When is a Contractual Limitation of Liability Invalid and Unenforceable? American Public Policy Exceptions to Exculpatory Clauses in Telecommunications
December 21, 2009 by Bierce & Kenerson, P.C.
An essential element of risk management in any commercial contract for the sale of services or goods is the clause limiting the vendor’s liability.
In the sale of goods, the policy limitations are set forth in the Uniform Commercial Code, which invalidates clauses that deprive the customer of an “essential remedy” or the clause is part of an abuse of a consumer under a contract of adhesion, and under the federal Magnuson-Moss Warranty Act and similar state laws. In the sale of services, the policy limitations reflect common law, which may include a judicial analysis of regulations and the fundamental nature of the relationship between the service provider and the enterprise customer.
A decision by a New York State Supreme Court judge in November 2009 highlights the limits on exculpatory clauses under American jurisprudence under principles of gross negligence, willful misconduct, “special duty,” breach of the implied covenants of good faith and fair dealing and prima facie tort. In addition, other legal theories – such as fraud, intentional interference with business relationship, negligent misrepresentation, breach of the implied duty of good faith and fair dealing and prima facie tort – might not be available to enterprise customers for a simple failure by the service provider to deliver proper accounting information relating to its services. So the “special relationship” theory (described below) merits special attention.
This court decision is a stark reminder that the autonomy of contracting parties is always limited by public policy. Enforceability of contracts thus must include contract planning and negotiation, express limitations on remedies and conformity to public policy exclusions that invalidate certain exculpatory clauses. This interplay sets the framework for risk allocation, contract pricing, performance standards, dispute resolution and competitive strategy for the enterprise customer and the service provider.
I. The “Special Relationship” among Telecom Carriers
The Duty of Connected Telecommunications Carriers to Each Other. In this case, Empire One Telecommunications Inc. v. Verizon New York Inc. (__ N.Y.S.3d ____, Nov. 2, 2009 NYLJ, p. 21, cols. 3-4), Justice Carolyn E. Demarest ruled that one service provider cannot rely upon its exculpatory clause when it has a special duty due to a special relationship with its customer. The decision goes beyond a simple analysis of claims that include gross negligence and willful misconduct, which have long been judicially viewed as exceptions to the normal rule that contractual limitations of liability are enforceable.
Historical Monopoly, Regulated for Competition. The Empire case reflects special character of telecommunications services as a regulated utility. In the Empire One case, Verizon and Empire One were competitors. By virtue of the historical breakup of the prior monopoly held by AT&T over a decade before, Verizon controlled the transmission equipment and lines that carried the telecommunications for Empire’s customers. Under the Telecommunications Act of 1996, 47 U.S.C. 151 et seq.), Verizon had a statutory duty to provide certain telecommunications services to competitors like Empire. Empire was a reseller of Verizon services. Empire was allowed by federal law to interconnect its own network (and other networks) with the Verizon network.
Implied Duties. Under the Telecommunications Act of 1996, Empire was entitled to control the business relationship with the ultimate consumer because Empire enrolled them as its customers and Empire’s own equipment delivered the final connection to the customer. Verizon was carrying calls that were originated with other carriers (such as but not limited to Verizon) that terminated using Empire equipment. Under the Telecommunications Act of 1996, as terminating carrier, Empire is entitled to bill the customer for the service and make a profit by charging the interconnecting carriers that originated the calls for using Empire equipment to deliver the “last mile” termination services. All calls are logged into the billing system of Verizon, since it acts as traffic controller. Verizon equipment, as the glue of the telecom system, is capable of providing information on date, time, origination and destination and the duration of calls as well as codes (LATA identifiers, a valid settlement code, a valid originating local routing number and other validation codes used in billing) that enables interconnecting carriers to bill each other for services.
Failure to Provide Billing Records. Empire complained that Verizon had manipulated the call records that it delivered to Empire by stripping essential information needed for Empire to bill other carriers. Empire alleged that Verizon rendered the call records “useless for the very purpose for which they are intended”. Empire complained that such omissions prevented Empire from determining the originating jurisdiction or the types of telephone calls (mobile, land-line), thus depriving Empire of the ability to charge the originating carrier for the termination services by Empire.
