Change Mismanagement
January 13, 2012 by Bierce & Kenerson, P.C.
“Change happens.” Sometimes it happens elegantly, with all parties agreeing. But change can be mismanaged, resulting in legal disputes on pricing, service level performance, duty to perform and impact on performance milestones Change mismanagement happens too.
Change as a Matter of Choreography. Contracts for business services resemble complex choreography for artistic dance, where each dancer minimizes effort and intertwines and exits from the scene according to a musical score. “Work flows,” “flow charts” and “algorithms” define the dance steps, the dancers and the music.
In business process management (BPM), “change management” choreographs the changes in the scope of work, pricing, scheduling, service levels and other essential commercial terms of the outsourced services. By contract, the parties can establish a predictable process for permitting such changes to ongoing contracts, without resulting in breach or termination.
Change Mismanagement. Sourcing and procurement procedures must define procedures for managing changes that will not break the contract. Experience shows that both the enterprise customer and the service provider are capable of mismanaging the change process. Such mismanagement results in litigation, waste (investment in the procurement process, startup costs and unwinding costs that may compensate the other party for unamortized profit).
Change Management Mistakes by the Enterprise Customer. Customers can make mistakes in planning that impact eventual operations:
- Inadequate financial analysis of the anticipated impact of the sourcing upon the operation, including neglect of costs of contract administration, price changes in the spot market over time.
- Inadequate “base case” that overestimates baseline demand, underestimates volatility in demand or fails to require internal procedures for governance of internal demand (such as charge-back pricing methodology for transparent allocation of costs of the services and contract administration).
Mistakes can occur in customer’s change management as well. For example, when the customer’s own clientele or consumers witness a severe decline in demand or transaction volume, the minimum monthly fees paid to the outsourcer might weigh heavily on costs. Of course, scalability in such volumes should have been anticipated, and the customer might have decided that the “price” of such minimum monthly fees was a safe bet in avoiding other capital investment that would otherwise have been necessary for continuing to offer the “services” in-house.
Severe volatility in such demand or transaction volumes can be very costly to the enterprise customer in a major outsourcing. For example, a supplier of mobile military equipment hired an IT service provider to ensure a high level of service that anticipated the government customer would be well-served. Then the military procurement strategists decided that the particular mobile equipment was not suitable for the next phase in the war. They wanted more mobility, less protection. So they canceled further purchases and continued only in “repair” mode for the existing fleet of such equipment. When the equipment supplier approached the IT service provider to reduce or redeploy the resources implied in the minimum monthly fees, the IT service provider refused, saying that such a change was too drastic and that the contractual termination fee was therefore due and payable upon presentation of an invoice. When the customer refused, the IT service provider sued. The matter was quickly settled with a substantial payment to the IT services provider and the customer’s loss of its upfront investment in the procurement process (lawyers, accountants, operations personnel and startup transition costs).
Change Management Mistakes by Service Providers. The biggest sin for a service provider is to invest additional time, effort and expense in providing services that are not paid for. Such change mismanagement can easily occur:
- Failure to notify the customer in advance of the need to change pricing due to customer requests for different services, different methods for service delivery or reduced or increased volumes of services.
- Failure to maintain records of changes in the services.
- Failure to obtain customer approval to changes in prices or pricing methodology.
- Failure to obtain customer approval for certain types of changes that have an impact on the smooth internal workflow of the customer’s in-house operations or the customer’s other service providers, and thus hamper the productivity of the enterprise customer.
For example, in 2005, Phoenix Signal and Electric entered into a contract with the New York State Thruway Authority to install cameras and signs along a toll highway. The contractor performed “extra work,” or “extras,” and claimed additional compensation. It claimed the extra work was justified because of the mutually unforeseen difficulty of performance, requiring an additional stage of work to provide sufficient cement foundations for the cameras and signs. Upon judicial review of the contractor’s claim for payment, the Court of Claims and the appellate court found that the additional stage was not an “extra” but was part of the base charges. Further, the courts rejected the contractor’s demands for payment of additional monies because the contractor had failed to meet two conditions precedent to payment: notice to the customer and adequate recordkeeping to enable the customer to audit the need and scope for the additional work. Phoenix Signal and Elect. Corp. v. N.Y.S. Thruway Auth., ___ N.Y.S. 3d ____, Dkt 512433 (Dec. 22, 2011, 3rd Dept App. Div.), NYLJ Jan. 3, 2012, dec.nylj.com/1202536924950. In short, depending on how the contract is written, the customer may refuse payment when the service provider mismanages the “change management” process.
