Do I need a business case for early contract termination?

By Allan Watton on

Pros and cons for business case for early contract terminationThe urge to exit a failed strategic supplier or outsourcing relationship can be so strong that clients leap to instruct their lawyers before they have fully assessed the operational (as opposed to contractual) risks of getting out of a failed contract, early. In short, they do not properly assess the business case for early contract termination. 

Common risks of early termination include: 

  • Disruptions or discontinuity in the service supply 
  • Significant and unplanned costs 
  • Damage to your reputation 
  • Loss of critical assets, software, know-how or other intellectual property 
  • Delays in the exit process 
  • Unauthorised disclosure of your information or data 
  • Being locked into inflexible exit arrangements 
  • Loss of critical staff 
  • Poor or insufficient termination assistance from the outgoing supplier.

You need to create a business case for early contract termination that fully analyses the strengths, weaknesses, opportunities and threats of terminating. Only if this analysis stacks up should you proceed with the exit. 

Your business case for early contract termination – what should it contain?

1. The outcome you are looking for

The first step in creating your business case for early contract termination is to work out your objective in bringing the problems with the strategic supplier to a head. What would be an appropriate outcome for you? If you exit, do you want to: 

  • Walk away with no money changing hands? 
  • Get the strategic supplier’s agreement to facilitate a move to an alternative strategic supplier, bring the services in-house and/or move to a mixed economy of supply (a mixture of multiple suppliers and in-house provision)?  
  • Reclaim money you have paid to the strategic supplier? 
  • Claim compensation that will help to pay for finding a new strategic supplier and transitioning to them? 

You should also think about what the strategic supplier would consider an appropriate solution, if it was to be ‘balanced’ about the situation. This will help you work towards an effective appraisal of your options. 

2. The circumstances under which you can terminate

Before considering termination, it’s vital that you understand the exit provisions in your contract. These are usually among your most valuable contractual protections. They help your business to continue during termination and give you leverage at a time when your relationship with your strategic supplier is likely to be severely strained. 

Most outsourcing agreements permit termination ‘for cause’. This is when your strategic supplier commits a material breach (usually a severe service delivery issue that causes you a significant operating problem and additional costs) and does not fix it within a specified period. Clear, independent technical evidence is required here. Without this, termination for cause can be difficult to prove. 

If your contract was well negotiated at the outset, you may be able to terminate ‘for convenience’ (i.e. without cause). However, you may end up only being able to terminate for a substantial price, usually referred to as a ‘termination for convenience fee’. You may also be missing a right to exit without paying this fee, when your service provider is meeting its contractual KPIs but failing in some larger way. For example, those KPIs might not be aligned to your business outcomes, or your service provider might be going out of business, in significant financial trouble or unable to keep up with changes in your market. 

Termination for convenience charges should be defined in your contract. If so, make sure you understand what those charges cover, such as sunk costs or lost revenue. Check whether your contract includes a cap on exit costs and whether it allows you to make milestone-based payments for exit, including for successful completion of knowledge transfer. 

If the contract doesn’t cover termination for convenience charges, or the contract terms are ambiguous, then your strategic supplier will need to scope out the work required, under a specific terms of reference. The charges in these after- the-event cases may be considerably more than if they were defined by the original contract. 

If you are satisfied with some of the services you are receiving, check whether your contract allows you to partially terminate, so you can exit from the poorly performing services but retain the others. Bear in mind that if you do retain some services from the legacy strategic supplier, there may be on-going service overlaps and dependencies between your legacy strategic supplier and your new strategic supplier for the remaining term of the legacy services. 

3. What else the contract covers

The next stage of creating your business case is to understand what else the contract entitles you to do while terminating and once termination is complete. 

This includes knowing: 

  • How assets such as hardware, software, documentation, processes, people, contracts and intellectual property are treated on termination. 
  • Whether you have the right to the information you need, to provide a level playing field for other bidders in any re-tendering exercise. 
  • Whether you can extend the exit period if there are delays in re-tendering and transitioning to an alternative strategic supplier, bringing the services in-house, or a combination of both. 
  • Whether you have any necessary access to strategic supplier premises, and what you will do if access is denied. 
  • Whether you have access to strategic supplier personnel post- termination, to ensure successful knowledge transfer support for a defined period to a new strategic supplier or in- house team. 

It’s also important for you to understand what obligations the contract imposes on your strategic supplier during termination. A contract that is appropriately ‘built for exit’ would usually oblige the strategic supplier to: 

  • Allow you to continue to use any facilities, software and equipment that you own or subcontractors that you have a right to use. 
  • Provide you with traditionally internal information, such as the mobile phone numbers of any key personnel that you don’t already have, or at a minimum allow you access to those people until agreed milestones have been achieved during the exit period. 
  • Allow you continued use of the business continuity or disaster recovery process for your services, if the strategic supplier’s or your business facilities were incapacitated during the exit process. 
  • Allow you to use any third party or sub-contract providers. Ask yourself what third party contracts will be affected or impacted and if you will inadvertently breach the terms of any of these agreements by terminating. Ideally, your strategic supplier should have created and maintained a third-party contracts register during your engagement with them. 
  • Cooperate with you in building internal capability or outside relationships with alternative strategic suppliers. 

