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Damages - Maximising the recovery on an IT system failure

 

The amount of damages that can be recovered following the failure of an IT system implementation will depend on the evidence that the customer has to substantiate its claim. It's often the case that efforts to implement a replacement for a failed IT system are the customer's primary concern and obtaining compensation for the damage caused by the failed implementation is secondary.  It's important for customers to know the sort of damage they might be able to recover at an early stage and that they take steps to maximise their recovery through keeping adequate records to provide evidence of their loss.

 

What loss is compensated?

 

As with any claim for breach of contract, the claimant who has been affected by a system failure or the failure of a system implementation is entitled to claim damages that would put the claimant in the position it would have been in had the system continued to operate, or had it been implemented in accordance with the contract.  These damages can include both direct losses, for example the money paid to a supplier, and consequential losses that would be within the contemplation of the parties under the long established principles in the case of Hadley v Baxendale [1854].

 

Misrepresentation

 

Claimants often also claim for misrepresentation based on pre-contract assurances they were given as to what would be delivered in terms of system functionality.  Damages for negligent or fraudulent misrepresentation are intended to put the innocent party into the position it would have been had it never entered into the contract, not in the position it would have been had the representation been true. 

 

As set out in the judgment in South West Water -v-ICL [1999] Masons CLR, a customer, if successful in a claim for misrepresentation, is entitled to recover the full price paid to the supplier and any consequential losses incurred by entering into the transaction. 

 

This illustrates the difference in the potential for recovery between contractual damages and those awarded for misrepresentation.  It will invariably be the case that recovery under contract is greater than for misrepresentation.  As a result, the calculation of damages in most IT cases will concentrate on contractual damages.

 

The Cost of Replacement

 

The primary claim is always for the cost of the failed system or, if the cost of a replacement system is more expensive, the claimant may, in principle, recover that amount.  However, there are usually arguments over what can and cannot be recovered. 

 

In IT contracts, the issue of whether the customer has bought a replacement system which is the same as the failed system is not always straight-forward.  This is particularly the case where the dispute involves a large bespoke system with a substantial element of consultancy fees for development work.  Suppliers will often argue that the replacement system has a higher level of functionality, but that is not in itself a basis for disallowing this element of the claim.  As was pointed out in the judgment in the case Peglar -v- Wang [2000], "it would be commercially nonsensical for Pegler to buy a system which had not been advanced technically beyond the system sold to them some years earlier by Wang.  The pace of computer development has been so fast that one simply cannot buy new computers built to old specifications". 

 

In order to make sure that there is as much evidence as possible to support the level of cost of the replacement system the customer should go through as thorough and well documented a tender process as is possible in the time available.  The customer will need to show that it has acted reasonably in mitigating or reducing its losses.  This is particularly the case where the original supplier substantially discounted the cost of the system in order to win the contract and the replacement system is substantially more expensive.

 

Disaster Recovery and Implementation Consultancy Fees

 

As well as the claim for the system itself, there are a number of associated types of loss which might be claimed from the original supplier.  These include the increased cost of computer maintenance and any consultancy fees paid in relation to disaster recovery.  For instance, in the case of an accounts system, the business may rely on the system to trade on a day-to-day basis and temporary procedures and systems will need to be put in place.  These costs may be recovered provided the customer has sufficient documentary evidence of the extra costs incurred.

 

Another element is the cost of consultancy services used to specify and choose a replacement system.  These costs can be significant and in Anglo Group plc v Wither Brown & Co. Ltd [2000] Judge Toulmin was not satisfied that consultancy fees could be recovered in that case because consultants had not been used to assist in the search for the original system.  He also made the point that if consultants were assisting in providing something more than simply a standard off-the-shelf system then those costs should be viewed as betterment.  Customers will often feel that they do not want to make the same mistake again and appoint consultants to ensure that they do not end up with a replacement system that also fails.  In doing so customers should be aware that they will have to justify that cost by showing that it was a mistake not to have used consultants the first time round.

 

Replacement or Additional Hardware

 

Another type of loss that a claimant may have suffered is the cost of purchasing additional or replacement hardware that is compatible with the replacement system.  In the case of Horace Holman Group Ltd -v- Sherwood International Group, the claimant claimed for upgrading PCs, but the claim failed because of a lack of evidence about when and why those PCs were purchased.  The case shows the importance of keeping contemporaneous records showing when and why items of hardware were purchased and how much was paid for them.

 

Management Time

 

The value of time wasted by directors and staff was recovered in the Horace Holman case.  There has long been debate over whether or not management time wasted in a failed implementation can be recovered.  In Tate & Lyle -v- GLC [1982] 1 WLR 149 the Judge indicated that, in principle, there should be compensation for the costs of managerial time wasted.  In that case he found that there was no evidence that managerial time had been spent in connection with the failed implementation.  In the light of that decision, the view for some time was that there had to be records of time spent by managerial staff and that it was not open to a judge to speculate on the amount of time that had been involved by applying a rule of thumb.  In the Pegler -v- Wang case the Judge held that even in the absence of contemporaneous records he was not prevented from considering witness evidence and expert reconstruction of time spent.  He did comment that the supplier's argument that Pegler should have recorded the time and that they had good reason to do so since they were likely to bring legal proceedings against the supplier, was a factor in the way that he approached that evidence.