Best Practices. All services agreements should define the parameters, processes and conditions for permitting changes. When the parties fail to plan, they plan to fail, and disputes will arise. A well-drafted Change Management procedure, implemented by regular reviews of performance against the contract terms, can avoid such mistakes.
Bribery, Fraud and Contract Mismanagement: The SAIC / “CityTime” Debacle in New York City
July 14, 2011 by Bierce & Kenerson, P.C.
They said “it couldn’t happen here!” In late June 2011, it was time to account for a failed time accounting system. A federal prosecutor alleged a fraud that was “epic in magnitude, duration and scope” in the history of New York. New York City Mayor Michael Blumberg demanded the repayment of $600 million (plus costs of investigation and remediation) from Science Applications International Corp. “because the project was apparently tainted by fraud and kickback schemes.” How could this happen in a city managed by an IT-enabled technocrat?
The “CityTime” Project. Several years ago, the City of New York hired SAIC to develop and implement time and billing software (“CityTime”) to track employee time, generate payrolls and manage the City’s workforce. The pricing was based on a “time and materials,” i.e., hourly rates plus expenses. Many consultants billed at $160/hour, or, at about 1,920 hours a year, about $300,000 per year. At the end of 2005, SAIC deployed about 150 consultants. Two years later, the number exceeded 300 consultants. In 2010, SAIC delivered the software, and the City is using it. Gerard Denault was reportedly SAIC’s project leader. In a letter dated June 29, 2011 to SAIC’s President, Mayor Michael Bloomberg acknowledged that “we have received a working system that will advance our management ability.”
The Fraud and Bribery. In late June 2011, a federal prosecutor indicted Mr. Denault but not SAIC. SAIC’s chief systems engineer reportedly entered a guilty plea in the fraud. A total of 11 individuals and one subcontractor, a New Jersey company named Technodyne, were allegedly involved in a massive scheme to defraud the City (and SAIC).
Allegedly, the fraudulent scheme involved:
- the payment of $40 million in bribes (“kickbacks”);
- inflating both hourly rates and the number of consultants without approval;
- establishment of dummy offshore companies and payments to them as subcontractors;
- use of accountants and the dummy companies to launder cash; and
- delaying the implementation of the project through fraudulent means.
In June 2011, SAIC voluntarily repaid nearly $2.5 million for work performed by Mr. Denault.
The indictment is extraordinary since it maps an alleged fraudulent scheme that internal audits or better project supervision might have avoided.
Warning to Investors. In its quarterly 10-Q report to the SEC on June 3, 2011, SAIC disclosed the bad news to its investors and warned that more storm clouds loomed on the horizon for the CityTime project:
[T]here is a reasonable possibility of additional exposure to loss that is not currently estimable if there is an adverse outcome. An adverse outcome of any of these investigations may result in non-payment of amounts owed to the Company, a demand for reimbursement of other amounts previously received by the Company under the contract, claims for additional damages, and/or fines and penalties, which could have a material adverse effect on the Company’s consolidated financial position, results of operations and cash flows.
The Restitution. About a week after the federal indictment, Mayor Michael Bloomberg demanded that SAIC repay $600 million. He claimed that SAIC’s management failures “raise questions about SAIC’s corporate responsibility and internal controls to prevent and combat fraud.” SAIC’s spokeswoman, Melissa Koskovich, reportedly expressed sympathy for the City’s plight but noted that the alleged fraud had been conducted by former employees of SAIC and its subcontractors. While inviting the City to discuss a “resolution” to the problem, she underscored that the SAIC had delivered a working system that supports time entries and payroll management for 165,000 City employees in 60 different City agencies.