Damages. Empire alleged its losses from 2004 to 2008 were approximately $2,500,000 in lost revenue plus approximately $160,000 in payments to Verizon for unusable billing records covering over 15 million telephone calls. The Empire court provided a refresher course in the liability that a breaching party is deemed to assume. A breaching party “is liable for those risks foreseen or which should have been foreseen at the time the contract was made.” Ashland Mgt. v. Janien, 82 NY2d 395, 403 (1993), quoted at Empire, page 22, col. 1.
Elements of a “Special Relationship.” The decision focused on the conditions that established a “special relationship” between one telecom carrier to another that used its telecom transport facilities (the equipment and the lines) for a fee. The decision focused on the statutory structure regulating public utilities for the public benefit, which, the court held, supports a finding of a “special relationship” between the service provider with a monopoly over the billing records and the service provider that needed the billing records to bill other carriers. “Public policy as reflected in the regulatory structure would also mitigate against enforcement” of the exculpatory clause. The concept of “special relationship” has precedents under prior New York judicial decisions where a public utility fails to perform its duty to furnish reliable service.
Unequal Bargaining Power. Verizon argued that there is no “special relationship,” and therefore the exculpatory clause is valid, where the service contract was negotiated by two sophisticated parties who negotiated in a commercial setting. Rejecting this argument, the court ruled there was clearly an inequality in bargaining power between the two public utilities since, in this case, the terms were not actually negotiated. To promote the public interest under the Telecommunications Act of 1996, the court said, Empire as customer should be afforded the “protection generally due a consumer when dealing with a utility with monopolistic control of the desired service.”
Published Tariff Filing. The general public policy against exculpation of gross negligence and willful misconduct was also written into the particular tariff that Verizon had filed with the public utilities commission.
Service Provider’s Termination of Service following Unresolved Billing Dispute. Other precedents under New York law dealing with Verizon’s wrongful refusal to provision telecom services have ruled that Verizon is liable for consequential damages to a reseller of telephone services over lines provided by Verizon where (i) Verizon had billed and actually been paid for a telephone feature that it had not actually provided (a “billing error”), (ii) the customer stopped paying for the feature allegedly not provided, and (iii) Verizon cut off the reseller from its network for non-payment. The court allowed the reseller to pursue lost profits as consequential tort damages for gross negligence or willful misconduct.
II. Other Classic Causes of Action when the Service Provider Fails to Perform Proper Accounting Services for its Services Performed
Gross Negligence. Under New York precedents, “gross negligence” must “smack of intentional wrongdoing.” Kalisch-Jarcho, Inc. v. Cit of New York, 58 NY2d 77, 385 (NY 1983). Gross negligence evinces a “reckless indifference to the rights of others.”
Fraud. Fraud involves (i) a false misrepresentation as to a material fact, (ii) an intention by the defendant to deceive the plaintiff by such false misrepresentation, (iii) justifiable reliance by the plaintiff on the misrepresentation, and (iv) damages caused by plaintiff’s reliance. Empire claimed each of these elements but the court dismissed the fraud claim since fraud claims cannot be used to duplicate the same elements of a breach of contract, where the fraud claim was “collateral to the contract” and not based on the same facts alleged as to the breach of contract. A fraud claim is insufficient if it merely alleges that a misrepresentation of an intention to perform services under the contract.
Implied Duty of Good Faith and Fair Dealing. Under common law, there is an implied duty of good faith and fair dealing in the performance of contractual obligations. Here, Empire’s claim that Verizon breached this duty was dismissed since it was equivalent to a claim for breach of contract.
Tortious Interference with Business Relations. In the Empire case, Empire as CLEC customer claimed that Verizon as service provider had interfered with Empire’s business relations by its failure to provide the call data needed to enable Empire to bill its interconnect customers. This legal theory requires the injured party to allege and prove (i) the existence of the actual or prospective business relationship with a third party, (ii) the defendant, having actual knowledge of that relationship, intentionally interfered with it; and (iii) the defendant either acted with the sole purpose of harming the plaintiff or used means that were dishonest, unfair or improper, and (iv) the defendant’s conduct thus injured the plaintiff’s business relationship.
In the Empire case, this legal theory was unsupported. Empire was unable to validly claim that Verizon’s failure to provide interconnect customer billing information was directed to harm Empire’s customers, not merely to harm Empire. The court noted that Empire merely alleged that it was unable to invoice interconnect carriers for transiting its network due to the invalid and inadequate call records that Verizon sells to it. “Empire’s inability to bill these third–party carriers, however, would not induce these carriers not to do business with Empire.” Hence, Empire was unable to sustain a claim of intentional interference with business relationship.
