in all, SLAs and penalty/liquidated damages clauses can have a number of hidden risks which can be overcome only through a strong cooperation between all the parties involved such as managers, commercial and IT persons as well as lawyers.

How can the scenario change with the digital revolution and the increased value of data?

Artificial intelligence, Internet of Things and machine learning can heavily impact the scenario above. The reliance on predictive maintenance should enable to potentially increase SLAs, but also risks that damages deriving from potential breaches are higher. I addressed all these issues in this blog post.

What is your view on the above? Also, you may review my series of blog posts on outsourcing agreements:

1. 3 most relevant issues on liability clauses in an outsourcing agreement

2. 3 top mistakes in negotiating SLA & penalties of an outsourcing agreement

3. 5 major issues on termination clauses of an outsourcing agreement

4. Top 3 issues for an outsourcing agreement on picking the right court and law

5. Outsourcing agreements and intellectual property clauses – the rights!

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Giulio Coraggio

I am the head of the Italian Technology sector and the global head of the IoT and Gaming and Gambling groups at the world-leading law firm DLA Piper. IoT and artificial intelligence influencer and FinTech and blockchain expert, finding solutions to what's next for our clients' success.

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