Contract Management. As happens in many big frauds, both the employer and the customer may share blame for poor management.
- Contract Monitoring. The employer apparently failed in its general obligation to monitor the conduct of its employees that might be illegal or fraudulent.
- It might have launched internal investigations when additional subcontractors were hired, apparently to remedy poor performance towards milestones and completion.
- It allegedly failed to act, or failed to tell the City how it acted, on a whistleblower complaint, as early as 2005, “regarding possible mismanagement of the project and alleged kickbacks to defendant Denault, SAIC’s lead Project Manager on CityTime.”
- The employer apparently failed to identify the real parties involved in the “subcontractors” and to employ financial controls and management controls over their recruitment, supervision, performance evaluation and actual time devoted to the project.
- Root Cause Analysis. The customer also apparently failed to manage the progress and to identify the root-cause sources of delays in performance. It probably believed that the project could be saved simply by hiring more consultants, without obtaining adequate disclosure of how such additional labor could resolve all the difficulties.
Legal Principles for Restitution. Several laws and equitable principles under common law could lead to restitution.
- RICO: Racketeer-Influenced and Corrupt Organizations Act. The federal RICO act permits civil lawsuits to recover triple damages and attorneys’ fees for injuries arising out of two or more violations of “predicate” crimes (wire fraud, postal fraud, extortion, etc.) in any ten year period. Due to its breadth, courts have been reluctant to apply RICO remedies unless the plaintiff shows that the defendant conducted its business as a corrupt organization, where corruption was part of the business model. And, the plaintiff still needs to prove the amount and causation elements of direct damages suffered. In the SAIC CityTime case, the City of New York might argue that there was a nest of corruption that SAIC neglected to identify and eliminate, causing damages. Since the customer is a governmental body, the City of New York might also seek injunctive relief under RICO, which permits equitable remedies ordering any person to divest himself of any interest, direct or indirect, in any enterprise; imposing reasonable restrictions on the future activities or investments of any person, including, but not limited to, prohibiting any person from engaging in the same type of endeavor as the enterprise engaged in, the activities of which affect interstate or foreign commerce; or ordering dissolution or reorganization of any enterprise, making due provision for the rights of innocent persons. 18 U.S.C. 1864.
- Federal Contractor Law. The Federal government requires its contractors to comply with many accounting regulations. Such regulations “flow down” to contracts where the customer (such as the City of New York) receives federal funding for a project. The City might pursue remedies under such laws.
- Recordkeeping Laws. The common stock of SAIC is traded on U.S. securities exchanges, and SAIC has registered with the Securities and Exchange Commission. The Sarbanes-Oxley Act of 2002 mandates recordkeeping and internal audit and compliance requirements for such companies. Securities “class action” fraud claims are allowable for cases where management fails to use reasonable measures to comply with such requirements. Such claims are made by shareholders, not by customers. However, if SAIC had sold its services based on a contractual representation or warranty of compliance with applicable laws, a SOX violation might be a basis for a civil fraud claim under common law and contract breach, but restitution might not be available as a remedy.
- “Faithless Servant” doctrine. Under common law, employers may seek the recovery of monies paid to their “servants” where the servant took the money and did not render the services agreed. A servant is responsible for restitution where he failed to perform the duties agreed and thereby breached a fiduciary duty of loyalty. See, e.g., Phansalkar v. Andersen Weinroth & Co., L.P., 344 F.3d 184 (2d Cir. 2003). This doctrine has been limited to require restitution only for transactions tainted by the breach of duty of loyalty, so SAIC might escape any liability for actual delivery of the working CityTime software.
- Equitable Restitution. Restitution is available under common law to rectify an abuse that is so fundamental that the court will order the parties to rescind the deal and restore the other party to the position existing before the contract existed. In a claim for rescission and restitution, the City of New York would have to return the working software as delivered as a condition for getting repaid the full amount.
Bottom Line. In conclusion, the SAIC CityTime case serves as a stark reminder to service providers to
- oversee failing projects and to look for possible frauds when costs balloon,
- send in the “Red Team” when a project is failing, and
- always ensure proper accounting and internal audits.