Calculating Liability in Service Level Agreements

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THIS ARTICLE WAS WRITTEN BY TANMAYI SHARMA, A STUDENT OF JINDAL GLOBAL LAW SCHOOL.

Introduction

            A Service Level Agreement [“SLA”] is a common feature of commercial contracts used by Service Providers. An SLA defines the relationship between the Service Provider and customer, particularly the level of service, quality, or performance which is required of the service provider.[1] In the event that the Service Provider is not able to perform at the expected level, the contract also defines the liability which is to be incurred by the Service Provider. This liability is referred to as ‘Service Level Credits’ [SLCs].[2] There are several different methods and mechanisms used to calculate Service Level Credit. This article will explore some common conditions imposed while drafting such agreements, the different ways of calculating liability, and the difference between calculating liability between SLA and Milestone agreements. In doing so, this article will consider how to achieve a balance when drafting liability clauses for an SLA.

            SLA are intended to be output based, in that they define specifically what service the customer would receive.[3] It is for this reason that the service levels and responsibilities  SLAs are generally recommended to be an addendum to the Main Service Agreement.[4] This is because the requirements of the user or levels of performance may need to be amended, and as an addendum the SLA can be altered without having to re-negotiate the entire contract. Thus, an SLA can be revisited every quarter, whereas a long-term supply agreement would only need to be revisited once in a few years.

Methods of Calculating Service Level Credits

Service Level Credits are credits given by Service Providers in lieu of damages, when their performance falls below the agreed-upon level.  The Service Provider offers credit to the customer, instead of paying monetary compensation. An important factor to remember when drafting such a clause is that SLCs are essentially a form of calculation of liquidated damages, and hence must be a genuine pre-estimate of loss. While it need not cover all damages incurred, it must be reasonably calculated.[5] Failure to do so will result in the clause being unenforceable, opening up the Supplier to remedies under common law, as well as forcing both parties to endure expensive and time-consuming litigation.

There are several different methods of calculating credit in service level agreements, which are commonly used in commercial contracts.

Percentage Rebate

This method involves the rebate of a particular percentage of the charges incurred by the user, for every drop, in level of performance. A prime example of such a method is in the Remote Resourcing Agreement (2005) between Healthaxis and TakCo,[6] where every 1% decrease in service level resulted in a rebate of 0.25% of the amount charged by TakCo.

Block Amount

Another method of calculation is to define several ‘slabs’ reflecting a different level of failure to perform, and impose a specific penalty for each slab. Thus, as in the Master Service Agreement between Level 3 Communications and Vonage Holdings (2006)[7], the liability is defined as a fixed amount in the contract itself, corresponding to amount of unavailability, i.e., decrease below agreed Service Level.

Scaled Approach

Another method which can be used is a scaled approach which serves to increase the liability imposed, for every repeated failure to perform. An example of the same is the contract between IBM and Exa Corp (2011),[8] where every subsequent interruption led to a greater penalty (1% gradation) being imposed on IBM.

Common clauses included when calculating Service Level Credits

Capping Liability

When calculating the credit for service level agreements, the amount may be capped at a certain percentage of the charges, or at a particular price. For example, in the Health Axis Contract, the liability was capped at 6% of the monthly charges.[9] Therefore, no matter the quality of performance of TakCo, they would always be paid 94% of their fee every month.

It is often assumed that capping liability dis-incentivizes suppliers from performing up to the required level, as they are always entitled to a percentage of the consideration. However, when liability is not capped these costs may be factored into the charges themselves, covering the ‘risk’ of failure. In addition, there may be other remedies other than capping liability, including termination of the contract. These will be discussed below.

Sole Remedy Provision

A hotly negotiated clause in SLAs is whether the liabilities imposed under the SLA would be the sole remedy available against the supplies; or if claims under the SLA would only be treated as compensation for the failure to perform, and would not bar any common law remedy to reclaim damages for any consequential loss which may arise.

Exclusion of First Failure

Often the contract may specify that the first failure is excluded from the calculation of credits. It is only multiple failures or re-occurrences of problems which are penalized. However, such a clause would typically not apply in cases of a ‘critical level failure’. Within the SLA, there is usually a specification of the required or expected level (Ex:95%) as well as a defined minimum acceptable level (Ex:80%). Falling below the minimum acceptable would be considered a critical level failure and open up the supplier to higher liabilities.  A critical level failure is usually also included as a ground for termination.