 

In the case of Horace Holman Group Ltd -v- Sherwood International Group the Judge confirmed that, as long as there is sufficient evidence to substantiate the claim, there is no reason why recovery should not be made.  System implementations often take up large amounts of management and staff time and staff involved should complete time-sheets showing the time they have spent working on the implementation.  That evidence will be invaluable if a claim is made and it will be useful to the customer in any event to enable it to assess the real cost of the implementation in terms of staff time.

 

Where the customer is not a profit making organisation suppliers may argue that they should not be able to recover management time.  This argument was rejected in the case of the Salvage Association -v- Cap Financial Services Ltd [1995] FSR 654 where, although the Claimant was not a trading corporation, the Judge held that management time wasted on the system implementation could and would have been put to productive use in activities in other areas and there was no reason in principle why those sums should not be recovered.

 

Increased Staff Costs

 

Another point of interest in the Horace Holman decision is the conclusion reached on the type of staff in relation to which recovery of damages can be made.  This is essentially a debate over whether employees would be paid by the employer in any event or, as Counsel in the Horace Holman case put it, "an accountants' theological debate" about whether costs are fixed or variable.  The supplier's usual argument is that salaries are part of the fixed costs of a business and have to be paid to employees whether or not they are usefully engaged in sorting out a system failure.  It is argued that unless an employee is distracted from a profit-making activity by involvement in a system implementation, then the cost of that employee should not be recoverable.  The Judge in the Horace Holman case held that it was unrealistic to try to distinguish between profit-makers and non-profit-makers, because backroom staff perform functions that allow staff in profit-making functions to do their job more productively. Mr Justice Bowsher did not accept that time wasted by staff and management would have no effect on the business and stated that:

                                                             

"Every employer values each employee at more than the employee is paid otherwise there is no point in employing him.  If time had not been wasted sorting out the SYMBAL muddle, the employees concerned would not have been doing nothing.  Mr Woolf also said that in the case of directors and senior employees, they do not work fixed hours and any time wasted on the SYMBAL muddle would have been made up in the evenings or weekends.  But, particularly in the case of directors and managers, the whole of an employee's time is a benefit to the employer.  If an employee is deprived of the benefit of leisure either in the evenings or at the weekends, productivity during the paid hours suffers."

 

This type of claim for damages can be worth a substantial amount of money. There must be records to establish the amount of staff and management time lost.  Ensuring that systems are in place to provide that type of information can prove invaluable should a claim be made.

 

Reduction in Costs/Overheads

 

The customer may have envisaged that the failed system, had it not failed, would have allowed it to reduce costs and overheads.  If, for example, the customer could have reduced the number of its staff once the system was implemented, then the delay or inability to make those savings is a cost to the customer.  In the Horace Holman case this formed a substantial part of the claim and the claimant was awarded a sum of £1.7million.  Another potential cost saving is audit costs and the judge also made an award in relation to those lost savings.

 

Loss of Profit

 

There has long been a debate over whether a claimant can recover both loss of profit and wasted expenditure or if it must claim one or the other.  In Anglo Group plc -v- Winther Browne & Co Ltd, Judge Toulmin held that the claimant could not claim for wasted expenditure and for loss of profits.  A reduction in the customer's profits following an IT system failure will be caused, primarily, by increased and wasted expenditure and any loss in revenue from the distraction of management staff involved in any implementation.  Usually any calculation of that expenditure will include elements which compensate the customer for its increased costs and loss of revenue and the customer is not entitled to be put in a better position than it would have been if there had been no breach of contract. 

 

In any event, any loss of profitability suffered as a result of disruption caused by a system failure or a delay in implementation is often difficult to prove.  There are many factors that may lead a business to suffer a loss in profitability, but it is important that businesses that have suffered a system failure are aware that they may need to justify the cause of any change in performance at a later date. 

 

Conclusion

 

If an IT system goes wrong, the customer should identify the potential loss that can be claimed at an early stage, and, equally importantly, collect adequate evidence of the extent of that loss.  The failure to provide the Court with that evidence can prevent the recovery of substantial sums of money.  More often than not a claim will be resolved through negotiation or mediation.  The stronger the evidence you have at your disposal when negotiating a settlement the more likely you are to get the settlement you want. 

 

Contracts for the supply of costly IT systems are often entered into without full consideration of what it will cost should everything go wrong. 

 

Suppliers should also consider the damages that the customer might claim when negotiating contractual exclusion clauses and reviewing their insurance cover. 

 

The terms that parties agree to and the procedures they follow during an implementation will strengthen their position should a claim have to be made.

 

Contact Details

If you would like further advice about any of the issues considered above please contact Paul Northwood on 01869 331753 or email him at paul.northwood@northwoodreid.com

 

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This article is not intended to be, and should not be taken as being, legal advice. The law often changes and it varies from jurisdiction to jurisdiction; the information in this article is generic in nature and specific legal advice should be taken before acting on any of it.

 

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