If your contract does not cover these items, there will probably be implied obligations on the strategic supplier to help support you and deal with these issues. 

4. The financial considerations

Before you consider a financial claim against your strategic supplier for poor delivery, it’s worth knowing whether your strategic supplier has sufficient assets to pay you. Many strategic suppliers have group structures that keep most of the assets in a holding company. However, strategic suppliers cannot move assets from one part of their organisation to another because a claim has been made against them. Most courts understand that this is a common issue for litigants and have processes available to recover assets that have been moved to avoid claims, either between group structures or offshore. 

In addition to their own assets, most strategic suppliers have professional indemnity insurance. This usually covers the strategic supplier against claims made for poor advice or unsuitable solutions provided. Limits of indemnity vary but with most operating agreements and major projects, the levels of insurance usually cover suitable recompense for you. 

Once you have established that your strategic supplier has sufficient assets or insurance, you need to decide what type of claim to make. There are two primary types of claim: reliance losses and expectation losses. 

– Reliance losses 

Reliance losses will put you back in the position you would have been in if you had not undertaken the project with the strategic supplier in the first place. You therefore claim for: 

  • The time that your organisation has spent working on the problems with the services/solution/project 
  • The problems with keeping the service/solution implementation agreement going, and 
  • The cost of setting up the services/solution agreement.

– Expectation losses 

Expectation losses will put you in the position you would have been in had the strategic supplier provided successful services and delivered the business benefits you expected. 

You therefore claim for: 

  • The time that your organisation has spent working around the problems (not on the problems, as with the reliance loss claim), to keep your organisation operating in a way that reduces any losses you are incurring and keeps them to a practical minimum. 
  • The cost of specifying, identifying, clarifying and contracting with a replacement strategic supplier. You do not claim for the cost of putting the original provider in place. 
  • Any gross profit margins on sales that you would have achieved had the service delivery been successful. This does not usually apply to public sector services, with the exception of Revenues services for local government or revenue generating government departments. 
  • Any operating cost reductions you were realistically expecting to achieve through outsourcing, as a result of more efficient service delivery. 

5. Other critical issues for your business case for early contract termination

In addition to the above, there are a number of other issues you’ll need to consider in your business case for early contract termination. Some of these are also covered in later steps, in particular Step 4: Plan your Exit.  

  • Determine which services are critical to all or part of your organisation. Consider the implications of exit for your business, how you will manage these implications and the impact on your end customer (or citizens, for public services). 
  • Consider and address the potential causes of termination. 
  • What are the specific issues involved in both planned and unplanned exits? An unplanned exit may occur if, for example, the strategic supplier goes bankrupt, runs into financial difficulty or doesn’t cooperate with you through the termination period. 
  • An unplanned exit may occur if, for example, the strategic supplier goes bankrupt or runs into financial difficulty 
  • Consider the difference between first and second generation outsourcing exits. If matters go to Court, the Court is likely to be more sympathetic to you and the way you have conducted yourself if it is your first outsourcing arrangement and you have a lack of experience, than if it is your second or third contracting arrangement. If these agreements keep going wrong for you, a Court is likely to wonder why, when your organisation is the common denominator. 
  • What views do your key stakeholders have on your exit strategy? If your stakeholders aren’t aligned, then you run the risk of derailing continuity in service delivery and, in certain circumstances, undermining your evidence of the provider’s non-performance. 
  • Are the majority of the people in the business that will be affected by the termination and exit agreed on how you will exit? 
  • Have you considered appropriate scenario planning? For example, what will you do if the evidence doesn’t stack up as you thought it did, or if the strategic supplier won’t cooperate with the exit process? 
  • Consider your leverage in the outsourcing marketplace. How easy will it be to create a competitive tender process? Carry out a financial analysis and risk review of each of the bidders. 
  • Appraise the resources required for transition. Consider splitting resources between those required to manage the exit and those required to transition to a replacement relationship. 
  • Consider the different skill sets required within your exit and transition teams. Identify your ‘A’ team(s) and ensure they have capacity to perform exit and transition roles. 
  • Consider the emotions of the people involved in the process. Some on the strategic supplier’s side may be your former colleagues who are anticipating transferring back to your organisation when the contract terminates. Others may be hoping to stay with the strategic supplier, but in a different role. 
  • Consider the impact of a ‘change freeze’ following notice of termination. This should include a restriction on personnel changes, including their terms of employment. 
  • Consider whether you have sufficient knowledge of the services you’ll be re-tendering. For example, did the contract require your strategic supplier to maintain up-to-date operations and process documentation detailing how the services are performed? This can be the basis for an RFP or a template for building internal capabilities. If you don’t have it, it can significantly derail your transition to a new strategic supplier or bringing the services back in-house. 
  • What about the IT systems involved in the service delivery? It is critical that these are retained, or at the minimum, that the data is migrated to alternative systems and fully tested before you exit. 

Gaining certainty from your business case for early contract termination 

Terminating your strategic supplier or outsourcing relationship will be a step change in how your business operates. Your business case for early contract termination should provide as much certainty as is reasonably possible that the benefits outweigh the costs, risks and business impact. Creating and sanity checking the business case will help you to decide and to overcome the inevitable emotions of your situation.