Negligent Misrepresentation. Empire also claimed that Verizon was liable for consequential damages due to Verizon’s negligent misrepresentation. Such a claim depends on alleging and proving three requirements: (i) the existence of a special relationship or privity-like relationship that imposes a duty on the defendant to impart correct information to the plaintiff, (ii) the fact that the information was incorrect, and (iii) the plaintiff reasonably relied on the information to its detriment. It is a question of fact whether there exists a “special relationship” sufficient to justify plaintiff’s legitimate expectation that the information would be true and accurate. In this case, the tariff and the contract were worded in a manner that denied this type of special relationship to Empire.
Prima Facie Tort. Empire unsuccessfully alleged that Verizon was liable for “prima facie” tort, a unique common law tort theory under New York law. The requirements for alleging and proving such a cause of action include (i) the intentional infliction of harm, (ii) which causes special damages, (iii) without any excuse or justification, (iv) by an act or series of acts that would otherwise be lawful, and (v) that the disinterested malevolence was the sole motivator for the defendant’s harm-causing conduct. Empire failed to allege the last point, which it probably could not prove since reaping unfair profits is not an act of malevolence but rather an act of greed.
III. Lessons for Everyone
The Empire One decision was framed in the area of telecommunications and invoicing. Separate from the area of regulated public utilities, it offers nonetheless several practical lessons for structuring an outsourcing agreement:
- Exculpation is Limited. Public policy exceptions for gross negligence and willful misconduct are implied in every contract, whether or not included contractually.
- Mutually Agreed “Special Relationship.” A “special relationship” may exist, and the service provider’s exculpation might not be valid or enforceable, where the enterprise customer depends on the service provider to provision the service,
- Mutually Agreed Consequences. As a contracting matter, the parties should identify the consequences if the service provider suspends service while there is a dispute over adequacy of its provisioning of services, over billing for past services and for the customer’s inability to obtain alternative services in the spot market without consequential damages.
- F&A Services: Special Negotiating and Drafting Issues. Legal theories of fraud, intentional interference with business relationship, negligent misrepresentation, breach of the implied duty of good faith and fair dealing and prima facie tort do not give any remedy to the enterprise customer that loses revenue from an inability to use the service provider’s billing records to invoice its own interconnect customers. For “finance and accounting” outsourcing, this lesson means that inaccurate or insufficient accounting services need to be identified as a breach, and the quantum and conditions of “damages” for “direct damages”.
Legislation in Outsourcing: Gain-Sharing under the E-Government Act of 2002
October 16, 2009 by Bierce & Kenerson, P.C.
Overview.
The E-Government Act of 2002 authorizes federal agencies to enter gain-sharing contracts for information technology (as defined in 40 USC 11101(6)). The new law refers to such contracts as “share-in-savings initiatives.” Under such contracts, the Government awards an IT contract to “improve mission-related or administrative processes” or to “accelerate the achievement of its mission.” The new law adds 10 U.S.C. §2332, which allows the Government to “share with the contractor in savings achieved through contract performance.” The act amends Title 10 of the U.S. Code and, for other contracts, it adds a new Section 317 to Title III of the Federal Property and Administrative Services Act of 1949. In signing the act, President Bush noted that gain-sharing contacts would enable contractors to “share in the savings achieved by agencies through the provision of technologies that improve or accelerate their work.”
Definition of “Share-in-Savings Contract.”
The E-Government Act of 2002 provides a statutory definition of a “share-in-savings” contract. A government purchase of eligible goods and services is a “share-in-savings” contract if the contractor shares in a portion of eligible “savings” and if the goods and services are “solutions for (i) improving the agency’s mission-related or administrative processes; or (ii) accelerating the achievement of agency missions.” 10 U.S.C. §2332(c)(3).
“Savings Eligible for Sharing: Alignment of Interests through Sharing only in “Mission-Related” or “Administrative Process.”
The contractor may participate in “savings” (as defined below) “derived by the agency from (i) any improvements in mission-related or administrative processes that result from implementation of the solution; or (ii) acceleration of achievement of agency missions.” 10 U.S.C. §2332(c)(B).
Types of Goods or Services to be Delivered to Federal Government.
The E-Government Act of 2002 covers all types of information technology procurements. This includes software, hardware, middleware, services and any combination thereof. It is likely that related telecommunications could be included, particularly for local area networks, wide area networks and virtual private networks. The law is not clear whether any “voice over Internet Protocol” telecommunications could be included in a “share-in-savings” contract..