Earn-back

Just as Service Providers are punished for falling below the required level, the contracts may allow for them to earn back the amount imposed as penalty by consistently providing service above (Ex:100% instead of 95). Such a provision may also be implemented in the form of a Bonus, for outdoing expectations. The difference between the two is that the earn-back only covers any liability already incurred, whereas, a bonus imposes an extra obligation on the Customer, in exchange for services they had not initially contracted for. Unsurprisingly, the bonus provision is usually resisted by customers, whereas the ‘Earn-back’ provision is considered to incentivize suppliers.

Leeway

There is usually a buffer period given to the supplier, after the commencement of the contract before calculation of credits begins.

Termination

Termination of a contract is allowed when one party breaches the contract, but this must be a material breach, going to the root of the contract.  Therefore, a temporary dip in the service level which causes minimal damages is not usually considered to be a material breach.[10] However, when a supplier is providing a continued service, which may vary greatly in quality, it becomes difficult to determine the exact point at which the parties have a right to terminate.

Step-in Rights:

In instances where the Service Provider is unable to perform, there may be a possibility that the User is able to step in and temporarily perform the services for the Service Provider. The Service Provider would then be responsible for compensating the customer for their expenses.

Notice

Another important point to note is that in such a contract it is usually that the Service Provider has an obligation to tell the Customer, if their performance ever falls below the required level. However, credit cannot be accurately calculated without accurate information about performance of the Service Provider. Therefore, it is always wise to incorporate a clause which allows for the customer to, or for an external third party to monitor and report the service levels of the provider.

Difference between Calculating Liability for an SLA and a Milestone Agreement

            The method for calculating liability in a Milestone Agreement is far simpler, as they involve certain set target dates, by which the deliverables must reach the customer. Any delay can be easily discerned by both parties, and a standard credit liability may be imposed depending on the amount of delay and nature of the contract.  Agreements may also include clauses which do not impose liability for a delay in a particular milestone, if the entire project or contract is completed on time.[11]

Conclusion

            Service level agreements are often complicated because they have to define the exact condition of performance, and every remedy in the case of a deficiency in this performance. Further, it is also difficult and expensive to continuously monitor the level of service. Service Providers often use the several clauses mentioned above to limit their liability. However, it is always in the interest of both parties for the service credits to actually represent the loss suffered, while being limited to the amount of consideration paid. Without this, they cannot be enforced. Thus, while drafting clauses for SLAs, lawyers must take great care to balance the interests of the customer with the protections envisioned for the Service Providers.

[1] “What Is A Service Level Agreement (SLA)? – Palo Alto Networks.” Paloaltonetworks.Com, https://www.paloaltonetworks.com/cyberpedia/what-is-a-service-level-agreement-sla.

[2] “Back To Basics: Service Levels And Service Credits.” Scl.Org, https://www.scl.org/articles/2067-back-to-basics-service-levels-and-service-credits.

[3] “What Is A Service Level Agreement (SLA)? – Palo Alto Networks.” Paloaltonetworks.Com, https://www.paloaltonetworks.com/cyberpedia/what-is-a-service-level-agreement-sla.

[4] Tavano, Joseph. “Master Service Agreements & Slas: How Well Do Yours Hold Up?.” Continuum.Net, https://www.continuum.net/blog/revisit-your-msa-agreements-for-better-client-relationships-and-profitability.

[5] Harrington, J. (2016). The Law relating to Service Credits. [online] Scl.org. Available at: https://www.scl.org/articles/3631-the-law-relating-to-service-credits

[6]“Agreement.” Lawinsider.Com, https://www.lawinsider.com/contracts/3F3pWX9JEYGBcuU5gWdvLd/healthaxis-inc/agreement/2006-10-10#service-level-credits.

[7] “Master Service Agreement.” Lawinsider.Com, https://www.lawinsider.com/contracts/bR7eSWiTFWuzb1qNcMPyW/vonage/master-service-agreement/2006-04-12#service-level-credits.

[8] “IBM Global Technology Services Statement Of Work For IBM Managed ….” Lawinsider.Com, https://www.lawinsider.com/contracts/76fKrzoEsxfGxkqP8xuqrh/exa-corporation/0/2011-08-03#service-level-credits.

[9]“Agreement.” Lawinsider.Com, https://www.lawinsider.com/contracts/3F3pWX9JEYGBcuU5gWdvLd/healthaxis-inc/agreement/2006-10-10#service-level-credits.

[10] Harrington, J. (2016). The Law relating to Service Credits. [online] Scl.org. Available at: https://www.scl.org/articles/3631-the-law-relating-to-service-credits

[11]Cornish, J. (n.d.). Service Levels and Service Credit Schemes in Outsourcing. [online] Lw.com. Available at: https://www.lw.com/presentations/Service-Levels-Whitepaper.