Bridging the gap in technology contracting
President Kennedy’s sentiment often is shared by many commercial IT manufacturers that negotiate with state and local governments. Needless to say, any company that has worked in the public sector understands that government customers face unique challenges and have different requirements than commercial customers. Yet it should come as no surprise to government customers that manufacturers are able to offer their products and services at competitive prices primarily because of the way they structure their commercial businesses. This dichotomy often engenders a struggle to reach consensus on contract terms.
In these tight fiscal times, state and local governments can ill-afford to continue in this manner. They must realize economies of scale, but without incurring much in the way of additional risk. The federal government reached this conclusion over a decade ago when it enacted the Federal Acquisition Streamlining Act of 1994 (FASA) and the Federal Acquisition Reform Act of 1996 (FARA).
The ensuing regulatory reforms of the mid-1990s led the federal government to adopt some commercial practices in its procurement procedures, and encouraged the purchase of “commercial-off-the-shelf” (COTS) products and services, rather than acquisitions tailored to unique government specifications. As a result, the federal government reduced the costs of major systems, improved the overall quality of contractor performance and reduced the time required to purchase goods and services supporting agency missions.
Many manufacturers accustomed to dealing with commercial customers and the federal government have found that their contracting policies and procedures do not translate well with state and local governments. Indeed, numerous contracting issues often arise that create unnecessary impediments to efficient acquisition of COTS products and services, including: objection to manufacturers’ channel partners; limited protection for confidential information; ambiguous and changing IT policies; inspection and acceptance periods; ownership of intellectual property; modification and creation of derivative works; lengthy and nonstandard warranties; no limitations on liability or nonstandard limitations of liability; and constitutional prohibitions against indemnification and control of litigation.
For publicly traded manufacturers, these contracting issues often require deferral of revenue recognition, or preclude doing so altogether, and create unquantifiable risks. Both of these results are poorly received by both shareholders and Wall Street. Their resolution may require state and local governments to consider whether acquiescing to more commercial contracting practices would be acceptable in light of their ultimate goal: the procurement of the highest-quality IT solutions for the best value.
Because there is no one-size-fits-all channel partner, manufacturers typically have large distribution and reseller networks comprised of multiple channels based on various criteria. Likewise, channel partners save customers the hassle of contracting individually with hundreds of manufacturers. In most cases, channel partners simply pass through the “shrink-wrap” commercial terms and conditions used by manufacturers.
Although some state and local governments generally agree to deal with channel partners, many still refuse to do so. One reason is the perceived need for direct recourse to manufacturers in case of warranty, indemnity or support claims, based on the belief that channel partners will not be around to handle them. But like their commercial counterparts, state and local governments have an obligation to scrutinize their vendors. In fact, they are in a better position to do so because of their broad investigatory and enforcement powers. Another reason is that they want manufacturers to sign noncommercial terms and conditions. Yet it is because of the inherent risks of such terms and conditions that many manufacturers choose to use channel partners.
The largest value component of IT manufacturers is their intellectual property. In addition to patents, trademarks and copyrights, intellectual property includes trade secrets, confidential information, business methodologies and general know-how. Manufacturers often insist on nondisclosure agreements (NDAs) prior to submitting proposals to their commercial customers, and in many cases, the commercial customers themselves insist on NDAs prior to releasing their RFPs. Although the federal government will not sign manufacturers’ NDAs, it can protect confidential information in proposals under broad exceptions to the Freedom of Information Act (FOIA).
State- and local-government policies relating to the protection of confidential information in proposals often are more restrictive than FOIA. Some require that companies submitting proposals cull out all allegedly confidential information and place it into a separate and self-contained section. While this requirement makes it easier on procurement officials to know what they can and cannot disclose to the public, it has the unintended effect of destroying the integrity of such proposals and creates an awkward situation involving the review of dozens, if not hundreds, of cross references to confidential appendices.
Some state and local governments require that all culled-out confidential information must qualify as trade secrets. This requirement is imposed through an affidavit signed by counsel under penalty of perjury that he or she is familiar with the trade secret law of the jurisdiction, and that the information qualifies as trade secrets under such law. This affidavit requirement creates a twofold problem. Legal counsel in the vast majority of cases does not have first-hand knowledge of the confidential information at issue, and could be subject to sanctions for the unauthorized practice of law by the state bar where the proposal is submitted.