“Savings.”
Under the E-Government Act of 2002, only two types of savings are eligible for sharing with the government contractor.
Monetary Savings.
“Monetary savings to an agency” may be shared. 10 U.S.C. §2332(c)(2)(A).
Time Savings.
An agency may also share the “savings in time or other benefits realized by the agency, including enhanced revenues.” However, any “enhanced revenues from the collection of fees, taxes, debts, claims or other amounts owed to the Federal Government” are not eligible for sharing. 10 U.S.C. §2332(a)(2)(B).
Savings Share Ratio.
Under the E-Government Act of 2002, the allocation of “savings” eligible for sharing is subject to a negotiable “savings share ratio.” This concept raises issues of legal construction that might need to be clarified in amendments to the Federal Acquisition Regulations.
- First, under a literal (and narrow) construction of the principle of applying “a savings share ratio,” only one saving share ratio can apply. Under the approach of “one savings share ratio” fits all elements of a contract, the government and the contractor might be precluded from identifying certain IT functions that have a higher degree of risk or higher degree of reward. The parties could not use different “savings share ratios” for such different commercial elements. Ordinarily, sophisticated dealmakers would then structure the transaction as multiple interdependent contracts, so that each would have its own separate “savings share ratio.” Under this narrow, literal construction of the statute, multiple deals would be favored. But the E-Government Act of 2002 also limits to five the number of share-in-savings, or gain-sharing, contracts that any agency can sign in one year. So a literal interpretation would effectively preclude the parties from negotiating for multiple, disparate “savings share ratios” in any individual gain-sharing contract.
- Second, the concept of applying a “savings share ratio” precludes the parties from applying sophisticated risk analysis along the methods of risk shifting and risk spreading applied under basic principles of reinsurance.
Quantifiable Baseline.
For purposes of quantifying “monetary” savings, the agency must establish a “quantifiable baseline” that will be the basis for applying “a savings share ratio.” 10 U.S.C. §2332(a)(4).
This implies a number of statutory requirements.
- First, the “quantifiable baseline” starts with the presumption that the government agency has identified all relevant costs of an information technology function before it is outsourced. Implicit in such a presumption is the concept of fully-distributed cost accounting. This concept could be defeated to the extent that the agency’s governmental accounting system (i) includes cross-subsidization of functions, (ii) lump (into one accounting line item) costs that can be reduced with those that cannot be reduced, or (iii) does not allocate costs uniformly across the same fiscal period, but instead involves some “financial engineering” of costs. In short, agency accountants will need to look closely at the methodologies of accounting.
- Second, a “quantifiable baseline” suggests that appropriate accounting exists to identify the costs allocable to the information technology being purchased. Depending on the nature and scope of the IT purchasing contract, such costs might not be identifiable, and no “quantifiable baseline” might be discernible from the beginning.
- Third, the monetary savings will be re-attributed to the agency whose budget originally bore the cost. Thus, assuming a perfect world of “chargeback” accounting, a “quantifiable baseline” can be discerned from the beginning. But if the actual “chargeback” accounting method does not accurately reflect the distribution of costs, no “quantifiable baseline” might be discernible from the beginning
Duration.
“Share-in-savings contracts” must normally have a term of not more than five years. Under exceptional circumstances where a five-year term would deprive the governmental agency of any opportunity to get a reasonable commercial contract, a “share-in-savings contract” may be awarded for a period of not more than 10 years. Thus, to exceed the five-year limit, the head of the agency must determine in writing prior to award of the contract “that–
`(i) the level of risk to be assumed and the investment to be undertaken by the contractor is likely to inhibit the government from obtaining the needed information technology competitively at a fair and reasonable price if the contract is limited in duration to a period of five years or less; and
`(ii) usage of the information technology to be acquired is likely to continue for a period of time sufficient to generate reasonable benefit for the government.”
The author of this commentary believes that the analysis of the term will be particularly difficult in many situations. While the new Act does not specify what happens if an agency head makes an “erroneous” determination, we can imagine a scenario where a disgruntled bidder might object to the special determination and try to get the agency to award a five-year contract only.
Performance-Based Standards.