Most state and local governments have IT policies that regulate issues such as strategic planning, enterprise/system architectures, Web site accessibility by the disabled, data privacy, identity management, network security and technology procurement. They often flow these policies down through their RFPs, and require bidders to certify that their products and services are compliant with such policies. Yet because such policies are neither statutes nor agency regulations, they typically are not subject to public scrutiny before being adopted, leading to discrepancies with current or future industry standards.
Additionally, government IT policies often lack objective compliance standards. Indeed, some policies are only single-page documents written in goal-oriented language, leaving it up to contracting officers to determine whether proffered products or services are compliant. The fact that such policies are constantly being updated also is problematic for bidders, because if they certify their continued compliance, they must monitor such policies for any updates. If they are unable to comply with the updated policies, their contracts may be terminated for noncompliance.
Acceptance periods are important in custom software-development contracts because they allow customers to determine if products are defective, which typically is not possible prior to completion. Acceptance periods generally are irrelevant to COTS products. COTS products are standard, known quantities, the reliability of which has been established by the marketplace. All customers receive the same product with minimal difference in design or functionality. Likewise, functionality descriptions are available through published technical specifications, allowing customers to determine whether COTS products meet their particular needs.
State and local governments often make no distinction between custom and COTS products when requesting lengthy acceptance periods. Manufacturers, however, are reluctant to provide their customers with acceptance periods because doing so would require deferral of revenue recognition until formal acceptance or the end of the acceptance period. Making things worse, an acceptance period effectively time-shifts the beginning of the warranty period until after acceptance, causing further deferral of revenue recognition. As a compromise, some manufacturers issue 30-day evaluation licenses free of charge. During the evaluation period, a customer can determine the acceptability of a COTS product for its particular needs, and then purchase it without further inspection and acceptance.
Manufacturers always retain title and prohibit modification or creation of derivative works of their intellectual property. Commercial customers simply receive a license for their internal business purposes. Most commercial customers understand and respect these requirements, as they often use the same terms in protecting their own intellectual property. Indeed, in some cases commercial customers impose more restrictive language because they do not want manufacturers using their confidential information to create products or services that could aid competitors in solving the same problem.
State and local governments frequently act differently regarding ownership of intellectual property. While they do not seek title to intellectual property created prior to their procurements, they often do for any created during the performance of any services on their behalf. The problem is that any intellectual property created during the performance of services is merely derivative of a manufacturer’s pre-existing technology. Likewise, and to the extent that it contains government-supplied confidential information, manufacturers usually agree not to use or disclose any personally identifiable confidential information in future commercial projects.
Additionally, state and local governments commonly request the right to modify any software products they license from manufacturers. It should come as no surprise that manufacturers are constantly developing their products, and giving away ownership of promising lines of development would foreclose future opportunities. Furthermore, if manufacturers permitted modification of their software, there is a significant chance that their competitors would eventually obtain the right to use or even own such modifications. These risks greatly outweigh the fact that state and local governments often have “legacy systems” that date back many years.
In commercial contracting, customers usually operate on razor-thin deadlines for the deployment of software. Even minor delays can significantly affect their bottom lines. Consequently, commercial customers usually are quick to deploy software to ensure that it operates properly. Standard industry warranties of 30 to 90 days from the date of delivery provide ample time for commercial customers to make such a determination.
State and local governments, however, frequently demand longer periods due to lack of trained personnel, availability of facilities and equipment, and unscheduled deployment dates. They also demand that warranty periods begin on installation rather than delivery. Both of these demands create significant revenue recognition issues for manufacturers. Warranties that extend beyond 90 days will cross fiscal quarters or even fiscal years, and warranties that begin upon installation have no outside date by which they can be considered fulfilled. In each case, manufacturers may need to defer recognizing revenue.
Manufacturers also are accustomed to express statements of warranties and disclaimers of all implied warranties. The reason for this is twofold. First, express warranties provide a clear understanding of what is warranted without the need to reference pre-agreement negotiations. Second, and more importantly, the Uniform Commercial Code implies warranties of merchantability and fitness for a particular purpose unless they are expressly disclaimed. Unlike their commercial counterparts, state and local governments often are reluctant to waive these implied warranties out of concern that procured software will be defective or fail to meet their particular requirements. These concerns are misplaced because manufacturers usually warrant that their software will function in accordance with its documentation, and the burden for determining whether software meets a customer’s unique needs properly falls on the customer.