The E-Government Act of 2002 requires that all IT contracts with the Federal government, whether for hardware, software, services or a combination, adopt “performance-based” methodologies “to the maximum extent practicable.”” To achieve this result, the contracts must “identify objective outcomes and contain performance standards that will be used to measure achievement and milestones that must be met before payment is made.” 10 U.S.C. §2332(a)(3).
Baseline Metrics.
Under a share-in-savings contract, the deal must include a provision containing “a quantifiable baseline” that is to be the basis upon which a savings share ratio is established that governs the amount of payment a contractor is to receive under the contract. The agency’s top procurement official must determine, in writing, before commencement of performance of such a contract, “that the terms of the provision are quantifiable and will likely yield value to the Government.” 10 U.S.C. §2332(a)(4).
Labor Law Considerations.
The E-Government Act of 2002 does not protect federal “civilian employees” from termination of employment or reassignment to a new job. But, in determining how much of savings will be shared under the share-in-savings contract, any savings from such a termination or reassignment will not be eligible for sharing. Such savings will belong solely to the Government. The E-Government Act of 2002 takes into account the difficulty of multi-year accounting for governmental appropriations. Any savings will be credited to the agency’s appropriation or funding account for future use in procurement of “information technology.” 10 U.S.C. §2332(a)(5)(A). Such retained savings will, “without further appropriation, remain available until expended” and must “be applied first to fund any contingent liabilities associated with share-in-savings procurements that are not fully funded.” 10 U.S.C. §2332(a)(5)(B).
Multi-Year Contracts: Termination and Cancellation Charges.
In outsourcing contracts in the private sector, the contractor might make a substantial initial investment to initialize the ongoing outsourcing services under a multi-year contract. If the customer wishes to terminate the contract early for no fault of the outsourcing contractor, the contract might provide for a termination or cancellation charge. Such charges can be tens of millions of dollars, or more, in a large outsourcing transaction.
Fiscal Years.
The E-Government Act of 2002 resolves the constitutional and statutory hurdles of funding termination charges by allowing such charges to be owed in not more than five contracts per fiscal year for each of the 2003, 2004 and 2005 fiscal years. No share-in-savings contracts may be entered into after September 30, 2004. Thus, all gain-sharing contracts will expire not later than September 30, 2005, a year later.
Sources of Funding.
Under Title II of the E-Government Act of 2002, “share-in-savings” contracts may authorize payment of contractually specified termination or cancellation charges. Because governments must follow constitutional appropriation procedures, the law must specify how such appropriations will be made. The costs of cancellation or termination may be paid out of three sources: (A) appropriations available for the performance of the contract; (B) appropriations available for acquisition of the information technology procured under the contract, and not otherwise obligated; or (C) funds subsequently appropriated for payments of costs of cancellation or termination, subject to certain limitations.
Payment of Cancellation or Termination Fees Where No Express Appropriation Has been Made.
The E-Government Act of 2002 allows an agency to may enter into share-in-savings contracts in any given fiscal year even if funds are not made specifically available for the full costs of cancellation or termination of the contract. Such unfunded cancellation fees are allowed provided that:
- “funds are available and sufficient to make payments with respect to the first fiscal year of the contract; and
- The amount of unfunded contingent liability for the contract termination or cancellation charges does not exceed the lesser of 25% of the estimated termination or cancellation “costs”; or $5 million; and
- unfunded contingent liability exceeding $1 million has been approved by the Director of the Office of Management and Budget or the Director’s designee. 10 U.S.C. §2332(b)(3)(A).
Implementing Regulations.
Under the new law, Congress mandated that, within 270 days after December 17, 2002, the Federal Acquisition Regulation will be revised to implement share-in-services provisions. Such revisions will
(1) provide for the use of competitive procedures in the selection and award of share-in-savings contracts to–
(A) ensure the contractor’s share of savings reflects the risk involved and market conditions; and
(B) otherwise yield greatest value to the government ; and
(2) allow appropriate regulatory flexibility to facilitate the use of share-in-savings contracts by executive agencies, including the use of innovative provisions for technology refreshment and nonstandard Federal Acquisition Regulation contract clauses.”
Conclusion.
The “share-in-savings” provisions of Title II of the E-Government Act of 2002 provide a framework for extension of a prior “pilot” program for gain-sharing, repealing 40 U.S.C. 11521. The framework is basic, generic and broad in its scope. However, it continues as small program, since the total number of such “share-in-services” contracts annually is limited to five per fiscal year, commencing in fiscal 2003 (ending September 30, 2003).