Limitation of liability
Like warranty periods, limitations of liability provide manufacturers with a clear statement of their potetial liability. Yet some state and local governments decline to limit liability, even in the context of procuring commercial products. There is no clear reason for this reluctance, except perhaps the fact that they owe a duty to their constituents not to waive any potential damages, claims or remedies when dispensing public funds. While understandable, this same duty is owed by companies to their shareholders, who, unlike the average citizen, actually have an ownership interest in such companies. It is only when all or most manufacturers bidding on an RFP raise the issue that state and local governments agree to some type of limitation of liability provision. Unfortunately, it usually falls far short of that used in commercial contracting.
Assuming a limitation of liability provision is included in an RFP, manufacturers usually seek to limit any recovery to direct damages. Direct damages are damages for a loss that is an immediate, natural and foreseeable result of a wrongful act. State and local governments often profess to be in such a unique position that they must have more than just direct damages, and either expressly include indirect, consequential and special damages or refuse to carve them out of a contract. Due to the amorphous nature of such additional damages, this makes it difficult for manufacturers to predict their potential liability.
Manufacturers also seek to cap their damages. In commercial contracts, a cap on damages can take one of two forms. One form is a statement that the parties’ maximum liability shall not exceed the fees paid or owed for the item(s) giving rise to a particular claim. The other form is an amount that the parties agree is reasonable to cover all potential damages. State and local governments often refuse to allow caps on damages, regardless of their form, because they assume an inability to calculate their damages sufficiently in advance, or that their damages will definitely exceed the amount they paid or owe. Despite this refusal, they generally have the power to mitigate their damages. In fact, many state and local governments, like large commercial companies, already have mechanisms in place for limiting their damages.
In commercial contracting, manufacturers expect that their customers will indemnify them against all claims arising out of the misuse of their products. These claims include combining their products with products belonging to third parties, or failing to use their products consistent with their accompanying documentation. Claims of patent infringement are particularly costly because they are complex; require significant resources to defend against; and can result in treble damages in cases of willful infringement. Notwithstanding such tremendous risks, state and local governments always refuse to indemnify manufacturers on constitutional grounds. They assert that they cannot give, lend or pledge the credit of the state or locality to anyone, or make a grant of public monies to anyone, without express authority. Compounding matters is the demand that state attorney general offices act as lead counsel in such cases. Despite their significant skills, state attorney general offices usually are ill-prepared to defend against intellectual property claims because typically they have little background in the substantive law and a minimal understanding of the technology at issue.
As the saying goes, “Rome wasn’t built in a day.” Thus, expecting state and local governments to adopt commercial terms and conditions wholesale is not practical in the short term. However, it is appropriate to expect state and local governments to consider some or all of the following reforms:
- Allow the use of channel partners as contracting parties, without requiring a flow-down of government terms and conditions to manufacturers.
- Become more flexible in protecting confidential information supplied by manufacturers and their channel partners.
- Update IT policies and work with industry to ensure that manufacturers and channel partners can comply.
- Dispense with acceptance periods for COTS products and encourage use of pre-procurement evaluation agreements.
- Refrain from seeking ownership rights for intellectual property created during the performance of services, as well as the rights to modify and create derivative works of COTS products.
- Agree to use standard commercial warranties that begin on the date of delivery, and accept disclaimers of implied warranties.
- Limit manufacturer and channel partner liability to direct damages and consider reasonable caps on such damages.
- Consider creative solutions to address constitutional prohibitions against indemnification, and encourage attorney general offices to allow manufacturers to take the lead in intellectual property claims.
Some state and local governments already have undertaken efforts to implement these reforms, though generally on an individual contract basis. To accelerate the reform process, a more systematic approach that focuses on broader policy change is necessary.
State and local governments must accept the fact that they cannot expect special treatment if they choose to participate in the commercial marketplace. Acquiescing to more commercial terms and conditions is only one of many procurement reforms that they should consider, but it is an essential step to obtain the highest-quality technology solutions for the best value. The time and resources spent on negotiating terms and conditions already deemed fair and reasonable, either by the commercial marketplace or by the federal government, could be better spent on increasing efficiencies and scaling operations. The resulting procurement environment will be a far easier place for everyone to do business.
About the author
David Kessler is senior corporate counsel for Cupertino, Calif.-based Symantec Corp. The views expressed in this article are solely those of the author and not those of Symantec Corp., its officers, directors, subsidiaries, affiliates, business partners or customers. To comment on this article, contact us at [email protected].